Looking for Good Data, but Not Too Good

The markets remain focused on macroeconomic data, which continued to come in mixed. However, the market seems to be hoping that macroeconomic and earnings data will be bad enough that the Federal Reserve will engage in a previously discussed second round of quantitative easing, but not bad enough to engender fears of a second recession. Our dither signal analogy continues to fit the economic data, which floated in mixed. The market also remained subdued this week in anticipation of the wave of material information that will come from third-quarter earnings results season, which kicked off after the close on Thursday.

The News

On Monday, the Commerce Department reported that nonmilitary capital goods orders rose by 5.1% in August and National Association of Realtors reports that pending home sales rose by 4.3%, ahead of expectations. However, brokerage rating cuts for Microsoft (MSFT) and Alcoa (AA) drove large-cap stock levels down less than a percent for the day, and uncertainty rose through midday before falling to close to flat.

Tuesday brought two pieces of material news, both of which were viewed positively by the markets. The Bank of Japan said that it would keep its benchmark interest rate at "virtually zero" until deflation has ended, and the Institute for Supply Management index of nonmanufacturing businesses rose to 53.2 from 51.5 in August. The news buoyed markets 2 percentage points and reduced uncertainty by 2 percentage points.

Uncertainty and market levels then moved sideways at stable levels for the next two days, despite some news flow. On Wednesday, Automated Data Processing's (ADP) advance employment report showed a 39,000 decrease in employment, less than a forecast 20,000 gain, but the small values of change and unreliability of this report allow the market to shrug off the bad news.

New jobless claims for the previous week fell by 11,000 on Thursday according the Labor Department, and job openings rose by 60,000, but the market elicited little reaction. American Airlines also announced it will be recalling furloughed flight attendants, and a number of retailers reported material same-store sales growth for the previous month, also without reaction.

The labor department employment report on Friday came in at a drop of 95,000 in payrolls, worst than forecasts of a 5,000 drop, but much of the decline was in government jobs, which was attributed to a drop in census workers and other municipal layoffs. Private-sector payrolls rose by 64,000, also less than forecasts. Also, Alcoa's earnings report after the close Thursday beat expectations, and the company issued a bullish forecast. By being mediocre enough to convince markets that the Federal Reserve will engage in a second round of quantitative easing while not being bad enough to revise fears of a double dip in the economy, this cocktail of news lowered uncertainty by almost a percentage point, and raised large-cap market levels by 60 basis points for the day.

The Numbers

The S&P 500 index of large-cap stock price levels ended up 1.8% from the previous week's close at 1,165, and uncertainty closed 2.1 percentage points lower at 22.50.

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 rose a hair from 8.0 percentage points to 8.1 percentage points. We believe that this level of increased uncertainty regarding small stocks continues to reflect the greater concern about the domestic economy and financing availability, both of which disproportionately affect small stocks.

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 increased by 10 basis points to 3.3 percentage points, indicating that the market is looking into the future for sources of uncertainty past this earnings season, which will be predominantly complete during the 30 days of tenor spanned by the VIX.

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 fell materially this week, from 70.5% to 64.9%. Expected correlations have been at unusually high levels, and we believe this decline may reflect realization that company performance may differ materially across companies during this earnings season.

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About the Author: Philip Guziec, CFA, is Morningstar's derivatives investing strategist. He leads Morningstar's Option Investor service, which applies Morningstar's fundamental research methodology and fair value estimates on 2,000 stocks to uncover option investing opportunities. Guziec joined Morningstar in 2003 after a career as an engineer and management consultant. 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.

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