Options Show No Black Swan in Emerging-Market Stocks

Options Show No Black Swan in Emerging Markets, Stocks Surge
Nassim Nicholas Taleb, author of "The Black Swan". Photographer: Daniel Acker/Bloomberg

Oct. 12 (Bloomberg) -- The smallest stock price swings and fastest economic growth in three years are convincing options traders that developing-nation equities are safer than ever relative to U.S. shares.

The MSCI Emerging Markets Index’s historic volatility, a gauge of price swings during the past three months, fell to 12.1 last week, the lowest level since July 2007, according to data compiled by Bloomberg. The cost of options insuring against a drop in the iShares MSCI Emerging Markets Index exchange-traded fund has declined to a record versus those tied to the Standard & Poor’s 500 Index, the data show.

While the U.S. recession in 2008 helped spur the MSCI index’s worst-ever bear market, a 66 percent drop, Goldman Sachs Group Inc. says America’s slowing expansion now will force central banks to keep interest rates low and fuel gains in developing-nation stocks. The gauge rose an average 25 percent in the 12 months after the last 10 periods volatility sank to this level, beating the S&P 500 every time, data compiled by Bloomberg show.

“We’re probably going into a period of relatively low emerging-market volatility,” said Christopher Palmer, who oversees about $6 billion as head of global emerging markets at Gartmore Investment Management. “The Black Swan way of looking at the world means that you have to take into account that there may be some things happening positively that are difficult to explain.”

Bull Rally

Nassim Nicholas Taleb, in his 2007 best-seller, “The Black Swan: The Impact of the Highly Improbable,” said most people underestimate the frequency of rare, high-impact events. He has built strategies to protect investors from unanticipated market swings using options, contracts that give the right to buy or sell assets at a set price by a specific date. The black-swan theory stems from the ancient misconception that all swans were white.

The MSCI emerging stock gauge has more than doubled from its bear-market nadir in October 2008 as the U.S. and Europe cut benchmark borrowing costs to all-time lows and developing-nation economic growth quickened to an annual rate of more than 7 percent this year, according to International Monetary Fund estimates. The index dropped 0.9 percent to 1,098.02 at 8:44 a.m. in New York.

Decoupling Bets

The three-month implied volatility for at-the-money options on the iShares MSCI Emerging Markets ETF was 25.92 on Oct. 8, compared with 20.65 for the SPDR S&P 500 ETF, according to data compiled by Bloomberg. The difference shrank to 3.72 on Oct. 4, the lowest since Bloomberg began compiling the data in March 2006. Implied volatility is the key factor in determining options prices.

“People think there’s going to be a decoupling,” said Rebecca Cheong, an equity derivatives strategist at Societe Generale SA in New York. “There are a lot of people demanding downside protection in the S&P and there’s less demand for emerging-markets protection.”

Investors’ growing preference for developing nations is also reflected in relative equity valuations and fund flows. The MSCI index trades for 2.06 times net assets, within 3 percent of the highest since March 2008 relative to the S&P 500, which is valued at 2.15 times, according to data compiled by Bloomberg. Emerging-market equity mutual funds lured $53.8 billion of net inflows this year, while U.S. funds had outflows of $65 billion, according to EPFR Global and Investment Company Institute data.

Bubble Risk

Rising valuations are leaving developing-nation stocks vulnerable to a renewed contraction in the U.S. economy, and investors should consider buying low-priced options that insure against equity losses, according to TCW Group Inc.’s Komal Sri-Kumar.

The Federal Reserve’s policy of cutting interest rates to a record low has had repercussions worldwide, including currency misalignments and the risk of asset price bubbles, Nobel Prize-winning economist Joseph Stiglitz said in a Bloomberg Television interview Oct. 6. Emerging-market policy makers from Brazilian central bank President Henrique Meirelles to Russian Deputy Finance Minister Dmitry Pankin warned last week that their markets may be forming bubbles as foreign investment pours into the nations’ assets.

The MSCI emerging gauge sank as much as 66 percent from its October 2007 high, nine percentage points more than the S&P 500’s peak-to-trough decline, after the U.S. recession and spiraling bank losses spurred the worst global financial crisis since the Great Depression. Profits in the 21-country MSCI index dropped as much as 50 percent from their peak, compared with 47 percent for the S&P 500, data compiled by Bloomberg show.

Cheap Insurance

“The risk of a double-dip is still very much present,” Sri-Kumar, the Los Angeles-based chief global strategist for TCW Group, which oversees about $110 billion, said in an interview. “If you can get yourself cheap downside protection, that would be a better position to take in the short term, rather than be naked.”

Price swings increased prior to the end of the MSCI emerging index’s 2007 rally. The three-month volatility measure jumped to 27 just before stocks peaked in October 2007, more than double the level of 12.1 on Oct. 8, according to data compiled by Bloomberg.

While the U.S. will probably grow at a 1.5 percent to 2 percent rate through the middle of next year, there’s a chance the world’s largest economy will fall back into recession, according to Jan Hatzius, Goldman Sachs’s New York-based chief U.S. economist. The Fed, which has already bought $1.7 trillion of debt to bolster economic growth, may take additional measures in its next meeting at the start of November, Hatzius said in an e-mail to clients last week.

Faster Growth

The biggest emerging-market economies will probably expand more than 8 percent as a group next year, according to forecasts in September from Goldman Sachs. Earnings in the MSCI emerging gauge will increase 28 percent in the next 12 months, topping the 22 percent growth for the S&P 500, analysts’ estimates compiled by Bloomberg show.

The slowing U.S. economy “may be one of the better scenarios” for emerging-market equities because it will ensure interest rates stay low without sparking another crisis, according to Goldman Sachs strategists including Kamakshya Trivedi in London. The iShares MSCI Emerging Markets ETF will probably outperform the S&P 500, the strategists said in an Oct. 8 e-mail.

The iShares ETF has climbed 11 percent this year, compared with a 4.5 percent gain in the S&P 500. The MSCI All-Country World Index of shares in emerging and developed nations has advanced 4.5 percent.

‘Silly Valuations’

Developing-nation stocks may continue to climb because some of the biggest industries were left behind in the rally, said Plamen Monovski, the London-based chief investment officer at Renaissance Asset Managers. The MSCI Emerging Markets Energy Index is little changed this year.

“To get to a widespread bubble, you need to see silly valuations across the markets and the sectors,” said Monovski, who helps oversee about $2 billion. “We haven’t reached insanity levels. Volatility can stay low for some time.”

To contact the reporters on this story: Michael Patterson in London at mpatterson10@bloomberg.net; Jeff Kearns in New York at jkearns3@bloomberg.net.

To contact the editors responsible for this story: Gavin Serkin at gserkin@bloomberg.net. Nick Baker at nbaker7@bloomberg.net.