Anything For You All: Evidence is mounting that the stock market could plunge into chaos this summer

Evidence is mounting that the stock market could plunge into chaos this summer

After spiking to a multiyear high in February, the Cboe Volatility Index has stabilized as investor nerves have calmed.
Bank of America Merrill Lynch, however, argues that worries are again mounting under the surface, which could derail the equity market over the summer.

The stock market has stabilized quite nicely after a 10% correction rocked major indexes earlier this year, so it's easy to understand why investor concern has ebbed.

This can be seen in the spot price for the Cboe Volatility Index, or VIX — also known as the stock market's fear gauge — which has declined precipitously, recently falling to its lowest level since January.

But that placidity is masking a potentially jarring situation mounting under the surface. Open interest in call options that bet on a VIX increase and expire in July has surged in recent weeks, according to data compiled by Bank of America Merrill Lynch.

Translation: Traders are piling into wagers that, by midsummer, the VIX will spike into the rarefied air it experienced in February. And since the fear gauge trades inversely to the S&P 500 roughly 80% of the time, that could accompany a rough patch for stocks, as it did earlier this year.

The dynamic outlined by BAML can be seen in this chart.

Digging even deeper into recent stock performance, BAML sees a strengthening US dollar fueling a rally in small-cap shares. Since the exports of larger, multinational companies are negatively affected by a stronger greenback, domestically focused firms tend to outperform when it's rising, which is exactly how things have played out lately.

But it's those same lagging mega-cap stocks that occupy the heaviest weightings in stock indexes, so any weakness they experience could be felt across the market. If a stronger dollar persists — and other headwinds like the prospect of higher rates and slowing earnings growth continue to worsen — investors would be well served to heed BAML's implied warning of a July sell-off.

And in ironic fashion, if traders do choose to hedge by buying VIX contracts, it will push the fear gauge even higher. In the end, it's a potential self-fulfilling prophecy that the market needs to figure out — and fast.

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