Morningstar Volatility Report for March 5, 2010
The market now believes that all the shoes have dropped.
Investing Specialists
Introduction
The Morningstar approach to options is focused on using fundamentals to determine both the value of companies and the uncertainty around the value of those companies, as measured by implied volatility. Looking over the changes in uncertainty within the stock market for the past week, I'll attempt to interpret the drivers of these changes.
This Week In Volatility
A combination of positive retail sales data released throughout the week and a smaller-than-expected decrease in nonfarm payrolls led the market to dramatically reduce is assessment of the chances of a double-dip recession. This conclusion allowed the market to remove the associated downside portion of the probability distribution of equity prices. Greece's latest austerity plan, and successful bond issuance this week, and contingency plan for funding under discussion from European Union members has also reduced concerns about negative global liquidity, currency, and economic scenarios, further reducing the market's perceived likelihood of the downside tail of the probability distribution.
Eliminating the two downside scenarios associated with a double-dip recession from it's assumptions has both led to a solid increase in share prices and to a reduction in the uncertainty about the future that resulted from the possibility of that downside. The S&P 500 rose throughout the week to a 2.7% gain and the small-cap Russell 2000 rose over 5%. The trailing-one-month realized volatility of the S&P 500 Index dropped to 11% from 18% a week ago as the big moves from one month ago were no longer a part of the calculation.
The VIX index of one month volatility on the S&P 500 traded in a range from 18.50 to 19.50 through Thursday as the market digested mixed the Fed's Beige Book economic results, the sale of AIG's Asian unit, strong economic numbers from India, and some merger deals, and very positive results from retailers. Friday morning's announcement of better-than-expected job loss data drove the VIX down to a Friday morning open at 18% and a decline through the day to a close Friday of at 17.42%, just above its low for the week and approaching January lows.
Last week, we pointed out that the VIX is just discounting the uncertainty level about the earnings power of the market, and that a VIX around the 20% long-run market average realized volatility is indicative of an economic and earnings outlook that is consistent with a normal economic recovery and a broad market that is roughly fairly valued and unlikely to make a major move. We think that this decline for the VIX below the long-term average volatility of 20% markets a new level of confidence, perhaps overconfidence, in the certainty of an economic recovery. Strategically, for OptionInvestor subscribers, these new lows in volatility should start to produce some potential buying opportunities for volatility, particularly for call options on those companies whose valuations don't fully reflect a return to normal economic conditions.
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 3.4 percentage points, up from 3.1 percentage points a week earlier. At these relatively consistent levels, we continued to think that the spread between small and large stock volatility is simply representative of the higher volatility that small stocks normally experience. 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.
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 continued its rise from 2.14 percentage points to 2.84 percentage points. At this point in the earnings reporting cycle and global news flow, we believe the 3 month to1 month implied volatility spread represents largely the greater uncertainty that stock prices will face as next quarter's earnings numbers are released, relative to small amount of incremental information remaining in this earnings season. The VXV closed the week at 20.1%. 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 percentage points 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 2011. The JCJ fell by 2.4 percentage points to 60.28%. The decline suggests that macro conditions that affect all stocks such as global or U.S. macroeconomic issues are becoming less of a concern relative to stock and industry specific sources of uncertainty, like earnings results.
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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