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Investing Specialists

Morningstar Volatility Report for May 21, 2010

Auf Wiedersehen to the euro?

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Introduction
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.

No Fat Fingers This Time
During the flash crash of May 7, the popular press forwarded the (erroneous) idea that a fat-finger error had caused the drastic sell-off. Fat fingers cannot be blamed this week, however, as bad news from Europe, uncertainty regarding the scope and impact of financial reform, weak economic numbers, and talk of a Gulf oil slick spilling into the Atlantic Ocean convinced market participants that discretion was the better part of valor when it came to the risky trades they favored even a few weeks ago. U.S. government bonds looked like a nice safe bet, and you could almost hear the sounds of the Treasury market vacuuming up the capital that had formerly supported equity and commodity markets.

In short, the theme for the week was uncertainty and risk aversion. The VIX, a gauge of uncertainty in the equity markets, responded by climbing 50%-plus during the first four trading days of the week and hit its highest level for 2010 on Thursday. Although present levels on the VIX are higher than the long-term historical average, I believe these levels make more sense vis-a-vis the uncertainty facing equity markets than did the lower-than-average VIX numbers about which I was shaking my head a few short weeks ago.

The Numbers
The week began tentatively, as this quarter's earnings season wound to a close. Retailers  Wal-Mart  (WMT),  Lowe's  (LOW), and  Home Depot  (HD), as well as a host of smaller chains, provided a mixed view of the U.S. economy. Wal-Mart's announcement that it did not see as strong a bounceback in spending among lower-income consumers in the U.S., and instead, that it had witnessed a big increase in the number of customers paying with government food stamps left this observer feeling a bit queasy.

But as the week wore on, attention turned from U.S. retailers to European politics. European investors bit their nails watching the German parliament debate a politically unpopular bill to authorize that nation's contribution toward the $1 trillion Eurozone stabilization package. Uncertainty regarding the outcome had investors questioning the very viability of the European Union as a political/economic entity.

Meanwhile, in the U.S., the latest weekly statistics detailing the number of newly unemployed showed unexpected softness in the job market. This weakness stoked fears that the U.S. consumer could not sustain spending levels and that the country would succumb to a double-dip recession. Financial news producers frantically searched their Rolodex files for "The-End-is-Near" commentators as equity markets tumbled on Thursday. While the S&P 500 did not breech the intraday low of the flash crash, the VIX shot up to its highest level in more than a year--and its closing value of 45.79 was nearly 12% higher than the closing value on May 7 (the day of the flash crash).

A rough overnight session in Asia and weak index futures premarket in the U.S. meant that stocks opened lower. This, in turn, pushed the VIX above 48% annualized on Friday morning. However, German politicians saved the day by blocking out the shouts of protests from their constituents and voting to approve eurozone funding by a slim margin. Removal of some of the European political uncertainty, helped the S&P 500 close up 8.65 points on the day and the VIX eased back from its previous closing high to end at 40.10%. This figure represents a 28% gain over the previous week, which was in turn up 31% over the week before. U.S. market participants, perhaps following the rule to expect the unexpected on option expiration day, chose to discount a Senate bill which would limit the trading of swap contracts by major banks. We'll see if they are more worried about it Monday morning when the market opens.

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 9.0 percentage points--54% higher than the 5.8 percentage point spread at the close of last week. This spread represents the higher level of uncertainty about small companies that is typical for market conditions when all stocks are affected by the same factors, regardless of size.

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 widened this week to close with 90-day implied volatility 2.7 percentage points below 30-day implied volatility. This indicates that the market believes that there is a better chance that present perturbations in the market are temporary and that concerns will be ameliorated during the next 90 days.

Expected Correlation
The S&P 500 implied correlation index (JCJ) measures the expected correlation between the stocks in the S&P 500 until January 2011. The rule is that when markets fall, all correlations approach unity, and this week, the JCJ did just that. It closed up more than 4 percentage points, at 69.2%--indicating that at present, macroeconomic concerns are swamping stock-specific considerations and that stocks are moving more or less in unison.

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

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Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.