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Beware of investor complacency

August 7, 2012: 9:49 AM ET

Investor malaise has settled in like a hot summer day. And it's just as uncomfortable.

"Our volume is as muted as it can be and the VIX is down sharply," said John Kosar, director of research at Asbury Research in Schaumberg, Ill.

Kosar is talking about the Chicago Board of Trade's volatility index (VIX), Wall Street's notorious fear gauge. It has barely budged above 20 during the past month. It is now hovering around 16 following two straight up days for stocks.

"Sustained market recoveries don't begin with a 15 VIX," said Kosar. Any reading below 30 signals a relatively low level of fear in the markets. No one is too nervous at the moment, and "that's when bad things happen," he added.

Investors have had a lot to contend with over the past several months: Europe's debt crisis, sluggish economic growth, Facebook's (FB) botched IPO, the Knight Capital (KCG) trading debacle, and growing worries about the fiscal cliff.

In that kind of environment, it's hard to get too excited about stocks. But the market has continued to rally.  The S&P 500 is less than 2% below its 52-week high. Kosar said that leaves the market vulnerable to a surprise, adding that it's more likely to be a negative one rather than a positive one.

You can get a greater sense of investor complacency by looking at CNNMoney's Fear & Greed Index. It tracks 7 key market indicators, including volatility, junk bond demand and stock highs and lows. Using the power of algorithms, we combined them all into a new index that tracks just how much risk investors are willing to stomach, on a scale of 0-100. Any reading above 50 is a sign that investors are shouting the casino mantra "place your bets." But when the number gets closer to zero, it shows that investors are starting to batten down the hatches.

Related: What is the Fear & Greed Index?

When the Fear and Greed Index is either in Extreme Fear or Extreme Greed mode, that might be a signal that the market is about to change course. Earlier this year, investors were throwing their money at stocks, with the Fear & Greed Index topping 90 twice! in January. The market had a stellar first quarter. The S&P 500 (SPX), Nasdaq (COMP) and Dow industrials (INDU) all closed out their best first quarter in decades, as things started looking up in Europe and the U.S.

The put/call ratio, which compares the trading volume of bullish call options (right to buy) against the trading volume of bearish put options (right to sell), was also sharply higher.

Of course, the euphoria was short-lived. Europe's debt crisis quickly reared its ugly head. Spain became the 12th European nation to fall into recession, talk of Greece leaving the eurozone grew louder, and signs of a slowing U.S. economy sidelined investors.

On June 1, the Fear & Greed Index hit a year-to-date low of 7. Since then, it's crept higher and is now hovering around 70. The Fear & Greed Index isn't back in Extreme Greed territory yet, which means that the market may have more room to run in the short-term. But it's clearly a concern that investors are willing to take on more risk even though there are still many macroeconomic worries to contend with.

Related: Investors still running away from stocks

So what's an investor to do? "A lot has changed" over the past decade, said Kosar. "Wall Street is a smaller place and you don't have that influx of retail money to smooth over the bumps."

The market has largely moved sideways since 2000 and "buy and hold doesn't work anymore," he added.

That means investors may need to be more active.

"The retail investor has to do a little homework and try to participate in the two or three quarterly moves the market makes every year," said Kosar.

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