Fighting Terrorism Relieves Some Worries

Stock prices had opened sharply lower on September 17, and continued to slide until reaching a bottom on September 21. This is ancient history at this point, but has relevance to the current market atmosphere nearly three months later. At that point, option premiums had spiked as fears over the impact on the U.S. economy and the potential for additional attacks on the United States were quantified. This has become known as the "terror premium." Now that we are tightening the noose and are near nabbing Osama bin Laden, the "Master Mind" behind the attacks on the U.S., the terror premium has nearly disappeared.

On September 20, the implied volatility level for the S&P 500 Index (SPX) rose to nearly 38% from 28% before the attacks. Now, while this might not seem like a high volatility reading (especially when compared to some of those crazy Internet stocks), it was the highest level produced in nearly three years. Implied volatilities on broad-based indices are usually lower than on stocks or industry groups, since risk is spread among all of the component issues that make up that index. Remember that among the 500 companies that make up SPX are defense contractors, which had a positive impact following the events.

Actions by the U.S. government, including the retaliation against Osama bin Laden, the Taliban government of Afghanistan, and the Al Qaeda network has gradually eroded some of the fears of American citizens. As a result, investors have stopped bidding up the prices for puts and calls, thus reducing the premiums and implied volatility levels. Implied volatilities have now dropped below the pre-attack levels, indicating that the risk premiums are gone, as illustrated on the chart below.


Figure 1 - A one year chart on the S&P 500 Index (SPX) implied volatility and 30-day historic volatility chart, from December 2000 to present.

SEASONAL FACTORS
As we have noted before, the November to April period is the positive half of the annual seasonal curve. Additionally, the period from November to January has historically been the strongest three-month period of the year. The "Santa Claus Rally" that normally occurs in December is the result of annual events, which include year-end asset allocations, positive capital monetary flow, and retirement contributions.

The seasonal pattern has been repeating itself so far this year. In fact, market performance has been extremely strong during this seasonal cycle. This is partly the result of the fact that stock prices were depressed following the bear market and the impact from the events of September 11. Another positive for the markets has been the decline in interest rates, which has resulted in growth being more attractive than safety value.

As the end of the year approaches, investors will likely adjust their portfolios to reflect their anticipations of next year. Traders are likely to focus on their short-term profits and will most likely close positions ahead of Christmas. Since the week between the Christmas and New Year's holidays is usually a quite period, we anticipate that implied volatility levels will fall again following next week's monthly and quarterly expiration of options and futures contracts.

We would like to take this opportunity to wish you a happy, healthy, and prosperous holiday season.