This column was originally published on July 12 at 8:00 a.m. EDT.

How on earth did we ever get to this point of serving tapioca and calling it Tabasco? The entire range on the

S&P 500

since the end of 2003 has been 170 index points, or about 15.3% in a little over 18 months of trading. The high-low range for the

Nasdaq Composite

in 2005 has been 301.77 points; there were eight separate

days

between 1997 and 2004 with greater absolute ranges.

Now our biggest excitement is trying to explain why bond yields are stuck in a trading range at low levels.

So what is so bad about all this, you ask? Isn't volatility the enemy? Doesn't it force everyone into running around and crashing into walls trying to explain things? And hasn't it been observed making various traders take losses? Yes, yes and yes.

But one of the very roles of a market is to force investors into rethinking their risk tolerances and asset allocations. Volatility by its nature forces weak hands out of the market and replaces them with more committed long-term investors. The market washouts of 1987, 1998 and 2002 accomplished this and set the stage for subsequent advances.

The present low and declining level of volatility in the stock market as represented by the VIX -- bond market volatility and returns are a separate issue -- represents a return to levels last seen before the bull market of the late 1990s.

The VIX began a persistent and gradual rise in early 1996, a year after the stock market's grand jaunt began, and remained at levels of 20 or higher until May 2003. The persistent downtrend in the VIX since that time is a unique feature in its history.

Low Volatility: A Trend in a Normal Range?

Source: Bloomberg

Volatility as a Market Dimension

Fewer dimensions of the stock market have defied simplification more than the VIX; witness the very

predictable lukewarm reception received by VIX futures or the perennial frustrations of those who want the VIX to perform as a trading indicator. As is often the case when you cannot find something, you were looking in the wrong place.

Implied volatility represents the market's price for insuring unknown events; these events can be arriving at a known time, such as an employment report, or at an unknown time, such as last week's bombings in London. In either case, the impact is -- or should be -- uncertain. The higher the volatility, the greater the perceived dispersion of possible outcomes -- gains as well as losses.

One of the consequences of this little truism is an upward bias: If returns are distributed lognormally, one of the tenets of the basic option pricing models, the dollar value of a gain will exceed the dollar loss of that same percentage loss. For example, a 2% gain on a $1 asset puts you at $1.02, but a 2% loss puts you at $0.980392.

This subtle bias makes any asset with an embedded call option, such as a convertible bond, more valuable when volatility rises. The expected gains start to dominate expected losses, and as volatility can rise further on an absolute basis than it can fall, the upward bias can become significant.

How does this value of volatility play out when it comes to stock market industry groups? We can calculate the relative volatility, or beta, of industry groups within the

S&P 500

large-cap, S&P 400 mid-cap and S&P 600 small-cap indices to the index as a function of the VIX.

These results as of the close of business on July 8 are presented below. A negative beta means relative underperformance by the group if the VIX rises, all else held equal. A positive beta means the opposite: Relative overperformance by the group if the VIX rises, all else held equal.

Where Are the Calls?

A look down the list at the high-beta groups indicates that some of the best-performing recent groups regardless of size, such as REITs, utilities and housing finance-related issues, all benefit from increased volatility. Many of these groups are yield plays whose extra kick in price derives from the volatility phenomenon discussed above.

The opposite observation can be made for the negative beta groups. Many of these are low-yield earnings-dependent issues whose total return is tied to price appreciation. Note the presence of the semiconductor and semiconductor-equipment groups in each column, or the presence of basic materials groups such as steel, paper and aluminum.

We can conclude that certain groups, such as the tech stocks, can bring their own call option, one derived from earnings. This combination did quite well during the late 1990s. Other groups, such as utilities, need the call option handed to them by market volatility; failing that, they have to get by on the attractiveness of their yields. This has done well recently.

Until and unless the earnings-driven issues take off under their own power, the yield-dependent issues will make the market vulnerable to a rise in interest rates. At that point, spice up the tapioca and start cheering for volatility, your new friend.

Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of

The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback;

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