First Quarter Ends…Volatility Remains High

Market performance for the first quarter of 2001 was disappointing (at best) to numbing (on the worst side). The Dow Jones Industrial Average (DJIA) realized its worst quarterly performance in 23 years, and was within points of the worst quarterly performance since 1960. The NASDAQ Composite Index (COMPQ) lost 22%, on top of the losses from last year. COMPQ is now down 62% from its all-time intra-day high.

Investors and traders remain concerned about the upcoming earnings reports. With the first reports now only a little more than a week away, hedging strategies appear to be favored, as noted by the increase in many of the put/call ratios.

Higher-than-average risk levels appear to be factored into the market. The implied volatility levels for many of the major benchmarks are remaining near their recent highs. Figure-I, shown below, illustrates that the implied volatility level for the Mini- NASDAQ-100 Index (MNX) is moving back towards its highs.

Figure-I: Mini-NASDAQ-100 Index (MNX) Daily Volatility Chart

Speculation Turns?
During the recent market decline, the put/call ratio for MNX was showing that speculators were very optimistic that the markets would have a sharp, short-term bounce. Call volume far exceeded put volume, even with the high premiums. Over the past week or so, the positive speculative bias has waned, evident by the declining number of calls traded.

Figure-II: Mini-NASDAQ-100 (MNX) - Daily Put/Call Ratio

One factor might be the anticipation that first quarter earnings reports will begin rolling in during the next 10 days. Other factors include continued announcements that companies are planning layoffs and/or plant closures, that the Fed will not intervene between two scheduled meetings, and that the world economy is slowing. Additionally, once again there is the assumption that gasoline prices will rise sharply during the summer driving season, pushing the price above the $2-per-gallon mark.

As in previous economic turns the consumer is expected to lead the economy out of recession. Lower interest rates and a cut in federal income taxes is supposed to give consumers the fuel to buy, buy, buy. However, if energy prices continue to rise and supply becomes short, and companies continue to reduce their workforces, consumer confidence will continue to drop while discretionary consumption wanes. This risk is partially quantified in the premiums of puts and calls, which are keeping implied volatility levels high.

Looking Forward
Evidence that the economic cycle is near a bottom should come forth soon. Stock prices typically bottom 3 to 6 months before the economy. However, the evidence that the market has set a bottom usually takes several weeks or months to be confirmed.

Pessimism is usually greatest at market bottoms. Most investors tend to become negative at the time that they sell their positions. Once these positions have been liquidated, negative pressure disburses, allowing prices to float higher as would-be bottom fishers begin to accumulate securities at depressed prices. This is something to watch for. If the economy is expected to bottom during or before the fourth quarter, stock prices should firmly bottom during the next month or so, based on historic market performance.

Take Advantage of High Premiums
Would-be stock buyers should consider the purchase of covered combinations or the writing of out-of-the-money puts as alternative strategies. This is only in the case where the investor is considering buying stock. If you are negative on the market, do not utilize bullish strategies, but instead consider the writing of out-of-the-money calls against long stock positions as a hedge against further market volatility. In the case where volatility levels are low, consider the purchase of at-the-money puts. Calculations and returns for the put writing, covered-call writing, and protective put strategies can be made using the worksheets available in The Strategist section.

For positions that are down 20% to 50%, the creation of a repair strategy is possible. This is an attractive alternative to buying additional shares and averaging down positions. For more information, please see the textbook Options: A Personal Seminar.

What to Watch For This Week
On Friday, the Department of Labor will release the Employment Situation Report for March. If the report shows evidence that the economy is growing or that average hourly earnings are growing too fast, selling pressure may push the benchmarks back toward their respective lows and raise volatility levels. Alternatively, a weak employment report would result in a continuation of the relief rally and probably an easing of implied volatility levels, neither of which would confirm that the much-anticipated bottom is in place.

Any further rise in prices or drop-off in volatility is unlikely to last for long as the stock market is more nervous about the potential for shocks and surprises resulting from corporate earnings announcements than it is about the overall level of economic activity. How the market reacts to these events in April, plus any last minute tax-related positioning, will give us a better idea of how close a bottom is at hand.