VIX Discount Erodes on European Concern

Options show traders expect Europe’s debt crisis to engulf the U.S. as contracts to protect against losses in the Standard & Poor’s 500 Index erase the gap with the euro region’s benchmark gauge.

The Chicago Board Options Exchange Volatility Index increased 33 percent last week to 41.25, bringing it within seven points of the 29-month high reached Aug. 8. The VIX, as the gauge is known, has eliminated more than half the discount to Europe’s VStoxx Index in the past week, cutting it to 7.3 points from 15 on Sept. 12, data compiled by Bloomberg show.

Traders are showing less confidence American equities can avoid losses that drove shares in Germany, France and Spain down more than 30 percent as the 18-month debt crisis threatens to spur the second global recession in three years. The S&P 500 fell 6.5 percent last week, the most since Aug. 5, bringing the loss from its 2011 high to 17 percent, according to data compiled by Bloomberg.

“As the situation deteriorates, the U.S. and U.S. volatility are starting to catch up,” Benjamin Bowler, San Francisco-based head of global equity derivatives research at Bank of America Corp., said in a telephone interview Sept. 23. “It’s becoming clearer that certain assets just haven’t moved enough to reflect the stress being built up in Europe.”

Global stocks entered a bear market on Sept. 22 when the MSCI All-Country World Index slid 4.5 percent, bringing its decline since May 2 to 22 percent. Benchmark gauges in at least 32 markets, including Hong Kong and Australia, have declined 20 percent or more, data compiled by Bloomberg show.

VIX, VStoxx

The VIX, which has averaged 20.4 in its 21-year history, touched 48 -- the highest level since March 2009 -- on Aug. 8 after S&P stripped the U.S. of its AAA credit rating. The gauge fell 5.4 percent to 39.02 in New York today. The VStoxx Index, which measures the cost of protection against losses on the Euro Stoxx 50 Index, climbed 13 percent to 48.54 last week. It increased 1.5 percent to 49.29 today.

“Concern about the U.S. had never gone away,” Manish Singh, head of investment at Crossbridge Capital, which oversees more than $2 billion in London, said in an interview Sept. 23. “It was just taking a rest when the negative news coming from the euro zone raced past.”

The Dow Jones Industrial Average fell 738 points last week to 10,771.48, the most since October 2008, as investors speculated central banks are running out of tools to prevent a recession. The U.S. Federal Reserve said on Sept. 21 that it will replace $400 billion of short-term debt with longer-term Treasuries to spur growth, and said there are “significant downside risks” to the economy. The Stoxx Europe 600 Index sank 6.1 percent.

Consumer Confidence

U.S. consumer confidence dropped last week to its lowest point since the recession ended in 2009, and European service industries and manufacturing contracted in September for the first time in more than two years.

“This outlines just how connected the global financial markets are,” Michael Hennen, portfolio manager at Raleigh, North Carolina-based Hatteras Funds, wrote about the narrowing spread between VIX and VStoxx in an e-mail on Sept. 23. The firm oversees $2 billion in hedge fund strategies. “It really displays how problems stemming from issues in Europe can quickly spill over to global markets.”

The VIX climbed above 30 on Aug. 4 and has stayed there for the 36 days since, a period of elevation that has foreshadowed economic deterioration in the past, according to UBS AG. When the VIX climbed above 30 five times between May and July 2010, it never stayed above the level for more than nine days in a row, data compiled by Bloomberg show.

‘Running Short’

“Time appears to be running short for the VIX to settle back down,” Mitchell Revsine, a New York-based equity derivatives strategist at UBS, wrote in a Sept. 23 note. “For this to happen, we would expect optimism on a European debt solution to grow, as well as third-quarter earnings guidance to instill confidence in relatively short order.”

Last week’s decline trimmed the gain in the S&P 500 since March 2009 to 68 percent. The benchmark gauge for American common equity is trading at 12.4 times earnings in the past 12 months, 4.4 percent below its average valuation at the lowest point during the last nine bear markets, according to data compiled by Bloomberg.

Companies in the S&P 500 are forecast to report third- quarter earnings that are 14 percent higher than a year ago, according to analyst estimates compiled by Bloomberg. Profits will climb 18 percent to $99.33 a share for 2011 and reach $111.08 in 2012, the data show. Companies had a record $2.05 trillion in cash and short-term investments at the end of the second quarter, the U.S. Federal Reserve said Sept. 16.

U.S. Safety

“The U.S. relative to world markets is the place to invest,” David Fingold, who manages about C$2.5 billion ($2.4 billion) at Dynamic Funds in Toronto, said in a telephone interview on Sept. 23. “The issues in the U.S. can be solved, they’re well understood and we’re talking about them.”

U.S. Treasury Secretary Timothy F. Geithner said at the annual meeting of the International Monetary Fund in Washington that failure to combat the Europe turmoil threatened “cascading default, bank runs and catastrophic risk.” Billionaire investor George Soros said Sept. 24 that “something needs to be done” to safeguard Europe’s banks as Greece, which has yet to secure a second bailout, may be unable to avoid default.

While the IMF vowed to “strongly support” Europe, Managing Director Christine Lagarde said in a plan distributed to the IMF steering committee on Sept. 24 that the Fund’s $384 billion lending chest may not be enough to meet all aid requests if the world economy worsens.

‘The Unknown’

“It’s fear of the unknown at this point, and is Europe a Lehman-type of event,” Dan Veru, chief investment officer at Fort Lee, New Jersey-based Palisade Capital Management LLC, said in a Sept. 23 telephone interview. The firm manages $3.4 billion. “If Greece defaults, it’s a counterparty exposure to the financial system in Europe that can create some level of contagion into the U.S. financial system.”

Implied volatility, the key gauge of options prices, for S&P 500 contracts at the current level expiring in three months jumped to 34.4 on Sept. 22, the highest level since April 2009. It closed at 33.17 the next day. For options on the Euro Stoxx 50, implied volatility fell 5.3 percent to 39.78 on Sept. 23, from its 30-month high of 42.01 Sept. 12.

VIX futures began trading at 8 a.m. New York time and will do so every weekday effective today, the CBOE Futures Exchange said in a Sept. 23 statement. The change from the previous 8:20 a.m. start time provides “more time to establish or offset VIX futures positions surrounding potential market-moving events” before the equity market opens, the statement said.

“The U.S. economic problems are less immediate, but they are the same as in Europe,” Alex Tedder, who helps manage about $12 billion in global stocks at American Century Investments in New York, said in a telephone interview on Sept. 23. “The Fed’s statement forced investors to consider how the U.S. will deal with the debt overhang given the lack of growth.”

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

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

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