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<< Return to Part I

In Part 1 of our analysis of the Japanese crisis, we discussed the potential for profit in the volatile currency market. In this installment we'd like to discuss the ongoing Japanese nuclear situation and its effect on U.S. stocks.

The Return of Volatility

The beginning of 2011 saw the U.S. marveling in the stock rally that started in the summer and continued spectacularly until mid-February. While many market pundits saw the low readings on the VIX and that almost three months elapsed without a pullback as reasons for caution, there was no catalyst for a correction. Socio-political uprisings in the Middle East and the Japanese earthquake have solved that problem.

The current stock market pullback has brought with it elevated volatility. The following chart shows the VXN over the past year (for those familiar with the VIX, the VXN is the same thing, only for the Nasdaq instead of the S&P 500).

Click to enlarge

VXN 1 Year Chart

The VXN primarily shows the value of put options on the Nasdaq 100. Because it is highly sensitive to changes in the value of put options, it is referred to as a "fear index." As can be seen, the VXN increased 81.34% since February 18 to its peak in yesterday's trading.

Over the history of the VIX and VXN, breakouts in the index have almost always been contrarian signals. For example, consider the most recent breakout in spring/summer 2010. While stocks did continue to languish until August, they did not suffer much more seriously from late May's lows, a time coinciding exactly with the VXN's peak. If a savvy investor had sold put protection to panicked traders during that time, the investor would have profited handsomely.

We believe the current breakout in volatility will shape up no differently. The amount that buyers of protection are currently willing to pay for put protection is quite high on a historical basis. The following chart shows the VIX over the last 10 years.

Click to enlarge

VIX 10 Year Chart

While the current VIX reading of 26.37 seems low based on the last few years of observations, it is actually high when viewed historically.

Adding in the fact that we are in an ongoing bull market, the VIX's current reading looks far too high. When comparing our current position in the bull market (almost exactly two years old), to the last bull market starting in 2002, volatility only hit a peak of around 20 or so in 2004.

Recent data also shows that the CBOE Put/Call Ratio (a contrarian indicator) has spiked. A chart is shown below.

Click to enlarge

CBOE Put to Call Ratio Chart

As can be seen from the chart, extreme peaks and valleys in the five day moving average put/call ratio correspond well to rallies and corrections, respectively. This is because investors tend to be the most complacent right before significant corrections, as well as the most fearful right before large rallies.

Our current put/call reading of .71 is high on a historical basis, and the fact that it has spiked to that level quickly makes us believe that this current correction may be short lived.

We believe a patient investor could profit from selling put protection to scared investors. Let's consider the fundamental story behind U.S. stocks as well before making a trade recommendation.

Valuation

When stocks fell in the summer of 2010, they looked attractive on a Price to Earnings ratio basis. The following chart shows the trailing 12 month P/E of the S&P 500 on the top panel and the P/E of the S&P 500 based on forward projections on the lower panel.

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S&P 500 Price to Earnings Chart

As can be seen from the chart, the S&P 500 bottomed in summer 2010 at a P/E of 13.58 and a forward P/E of 12.53. It would stand to reason that the same level would serve as a hard floor this time around.

Also, our current bull market's P/E as well as estimated P/E are both considerably below the bull market of 2002-2007. It could also be argued that current valuations on stocks are too low given how low the U.S. treasury note yields. The current earnings yield of the S&P 500 (6.7%) is 3.43% higher than the yield on the 10 year treasury note. This spread is almost twice as high as the average spread during the 2002-2007 bull market.

Investors' fear since the financial crisis has decreased their willingness to pay high multiples for stocks, but even at this current rate of risk aversion, U.S. stocks are cheap on a historical basis.

Japan's Economy and its Effect on the U.S.

We should also consider Japan's economic effect on the United States. In January, the U.S. exported about $111 billion worth of goods. Of those, less than $5 billion were to Japan (about 4.5%). Additionally, the U.S. imported $9.97 billion worth of goods from Japan, so the U.S. actually imported almost $5 billion more than it exported.

Since Japan comprises so little of U.S. exports, a slowdown in Japan will have little effect on the U.S. economy. Furthermore, since Japanese manufacturers will be reducing their output for the time being, the amount of goods imported to the U.S. will decrease. This slack could and should be picked up by U.S. manufacturers. In this manner, the slowdown in Japan could actually be a boon to the U.S. economy.

Trade Recommendation

Because of the heightened state of volatility mentioned earlier, we favor a strategy of selling put options to nervous investors (more on the importance of options selling to the Lakshmi Capital Absolute Return Strategy).

One such trade could be to sell the December 2011 put on the NDX for the strike price of 2000 for the premium of $120, or $12,000 per contract. An investor would profit from this strategy if the Nasdaq 100 Index was above 1880 on December 17, 2011, 15.5% down from current levels. Given the relatively healthy state of the U.S. economy, a drop of a further 15.5% from current levels seems unlikely.

More conservative investors could choose to sell put options on the Nasdaq at lower levels. For example, the December 2011 1600 put sells for ~$43, or $4,300, per contract. Such a strategy would be profitable as long as the NDX was above 1557 upon expiration, or 30% below the current level of 2225. A decline of 30% between now and December is extremely unlikely, and could only be caused by another financial crisis or similar cataclysm.

The fact that investors are willing to pay this much for put protection indicates their current level of fear. While things could get worse in Japan and elsewhere, savvy investors would be well-advised to use the current uncertainty as a buying opportunity.

Source: Japanese Crisis Analysis Part 2: U.S. Stocks and the Return of Panic