Options Market Offers Contrary Signal

   This past weekend, Barron's ran an article titled In Love With Stocks, Again by Steven M. Sears. The article points out the recent apparent lack of fear in the market through a view of the Options markets. For those less familiar with options, skew refers to the difference in implied volatility between calls (rights to buy stock at a given price) and puts (rights to sell stock at a given price). Skew offers a good way to interpret any current bias in the market. During normal periods skew is positive since stocks tend to fall faster than they rise, implying greater volatility. Sears notes that recently skew has flattened dramatically on the heels of QE2, implying the expectation of reduced downside risk in the market. Although this may be correctly interpreted as a bullish short-term signal, history tells us that when investors believe risk is marginal, the time to sell is near.

   Today was marked by a continuation of the recent reversal in Treasuries. Since announcing QE2, 10-year yields have risen nearly 60 basis points to almost 3%. The sell-off across all maturities has been dramatic since the Fed actually began purchasing Treasuries on Friday. If the Fed's continued purchases cause further sell-offs and rising yields, could they be inclined to cut the program short? What level of inflation or unemployment in the next 8 months could also be cause for a shortened QE program? Although these outcomes seem improbable, at times of such certainty, unexpected events may actually carry the greatest risk.