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THE HIGHTOWER REPORT
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(November 19, 1997) STOCK INDICES: There seems to be a consensus building that the U.S. economy is the best in the world given its balance of growth and inflation which could set up a quick return to all time highs in stock prices. However, it's the job of the market to anticipate and factor into prices future events. Given the massive gains (on paper) held by a vast number of investors, it might be prudent to begin thinking about taking profits or at least tempering exposure. With the current run extending beyond all historical records, the market should be assumed to have few cracks in its foundation. However, volatility seen since the August top should suggest that something is changing. We think the end of the current bull market comes not from worsening economic conditions, inflation or some other negative device, but from a simple rotation to international markets looking for the next “big market.” Money managers the world over are already feeling the pressure to continue performing above the historical norm with investors already spoiled by excessive rates of return. Therefore, we feel the August reversal in European currencies signals an attempt to anticipate the next phase of speculative flow. With Asia still reeling from wild currency fluctuations, the risk and reward in that area is probably the widest in the world and too much for investor sentiment until the spring of 1998. Even if the U.S. bull market in stocks is not over one would have to conclude that the era of easy money (high rates of return, low rates of risk) is probably past. Even the Chairman of the Federal Reserve is concerned about the evaluation of the U.S. market. We would maintain that the actual pace of the economy can't be expected to fuel prices significantly with seeing the Fed act and therefore, the next stage of the bull market must be fueled primarily by productivity improvements.
At the very least, investors with significant profits should begin to investigate ways to protect gains from either rotational volatility or a return of Asian currency concerns. Given volatility levels since August of 1997, the use of hedge strategies looks to be more effective now than at any time in the last five years. If the pattern of short lived corrections is broken that would suggest to us that protection is warranted. Exiting the stock market too early might mean excessive opportunity costs in a market environment lacking acceptable rates of return on interest bearing instruments. Therefore, it makes logical sense to begin hedging stock portfolios or exchanging some profit potential for piece of mind! If the market resumes its record breaking pace the cost of hedging will be well worth the expense.
HEDGING BENEFITS OF THE DOW CONTRACT AT THE CBOT!–The advent of options on the Dow creates an opportunity to hone in on the core of the U.S. market. Also, blue chip stocks have until recently led the entire market higher and might be considered the most over valued if the market goes into a sustained decline and, therefore, a more effective hedge vehicle. The most important reason to use put options on the Dow as a hedge vehicle comes from the fact that most of the Dow stocks are multi-national corporations that could see a direct negative impact if conditions outside the U.S. falter again as they did in Asia back in October.
AN AGING BULL?–In a much longer-term vein, the relationship between the S&P and the Value Line Index also speaks of a coming end to the bull market. Historically, some analyst think the end of a bull run is signaled by a rotation of investment interest away from the safety of the blue chips and into the smaller capitalized stocks. This supposed rotation of investment flows can occur for a number of reasons, but the two most notable reason seem to be that the blue chip stocks have reached fair value in the early stages of the bull market and investors are looking for alternatives. Secondly, it seems that once the economy is firmly entrenched in an economic expansion investors are comfortable enough to move out on the risk continuum to the small more risky stocks. It retrospect it seems that the Value Line/S&P spread made a major bottom between June 16th and July 21st or at least the correction against the downtrend was the largest since 1992-1993! Therefore, we have reason to suspect that the “high cap” stocks have topped and that the Dow option stand a good chance of being the best hedge vehicle in the coming six months.
BENEFITS OF OPTIONS: TO LOCK EXISTING PROFITS OR DEFRAY LOSSES!–The purchase of long put options still allows participation in the bull market if it continues on for a defined cost. Puts can have the tendency to expand in value during periods of panic which means a fully hedged portfolio could be more than protected in certain cases. It is also possible that your protection could underperform if the break came close to expiration of the options!
TO EXIT THE MARKET BUT CONTINUE TO PARTICIPATE!–While the benefit of purchasing put protection can help defray losses in a market washout, traders might even consider liquidating their stock portfolio and purchasing call options as a way of staying long the market without having stock specific exposure. This alternative could also lessen the time and cost of liquidating an extensive portfolio during a severe market debacle. While long calls are decaying assets, greatly reduced transaction costs might make the play a little more attractive than many realize.
SUGGESTED HEDGE ALTERNATIVES–1) Straight Protection: Buy January Dow 7500 puts for 1600 points for protection through the third week of January.
2) Protection & Ease Of Execution: Liquidate blue chip holdings and buy a January 7900 Dow call for 1100 points for coverage into the middle of January.
3) Long-Term Strategy To Lower Hedge Costs: Sell January Dow 7900 calls for 1800 points and then buy a January 7500 put for 1700 points!
For daily market updates of the Hightower Report of Comprehensive Commodity Research, call 900-225-2200, extension 2 for Financial Market Forecast. The cost per minute is $1.33.
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