Data Points Appear to Be Cancelling Each Other Out
Morningstar Volatility Report for July 30, 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.
A Flat but Noisy Week
Mr. Market danced a little jig while staying in one place this week. Both the level of the market and market uncertainty ended the week about where they started, despite largely positive earnings but noisy macroeconomic news flow. It appears that Mr. Market was pushed from both sides equally, stumbling up in response to one blow only to stumble down in response to another. On balance, earnings reports show strong profit growth for the second quarter from both revenue-boosting and cost-cutting; at the same time, economic data show slowing growth, raising concerns about the future.
Earnings reports Monday largely brought no material news, and the market rose 1% while uncertainty eased.
Tuesday brought conflicting economic data with the Conference Board's confidence index falling to 50.4 from a revised 54.3 in June, lower than a forecast 51, while the S&P/Case-Shiller index of property values rose 4.6% from May 2006 vs. a forecast 3.9% rise. Ford Motor (F) also reported positive earnings but lowered its U.S. vehicle forecast to 11.5 million-12 million from 11.5 million-12.5 million. On the bright side, even the reduced projection is still well above last year's 10.4 million vehicles. Finally, FedEx (FDX) reported stronger-than-expected shipping volumes in the second quarter, a sign of increasing economic activity. The combined effects almost completely canceled each other out, and uncertainty moved sideways from Monday's close.
On Wednesday, the Fed's beige book reported that economic activity has continued to increase but growth has slowed during the past two months, with positive growth in nonmilitary capital goods, excluding aircraft. The measure was up 0.6% in June, less than the 1% forecast by economists, following a corrected 4.6% jump in May. Uncertainty rose on a market decline of 0.7%.
Thursday's report that jobless claims in the U.S. declined to 457,000 the previous week, which was down 11,000 from a revised 468,000 but in line with median forecasts of 460,000. The VIX uncertainty gauge opened lower than the previous close, spiked midday, then eased to close down slightly from the previous day. The equity market also closed slightly below the previous day, possibly in anticipation of weak gross domestic product data, which did in fact appear on Friday.
Uncertainty spiked, and the market gapped down 1% at Friday's open on a slowdown to 2.4% GDP growth in the second quarter, less than a forecast 2.6% but on the heels of an upwardly revised 3.7% growth rate in the first quarter. Despite the weakness, uncertainty eased, and the market rose at the close to almost erase losses for the week with almost flat uncertainty from the previous week's close.
The Numbers
The VIX index of S&P 500 implied volatility swung to a low for the week on Tuesday's open at 22.3% to a high for the week of 25.45 midday Wednesday, then closed the week at 23.5%, down just 0.2 percentage points.
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 just 0.3 percentage points. The spread is now 8.6 percentage points, still indicating that macroeconomic or financing issues facing the market are viewed as much greater sources of uncertainty for small-cap stocks than for large-cap stocks.
Uncertainty About Next Quarter vs. This Quarter
As we roll through second-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 fell by 40 basis points, continuing an easing trend through earnings season. We think the market is now looking to both economic data and next earnings season for additional information on the path of the economy. The spread between the VXV and the VIX is now a positive 3.1 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. Implied correlations continue to rise and fall in unison with the VIX, suggesting that, despite the market digesting information from individual earnings reports, it is using this information to evaluate uncertainty around macroeconomic concerns that affect all companies.
Implied correlation peaked for the week on midday Thursday and again Friday morning at 77%, just below the previous week's peak, and closed at 74%, flat from the previous week's close.
Despite low realized volatility for the week, based on these measures, we continue to think the market is far more concerned about macroeconomic issues and the strength of the economic recovery in the U.S. than any company specific issues.
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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