Morningstar Volatility Report for March 12, 2010
Understanding the power of Mr. Keynes' consumer.
Investing Specialists
Introduction
The Morningstar approach to options is focused on using company and economic fundamentals to interpret and estimate the value of the uncertainty around stock prices, as reflected in implied volatility in the options market.
Mr. Market's Obsession With Mr. Consumer
Putting fears about the solvency of Greece behind it, the options market remained relatively confident about its ability to predict the near future, with most blips in uncertainty driven by attempts to interpret the mental state of the consumer. This week's information flow was a mixture of macroeconomic data which came in mixed and earnings reports from retailers which were largely positive.
The best way to understand the market's obsession with every consumer whim as we recover from the round bottom of this recession is to recognize consumer psychology as a key element of the classic Keynesian macroeconomic model. The Marginal Propensity to Save, also known through its inverse--the Marginal Propensity to Consume--is the key variable in the Keynesian model that measures consumer mood or, "animal spirits" as Keynes described it. The Marginal Propensity to Consume/Save measures what a consumer does with each incremental dollar he receives. As Mr. Consumer's confidence improves, he is inclined to spend a larger percentage of each extra dollar he receives, which cascades through the economy, creating orders for goods, which improves demand, which increases earnings and improves confidence in a virtuous cycle. However, if he is scared and keeps a greater percentage of every extra dollar he receives in his pocket for a rainy day, he causes the rainy day he is saving for as the economy slows and demand falls. Whether or not you're a believer in Keynesian economics, Mr. Market reacts to news as though he is a believer.
The importance of the consumer's propensity to spend a dollar should make sense to you, and should explain the stock and option market's current obsession with the consumer. The current conditions represent a consumer who is finally gingerly reaching for his wallet. If he continues to open his wallet and spend, the recovery should get more solidly on its way, however if he gets spooked and doesn't increase spending, the economy could fall back into the dreaded "double dip."
Stronger-than-expected sales results for February from a consumer that overcame poor weather was a highly positive signal regarding the Marginal Propensity to Consume. Because spending is a more direct insight into how the consumer is feeling than the psychological measure of confidence (which came out worse than economists expected), Mr. Market's reaction to the conflicting data in estimating the consumers Marginal Propensity to Save is to average out the positive and negative reports, with the positive slightly outweighing the negative. The option market, however, should really be looking at the conflict in the data, and the drop in confidence as a source of greater uncertainty about future spending, yet the VIX ended the week about flat. This lack of a move in the VIX may imply that the market is too complacent about the future, and is discounting the possibility of a double-dip recession.
The Numbers
The S&P 500 rose throughout the week to a 0.9% gain and the small-cap Russell 2000 rose over 1.5%. The trailing-one-month realized volatility of the S&P 500 Index dropped below 10% as news over the last month has continued to come in mixed but, on average, near expectations.
The VIX index of one month volatility on the S&P 500 traded in a range from 17.5% to 19.3% for the week. The high for the week came on Thursday as China reported higher-than-expected inflation, increasing uncertainty about potential monetary tightening and its potential impact on global demand. The VIX closed the week at 17.65%, nearly the week's low, and below the long run average realized volatility of the market of 20%. We continue to think the VIX below the long-term average volatility of 20% may indicated overconfidence in the future, especially this early the economic recovery from such a severe recession. For OptionInvestors, these lows continue to point towards potential buying opportunities for options, both calls on those companies whose valuations don't fully reflect a return to normalized economic conditions and puts that more than fully reflect normalized valuations.
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 1.4 percentage points, down from 3.4 percentage points a week earlier. At these relatively consistent levels, we continue to think that the spread between small and large stock volatility simply represents of the higher volatility that small stocks normally experience, and perhaps even too low to be fully representative of that difference. 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 has been inching up for weeks as the market increasingly looks to next quarter's earnings announcements as the next major expected driver of stock price movement. The VXV closed the week at 20.61%. 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 rose by 73 basis points to 61.01. The measure of expected correlation during the next year 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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