Morningstar Volatility Report for June 11, 2010
Boredom, Terror, and Euphoria.
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.
Long Stretches of Boredom
A veteran friend who fought in the Vietnam War once described his service experience to me as "Long stretches of total boredom, punctuated by sudden moments of abject terror." This seems an apt description of the markets lately, as long as one appends the phrase "...and brief interludes of giddy euphoria."
Last week, we saw some moments of abject terror, whereas this week was more along the lines of total boredom with a dash of euphoria. We are between quarterly earnings announcements in the United States, and into the post-Memorial Day summer trading months to boot, so news flow tends to be light.
Until Wednesday, other than a report on consumer credit (on Monday), equity markets seemed to take their cues from the relative valuation of the euro with the dollar. When the euro weakens, U.S. equity investors take this as a sign Europe will "implode" (whatever that means), and the currency sells off. Contrarily, when the euro strengthens, U.S. equity investors take this as a sign that everything in Europe will "be all right" (whatever that means), and the currency rises.
It is watching this type of irrational tail-chasing in markets which reaffirms my suspicions of the academically favored Efficient Market Hypothesis. No one in the crowd knows what is going on, but sees another (completely clueless) crowd moving in one direction and believes the movement of the other crowd has some bearing on the direction they too should move! Those with some time to kill should type "Behavioral Finance Herding Effect" into your favorite search engine and start reading through the articles that search brings up.
For the first three trading days of the week, the VIX index of S&P implied volatility opened and closed in a band of less than 10% around last week's elevated closing value of 35.58. On Wednesday, rumors that there was some additional uncertainty in the Deepwater Horizon spill ("BP might be forced into bankruptcy," "The Gulf spill is worse than BP is reporting again,","President Obama wants to kick BP's [behind]," and so on) sent the British oil giant tumbling.
The euro also weakened under the 1.20 mark, and the Beige Book (the Fed's collection of anecdotes about current economic conditions, published twice quarterly) revealed that Fed bank presidents believed an economic recovery was under way, but weak (thank you for that insight, distinguished ladies and gentlemen). For the equity herd, these catalysts, accompanied by an accumulation of free-floating angst, were enough to send many running for the exit doors. This turned what had looked to be a nice equity rally in the making into a loss across all domestic markets. The VIX, which had dipped under 31 in the morning, shot back up in the afternoon, to close again just 5% lower than the closing value the day of May's disappointing employment report.
On Thursday, the big news was that Asia seemed strong in spite of eurozone weakness. China reported its exports were up again by half above May 2009, which sounds very good as long as one doesn't think too much about what the economic mood was in May 2009.
A separate report that average selling prices in the frothy tragedy-in-waiting that is China's real estate market was also taken as a bullish sign. Other good economic news out of Asia (Korean and Australian employment and Japanese gross domestic product) convinced the herd worldwide that things are "all right"; markets across the globe soared. Indeed, because Europe is China's largest export market, the above-mentioned report indicates that European consumers and businesses may be less concerned about their economic situation than recent reports have led us to believe, so the drop in the VIX by Thursday's close to under 31 might be justified.
Closer to home, the Labor Department reported that while those claiming jobless benefits for the first time fell less than expected, the number of people still on the government dole shrunk significantly. Some observers took this as a positive sign, but it is tough to know whether those who stopped claiming benefits did so because they had found new jobs or simply because their maximum allowed claim period had ended.
Friday, the big economic news centered around the indomitable American consumer. Two reports--one, the Michigan Consumer Sentiment survey with preliminary June data, and the other, retail sales statistics for May--presented divergent views on consumer attitudes and actions. The sentiment survey was more positive than economists predicted and was the highest value since January 2008. Retail sales numbers, on the other hand, unexpectedly shrank 1.2%, partially because of a large fall in building materials. Some observers have tied this fall in building-materials sales to the end of tax breaks for the purchase of energy-conserving appliances.
Whatever the cause, the sales numbers were disappointing, but the timing difference between the two studies (the positive sentiment survey is for the month of June and is prospective, whereas the retail sales survey is slightly older news and backward-looking) probably means that the positive sentiment number holds greater weight than the negative sentiment number. By the end of the trading day, it seems that the market agreed with my take; after spending the whole day moderately under water, the major indexes spiked at the close. The VIX responded by closing the day and week at 28.77, 19% below its settlement value last week.
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--virtually flat with last week's close. The fact that the spread did not tighten even though the VIX fell surprised me and makes me think that some small-cap investors are still skittish about the macroeconomic issues facing the market.
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 increased by more than 3 percentage points this week and is now positive by 2.2 percentage points. This was brought about because the VIX fell nearly twice the amount in percentage terms than did the VXV. The lowering of the VXV implies that the market believes there is less uncertainty about future economic outcomes. The increase in the spread between the VXV and the VIX indicates that S&P large-cap investors are becoming more conscious of the uncertainty surrounding earnings in the upcoming announcement season than present macroeconomic uncertainties.
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 decreased only very slightly from last week's elevated levels to end at 70.7%. The failure of the correlation index to lower significantly, taken in conjunction with the failure of the small-stock uncertainty spread to close, makes me think the market is still very focused on macroeconomic issues, over and above stock-specific ones. When looked at in conjunction with the spread between present and future implied volatilities, I think it is fair to say the market is continuing to perceive an elevated level of uncertainty regarding macroeconomic perturbations, and is now beginning to worry what effect these perturbations will likely have on next quarter's corporate earnings.
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