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THE SPECULATOR
Prepared by Berkeley Futures, Ltd.
Financial Typhoon
The financial typhoon that has been blowing around Southeast Asia hit Hong Kong a fortnight ago with such force that the reverberations were felt all over the world.
Until last month. Hong Kong had remained relatively unscathed by the waves of selling pressure that hit other markets in the region. But eventually the target of Hong Kong's currency peg with the U.S. Dollar proved irresistible to speculators. The Hong Kong monetary authority, which prior to this month's crisis was estimated to have foreign exchange reserves of some U.S. $85 bn, decided to take the speculators on. Their first move was to raise overnight interbank interest rates to 200 percent. This immediately put pressure on property and financial companies and it was these two sectors which led the stock market retreat.
The collapse in Hong Kong share prices split over to the other major markets because it has much stronger links with the west than other markets in the region. For example, on Friday 24th October, around 16 percent of the FTSE's 157-point slide was attributable to falls in the share price of HSBC, Cable & Wireless and Standard Chartered–three companies with very close ties to the former British colony.
Trying to pin-point the exact starting point of this crash is, however, a fruitless exercise. Hong Kong was simply the last straw that was laid upon a very over-valued camel's back. The U.S. market had been trading at 26 times annual profits and the UK at 20 times earnings. Even with the advantages of the technological `new paradigm,' these figures looked frothy. Asset prices had got ahead of underlying economic performance, causing the familiar `bubble' that has periodically hit markets since the Middle Ages. The collapse in share prices pricked the bubble. There may be some knock-on economic effect–especially in countries such as the U.S. where the `wealth effect' of asset price inflation is more pronounced than, for example, in some European countries. But it is not likely to herald the start of a prolonged economic recession such as that seen in the 1930's.
One of the reasons why the link between the underlying economy and asset prices became disconnected is that, by targeting the retail price index, monetary policy only controls wage-price inflation. The chairman of the U.S. Federal Reserve Bank, Alan Greenspan, highlighted this problem in his much-quoted remarks about the “irrational exuberance” of the stock market. He is already looking at ways of targeting inflation that would include some measure of asset price inflation.
Japan, which many analysts thought was a more obvious target for the Southeast Asian financial typhoon, provides an interesting illustration of the other extreme of this problem. Efforts to curb the 1980's property market asset bubble have been too successful. Investor confidence is at such a low ebb that not even real interest rates of zero can reflate the market.
Once this storm has blown itself out, financial authorities will be looking at ways to use monetary policy to curb asset price inflation because, if they do not, crashes will become a regular feature of the equity markets.
Deborah Owen, Editor
How To Use The Dow Jones Future Contract
In this article the Chicago Board of Trade describes the basic mechanics of using DJIA futures contracts to decrease or increase equity exposure in response to anticipated market cycles and to reallocate portfolios across different asset classes and different stock market segments.
Note: For the sake of example, daily mark-to-market payments are excluded. These would have some impact on the final profit or loss outcomes of any futures strategy.
Note also that in all examples with a money market investment, the rate of return is assumed as equal to the cost of carry, measured as the price of the futures contract/value of the DJIA at initiation of the position.
1. Protecting Your Stock Investment
Scenario: You have been positioned in the market for quite some time and reviewed both fundamental and technical analysis in formulating your investment decisions. Your present portfolio is comprised of $334,000 of large capitalization stocks similar to the DJIA and $66,000 invested in a money market fund.
In August, the value of the DJIA is 7800 and the stock market continues to rise. A variety of technical and fundamental factors that you have been charting, however, suggest a possible short-term downturn as early as September. Consequently, you believe you should change the mix of your investments to $100,000 in stocks and $300,000 in money markets, or 25%/75%. With this reallocation, you still keep some exposure to equities in case the market does not decline.
Strategy: Because you feel any market decline will be short-lived, you would like to keep your cash portfolio intact. The CBOT DJIA futures market provides a proxy for the reallocation of assets in your position. To decrease your equity exposure by $234,000 (to achieve the 75% allocation) you sell CBOT DJIA September futures contracts. The futures price is 7839. (Therefore the cost-of-carry rate = .5% or 7839/7800 - 1.)
Inputs: The DJIA is 7800. The appropriate number of contracts to sell is: $234,000/($10 x 7800) = 3 futures contracts.
Results: Your market expectations were correct. At expiration of the September futures contract, the DJIA is 7644, giving you a return of —2% on your portfolio (exclusive of dividends). The money market portion of your investment has earned a rate of return of .5%. (This is the same as the cost-of-carry rate, because the futures price is assumed to be at its fair value.)
Value of portfolio with no market action taken: Stocks $334,000 x .98 $327,000; Money Market +$66,000 x 1.005 $66,330. $393,650.
Value of portfolio with futures position: Short DJIA futures 3 x $10 x (7839—7644) $5,850; Total $399,500.
Value of portfolio with reallocation of assets in cash market: Stocks $100,000 x .98 $98,000; Money Market +$300,000 x 1.005 $301,500. Total $399,500.
Comments: By using the futures market to achieve your objectives, you now hold the equivalent of a $100,000 investment in DJIA stocks and a $300,000 investment in the money market instrument. The stock market decline now only impacts $100,000 of your stock portfolio rather than $334,000; in addition, you earn a money market rate of return of .5% on the $234,000 difference.
Without futures, your portfolio is worth only $393,650. The $5,850 profit on the short futures position offsets the loss on the $234,000 of your portfolio that was moved out of equities by the short futures position. Therefore, by selling futures, you are able to shield $234,000 of your initial wealth from a stock price decline, achieving nearly breakeven given these market conditions. Of course, had you been more confident of the market decline, you might have completely neutralized the equity risk on the portfolio by selling more futures contracts. This would have converted the entire stock position to a $334,000 investment in the money market. The amount of protection you should obtain depends on your assessment of the market and tolerance for risk.
2. Creating Spreads For Asset Allocation
In addition to equities and money market investments, portfolios are often comprised of other assets, such as bonds. Your portfolio can be managed easily for both fixed-income and equity market performance by combining DJIA futures with CBOT Treasury bond futures.
Continuous changes in the anticipated rate of inflation, news about company earnings and Federal Reserve policy changes are some of the market influences that drive investors to switch from bonds to stocks or stocks to bonds. As you will see, an efficient and inexpensive method of carrying out this reallocation between stocks and bonds is to trade spreads of CBOT Treasury bond futures and DJIA futures.
Scenario: As a prudent investor, you have always balanced your portfolio between government-backed securities and the stock market. The recent performance of the market, however, has prompted you to consider enhancing your equity portfolio while diminishing your bond portfolio. In August, you have $200,000 invested in stocks comparable to DJIA stocks and $200,000 invested in Treasury bonds. You would like to take advantage of the sustained market rally by increasing your equities exposure to 75% and decreasing your bond holdings to 25%.
Strategy: You can reallocate both sides of your portfolio–buying $100,000 of stocks and selling $100,000 of bonds–with the sale of CBOT Treasury bond September futures and the purchase of DJIA futures.
Inputs: The Treasury bonds in your portfolio have a market price of 102-04 (bond prices are quoted in 32nds; the price is 102.125). The price of September Treasury bond futures is 102-20 per $100 of face value, and $100,000 of face value must be delivered against each contract. The value of the DJIA is 7800 and the price of the September DJIA futures contract is 7839.
The number of T-bond futures to sell is short T-bond futures: $100,000/(102-04 x $1,000) = 1 (rounded up to the nearest whole number).
The number of stock index futures to buy is: Long stock index futures: $100,000/($10 x 7800) = 1 (rounded to the nearest whole number).
Results: At September futures expiration, the value of the DJIA is 8112, a rate of return of 4%, and the market value of the bonds is 101-08, a rate of return of —1%.
Portfolio value with no market action taken: Stocks $200,000 x 1.04 $208,000; Money Market +$200,000 x .99 $198,000. $406,000.
Value of futures positions: Long DJIA $10 x 1 x (8112—7839) $2,730; Short Bond +$1,000 x 1 x (102- 20—101-08) $1,375 = $4,105. Total $410,105*.
Portfolio value with cash market transactions: Stocks $300,000 x 1.04 $312,000; Bonds + $100,000 x .99 $99,000. Total $411,000*.
*The difference between the futures and cash-equivalent outcomes are due to the rounding of futures.
Comments: The reallocation of the portfolio involves two steps: The short position in Treasury bond futures converts $100,000 of the investment in Treasury bonds into a $100,000 investment at the money market rate. The long stock index futures position then converts the $100,000 money market investment into a $100,000 investment in stocks. The result is an increase in the final value of the portfolio from $406,000 to $410,105. The same return could have been received with transactions in the cash market but would have involved substantial time, effort and expense to buy and sell the stocks and bonds. Futures allowed you to take advantage of your market perspective without disrupting your existing portfolio.
3. Altering The Mix Of Large Cap And Small Cap Stocks
Large capitalization stocks (i.e., with large market values like those in the Dow Jones index) often rally before the end of the year. At the beginning of the new year, small capitalization stocks tend to rally in what has become known as the January effect. Small cap stocks also frequently lag behind large cap stocks during a market rise and sometimes never catch up. You can take advantage of these seasonal patterns of different classes of stocks by trading spreads between DJIA futures and futures on a small capitalization index.
Extract from `Advanced Strategies for Individual Investors' published by the Chicago Board of Trade.
Spinning The Pound
Over the past three weeks, the UK Labour party has shown its first signs of disunity since coming to power. As with the Conservatives before them, the topic that has tripped them up is that of European Monetary Union (EMU) and the possible participation of the pound. Ironically, this has not come about because of a backbench revolt but rather from mistakes in briefing the media–an oddity considering how good they were at spinning policy in their days in opposition.
The mist surrounding European policy has cleared somewhat with the Commons statement last week by Gordon Brown. The pound will definitely not enter EMU in the first wave in 1999, although the government will do all it can to support the venture. It has also been confirmed that there will be a referendum on EMU before the UK joins. Entry within the life of this parliament (to 2002) is therefore most unlikely. This consideration, coupled with the fact that the interest rate cycles of the UK and mainland Europe are clearly out of synchronization, should give sterling a firm underpinning. In this context, it is interesting to look at the technical position of the pound against both the Deutschemark and the yen.
Although the pound has corrected sharply from the Dm3.08 high seen earlier in the year, the overall technical picture for sterling continues to be positive. It remains well above its current medium-term trend, which is fairly strong having been tested some four times dating back to April this year. This trend is also close to the 200-day moving average at Dm2.8288. So, there is good support for sterling below the current rate but this does not give much indication as to whether sterling can make strong gains against the Deutschemark once more. The present price action suggests that there is a good chance that the price may slip to fill the gap between Dm2.8655 and Dm2.875. If it does, then the price action is likely to remain between the trendline support at Dm2.8315 and the strong resistance area at Dm2.9310/25 for some time to come. Indeed, this would heighten the probability of an eventual break down through the trendline and 200-day moving average supports with the next objective Dm2.8080. A break of this level would then produce a target of Dm2.6850.
If the gap between Dm2.8655 and Dm2.8775 remains unfilled, the bullish case for the pound is significantly enhanced and would increase even more with a move through the resistance level at Dm2.9310/25. Once above this level, the pound should head to the next significant resistance at Dm2-9735. A break above this level would then suggest a target of Dm3.0540.
After the sharp fall of early summer, the pound has been through a period of consolidation against the yen–although this has been of a very volatile nature. In the course of the last few days, the pound has received a significant boost by breaking through the strong neckline resistance at ¥199.25. This suggests that the price action may be in the process of forming a steep upward channel, the lower trendline of which is currently at ¥195.55, close to the 200-day moving average at ¥195.02. The 60-day moving average provides further support at ¥192.55. The initial target for the upmove should be to fill the gap between ¥202.75 and ¥203.75. Once this is achieved, the cross should move on to complete the channel by confirming the upper trendline at ¥206.40. However, it should be noted that this is a steep trendline and the price objective is rising at the rate of 25 points per day. Beyond this is the previous high of ¥207.25. which could prove difficult to break.
November 3, 1997Berkeley Futures, Ltd.
38 Dover Street, London, U.K., W1X 3RB
Copyright 1997, by Consensus Inc. All American and Pan American rights Reserved. editor@consensus-inc.com
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