Giddiness Over a Live Consumer
Morningstar Volatility Report for July 9, 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.
Giddiness Over a Live Consumer
This was one of those summer weeks when vacations make for light volumes, and little news flows while the market awaits earnings results. Most of the rise in market value and decline in market uncertainty for this week can be attributed to signs of life from the U.S. consumer, with a little help from a bank's optimistic comments.
On the Tuesday after the holiday weekend, the Institute for Supply Management's index of nonmanufacturing businesses fell to 53.8 in June from 55.4 in May, short of the forecast of 55, which damped an early rise in the market. The market's sighting of a living, breathing consumer occurred on Wednesday with the report of a 4% rate of growth in retail sales by the International Council of Shopping Centers, and also a report by the American Banker's Association of a drop in bank card delinquencies to the lowest rate since 2002. The sighting put a tailwind behind retail and banking shares, driving the Standard and Poor's 500 up about 4% while causing a concomitant drop in market uncertainty.
The market eased through the day on Thursday, despite an increase in the IMF's forecast for worldwide growth, a drop in apartment vacancies in the U.S. in June, and a report by the Labor Department that the number of Americans applying for jobless benefits fell more than estimated for the week ending July 3. A same-store sales report from Costco (COST) drove a rise in retailers into the close. Friday saw little news, but there was still a late-day rally and decline in uncertainty that was broadly attributed to rising expectations for the coming quarterly earnings reports.
The Numbers
The VIX index of S&P 500 implied volatility rose through the day to peak at 30.9% just before the close on Tuesday, the first day of the shortened trading week. The value then drifted down through the week to close 4.6 percentage points below last week's close at 24.9%.
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 0.8 percentage points at a continued elevated 8.8 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, and an increasing magnitude of movement of the Russell 2000 index relative to the S&P 500 index, possibly indicating the rise and fall of financing concerns for smaller companies with changes in economic and financial expectations.
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 fell slightly by 0.2 percentage points following a rise the previous week. The spread between the VXV and the VIX is now a positive 3.1 percentage points. With second-quarter earnings just around the corner, it remains interesting that VXV remains higher than the VIX, suggesting that the market is already looking past next quarter for sources of uncertainty for the market.
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 rose and fell through the week in unison with the VIX, suggesting that macro concerns that affected all stocks were waxing and waning. Implied correlation peaked for the week at the close on Tuesday at 75%, before easing through the week to near it's opening level of 68.6%. 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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