Losing Confidence
Morningstar Volatility Report for July 16, 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.
Building Anxiety
Early in the week Alcoa and Intel (INTC) reported strong earnings, and Spain conducted a successful debt auction which eased concerns regarding the European debt crisis. This news, on a light volume week when many financial professionals are on vacation, led to a risking market early in the week, and easing uncertainty. However, on Wednesday, the U.S. Federal Reserve Bank reported that it saw no need for additional stimulus, but lowered it's growth outlook for the year from the 3.2% to 3.7% range down to 3.0% to 3.5%; this was enough to stop the market's advance.
Thursday's results from J.P. Morgan Chase (JPM) came in ahead of expectations on reduced provisions for bad loans, and strong investment banking revenue, and initial jobless claims for the week declined by a more than expected 29,000 to 429,000, the lowest level since mid 2008, but the New York Fed's Empire State Index of manufacturing growth Fell to 5.1 in July, a low for the year. The Empire State data, combined with a report showing slowing economic growth in China contributed to a weakening stock market.
Friday turned ugly as Bank of America (BAC) reported weaker than expected earnings and the Thompson Reuters/University of Michigan index of consumer sentiment for June fell to 66.5, well below the forecasted range. The loss of consumer confidence suddenly increased concerns about the health of the consumer, leading to a market sell-off to a slight loss for the week on greatly increased uncertainty about the U.S. economic recovery.
The Numbers
The VIX index of S&P 500 implied volatility eased through the market rise on Tuesday, then rose throughout the rest of the week to close at 27%, below the week's high on of 28% on Friday morning, but up 2 percentage points on the week.
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 1.2 percentage points. The spread is now a very elevated 10 percentage points, indicating that rising concern about macroeconomic issues facing the market are greater sources of uncertainty for small-cap stocks than for large-cap stocks. The spread can be attributed to either of increased concerns about the availability of financing or greater impact of a slowing economy on small-cap stocks, both indicating increasing expectations for the magnitude of movement of the Russell 2000 index relative to the S&P 500 index.
Uncertainty About Next Quarter vs. This Quarter
As we enter the first week of first quarter corporate earnings season, 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 percentage point following a slight rise the previous week. The spread between the VXV and the VIX is now a positive 4.1 percentage points. As we enter second-quarter earnings, it remains interesting that VXV remains higher than the VIX, suggesting that the market is already looking past this quarter's results for sources of uncertainty for the market. We think that the market is more concerned about large potential swings in economic numbers in the coming months than current earnings results.
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 continue to rise and fall in unison with the VIX, suggesting macro concerns that affect all companies are a greater focus of the market's concerns. Implied correlation peaked for the week on Friday morning at 79%, and closed at 76.4%, up 7.8 percentage points. This measure, in concert with the increasing long term focus of the option market and the heightened cost of small stock uncertainty relative to large stocks confirm a continued heightened state of alert and uncertainty in the market with a focus 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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