VIX at 2007 low is like sensory deprivation for stocks

SAN FRANCISCO (MarketWatch) — Low stock trading volume and volatility are messing with investors' heads, fogging their view of the stock market. One analyst thinks these doldrums could turn out to be the new norm.

Once again, the Dow Jones Industrial Average (DJIA)  and the S&P 500 Index (SPX)  finished the week at record closing highs and the Russell 2000 Index (RUT)  finally broke back into a gain on the year.

Stocks rose in lock step Friday following a jobs report that was in-line with expectations and unlikely to change any tapering plans at the Federal Reserve.

/quotes/zigman/2766221/realtime VIX 10.73, -0.95, -8.13% CBOE Volatility over past 12 months

But it all happened on the ninth-lowest volume day of the year. The CBOE Volatility Index (VIX) fell 8% to 10.73 on Friday, its lowest close since Feb. 23, 2007. Low volume and low volatility, coupled with record-high stock prices, have some investors nervous and thinking it might be 2007 again. That is, the rally before the plunge.

"Things are dull, and that's a bad thing for financial professionals who are always looking for the next big thing," said Nicholas Colas, chief market strategist at ConvergEx, in a recent note. "Volatility is the most powerful sensory input for investors and brokers alike."

In the past week, daily trading volume has run below average compared to the average volume over the past four quarters, according to Barclays data.

Low stock volatility and thin trading volume are having a strange effect on investors. It's a lot like when someone is placed in an isolation tank, said Colas.

Read: What's lurking under the low VIX?

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With a lack of input, a mind in a sensory deprivation chamber seeks to make up its own input to compensate for the deficiency, resulting in hallucinations. Low volatility and volume are having a similar effect on the market, Colas reasons, resulting in "hallucinations" of both the bullish and bearish varieties.

For bears, the hallucination is that record high stock prices are solely the result of Federal Reserve easing, and that everything will fall apart when easing is gone, Colas said. For bulls, the hallucination is that economic growth with very little inflation is nearly guaranteed for the second half of the year.

While there may be a bit of truth in both, the "hallucination" is the part where the lack of market activity and movement is pushing investors to fill in the blanks.

What's closer to the truth, Colas said, is that investors got so used to the levels of volatility and volume from the crisis years that current levels seem unnaturally low by comparison. What's certain is that markets are structured differently than in 2007, so perhaps current volume and volatility has become the norm for the new structure, he said.

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"The appetite to move around has diminished," Colas said in an interview. "People are more confident in their positions."