CBOE Volatility Index ( VIX) is down 1.05 to 29.65 today and now off 35% in less than two weeks. VIX has not closed below 30 for more than past two months and the dramatic decline in the market's "fear gauge" reflects a sharp decline in investor anxiety and risk perceptions seen during the past two weeks. VIX tracks the implied volatility priced into S&P 500 Index (.SPX) options and rallied to 45.45 on October 3 amid worries about the European Debt Crisis. Also, on October 3, the euro fell to 8-month lows against the dollar and decade lows on the yen.
The European debt mess continues to drive a lot of action in the US equity market and the S&P 500 has rebounded along with the euro and European equity markets since October 3. VIX has been falling during that time and, at 29.65, reflects expectations for lower levels of market volatility in the weeks ahead. Since VIX tracks implied or expected volatility, it is a forward-looking indicator. By way of comparison, the actual volatility of the S&P 500, which is based on previous closing prices, is 35.4% over the past 60 days. VIX is now 16.2% below the 60-day actual volatility.
Looking across sectors of the market, the difference between the expected volatility priced into options and actual volatility is even more striking. For example, implied volatility in the options of the SPDR Basic Materials ETF ( XLB), which holds all of the metal, chemical and other "basic material" names from the S&P 500, has fallen to only 22.6%. The actual volatility of the fund over the past 60 days is twice that, or 45.1%. (See Table 1 for a breakdown of volatility by sector). Since the options market is often very efficient in anticipating changes in market volatility, the falling levels of implied volatility across all S&P sectors could be signaling a return to more orderly market action in the weeks ahead - i.e. the extreme levels of market volatility seen in August and September will subside.
While implied volatility is falling across the options market due to the diminishing fears about the European Debt Crisis, the third quarter earnings reporting season might offer some good news as well. Analysts currently expect year-over-year earnings growth of 13% for S&P 500 companies; with only the financials showing a decline (see Table 2). Overall earnings in the Energy sector is expected to improve to $12.49, up almost 50% from the $8.39 a year ago. Information technology, basic materials, and consumer cyclical sectors are expected to see strong year-over-year growth as well.
While third quarter results are expected to offer good news across most sectors, forward-looking guidance will be scrutinized for clues regarding future earnings. Ultimately, earnings are the primary driver of valuations and other news, like economic data, political events, or turmoil in the credit markets, only matter to the stock market when they affect earnings. As Briefing's Dick Green recently pointed out,
"The market is afraid that earnings will plunge in the quarters ahead if European credit markets and economic growth implode. That, of course, so the thinking goes, will lead to a recession in the U.S. that will drive U.S. profits sharply lower. The fears of the future are trumping current good news."
After an 18.2% market decline from July 21 to October 3, the S&P was clearly priced for a sharp decline in earnings. The question is whether such a decline is justified given that Corporate America is still delivering solid earnings growth - 17% year-over-year earnings growth is expected for the fourth quarter and 13.5% in the first of 2012. There is a good chance that many quality companies with solid long-term earnings prospects have been unfairly punished during the market decline of August and September.
Of course, not all earnings reports will be spectacular and some sectors are likely to fare better than others. Industrials, Energy, Technology and Healthcare names are expected to continue to deliver solid earnings growth in quarters ahead. These sectors are worth a closer look for bullish set ups and upside options plays in the months ahead. Volatility is likely to continue in the Financials. Meanwhile, Consumer Staples and Telecomms might be worth a look for longer-term horizontal plays like calendar and diagonal spreads.
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