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By Jason Stipp and Erik Kobayashi-Solomon | 06-13-2012 03:30 PM

'Bernanke Put' Props Up the Market

As negative headlines continue to roll in, a market upswing suggests investors are expecting more stimulus action from the Fed.

Jason Stipp: I'm Jason Stipp for Morningstar.

We've had a spate, recently, of negative headlines, but the market has not always reacted as expected.

Here with me to dig into that, and the volatility of the market, is Erik Kobayashi-Solomon. He is the editor of Morningstar OptionInvestor and also an option strategist here at Morningstar.

Thanks for being here, Erik.

Erik Kobayashi-Solomon: Thanks for inviting me, Jason.

Stipp: We've had a lot of news over the last few days. We've heard some bad news out of Spain with their banks; there's talk of Italy needing more money. We got retail sales on Wednesday. Retail sales upset the market, maybe as expected. But after some of the other bits of news, the market actually went up when we were getting bad news in the headlines.

What's the story with volatility? What's going on there?

Kobayashi-Solomon: You know, I have worked in the markets for so long that sometimes I forget what a topsy-turvy world it can be.

So, last week, the last time we talked, we just had some terrible news on the unemployment data, and yet we were in the midst of the biggest up week that the market has ever seen.

Then, people were worried that Spain might really go bankrupt and need a bailout. Well, sure enough, over the weekend, they announced, we need a bailout, and the market sold off a little bit on that news. I think really what we were seeing was "buy on the rumor and sell on the news."

Another thing that came out, which I think is kind of the real news that's moving this market, is the concept of a "Bernanke put." Chairman Ben Bernanke spoke last week, gave congressional testimony, and said, we are not going to provide more liquidity to the market unless things look really bad in Europe. And so, as things look really bad in Europe, guess what, the U.S. market is going up in anticipation of more liquidity, more Fed liquidity.

Stipp: So, it sounds like the bad news is good news in that case, at least from the traders' perspective.

Kobayashi-Solomon: It seems crazy, right.

So, the one thing that you can say is that even though the market has come back up from under 1,300 after the unemployment report, volatility is not coming down as much. In fact, just as we are filming this, we are right at about the same spot as we were last week, when we filmed the last one.

Stipp: So you mentioned last week that in some ways, volatility could be seen as the mirror of the S&P, but it also sounds like you are saying now that we haven't seen volatility shift as much as you might expect. What's the relationship been between the S&P and the VIX recently?

Kobayashi-Solomon: Well, if you look at a chart ... of the S&P and the VIX over the last month, you can see really clearly this mirror relationship. As the S&P 500 goes up, people get less worried and want to buy less insurance, and so the VIX goes down.

But the one thing that I've noticed is, even though the S&P has come up recently, the VIX is still staying above its long-run average of about 20%. Right now it's at around 24%.

Stipp: So, does that indicate that we are in for a longer period of volatility or that people aren't sure about what's going to happen? Even though we got a relief rally, there are still some concerns out there?

Kobayashi-Solomon: You know, I think it all comes back to the Bernanke put. People are saying, is Uncle Ben going to give us a lot more money to play with? Is he really going to protect our downside and let us keep speculating? So, I think there's a lot of uncertainty about that.

Stipp: So, I can't let you get away without some investing ideas. You look at the volatility, you look valuations, and some of the underlying fundamentals, and you often find some opportunity in the market based on what you are seeing on both those fronts.

Do you have any thoughts today on some further option investments that investors might want to consider.

Kobayashi-Solomon: You know, it's funny because as I said last week, whenever volatility picks up, most people get worried about it, and I think of it as an opportunity.

So, I just published something on Morningstar OptionInvestor--it's a short put idea on Cisco Systems. That's selling a put on Cisco.

Cisco is a wide-moat stock, a medium uncertainty stock, and it's now trading for under its 5 Star price, in other words, its "consider buying" price. Then, by selling a put, basically what we're doing is just promising to buy that stock at a 5-star price, and actually even getting a discount from there.

Stipp: And in the meantime then, what happens as you've had that contract out there?

Kobayashi-Solomon: Well, basically for a short-term investor, they might be very worried that the price of the contract is fluctuating a little bit, but for a long-term investor, you don't need to worry about it. If the put expires and you don't end up owning the shares, then you've just made 14% annualized over the next year. But if ... you end up owning the stock, then Morningstar's fair value would imply that you are going to make about 20% per year over the next couple of years.

Stipp: On a wide moat stock, no less.

Kobayashi-Solomon: On a wide moat stock. So, just as I said last week, it's heads you win, tails you win.

Stipp: All right, Erik. Thanks for the update on volatility and some recent events in the market, and for the investing idea.

Kobayashi-Solomon: Thanks so much.

Stipp: For Morningstar I am Jason Stipp. Thanks for watching.

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