Morningstar Volatility Report for April 9, 2010
A happy brew.
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 market prices, as reflected in implied volatility in the options market.
Continued Complacency
Last week I discussed how current market conditions felt like implied volatility was falling to zero. This week, it feels like implied volatility is bouncing along the bottom while slowly sinking into the mud. The equity markets continue to turn in gains of about a percent a week, and the VIX has settled at around 16%, implying that stable and rising markets are viewed as an ever more normal condition. As economic and interest rate data come out, the market is becoming addicted to a happy brew of continued low interest rates and a recovering economy driven by increasing consumer spending. Any data that deviates from this happy brew, however, generates blips in market values and implied volatility. As Morningstar's bottoms-up estimate of fair value for the S&P 500 currently hovers around 1,250, our analysts generally agree with the market's assessment. The markets for mortgages and commodities also agree with the equity market, climbing noticeably this week.
The Declining Numbers
As I write the first sentence of this section, I'm beginning to feel like Bill Murray in the movie Groundhog Day, reliving the same day over and over. The bull market continued its seemingly inexorable climb, with the S&P 500 chalking up yet another 1% gain, with a midweek blip down to a tiny loss. The Russell 2000 was up just over 2% for the week, compensating for last week's decline relative to the S&P 500, and reversing a trend of divergence between the two measures. The trailing-one-month realized volatility of the S&P 500 Index fell slightly further below 8%, which should keep exerting a downward pull on implied volatility.
The VIX index of one-month volatility on the S&P 500 eased through the week from last week's close at 17.62% to close the week at 16.21%, down 141 basis points. There was a brief jump in uncertainty on Monday resulting from a decreased consumer credit number on Friday, but the Monday VIX high of 18.92% fell off as rising employment and increased March same-store sales estimates continued to confirm a recovering consumer. The Fed suggested it plans to continue leaving rates low on Tuesday, further placating the market.
Concern over a default by the Greek government reared its head again on Wednesday, but by the end of the week, the European Union announced a support plan, curbing those fears. Increases in energy and commodity shares in response to increased demand also buoyed stocks and were consistent with reduced market uncertainty about a recovery.
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 4.88, losing about 40 basis points for the second week in a row, but still elevated relative to recent norms.
The reconvergence between small- and large-stock movements could represent a relaxation about concerns about the quality and stability of earnings of smaller companies. The spread between the uncertainty regarding the short-term share price of small stocks versus that of large stocks had fallen from a high of more than 12 percentage points last April 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 is now looking to next quarter's earnings announcements as the next major expected driver of stock price movement, and remains stable around 2.5 percentage points.
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 5 percentage points this week, after months of stability near 60%, to 55.89%, signaling a large decrease in broad market concerns relative to stock-specific concerns, confirming the continued acceptance of a general economic recovery and a bailout for Greece.
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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