If you're an investor, you might have noticed an uptick in market volatility during the month of March. The increase actually started on February 27, when the Dow Jones Industrial Average ($INDU) slid more than 400 points and the CBOE Volatility Index ($VIX) surged 58% for its best one-day gain ever. Since that time, trading has remained volatile. At the same time, it has affected some sectors more than others.
Before looking at specific sectors, however, let's first define what we mean by volatility. VIX is one measure. The volatility index measures the expected volatility priced into S&P 500 Index ($SPX) options. It is computed using an options pricing model and reflects expectations about future market volatility. So, VIX is a measure of expected or implied volatility. During the month of March, the average closing value of the volatility index is 16.2 percent, which compares to 12.80 percent in all of 2006. Therefore, market volatility is considerably higher now than it has been in the recent past.
While the S&P 500 Index offers a gauge of market trends because it includes five hundred of the top companies that trade on the US exchanges, the Select Sector SPDR Funds offer a relatively easy way to view volatility by individual market sectors. These nine exchange-traded funds [ETF] hold the same stocks as the S&P 500 Index grouped into specific sectors. For example, the Select Sector Financials (XLF) holds all the financial stocks from within the S&P 500 Index. There is also a technology, a utility, and an energy fund. Looking at the implied volatility of the SPDR funds is similar to looking at the VIX, but it compartmentalizes volatility by sector.
Table 1 shows the nine Select Sector Funds and the implied volatility of the options today compared to the IV in November 2006. In November 2006, the VIX was falling below 10%. Today, it is near 18%. It has risen 80% from late November to March 2007. Meanwhile, the Select Sector Financials has seen a bigger increase in IV. The implied volatility of the XLF is up more than 85%. The rise confirms the obvious. Namely, investors are worried about the financial sector and, compared to November, are now expecting higher levels of volatility going forward, which has a lot to do with the problems in the subprime sector and worries about a possible credit crunch.
However, the financials are not the only ones seeing an increase in volatility. Industrials, consumer discretionary (or "cyclicals"), and consumer staples have seen a noticeable rise as well. The only sector that has not seen a meaningful increase is energy, which is not likely to be affected by the ongoing problems in the financial sector. Instead, the energy sector reacts to changes in oil and gas prices.
Select Sector SPDR
CBOE Volatility Index
Table 1: Implied Volatility [IV] by Sector
Another way to look at volatility is a measure known as statistical volatility [SV]. Unlike expected or implied volatility, SV is not computed using options prices. Instead, it is computed using closing prices during a past number of days. For example, the 20-day statistical volatility is computed as the annualized standard deviation of closing prices during the past twenty days. The S&P 500 Index currently has a 20-day SV of 17.5%, which is not much different than its IV. However, compared to November, it is almost 1.5 times greater.
Some of the specific sectors of the market have also seen a dramatic increase in actual or statistical volatility. Financials are once again at the top of the list (Table 2). Utilities, information technology, basic materials, consumer staples and industrials are also much more volatile than they were just a few months ago. Meanwhile, healthcare and energy stocks have seen only a modest increase in volatility.
Select Sector SPDR
Table 2: Statistical Volatility [SV] by Sector
So, the recent increase in volatility has not affected all market sectors the same way. Energy, which has been the most volatile in recent years, is not seeing a big change. Meanwhile, the financials are clearly the biggest reason for the jump in market volatility. However, other sectors are also seeing much more volatility than just a few months ago. For instance, SV has more than doubled in the utilities, technology, and the basic materials sector when compared to November 2006. The rise in actual volatility across many sectors helps to explain why the VIX is so much higher today than throughout most of last year. Namely, expectations about future volatility are on the rise because the market has become a much more volatile place. In addition, since statistical volatility is not yet coming down, and might in fact continue rising, there is also a chance that the VIX will continue to climb higher from here.
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