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Investing Specialists

Morningstar Volatility Report for June 4, 2010

What's a recovery without jobs?

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.

Look Out Below
Barring a hiccup or two, the holiday-shortened week marking the unofficial beginning of summer seemed to be going well early on. The markets sloughed off a raft of potentially negative geopolitical stories from over the weekend, but the big economic news for U.S. investors came on Friday in the form of the monthly payroll and unemployment numbers. The payroll report, released as always on the first Friday of the month, showed that, barring temporary workers hired to conduct census interviews, the U.S. economy as a whole had generated only 20,000 net jobs in the month of May. Equity markets dropped and uncertainty rose on the prospect that the hoped-for strong economic recovery in the U.S. would be hampered if job creation remained as anemic as these numbers suggest.

With European sovereign default a continued, underlying concern, investors globally have been hopeful that the United States would hold aloft the torch of consumerism and light the way for a full-fledged global economic recovery. But without jobs or the ability to use their houses as ATMs any longer, how can this happen? Although it might seem easy to be skeptical, this observer has found that betting against the U.S. consumer is a good way to wind up seriously bruised.

As the S&P 500 plunged, Wile E. Coyote-style, the VIX soared. Hopefully some of the bearish among you took the advice in last week's column to buy some relatively cheap put protection then.

The Numbers
Over the Memorial Day weekend, domestic and overseas news added fuel to the fire of geopolitical uncertainty. Domestically,  BP (BP) announced that its "top kill" operation had failed to stop the Deepwater Horizon spill in the Gulf of Mexico, and scientists confirmed the presence of a massive underwater oil blob drifting toward the Florida Keys. In Europe, German president Horst Koehler announced his resignation, placing even more weight on the shoulders of embattled chancellor Angela Merkel. In the Mediterranean, nine passengers on a Turkish ship attempting to break the Gaza blockade were killed by Israeli commandos. Just to round off the bad news, statisticians announced that the Chinese purchasing manager index for May had come in worse than analysts had been expecting.

Despite these developments, U.S. investors bid up market prices for equities Tuesday, and volatility dropped slightly below its close from the week before. Economic news in the U.S. (ISM and construction spending) was generally better than expected, and this added to general confidence that the U.S. recovery was safely under way. News out of Washington late in the day that the Department of Justice was opening both civil and criminal investigations into the Deepwater Horizon spill threw a new layer of regulatory uncertainty into the energy sector, and the S&P 500 took a quick dive into deep water itself; the VIX ended the day about 10% higher than its previous close on the sudden market drop.

But time heals all wounds, and by 9:30 a.m. the next morning, after a positive existing home sales number was announced, investors decided that all was right with the world again. Markets rebounded for two days running, sending the VIX steadily lower. By Thursday's close, the VIX had fallen under the 30 mark to 29.46, its lowest closing value in nearly three weeks.

U.S. investors woke on Friday morning to see the euro losing ground and domestic equity index futures under pressure. Underlying the weakness were two incidents overseas: unconfirmed market rumors that French investment bank Societe Generale's derivatives department was sitting on top of sizeable trading losses, and little Hungary (a European Union member since 2004) mentioning that it was feeling a little sick like its friend Greece. European analysts hoped that a rosy jobs report in the United States would lighten the mood, but they were to be sorely disappointed.

As mentioned above, backing out temporary workers hired to conduct the once-in-a-decade census, private-sector employers hired what only amounts to a statistical handful of people. European markets dropped on the news, and as soon as U.S. markets opened, our domestic indexes continued the trend. In a maniacal game of dominos, as global equity indexes fell, so did the euro--closing the week at a rate of less than EUR 1.20 per $1 (it looks like I will get some good shopping done during my upcoming vacation to Spain). S&P Index volatility as measured by the VIX was one of the best assets to be long; it rose a whopping 20.43% to close the day and the week at 35.58.

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 8.2 percentage points--up by nearly 30% over last week's close. The widening of this spread indicates the market's belief that macroeconomic issues are outweighing stock-specific ones and that small stocks are more likely to be hurt than large ones.

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 decreased by 110 basis points this week and is now negative by the same amount. This inversion implies that the market is relatively more uncertain about present conditions than it is about next quarter's corporate earnings.

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 71.0% (versus 70.7% the previous week). This increase is typical during drastic movements in the equity markets; in a crisis, all correlations move toward unity.

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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