Uncertainty and Schizophrenia
Morningstar Volatility Report for June 18, 2010.
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.
Sources of Uncertainty
For every option investment we make at Morningstar OptionInvestor, we strive to identify the "sources of uncertainty" of the underlying stock. The sources of uncertainty are the key identifiable variables that will drive the outcome of the investment. When a stock's value swings because of a source of uncertainty, the magnitude of the swing is a measure of the implied volatility that can attributed to that source of uncertainty. So, companies with lots of factors that can drive the value of the company up or down dramatically have higher uncertainty overall and should have options with high implied volatility.
For example, for OptionInvestor portfolio position in Apollo Group , the key sources of uncertainty are political action against the for profit education industry and any questions regarding the consistency and utility of the education provided to the students of Apollo's programs at University of Phoenix. Either source of uncertainty could drive dramatic swings in the value of the company, and therefore the implied volatility of the options is highly elevated.
Mr. Market's Schizophrenia
Legendary value investor Benjamin Graham describes in his classic book "The Intelligent Investor" a character called Mr. Market who is willing to buy or sell stocks at different prices each day depending on his whim. The online-user-defined encyclopedia Wikipedia states schizophrenia is a mental disorder characterized by abnormalities in the perception or expression of reality. Graham never formally diagnosed Mr. Market with schizophrenia, but I think he would agree that there is no better description of the flaws in Mr. Market's processing of information than the definition of schizophrenia.
Mr. Market typically, but not always, reacts to changes in the sources of uncertainty that are reasonably relevant to most of the companies in the market, and Mr. Market is usually directionally correct about how changing expectations for the sources of uncertainty should affect the value of the market. But Mr. Market is most schizophrenic about the magnitude of the impact of the changing expectations, or the value of the changes in uncertainty as reflected in the changes in the implied volatility of index options. There are also a near infinite number of sources of uncertainty that can have a material impact on the market as a whole. Because Mr. Market has limited ability to process information, sources of uncertainty tend to fall on the radar screen, and the magnitude of its reaction to those factors tends to vary widely.
The sources of uncertainty that drive the market are usually conceptual measures that are evaluated using a number of different data points. The concepts that were on the radar this week are "health of the consumer," "European debt contagion," and health of the global economy. Recent sources of uncertainty that have slipped off the radar for the moment are "health of the financial system" as measured by every legal hiccup at Goldman Sachs (GS). Let's walk through the details of this week's sources of uncertainty.
The Numbers
The VIX index of S&P implied volatility opened the week flat with the previous week's close of 28.77 after strong European industrial data reports and slid before a Moody's Investors Service downgrade of the credit rating of Greece to junk status, which brought the European debt contagion source of uncertainty into focus, driving the VIX up to the close.
Markets rose Tuesday, and the VIX eased as a rising financial sector was attributed to a strong IPO performance by futures and options exchange CBOE Holdings, while the expiration of a first-time home-buyer tax credit allowed Mr. Market to ignore a decline in the National Association of Home Builders residential builder's sentiment index from 22 to 17. A decline in consumer defaults in May, also reduced uncertainty about both the health of the consumer and the health of the financial system. The perceived health of the consumer was further boosted after two large semiconductor producers pointed to growing global demand.
The VIX remained flat Wednesday and Thursday as a decline in housing starts and an increase in jobless claims failed to raise broad market concerns, but concern over the health of the consumer did increase as a the jobless claims caused a decline in retail stocks. The Federal Reserve Bank of Philadelphia said on Thursday that manufacturing activity in June increased at a much slower pace than May, which also failed to raise concerns.
On Friday, former Federal Reserve chairman Alan Greenspan said the U.S. may soon face higher borrowing costs as the level of the deficit may raise concerns regarding the riskiness of U.S. debt, but the S&P 500 remained flat for the day, and the VIX declined, closing at 23.91.
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 up slightly at an elevated 8.4 percentage points, confirming that investors remain increasingly concerned that the macroeconomic issues facing the market are a greater sources of uncertainty for small-cap stocks than for large-cap 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 by another 1.8 percentage points following a 3 percentage point increase a week earlier. The spread between the VXV and the VIX is now a positive 4 percentage points, indicating that S&P large-cap investors are becoming more conscious of the uncertainty surrounding earnings in the upcoming announcement season than present macroeconomic uncertainties.
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. Implied correlations edged down 2.5 percentage points, further down from elevated levels to end the week at 68.2%. The failure of the correlation index to fall significantly, taken in conjunction with the failure of the small-stock uncertainty spread to close, indicates that the market is focusing on macroeconomic sources of uncertainty over and above stock-specific concerns. Overall, the market is continuing to perceive an elevated level of uncertainty regarding the health of the consumer and the global economy.
Philip Guziec is co-editor 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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