Correlation Bets Climbing as Europe Overwhelms Earnings: Options

AppId is over the quota
AppId is over the quota
September 16, 2011, 4:30 AM EDT By Jeff Kearns and Cecile Vannucci

Sept. 16 (Bloomberg) -- U.S. options traders see almost no chance that earnings, dividends or buybacks will influence stock prices through the end of 2011, instead placing record bets that equities move in lockstep in reaction to Europe’s debt crisis.

The Chicago Board Options Exchange S&P 500 Implied Correlation Index jumped 34 percent since the end of July to 79.31 yesterday, and reached 81.52 on Sept. 14, the highest level ever. The gauge uses options to measure expectations for how much Standard & Poor’s 500 Index shares will move together.

Traders are speculating correlation among equities, already the highest since the crash of 1987, will increase as the threat of a banking crisis in Europe drowns out news about individual companies. Equity prices moving in unison have hurt returns for money managers who seek relative value among stocks and industries, leaving hedge fund managers with fewer ways to beat their benchmark measures.

“Europe is a big macro issue and it’s so pervasive that at the top of investors’ minds, there’s nothing to do with individual companies,” Scott Billeadeau, who helps oversee about $17 billion at Fifth Third Asset Management in Minneapolis, said in a telephone interview. “There’s been no individual stock selection going on,” he said. “I’m just buying stocks or I’m selling stocks, versus buying IBM and selling Hewlett-Packard.”

20% Plunge

Stock prices for S&P 500 companies are moving in lockstep more than any time since 1987, when the index posted a record 20 percent slump on Oct. 19, according to data compiled by New York-based JPMorgan Chase & Co. The Hedge Fund Research Equity Hedge Index posted a 5.64 percent loss in August, beating the benchmark measure for U.S. stocks by 0.04 percentage point. That’s the smallest difference in returns since January 1998.

The VIX fell 7.6 percent to 31.97 yesterday, versus an average level of 20.42 in its 21-year history. It reached a 29- month high of 48 on Aug. 8, when it jumped by 50 percent, the most since February 2007. The gauge posts its biggest two-month swings in September and October, moving an average of 26 percent, according to data compiled by Bloomberg.

The VStoxx Index, which measures the cost of options protecting against losses on the Euro Stoxx 50 Index, climbed to 53.55 on Sept. 12, its highest level since January 2009. It gained 1.6 percent to 42.94 at 10:04 a.m. in Frankfurt.

Speculation about Europe’s debt crisis and the prospects for the global economy is sending stocks up and down in unison. There have been 39 days in which 400 or more stocks in the S&P 500 moved in the same direction this year, data compiled by Bloomberg show. Should the rate persist, it will happen 55 times in 2011, beating the record 52 in 2008.

Default Odds

Investors saw an almost 100 percent chance this week that Greece will fail to pay its debt within the next five years, according to credit-default swap prices compiled by CMA. Officials in German Chancellor Angela Merkel’s government are debating how to protect the nation’s banks if Greece defaults, three coalition members said Sept. 9. The same day, Juergen Stark resigned from the European Central Bank board, spurring concern leaders disagreed on how to contain the crisis.

“Fear drives correlations,” Christian Wagner, who oversees $200 million in assets including options as chief investment officer of Longview Capital Management LLC in Wilmington, Delaware, said in a telephone interview yesterday. “There are so many different macro events that could trigger a major selloff, so we are teetering on the next news item, and that’s been the greatest driver. It makes it harder to invest with conviction.”

Ackman Buys Options

The lockstep moves have sent some investors to new areas as they seek market-beating returns. Pershing Square Capital Management LP’s William Ackman, known for investing in companies he believes are undervalued, said this week that he bought options on Hong Kong’s currency, betting the government will let it appreciate against the U.S. dollar.

“It’s frustrating to investors because it used to be you could sell growth stocks to buy Johnson & Johnson, Coca-Cola, McDonald’s or other defensive names to make money in a recession,” Randall Warren, who oversees $75 million including options as chief investment officer of Warren Financial Services & Associates Inc. in Exton, Pennsylvania, said yesterday in a telephone interview. “With everything highly correlated, you can’t because they’re all moving in the same direction as the market.”

Investors will turn their attention back to dividends, buybacks and speculation about takeovers, said Malcolm Polley, who oversees $1 billion as chief investment officer at Stewart Capital in Indiana, Pennsylvania.

Profit Forecasts

S&P 500 companies have beat analysts’ profit projections for 10 straight quarters, and per-share income is seen rising 12 percent in 2012, data compiled by Bloomberg show. About 62 percent of dividend-paying corporations raised their payouts this year, Bloomberg data show. Companies authorized $43 billion in repurchase plans last month, putting 2011 on track to be the third-biggest year, according to data compiled by Westport, Connecticut-based Birinyi Associates Inc.

“M&A activity is going to drive performance for a while, and dividends will, too, because if you’ve got a 2, 3 or 4 percent dividend, that’s that much less return you have to get from capital gains,” Polley said yesterday in a telephone interview. “Those are going to be the differentiating characteristics of stocks that’ll do better.”

CBOE’s Implied Correlation Index shows expectations for how much stocks will move in tandem by comparing implied volatility, a gauge of prices, for S&P 500 options versus the levels for the 50 largest companies in the index. The correlation index, calculated from December S&P 500 options and January options on corporations, is 22 percent above its average for the past year.

“The risks we see in the marketplace are driven by broad macroeconomic stories as opposed to fundamental valuation issues,” Michael Schmanske, head of U.S. equity index volatility trading at Barclays Plc in New York, said in a Sept. 14 telephone interview. “The main macro consideration is definitely still Europe and sovereign credit risk.”

--With assistance from Whitney Kisling and Katherine Burton in New York, Abigail Moses in London and Fion Li in Hong Kong. Editors: Joanna Ossinger, Nick Baker

To contact the reporters on this story: Jeff Kearns in New York at jkearns3@bloomberg.net; Cecile Vannucci in Amsterdam at cvannucci1@bloomberg.net

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Andrew Rummer at arummer@bloomberg.net

View the original article here