Shifting Sentiment
Morningstar Volatility Report for July 2, 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.
Shifting Sentiment
Attention continued to be focused on the global economy this week as indexes fell and uncertainty rose on increasingly negative investor sentiment. Market participants reacted to several releases of economic data in a way that suggests they are assessing a greater probability of downside risk to global economic recovery.
Monday's Commerce Department reports of increases in purchases and incomes of 20 basis points and 40 basis points respectively were in the ballpark of economists' expectations, and were shrugged off by the market, but the S&P 500 started on a 5% decline on Tuesday and Wednesday, thanks to disappointing news overseas. Monday night, China's leading economic index was revised to a 30 basis point increase in April, down from an originally reported 1.7 percent increase. This shift in perceptions about China's growth from robust to tepid led to a sell-off in global stock markets. U.S. markets reacted in sympathy on Tuesday's open, and retained the losses throughout the day. Wednesday's increasing uncertainty was driven by the ADP Employer Services report of a 13,000 gain in payrolls, far short of economists forecast of 60,000.
Thursday and Friday saw market volatility, but little final movement in index levels and a decline in uncertainty. Thursday's major news was an increase in initial jobless claims by 13,000 to 472,000 and a greater than expected drop in the Institute for Supply Management manufacturing index in June.
More job market news came on Friday as the Labor Department's figures showed June payrolls declined by a net 125,000 workers. 225,000 job losses were attributable to the government's laying off of temporary census workers; 100,000 jobs were created--83,000 of them in the private sector--leading to the net figure. While the numbers were slightly weaker than expected and the market shuddered through the day, a mild rally late in the day capped losses.
Given the noise in this quarter's economic activity (for example, the expiration of the home buyer tax credit and the completion of the 2010 U.S. census), the tendency for economic recoveries to display periodic "pauses" (as was mentioned by former Fed chairman Allen Greenspan in a television interview), and the continued increases in consumer incomes and purchases, we think present market uncertainty is higher than appropriate. As such, we believe the time is once again upon us to opportunistically sell overvalued downside volatility or buy upside exposure to the most undervalued companies.
The Numbers
The VIX index of S&P 500 implied volatility opened the week up 1.4 percentage points from the previous week's close of 28.5%, but began to climb on Tuesday's news and peaked on Thursday morning at 37.4%, before easing through Friday to close the week at 29.53, up just over 1 percentage point.
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 1.4 percentage points to a well elevated 8.0 percentage points, reflected rising concern that the macroeconomic issues facing the market are greater sources of uncertainty for small-cap stocks than for large-cap stocks, possibly indicating the resurgence of financing concerns for smaller companies.
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 rose by 1.1 percentage points following a decline the previous week. The spread between the VXV and the VIX is now a positive 3.3 percentage points. Given that second quarter earnings results should occur within the one month window covered by the VIX, the fact that the VXN is still higher and rising is difficult to interpret. S&P large-cap investors appear to be shifting their areas of concern further into the future than the earning results from this quarter, possibly meaning that economic data coming beyond the next month are the areas of concern.
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 opened the week at 71.3%, flat with the previous week, then spiked on Tuesday and Wednesday's news, before easing to 70.4%. We're surprised by this falling level of expected correlation, given the market's increased uncertainty regarding macroeconomic factors that should affect all companies. Overall, we continue to believe that the market's heightened state of alert and uncertainty is focused on 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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