Morningstar Volatility Report for April 30, 2010
The Morningstar approach to options is focused on using company and economic fundamentals to interpret and estimate the value of the uncertainty around market prices, as reflected in implied volatility in the options market.
Is the Party Over?
This week, sovereign debt downgrades for both Greece and Portugal, as well as talk of a downgrade to Mediterranean neighbor Spain, sent equity markets across the world tumbling and implied volatilities soaring, despite encouraging earnings news from U.S. firms. If there was a publicly traded market for words, the stock of 'contagion' would have been on a bull run this week. Jittery equity investors were sure that the sky was falling, and that little Greece's problems would somehow pull down all of Europe. Adding to the uncertainty this week was the revelation that the Justice Department is launching a criminal probe into Goldman Sachs' (GS) trading operations.
The week started quietly enough. Good earnings results from U.S. bellwether Caterpillar (CAT) and appliance maker Whirlpool (WHR) along with positive comments by company managers about a robust return to economic activity convinced the market that the economic recovery was proceeding apace; the VIX spent much of the day in its 17% comfort zone. But the halcyon moments were not to last.
Soon after the equity markets opened in the U.S. on Tuesday morning, a debt rating agency downgraded the sovereign debt of Greece to 'junk' status, and lopped two grades off the sovereign debt rating of Portugal. While this is indeed bad news for the countries involved (and perhaps for German taxpayers), we would be hard-pressed to say it was surprising. If the debt downgrade was not enough, an index of U.S. house prices came in a little worse than expected that morning. Between the European news and the hint of soft real estate prices in the U.S., equity markets went on a quick trip southward and the VIX rocketed past last week's high of 19.5%, to end the day at 22.4%. This was in fact the VIX's highest level since February of this year, the last time the market had worried too much about Greek sovereign debt.
The simple fact that fire and brimstone was not falling from the sky on Wednesday morning was enough to allow the market for index options to relax a bit. A full-blown equity rally the next day then dropped the level of the VIX a full 8% to under the 19% annualized volatility mark once again.
Friday saw mixed news on the economic front. The initial reading of the gross domestic product number at 3.2% growth was shy of economists' 3.3% growth expectations, but consumer spending numbers were much stronger than expected, offsetting some of the headline disappointment. The Chicago Purchasing Managers Index and Consumer Confidence index also came in better than expected, with the former turning in its best number since 2005.
The VIX dipped early on, but news that the Justice Department had decided to launch a criminal probe of Goldman Sachs' mortgage trading operations spooked investors, sending the average price of equities down and the VIX back up. Added to problems in the world of investment banking was an earnings miss in high tech. MEMC Electronic Materials (WFR)--a firm which produces the refined silicon used in semiconductors--tumbled 18% after reporting bad earnings. In a story not dissimilar to little Greek taking down all of Europe, little MEMC's earnings miss ended up shaving off $3.5 billion dollars of Intel's (INTC) market capitalization. This contributed to a tough week for the Nasdaq and to a bit of the rise in index volatility.
Option sellers love volatility and they should love this week! The VIX closed the week at a rate of 22.05%, up more than 33% from last week's close, but only slightly higher than the long-term average.
Small Stock Uncertainty
The spread between implied volatility on the Russell 2000 Index of small stocks (RVX) and the VIX index of implied volatility on the large-cap S&P 500 closed the week at 6.14 percentage points, up a full 33.48% from last week's closing spread. Obviously, investors think that smaller firms are more susceptible to a downturn in economic activity, and are willing to pay up for insurance on those companies.
Uncertainty About Next Quarter vs. This Quarter
The spread between the implied volatility of the three-month options on the S&P 500 Index (VXV) relative to the implied volatility of the one-month options represented by the VIX still looks to the future, past the current earnings season. The spread tightened to 1.62 percentage points, down almost 1.3 percentage points from last week's close, with the VXV equal to 23.67%. The tightening could represent investor's belief that the present market dislocations are temporary, and will have largely worked themselves out by the time the next quarter rolls around.
The S&P 500 implied correlation index (JCJ) measures the expected correlation between the stocks in the S&P 500 until January 2011. In times of large market movements (especially downward ones), correlations head toward unity (that is, there are no winners in a market crash), and this week's JCJ showed that in spades. The index closed at 58.37%, a full 4.2 percentage points higher than last week's closing value of 54.1%.
Erik Kobayashi-Solomon is co-editor of the Morningstar OptionInvestor online newsletter and research service, and is co-author of the Morningstar Investor Training course on Option Investing. For more about Morningstar's fundamental approach to investing in options, please use the link below to download our free guide to option investing:http://option.morningstar.com/OptionReg/OptionFreeDL1.aspx
Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.