What a Cycle Part 2

What a Cycle! – Part 2

The first part of this cycle generated large amount of feedback. Many customers were calling with the same questions. “How do I do it?” How do I use commodity futures hedge my portfolio if I think there is further downside?” I also received the opposite question, “I don’t think this will last forever. How do I take advantage of the move back up?”

First, let’s deal with some basic mathematical issues and market barometers. The Dow peaked at 14,198 on October 11^th. Currently, we are around 10,600. This is a decline of almost 3,600 points or, 25%. Now, if we were to bottom here, and I’m not saying we will, the 25% decline lost in the blue chips will need a rally of 34% to reach the same highs.

Here is a table for the other indices:

Market High Current % Decline % Rally to Reach Highs

S&P 500 1576 1140 25 38

Russell 2k 857 658 23 30

Nasdaq 100 2239 1137 49 97

NYSE Comp 10301 7319 29 41

The Point here is to illustrate that an account that is off 25% is going to need far more than a 25% rally to get back to even. Now, the month of September was particularly brutal. The S&P lost more than 13%. I went back to 1970 and I could only find nine other occurrences when the S&P lost more than 9% in one month. Unfortunately, the months following the decline don’t show a clear pattern. However, a couple of general assumptions can be made. First, the worst of the decline is usually over. The market is steady to higher in eight out of nine observations. Also, the market can rally substantially from oversold levels as we saw in 1998 and 2002.

Now, for the practical concerns of implementing an equity portfolio enhancing futures strategy we can begin with some practical portfolio composition issues. Let’s assume that one has a $100,000 portfolio and at this point is allocated to 50% stocks, 30% bonds and 20% cash. Using the S&P as a broad market proxy, the equity portion has lost 25% of its value and now has a current market value of $37,500. Sobering, isn’t it? As we discussed earlier, the S&P will have to rally 38% for the equity portion of this portfolio just get back to where it was one year ago. Does anyone want to add in the attrition of a 5% inflation rate?

Here are the tools we have to work with.

Market Contract Size Margin

S&P500 $285,000 $22,500

Mini S&P $57,000 $4,500

Russell 2K $329,000 $26,250

Mini Russ $65,800 $5,250

Dow $106,000 $7,005

Mini Dow $53,000 $3,503

Also, we have an entirely different commodity futures product called Single Stock Futures. These have been around for a couple of years and have built up pretty good volume. There are a few important things to know. First of all, SHORT TRADES are allowed. Secondly, they are 100 share contracts at 10% margin. In other words, Microsoft trading at $26 dollars a share in single stock futures would be worth the trade price multiplied times 100 shares or, $2,600. The margin, at ten percent of contract value, is only $260.

Therefore, these products can be used by smaller accounts or, to protect individual market sectors and individual issues. For example, there is a single stock banking industry contract, as well as several others. The Narrow Based Indexes can be traded just like the futures indexes because they are cash settled, which eliminates any delivery issues.

Here are the single stock futures with the highest open interest as of 9/30.

Verizon Kraft Chevron Corp. Bristol-Myers Squibb Wyeth

Juniper Networks Inc. Exelon Corp. Boeing Co. Marsh & McLennan Co.

I think this provides a good detail of the products that are available and the actual dollars involved in trading. The last step is making the transition from cautiously reading and internalizing the information to actually putting this information to use in your own accounts. I understand that no one wants to accept the current values of their portfolios. Believe me, I get it. However, for those who did nothing on the way down, hoping that it would, or will, turnaround, I strongly suggest putting these products to work in your own accounts. I will be happy to discuss an appropriate combination that makes sense for your portfolio and your objectives.