Weekly Chartology : "Investors Uncertain About Lower Uncertainty"

Many wonder why hedge funds underperformed the market as dramatically as they did in October: simple - few, if any, had any conviction in the rally, and only those with an already abysmal Sharpe ratio and a penchant for risky beta chasing threw themselves headfirst into the turbulent short-covering riptide. David Kostin summarizes it best with the title of his latest weekly chartology: "Investors uncertain about lower uncertainty." - and indeed they are, as intuitively all know that nothing has been fixed and the only reason the market lurches from one extreme to another is the fear that a career rally will leave many of them with no LPs, if only to be faced with even worse news tomorrow, and suffer an even greater loss to AUM. Which is why those that are outperforming the market to date have battered down the hatches and are enjoying the sluaghter from the sidelines, knowing full well they will be able to pick off stocks at Greece-like valuations. As for the others: all the best, as the volatility experienced in the past few days will certainly persist through year end: "Investors are generally skeptical about the pace and magnitude of the market recovery. We expect uncertainty and below-trend growth to persist..."

So what is trader with (other people's) cash to burn to do? "Uncertainty is reflected in elevated equity option implied volatility. The average 3-month implied volatility of S&P 500 stocks is 33%. That level is consistent with Spring 2010 when Europe risks first emerged and about one-third higher than July of this year. Elevated implied volatility reflects high realized stock moves and perceived future uncertainty but provides opportunity for equity investors to increase yield by selling options." 

Kostin on recent developments out of Europe:

Recent developments in Europe may have reduced the likelihood of severe downside policy scenarios while stable, albeit uninspiring, US economic data have lowered the odds of recession. A decline in equity implied volatility reflects that progress. However the prospects for abovetrend growth in both regions are bleak and policy risk is persistent with key events such as the US fiscal committee outcome on the horizon. Extremely high equity option skew highlights those risks.

On valuation:

Over the past month our uncertainty P/E estimate is up to 11.0x from 9.4x bottom-up consensus due to lower implied volatility. One-year implied variance has fallen by 8 points to 31 from 38 adding about two P/E points to our valuation estimate. Lower inflation expectations are also a mild  tailwind but largely offset by a slightly wider distribution of analyst estimates.


The shift in the P/E is similar in magnitude to changes in our uncertainty estimate, suggesting that the recent move higher has been driven more by sentiment than modest improvement in US growth data or 3Q11 earnings season. Admittedly sentiment is impacted by those factors. Our discounted cash flow, US output gap, and yield-based valuation approaches coalesce around a P/E level of about 13x implying a continued uncertainty discount despite some moderation.

And one way to take advantage of this situation:

Overwrite quality stocks: generate 1.9% yield over next 3 months while maintaining 10% upside. Along with our US Options team, we estimate that selling 3-month call options with a strike price 10% above the current share price on constituents of GSTHQUAL would generate an average premium of 1.9% in exchange for accepting the risk of selling those shares at the strike price during the next three months. That 3-month yield is equivalent to the estimated 1.9% current annual dividend yield on our equal weight basket. Call options on 15 of those stocks would generate more than 250 bp of premium yield each.


Covered call selling at the index level also remains attractive. The average large cap core mutual fund is down 1.7% in 2011. Selling a  3-month 10% out-of-the-money (1375 strike) S&P 500 call option generates an estimated 100 bp premium as does selling a 1325 strike call to year-end at mid-market listed prices. That yield could shift an “average” core mutual fund to the 61st percentile its peer group based on current performance.

Summarizing all this visually:

Full presentation:



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