Volatility still high, but service sector still fine; plus a note on the role of hedge funds

Markets are still on edge, worried that a China slowdown will prove contagious to the rest of the world—a new twist on the old catchphrase "When the US sneezes, the rest of the world catches a cold." But the mainstay of the U.S. economy—the service sector—is still quite healthy. The U.S. economy has been underperforming for years, but that has everything to do with our own bad policy choices. Even a substantial slowdown of the Chinese economy would have little impact on the U.S., since China's purchases of goods and services from us represent a mere 0.7% of our annual GDP. 

As the chart above shows, the service sectors of both the U.S. and the Eurozone have been gradually improving over the past year or two (and the U.S. survey beat expectations, 59 vs. 58.2). This arguably trumps any slowdown in the growth of the Chinese economy.

The Business Activity subindex of the ISM service sector survey is still at historically high levels, and doing much better than at anytime during the current expansion. This represents about 80% of our GDP. This is great news.

The Employment portion of the ISM service sector survey is still at relatively healthy levels. This suggests that businesses are reasonably confident about their future prospects.

Despite all this good news, the market remains very nervous. The Vix/10-yr ratio today was about as high as anytime in the past two and half years (excluding last week).

The chart above compares the daily closes of the S&P 500 and the Vix index. Note that the two lines are virtually mirror images of each other. Rising fears accompany lower stock prices, and vice versa.

The chart above uses the same indices as the previous charts, only it flips the Vix index to show how the two move in inverse lockstep. The correlation between these two series is an impressive 0.87.

Background: the Vix index is the implied volatility of equity options. As such, the Vix index is a proxy for how cheap or how inexpensive options are, because the more volatile prices are, the more likely an option is to hit its strike price.  A higher Vix thus implies more expensive options. Buying options is a classic way for investors to lower their risk profile, since the worst that can happen to an option you purchase is that it expires worthless. In contrast, the worst that can happen if you own stocks is that you can lose everything. But if things go well, buying call options gives you the opportunity of participating in most of the upside of stock prices, and buying put options gives you the opportunity to profit from most of the downside of stock prices. When people are nervous about the future, one natural strategy is to replace outright ownership of stocks with call options, and to replace outright selling of stocks with the ownership of put options. But either way, the more nervous people get, the more expensive options become.

What many investors arguably fail to appreciate is that the people selling options to the public are not likely taking on unlimited downside risk by being "naked" short sellers. They are hedging their positions by selling stock as stock prices fall, and buying stock as prices rise (aka "delta hedging"). If there is a surge of interest in buying stock options, the sellers of those options must immediately establish a hedge by selling stocks. So there is a hedging connection between implied volatility and stock prices: the higher the implied volatility the more selling of stocks there is, and vice versa. Bloomberg has a story today which helps to explain this.

What all this suggests to me is that the volatility of stock prices is almost exclusively a function of the market's intolerance for risk. Fears, not reality, are the driving force behind volatile stock prices, and the mechanism which links fears and stock prices is hedging (e.g., mechanical) activity, not necessarily a deterioration of the economic fundamentals. This type of hedging activity has the potential to destabilize markets if mechanical selling overwhelms the ability of natural buyers of stock to respond. But at the same time, the higher cost of options provides a huge incentive for speculators to effectively become sellers of options and (via their hedges) buyers of stock. These episodes can be terribly nerve-wracking, but eventually they sort themselves out and the fundamentals reassert themselves. I suspect that's what will happen this time too.