They Just Don't ScareBy Scott "The Strategist" Fullman
July 30, 2001
Stocks remained in a narrow trading range during July as investors and traders took the opportunity to vacation. The market benchmarks, which rose and fell by significant amounts on certain days, tended to correct those movements. Reports that the U.S. economy continues to slow and of declining earnings results were not enough to turn the market sharply lower.
Economic growth continues to slow, with the preliminary reading of Gross Domestic Product (GDP) for the second quarter reported at 0.7%. GDP readings for 2000 were also revised lower, indicating that the drop in the growth rate was more significant than originally registered. Economists are still debating when the actions of the Fed and tax breaks for consumers will ignite stimulation for the economy.
Almost 80% of the companies in the S&P 500 Index (SPX) have reported their second quarter (or appropriate fiscal quarter) results, with a fair number of disappointments, despite the number of warnings that were issued. Additionally, many of these companies have warned that they do not expect a turnaround for the third quarter, and may not see a pickup in activity until next year.
VOLATILITY LEVELS REMAIN LOW
Negative comments and forecasts, sharp price swings, and lower volume numbers have not been enough to raise the implied volatility readings for the major market benchmarks. For example, the implied volatility level for the Index on the Dow Jones Industrial Average (CBOE - DJX) is at 18.77%, far below the 30.74% registered on April 5. The IV for the Mini-NASDAQ 100 Index (CBOE - MNX) currently reads near 43%, far below the 73% logged on December 20 and not much above the 37.6% reading on June 29. As we noted two weeks ago, lower volatility levels are to be expected, given the decline in interest rates, but not to the extent that we have seen. Therefore, it might be concluded that option traders have left the markets, or that there is no reason to be concerned.
Figure I - Implied Volatility Index and 30-day Historical Volatility on the Mini-NASDAQ-100 Index (MNX).
As contrarians, we note that, when others are not concerned, it is time to get concerned. Complacency is a characteristic that is best not ignored. When volatility levels decline, too many people are either too optimistic, too understanding, or too out of touch. While this may not be the case 100% of the time, strategists have noted a high correlation between low volatility, lack of fear, and the potential for downward pressure.
Another negative factor about low levels of volatility is that while the markets may not move down quickly or even much further, there might be a long period of consolidation that could keep prices depressed for a period of time. As a result, the low levels of implied volatility may be caused by an expectation that the markets are not going to do much over the next several weeks; therefore, investors and traders are remaining on the sidelines, soaking up the sun, and enjoying the summer on the beach instead of in the trading rooms. Whatever the reasons, we will not know the impact of these lower volatility levels until after a decisive movement has been made by the markets.
PUT/CALL RATIOS CONFIRM COMPLACENCY
The volume of puts traded compared to the volume of calls traded confirms the higher level of complacency. The put/call ratios for some of the important benchmarks that we follow remain on the low side. This indicates that speculators believe that the markets will have a significant appreciation over the near-term. These speculators generally make short-term trades with the goal of making quick profits. The problem is that they are generally on the wrong side of the market and tend to reverse their outlooks frequently.
All of this points to one fact: Traders, speculators, and short-term investors are not scared enough to believe that the markets are going to move lower. As a result, there is less hedging activity and more have a wait-and-see attitude.
Lower interest rates by the Fed have not provided a great deal of positive impact for the U.S. economy. We have now passed the six-month point from the Fed's first easing, and with 5 additional actions, there has been little evidence that economic activity is beginning to expand.
The federal government has started mailing rebate checks to taxpayers. Additionally, tax-withholding levels have dropped, putting more money in the hands of consumers. Since this action only began a few weeks ago it is hard to determine what impact it is having on the economy and consumer spending.
Another positive factor has been a decline in crude oil and gasoline prices. Forecasts of $3 per gallon gasoline for the summer have turned into a drop in actual prices toward $1.50 per gallon.
As we end the month of July it is important to be reminded of all of the crosscurrents being presented in the markets. The most important point to remember is that trends tend to continue until clear signs of reversal emerge.
Low implied volatility levels, a result of low option premiums, makes the use of protective puts a prudent strategy at this time. Risks remain high and, while most analysts anticipate a positive change before the end of the year, the use of defensive strategies and hedged positions can be beneficial.
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