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Investing Specialists

Morningstar Volatility Report for May 28, 2010

China to the rescue!

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.

Thanks, China
For weeks, investors all over the globe have been fretting that the eurozone was crumbling--whatever that means. A report in a respected European newspaper that China's state investment fund was considering reducing exposure to the euro was the ton of bricks that broke the camel's back. The global markets panicked for a day until Chinese officials (after having spent hours on the phone listening to finance ministers from across the globe grovel, no doubt) denied the rumors as baseless.

The markets breathed a sigh of relief and sped upward, while index volatility eased from its lofty peaks. In the fall of 2008, the market would rally whenever a sovereign wealth fund announced it was dumping money into one struggling bank after another. Now the trend seems to be sovereign wealth funds announcing they are dumping money into struggling nations and currencies one after another. Even with an uptick in index volatility on Friday brought about by a downgrade of Spain's sovereign debt, we still saw week-over-week volatility levels shrink materially.

In short, the theme for the week was relief. Faced with a stressful situation long enough, humans become inured to it; even the huge sell-off in the markets on Wednesday morning did not boost the level of the VIX past its highs of the previous week. For those of you more inclined than not to worry that European problems may get worse before they get better, this might not be a bad time to think about buying downside index protection--the prices have become much more favorable over just one week, after all. For those of you more inclined to believe that the European situation has been overblown, now might be a good time to buy out-of-the-money calls on some of your favorite risky bets.

The Numbers
The week started with news of the seizure of a regional bank in Spain. LIBOR increased and stocks fell as investors on both side of the Atlantic continued their skittishness about macroeconomic issues. Interestingly, the VIX also fell just more than 4% for the day, contrary to what one might expect given an increase (or at least no decrease) in uncertainty. Some commentators suggested that this drop versus the previous close may be a data artifact, and that the VIX close on the previous Friday was unnaturally elevated because of options expiration in the United States.

Tuesday saw enormous drops in Asian markets as tensions on the Korean peninsula flared. U.S. markets took their cues from Asia and Europe and started the day down several percentage points. This boosted the VIX to its highest level for the week at 43.74; however, as mentioned above, this was still nearly 10% lower than the previous week's peak. In terms of economic news in the U.S., consumer confidence readings on Tuesday were much higher than economists' expectations; this, along with what may have been the realization that while crazy, North Korean leadership was not crazy enough to start a nuclear war, allowed the S&P 500 to end the day flat. With the perceived reduction in uncertainty, the VIX fell by nearly 10 percentage points.

Wednesday's markets started strong, and the VIX fell to under 30--a drop in nearly 33% from the previous day's highs. Positive numbers on new home sales and durable good orders fueled the optimistic tone and convinced investors that uncertainty regarding economic conditions were abating. The newspaper article mentioned above led to a late market fall and an attendant slight rise in the VIX on the day.

However Chinese refutations of the news story on Thursday sent the VIX down by 5.34 points while equity indexes soared. Even though the second revision to first-quarter gross domestic product estimates came out a bit weaker than was expected, this news seemed to be largely ignored by the markets. On the corporate news front, increased earnings expectations from luxury retailer  Tiffany (TIF) and reports from various companies that tech spending was rebounding worldwide added to the sense that the global recovery continues apace.

The day before a long holiday weekend is not generally filled with much corporate news. Chicago PMI came in a bit weak, but the junior traders manning the desk in place of their bosses who were heading toward the Hamptons didn't seem to notice. News that a ratings agency had downgraded Spain succeeded in causing the VIX to spike at midday. The VIX closed the week at 32.07 down 20% from the last week's close and just a hair above the close of two weeks ago.

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 6.4 percentage points--down by nearly a third from last week's close. The tightening of this spread may indicate the belief that stock-specific issues are returning to prominence in the minds of investors over macroeconomic ones, at least for small-cap names.

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 closed flat for the week. This flattening implies that corporate earnings are not the main driver for uncertainty at present.

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. Implied correlations increased slightly from the previous week to end at 70.7% (vs. 69.2% the previous week). This means that, contrary to the indication referred to in the Small Stock Uncertainty section, the market expects for macroeconomic issues to be relatively more important than stock-specific valuation concerns.

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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