Morningstar Volatility Report for January 22, 2009
The S&P volatility increased while financial regulatory concerns affected large and small caps.
Investing Specialists
Introduction
The Morningstar approach to options is focused on using fundamentals to determine both the value of companies and the value of the uncertainty on those companies. However, just as a fundamental stock investor is still interested in understanding the drivers of the movements of the stock market as a whole, option investors are interested in understanding the movement of the option markets as a whole. The weekly Morningstar volatility report discusses drivers of the changes in different measures of implied volatility during the trailing week.
Broad Market Uncertainty
Trailing one-month realized volatility of the S&P 500 rose to 14% from 10.5% one week ago as the S&P 500 declined by 2.3%, erasing the index's gains for the year. The decline can be attributed in large part to fears over President Obama's plans to saddle the financial services industry with increased regulation and concerns that Federal Reserve chairman Ben Bernanke's confirmation for another term may be at risk.
The threatened regulation is expected to have a material negative impact on the earnings power of the financial services industry. The same sources of uncertainty that drove the market decline drove a quick rise in the index of implied volatility (the Chicago Board Options Exchange Volatility Index--VIX) on the S&P 500 to 27.7%. Prior to this cause for concern, the VIX had slowly decayed from its 2009 market crash highs north of 80% to close last Friday at 17.91%. The VIX remained relatively flat earlier in the week on mixed but healthy earnings reports, then rose throughout the week, accelerating on Thursday and Friday as additional information increased regulatory concerns.
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 3.3 percentage points, placing the RVX at 30.06%. The spread between the uncertainty regarding the short-term share price of small stocks versus that of large stocks had fallen from an April high of more than 12 percentage points when greater uncertainty about the ability of small stocks to obtain financing during the credit crisis drove small stock implied volatilities far above the then high implied volatility for large stocks. During this week, the concerns that affected large-cap stocks made an effect small-cap stocks, as well, and the spread continued to converge, suggesting that concerns about the regulatory impact on the financial services industry would not disproportionately affect small company access to funding.
Tech Stock Uncertainty Relative to the Market
The spread between implied volatility on the Nasdaq 100 companies (VXN) relative to the VIX has remained near zero for the last year, and remained nearly constant on this week's concerns. We interpret this to mean that the market believes uncertainty would affect mature tech companies and the 500 large-cap stocks equally. The VXN closed Friday at 28.37%, just 1.06 percentage points greater than the VIX.
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 fell this week by 4.87 percentage points to a negative 1.35%, the first time it has turned negative since March of last year. This reversal indicates that the market expects news regarding the current major drivers of uncertainty over the coming month, and has lower uncertainty three months out than it does during the next month. The spread between longer-dated three-month options and short-dated one-month options is a measure of the expectations for future uncertainty about the market, relative to current uncertainty, looking out one quarter into the future. The VXV closed the week at 25.96%, showing that uncertainty about stock prices this month is greater than the uncertainty about stock prices one quarter in the future. For reference, during the banking crisis at the end of 2009 and the beginning of 2010, volatility was expected to fall significantly and the VXV fell to more than 23% below the VIX.
Expected Correlation
The S&P 500 implied correlation index (JCJ) measures the expected correlation between the stocks in the S&P 500 until January of 2011. The JCJ rose this week to 66.24% from 62.98%, indicating that the legislative sources of uncertainty for this week are expected to cause the 500 large-cap companies to move more closely in tandem until the beginning of next year, meaning the concerns over the impact on the financial services industry are likely to affect the earnings power of all large-cap firms, not just the financial services industry.
Philip Guziec is co-editor and portfolio manager 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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