The CBOE Volatility Index (.VIX) is trading down 0.56, to 15.83 midday Friday, and has suffered a 7.6% loss on the week. VIX, which tracks the expected volatility priced into S&P 500 Index (.SPX) options, is a far cry from the levels seen one year ago, when the index made a run towards 28 on January 22. The recent decline in actual market volatility has been even more impressive. Trading has been eerily quiet, even as macroeconomic uncertainties persist and the floodgate is set to open on fourth quarter earnings reports.

Volatility By Sector

The average daily point move in the S&P 500 Index over the past twenty days has been just 3.9 points, or about 0.3%. The market simply isn't moving much from one day to the next. Consequently, the actual or realized volatility of the S&P 500 (during the past 20 days) has fallen to only 6.2%. By way of comparison, it was near 20 percent in August.

The decline in actual volatility has been seen across a variety of sectors. 20-day actual volatility of the Technology Sector Fund (XLK), the Industrial Select Sector Fund (XLI), and Basic Materials Fund (XLB) all have actual volatility in the single digits. The Financial Select Sector Fund (XLF) and the Energy Select Sector Fund (XLE) are the only two sectors seeing double digit levels of actual volatility. The table below shows the 9 Sector Funds that collectively hold the 500 S&P stocks. It also includes the Consumer Discretionary (XLY), Healthcare (XLV), Consumer Staples (XLP), and Utilities (XLU) .

Source: Trade Alert

Just as VIX is substantially higher than S&P 500 actual volatility, the implied volatility IV in options of each of the ETFs is much higher than the actual volatility of the funds. Without going into a lengthy discussion about options pricing, suffice it to say that the market is implying much higher levels of volatility going forward. For instance, the actual volatility of the XLK tech fund over the past twenty days is an anemic 6.4 percent. Yet, IV of XLK options is 16.4, or 156% higher than actual volatility. Since implied volatility is forward-looking, the huge difference between actuals and implieds indicates that the market is bracing for an uptick in volatility in the weeks ahead.

Earnings Outlook

While the market might be priced for an uptick in volatility going forward, the relatively low levels of actual volatility have happened for several important reasons.Steady trading in the equity market is being supported by low inflation, low interest rates, accommodative Fed policy, and improved earnings. Estimates compiled by Standard & Poor's suggest that S&P 500 companies could earn $45.45 over the next two quarters. During the past two quarters, earnings totaled an estimated $43.40. The S&P 500 is therefore trading at a reasonable P/E ratio of 14.5.

The primary focus going forward will be on the flood of earnings reports due out over the next few weeks. Three Dow components - Intel, Alcoa, and JP Morgan - released results this week, but the floodgate on fourth quarter earnings doesn't open until after the Martin Luther King holiday. Low levels of actual volatility and a higher S&P P/E mutliple can only be supported by positive earnings growth and, on that front, the outlook is a bit less bullish.

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