Insight Line—July 16, 2007

Within days, Rule 10a-1 of the Securities and Exchange Act of 1934, known more commonly as the “uptick rule”, is set to expire. And when it does, I believe the widely followed VIX (Chicago Board of Options Exchange Volatility Index) may become as relevant as yesterday’s news.

Without venturing too far into the technicalities, the VIX is an options-based mathematical model designed to anticipate the expected near-term movement of the S&P 500® Index. Introduced in 1993, the VIX has become a commonly cited gauge of investor sentiment. Even with its limited real-time history, the VIX’s directional correlations appear compelling enough that market pundits regularly discuss the VIX as an indicator of market psychology as well as a means of forecasting the future outperformance of one style or capitalization class of equities over another. Market technicians suggest that elevated readings are a bullish indicator while depressed readings are cautionary. Simply put, the VIX represents a shorthand statistical measure of market volatility.

By comparison, the history of short selling is long and to say the least checkered. In fact the Securities and Exchange Commission (SEC) essentially banned short selling as a trading strategy by instituting Rule 10a-1 in 1934. The ruled prohibited the sale of any share of stock at a price lower than the previous price (later modified to zero-plus, or no change from the previous price). Rules for delivery, lending and manipulation of shorted shares span page after page of restrictions. In short, though not eliminating short selling with Rule 10a-1, the SEC made it expensive at worst and difficult at best.

However, the advent of equity options altered the equation for short sellers. Put options—that is, buying the right to sell a stock at an agreed upon price and time—enabled short sellers to move from trading actual shares of stock to trading derivative instruments. And, therein, I believe, lies the VIX’s potential vulnerability to the upcoming regulatory change.

All of which may soon change.

You see, the rationale for the SEC’s recommendation to remove the short selling restrictions of the “uptick rule” relied heavily upon academic and real time analysis of the SEC’s 2004 Pilot Program (unrestricted short selling on a few selected stocks). The results of the test trial argue strongly that unencumbered short selling appears to have no measurable impact on specific share volatility. Furthermore, the Pilot Program seemingly confirmed previous academic studies advocating unrestricted short selling as potentially reducing overall market volatility.

Arguably any technical tool, such as the VIX, is only of value if offers its practitioners identifiable and demonstrative action points. In the case of the VIX, as many aficionados argue, measures at the extremes provide the most actionable trading triggers. However, as I see it, if the SEC’s contention that unrestricted short selling ultimately delivers lower volatility in the market, the extremes in the VIX will just be that much harder to come by—if at all.

¹ “From the Horses Mouth: Gauging Conditional Expected Stock Returns from Investor Survey,” by Gene Amromin and Stephen A. Sharpe, Working Paper 2005-26 Finance and Economic Discussion Series, Federal Reserve Board, Washington, D.C., April 2005.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 07/13/07

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

The June employment data suggests little new information on the state of economy. Payroll growth, after strong upward revisions to the previous two month’s readings, recorded 132,000 new hires. The unemployment rate remained at 4.5 percent as job creation essentially matched the increase in the labor force. In summary, the overall data, including hours worked and wages earned, supports the consumers’ continuing contribution to economic growth in the second half of the year. As such, I suggest the appropriate action on the table is to circle Up.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

May’s Personal Income data moved once more to the upside, rising 0.4 percent. (Recall April’s decline due to statistical revisions.) Wage and salary levels also recovered, but remain below record levels set in March 2007. That said, Personal Income data remains, I believe, somewhat supportive of economic activity in the coming months. Please circle Up on the table.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The consumer, after a strong showing in May 2007, seemingly “sat home” as retail sales in June 2007 softened in a number of areas. Housing related sales had the weakest showing in months. Total seasonally adjusted sales for the month were $374 billion. In summary, I believe the data suggests my preference for suggesting down as the appropriate action on the table remains in place.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

Durable goods orders for May suggested moderate but continuing strength in the nation’s manufacturing sector. New orders, inventories, shipments and unfilled orders all registered positive gains. If there is any negative in the report, it is that manufacturers, while building inventories, are completing current sales from inventory on hand rather than from production. As such, this may signal that any contribution to overall economic activity from the manufacturing sector might be short lived. Therefore, I am leaving Down as the preferred circle of choice.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures ex-food and energy price changes, as of May 2007 rested at 1.9 percent year-over-year. Inflation, though within the acceptable range for some members of the Federal Open Market Committee (FOMC), has yet to demonstrate to other FOMC members its ability to remain within accepted targets. Therefore, in accordance with the FOMC’s elevated concerns, I am rescinding my suggested Low reading by moving the circle to High.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

The news from the U.S. Treasury for the month of June 2007 (ninth month of the fiscal year) continues better than expected. Revenue growth once again exceeded forecasts as corporate tax payments pushed monthly cash flow to a positive $27 billion. With just three months left in the fiscal year, even the most skeptical of forecasters now concede a marked improvement in the Treasury’s cash balances—for whatever reason—is a reality. Please circle $In on the chart.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC held the overnight inter-bank lending rate at 5.25 percent for the eighth policy meeting in a row. Though my forecast for a rate cut in 2007 seems less likely, a clearer picture of the FOMC’s intentions will emerge from Chairman Bernanke’s Monetary Policy report to Congress in the coming days. That said, until convincing evidence to the contrary appears, I expect the next move of the Committee is to lower the federal funds rate. Therefore, please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The yield curve, as measured from the discount yield on the 90-day U.S. Treasury bill to the yield to maturity of the 10-year U.S. Treasury note rested at a positive 25 basis points on July 13, 2007. If history can be any guide, the relative flatness of the curve suggests economic expansion over the coming months.
Please Circle Positive.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

Sufficient anecdotal evidence exists that the nation’s GDP in the second quarter recovered smartly from the 0.7 percent annualized growth in the first quarter. Inventory restocking, a reduced drag from housing and improved consumer consumption more than likely moved the second quarter’s GDP upward toward an annualized growth rate of 3 percent. That said, most of the contributing factors to the second quarter’s growth appear short-lived. Therefore, I continue positioning the appropriate circle as Below.

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