By Andrew Giovinazzi
The government shutdown has everyone spooked and rightly so. Never has so much money, been in the hands of so few, who had no idea what to do with it, to paraphrase Winston Churchill after the Battle of Britain. Stocks find themselves in a nervous, illiquid state. Today the hint of a deal is sending things roaring so the market clearly wants this resolved.
The obvious cue for worry is the VIX. The run up in VIX has far outpaced the realized volatility of the market. I have the VIX closing at 19.60 on Oct. 9, with 10-day realized volatility at just 11%. That is a pretty big risk premium for the current movement, so the VIX is really looking at something else.
The result of the deficit talks will be either really bad, see my Churchill quote, or we get back to where we were assuming the government is closer to balancing its books. That is the typical binomial outcome of, say, 1590 for SPX or 1710 which is 3% on a gap in either direction. The assumption I will make is that congress and the president will get a deal done sometime in the near future, perhaps in the November cycle.
On the plus side, implied volatility is higher. On the minus side, any sellers of options will have to wear them if the government cannot agree on a budget proposal soon. The VIX fell today on the news the president wanted to talk with congressional leaders. The drop today in the VIX from the highs pretty much mirrors what happened last week when the president agreed to meet with leaders. Needless to say, the VIX made a near-term high Wednesday before the announcement.
The second almost-unnoticed event was the nomination of Janet Yellen and the release of some FOMC meeting minutes Wednesday. The taper looks like it will be coming off through 2014. That news was pretty much ignored by the market, and emerging markets in particular. The big selloff in emerging markets this year has priced in the taper. Today, with the threat of a U.S. government default subsiding, although by no means gone, it is worth looking at the iShares MSCI Emerging Markets ETF /zigman2/quotes/201454250/composite EEM +0.37% .
In general, short-term uncertainty makes for a good entry into a long-term position. Like I mentioned, higher IV means better prices for premium sellers and those investors who like to operate below the market. The EEM is still trying to get to even for the year. After a couple of trips to $36 and the taper now a forgone conclusion, slowly selling some put spreads would make sense to gain some exposure.
For example, an investor could build a position in three parts. One could start with selling the EEM Dec. 38/40 put spread now for .40 and add selling the Dec. 40 puts once the U.S. budget impasse is resolved. The goal here should be ownership at the 40 level in EEM or to keep selling the 40 puts until you get the underlying. There should be plenty of dough in the kitty by then.
Disclosure: Giovinazzi has a position in EEM.