U.S. stocks could see big swings to the downside this week on any remotely "bad" news because volatility indexes are at levels considered too low.
Investors also will face a blizzard of earnings, which many analysts believe will continue to support the rally that began early this month. But any disappointments in either earnings or outlooks could, of course, trigger a sharp sell-off.
What's more, the market is likely to continue to garner support from investors' hopes that the Federal Reserve will take more steps to stimulate the economy, in what is known as "quantitative easing" or "QE2." The Fed is expected to unveil its initial commitment under QE2 at its Nov. 2-3 meeting.
The Chicago Board of Options Exchange Volatility Index, or VIX, a gauge widely used to measure investors' anxiety levels, fell 2.54 percent Friday to close at 18.78, its lowest level since April. The VIX, which rose to near 50 in May, has been around or under 20 for the past two weeks.
Options traders note that there is a clear sign of extreme complacency in the VIX and that it is making the market more vulnerable than before.
"The 'market volatility' index will see a lot more volatility (this week) since it is at such low levels now," said Steve Claussen, chief investment strategist at online brokerage OptionHouse.com.
The iPath S&P 500 VIX Short Term Futures exchange-traded note, or ETN is also at a new 52-week low of 12.83. The ETN offers directional exposure to volatility and is based off of the front two-month VIX futures.
"If you look at VIX futures, investors seem to be always preparing for something to trigger the volatility to spike up again, yet there is nothing major in the immediate future that justifies that," Claussen said.
The VIX futures were traded at around 21 for November and 24 for December, but going into 2011, they were showing an increase of 40 percent, trading above 26.
The VIX, widely known as Wall Street's fear gauge, is a 30-day risk forecast of stock market volatility. The index typically has an inverse relationship with the S&P benchmark as it tracks option prices that investors are willing to pay as protection on the underlying stocks.
Last week, the VIX instantly shot up nearly 12 percent on Tuesday when stocks suffered their steepest one-day decline since August after a surprising rate increase from China.
Earnings will remain the center of attention this week. Many analysts predict that earnings will continue to support the market rally that kicked off October. If more companies report strong results, that could bolster sentiment, along with hopes for more Fed easing.
In the last week of October, 177 S&P 500 companies are due to report their balance sheets, of which seven are Dow components. Among them are energy giants Exxon and Chevron and technology giant Microsoft.
S&P 500 earnings are expected to increase 28 percent for the third quarter from a year ago, up from a growth estimate of 24 percent last week, according to Thomson Reuters data.
"The earnings are expected to be good (this) week as well ... we are not expecting any bad news out of there," said Peter Cardillo, chief market economist at Avalon Partners, in New York.
But Cardillo said that negative news from economic data could spark market volatility, especially as it would come just a week before the Nov. 2-3 meeting of the Federal Open Market Committee, or FOMC, and in the week preceding the Nov. 2nd mid-term elections.
Major economic data for the coming week includes existing home sales, durable goods orders and third-quarter GDP.
Elliot Spar, an options market strategist at Stifel Nicolaus, also said a sell-off could begin as early as this week in anticipation of the Fed meeting and the mid-term elections.
"For those that are waiting for the 'sell on the news' event on Nov. 3 when the Federal Reserve Open Market Committee concludes its meeting to discuss the prospect of another round of quantitative easing, I believe that the sell-off in the market will start during the week of Oct. 25."
All three major indexes capped a third straight week of gains at Friday's close. For the week, the Dow and the S&P 500 each rose 0.6 percent while the Nasdaq gained 0.4 percent.
From the technical viewpoint, a key support for the S&P 500 was seen at the 10-day moving average, which was at 1,175 as of Friday.
"A clear one-day break of the 10-day moving average with a follow-through to the downside the next day could be the catalyst for a meaningful pullback in the market," Spar said.
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