Krag Gregory's derivative trading desk has had its share of success over the past several years which is why we present the latest compilation packet by the Goldman Derivative traders. While it is not surprising that this particular silo of Goldman is alligned with the prevalent theme at GS, which is S&P500 at 1,500 or bust, which obviously would imply ongoing declines in vol (with or without the assistance of the Fed), there are some obseravtions that deserve to be highlighted...
First, here are the top trading themes in the current edition:
#1 Tablets drive change in the PC landscape: Buy calls on likely winners as investors evaluate 10 tablet launches in 2011; sell calls on traditional PC exposed names.
#2 Consumer buy-writes are attractive: Our analysis shows consumer stocks tend to rise but lag the broad market at this phase in the cycle.
#3 Energy calls are inexpensive relative to upside volatility potential; we identify the top nine call buying opportunities based on price targets, earnings growth, and multiple expansion potential.
#4 M&A: We identify options trades on 7 stocks to benefit from potential deal announcements
This is great, although we will pass. Instead we focus on two neutral themes which actually are based on facts, not opinions. First, from "Cross-asset indicators for equity portfolio managers"
We track the movements in S&P 500 equity, implied volatility, and CDS spreads to identify market divergences. We investigate these divergences with the goal of deciding which market has an information edge that could cause the other asset classes to follow. We use several statistical methods to understand the short-term and long-term divergences between these three asset classes, including analyzing returns over short periods, log levels over long periods of time, and techniques which integrate both short- and long-term components such as Vector Error Correction models (VECM). Our current observations:
(1) Derivatives markets suggest moderate risk for equity. Over the past month, the relationship between credit, equity and volatility has been stable. The 5% rise in the S&P 500 has been accompanied by a 3% decline in 5 year CDS spreads (bullish), and a 19% decline in 6 month implied volatility (bullish). Based on the relationship between these metrics over the past eight years, equity appears to have traded in-line with the derivatives markets since 17-March. Based on divergences earlier in the year, S&P 500 equity appears to be modestly above where these metrics would suggest.
(2) Financials equity has underperformed moves in CDS and options over the past month. CDS spreads of financials in the XLF have tightened by 4% in the past month and options implied volatility has declined by 14%. The sharp decline in financials implied volatility benefited last month’s top theme #4, where we advocated selling Financials volatility. Based on past relationships, we would have expected XLF equity to rise 10%, but it declined 1%. These moves resulted in the “upside to Financials” moving from +12% to +23% over the period. Many investors have argued that the increased capital requirements and regulation should cause Financials bonds to outperform equity. While we generally agree, this sentiment has been discussed for the past two years. We believe the speed of the divergence over the past month is notable and is bullish for financials equity. We continue to recommend selling BAC and JPM Jan-2013 strangles to benefit from further implied volatility relaxation.
Below, we show the “upside to model price” for each of the major S&P sector based on a log-level regression from 2003 to 2009. Again, while we do not place huge stock in the absolute over/undervaluation shown for each S&P sector, we believe this is a reasonable way to track moves over time.
(3) Investors expect lower volatility for Financials. Seven of the top 10 volatility decliners were in the financials sector (AXP, PNC, COF, EV, BAC, BEN, and WFC).
And the next topic of note is something we have touched upon before: Skew.
While the volatility priced into index options is moderate relative to history, the downside skew to that volatility remains elevated. Options continue to price in higher potential for a sharp down-move than a sharp up-move. Investors interested in hedging at these levels are likely to find put spreads more attractive than normal for the SPX and single stocks with high skew. S&P 500 normalized skew at the index level is above average over the past ten years.
Consumer Staples and Technology have the highest normalized skew of the 9 major sector ETF’s. CDS spreads are also elevated in these sectors as investors see the potential for M&A to drive increased leverage and risk in these sectors. Highlighted single stocks with unusually high skew include PM, KO, PEP (Staples), NSM, NFLX, ORCL, IBM (Technology).
Financials and Utilities have the lowest skew as investors see downside risk as less likely than normal. For Utilities, a recent rise in call premiums has been a contributor to the drop in normalized skew. Highlighted single stocks with low skew are BAC (Financials) and PGN (Utilities).
Full report for the options mavens below: