Today’s themes –Volatility, S&P 500 index, VIX, Eurodollars, Dollar index, Euro currency and Altria options
Seeking Volatility
It’s hard to imagine a more volatile set of circumstances. Curiously, we note two strange events in this weekly issue. The first is the fact that, unlike the last several public holidays in the United States, the Martin Luther King Day observation was marked by a strong dollar rally. Not that international investors need to wait until America is sleeping to plunder the dollar, but we find the dollar’s latest rise fascinating given the Asian meltdown for equity markets on Monday. Second is the fact that global markets fell in isolation of the American markets. In other words, there was no catalyst from the close on Friday last week, no weekend news that triggered the sharp falls on Monday.
When the S&P 500 index closed at 1325 last Friday the CBOE VIX index actually declined on the day to close at 27.57. That was hardly predictive of Monday’s global market liquidation. But to put this better in perspective, the worries that Wall Street has shouldered recently have become more apparent to the outside world. As such, mounting recessionary fears have translated into that valuable discounting mechanism, which manifests itself in a market crash. Value is thrown out the window at such times, leading to high-volume decision days when the market changes shape. The question now is whether the selling pressure that swirled around the world before lapping back up on American shores will be marked by such capitulation. Here’s the latest view of the S&P plunge.
Chart: InteractiveBrokers
Yesterday we noted to CNBC viewers that current implied volatility only afforded investor protection should the S&P 500 index sink below 1182. When markets opened Monday, despite the prior slash in interest rates from the Fed, the VIX spiked sharply higher. It wouldn’t be capitulation without such a spike, though, would it? The index shot up to briefly take out the August peak at 37.50 by just a whisker before succumbing to selling pressure. Having said that, buyers need to beware what they are letting themselves in for. With the S&P trading at 1300, a reading of 31.25 on the VIX implies potential 30-day fallout of a 9% magnitude, which is still down to 1183. Makes us think that it’s a little late to start thinking about protection.
Financial stocks took heart from the Fed’s action on Tuesday. Again we watched with curiosity as implied volatility continued to rise. Today, however, the financials are spearheading a direct challenge against an early 3% decline on the session. While volatility abounds, it will be no surprise to see a positive close to the session sometime soon. The Financial Select Sector SPDR (XLF) is already higher by 2.2% on the day with implied volatility dropping 3.8% to stand at 45.7%
Eurodollars
The reason that financials have turned around is primarily thanks to the Fed. The XLF has already dropped by more than 38% and it’s hard to see much more bloodletting in the form of write-downs this quarter. While this alone is hardly a rationale for buying bank stocks, the Fed is clearly hell-bent on ensuring that credit reaches parts of the economy, whatever the cost.
For some fast and furious action, take a peek at the March 2008 Eurodollar future below. It’s taken three months to travel exactly 1%, which for Eurodollars is a huge move. Drastic times make for drastic measures. What is of interest to us here is how the curve has shifted. Several weeks ago, we noted in this column how interest rate traders were looking for a decent shift in official rates to the downside, but their expectation languished into 2008.
As has just been shown at the Fed, the need to move is a top priority and the Fed won’t stop in a hurry if it’s got a target in mind. To our minds, at least this means that the extreme front of the curve will be the biggest beneficiary of rate cuts and that the market will begin to discount an end to the easing process. The yield curve already became a lot less inverted on Tuesday. Today as the market reflects further, the far-dated contracts continue to underperform front months. At current prices, the March future is predicting two more quarter point rate cuts from the Fed. Who can blame this hardly irrational exuberance?
Chart: InteractiveBrokers
The U.S. dollar
As risk becomes less and less attractive around the globe, there are a couple of intriguing outcomes. First, the carry-trade candidates of the yen and Swiss francs are hurtling higher. We can almost hear forex traders abandoning their short positions with a quick “thanks for the loan” note to the bank tellers in Tokyo and Zurich. So fast is this repatriation of short positioning that it appears that traders almost anticipate that those tellers are about to draw down the green blind over their booth saying “Closed. Please use next window.”
The second observation that we note lies in the strength of the greenback. That comes despite the fact that the dollar is more than ever at the epicenter of this financial earthquake. It also comes despite comments earlier in a speech from George Soros delivered at Davos, Switzerland. There he decried the dollar and predicted that this multi-decade-long binge on easy credit would mark the death knell for the dollar and in particular its role as a reserve currency. But right now, investors aren’t falling over one another to sell the dollar in the same way that they are indiscriminately dumping equities.
Chart: InteractiveBrokers
It’s been interesting over the last several weeks listening to dollar bears bark about the likely decline of the dollar due to a loss of yield brought about by lower interest rates. At the same time, interest rate futures markets have been predicting such a slide in official rates, implicitly undermining that view. And when all is said and done, only when lower interest rates bite and perhaps when the fiscal cake is baked, will the economy improve. We’d actually make the case that the longer yields remain high, the less likely is a recovery for the economy. And therefore the delivery of rate cuts is actually beneficial to the dollar, especially now that given that contagion smacks of a global slowdown. That also should boost the dollar’s value since it could emerge fastest from recession.
Chart: InteractiveBrokers
The value of the largest weighting in the dollar index belongs to the single European currency. It’s at the very least odd that the euro was unable to print a fresh high in January as the dollar dropped sharply to start the year. Now, however, investors are backing away from the euro thanks to the emergence of a conflicting storyline from both the European Central Bank and courtesy of economic data depicting activity that is a far cry from boom time.
The ECB is behind the eight ball in worrying about inflation. In case they haven’t noticed yet, the price of crude oil has just recoiled around 13% in 2008. Energy prices are the root of modern day inflation. Activity and confidence measures in Europe are waning and that doesn’t make us want to predict fresh highs for the currency. But looking ahead the ECB may yet be forced to drop the inflation argument in exchange for growth worries. That would narrow the yield spread between it and the dollar and the tardiness of the ECB would almost guarantee that the Euro zone would emerge after the United States does from any recession.
U.S. equity options movers – Altria Corp. (MO)
What about “Cokes and Smokes?” Shares in Altria, the holding company behind Philip Morris tobacco, continues to slide Wednesday having closed 2.7% lower on Tuesday. Today its shares are at $71.75. Despite a great deal of favor from analysts and pundits favoring the defensive posture of tobacco-related stocks, the picture continues to worsen in the chart.
Chart: InteractiveBrokers
Our attentions were captured, however, by a widening disparity between its 19.0% historic volatility reading, and the 33.4% implied reading weighing in at 1.8 times the latter gauge. This is the widest spread between historic and implied volatility in our records, and indicates option prices currently factoring in about 65% more price risk for Altria shares than they have shown historically. Also noteworthy was the degree of buying interest we saw in March 70 puts, which traded for $2.00 on Tuesday – a 53% higher price than Friday. A buyer of this contract secures the right to sell Altria shares for $70 in March but needs to see a decline below $68 before the position becomes profitable. This means 7% more downside from current levels. In today’s session, these same puts have ramped up by a further 34% in price.
We wonder what the reason is for such a slide in the share price, but the options activity smacks of a larger pending move. We wonder whether investors are positioning for some rotation out of staple stocks at a market bottom in favor of another sector. Time will tell.
Andrew Wilkinson and Rebecca Engmann Darst
ibanalyst@interactivebrokers.com
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