An Unusual Development In The Volatility Markets Is Flashing A Stock Market Warning Sign

Since the U.S. government shutdown in October, there has been a broad collapse in volatility across the global financial market landscape.

ConvergEx Group chief market strategist Nick Colas publishes a monthly review of implied volatilities in various asset classes for clients, and he says the latest data point to complacency among investors in an unusual way.

"The CBOE VIX Index is broadly lower (although it had a bounce yesterday) and so is the VIX of gold, silver, industrial stocks, high yield bonds, emerging market stocks… You get the idea," writes Colas in his report. "That's an unusual development in our book, and typically only occurs when the VIX is falling from a high level (+20) in the aftermath of some crisis. That's not the case here, so we chalk it up to an extremely high level of investor complacency about near term market direction."

Wall Street continues to convey a bullish stance on stocks headed into the final weeks of 2013.

Today, Oppenheimer chief investment strategist John Stoltzfus raised his year-end S&P 500 price target to 1812 from 1730. Friday, JPMorgan chief U.S. equity strategist Tom Lee hiked his target to 1825 from 1775. The index closed Monday at 1791.

"In our view, the case for continuing to maintain a positive stance on equities remains in place given: (i) improving economic momentum to support upward EPS revisions (pent-up demand in U.S. housing, autos, construction, capex and a recovery in the euro area); (ii) attractive relative value (particularly vs. corporate bonds), (iii) supportive monetary policy and (iv) sentiment that is not excessively bullish," said Lee in a note.

Normally, the implied volatility of an asset falls when the price of the asset rises.

However, Colas notes that despite the across-the-board decline in volatility over the past month, it is not the case that all of these assets have been rallying.

"Far from it, in fact," says Colas. "Precious metals lost ground in the past month, as did emerging markets, telecom stocks, corporate bonds, and energy names."

So, why is implied volatility down across assets?

"It's pretty clear that equity market participants feel they have everything figured out," says Colas. "No news from the Fed until Chairwoman Yellen takes the helm. Some increasing hope for an accelerating global economic outlook in 2014. Still high corporate profits. Low interest rates."

Despite the implications of continued easy monetary policy and a generally bullish stance toward stocks, Wall Street strategists stress the importance of improvement in fundamentals to a continued rally in the market.

"Year to date, 75% of the S&P return has come from its [price-to-earnings ratio] expanding to 16.5x from 13.7x trailing EPS at 2012 end," writes Deutsche Bank chief U.S. equity strategist David Bianco in a note to clients. "Excluding 2009, this is the largest [valuation multiple] contribution to market return since 1998. Before assuming further [multiple] expansion we think it is important that investors be confident in healthy EPS growth next year. Hence, we encourage frequent re-examination of the capex and loan outlook upon new data points."

Colas leaves clients with a note of caution.

"The data from our monthly [implied volatility] review make us think that the light might be turning yellow soon," he says. "All the cars around us are picking up the pace, confident that they can stop when the light shifts from vermillion to sunflower. And maybe they will be able to see the light, respond, and slow down quickly when the time comes. But as with real traffic lights, investors may not have enough time to respond."