WASHINGTON, July 18 (UPI) -- Rather than continue my consumer finance column "Wing Collar" on a regular basis I thought it more useful to readers to begin a "UPI Portfolio" in which I will take a notional amount of money, invest it and, over time, attempt to beat the various share indexes and achieve an attractive absolute return. I intend to confine myself to a few portfolio selections, and give considerable analysis for each selection, so readers can see my thought process at the time of a selection, and judge for themselves whether an investment idea has merit.
To "benchmark" the process, we will invest a notional $100,000, based on the closing market prices on the Friday the particular column appears. This amount of course represents a retail rather than institutional investor; it can easily be scaled up to $1 million by multiplying by 10, or to $10 million by multiplying by 100, but if you're running CALPERS and decide you wish to follow these recommendations, maybe you should think again; many of the markets in which the portfolio is active will be only moderately liquid, so that a purchase of say $2 billion, or even $20 million would completely swamp the market's liquidity and be very difficult to execute at a reasonable price.
All portfolio managers have a particular style, things they are good at. Some people are very good stock pickers, some people have a very good "feel" for the short term trends in a market, and some people have a deep understanding of the latest technologies, and are thus able to pick tech stocks successfully.
I have none of these abilities. Indeed, this may be why I have never managed money professionally, something which anyone seeking to copy this portfolio should bear carefully in mind before plunging. However, as a merchant banker for many years, albeit a specialist in bond and derivative markets, I acquired a pretty good idea of valuation, and past experience shows that I should have some useful things to say about "asset allocation" -- the distribution of assets between bonds, domestic shares, foreign shares and more exotic opportunities.
The portfolio will therefore specialize in non-traditional asset classes, albeit in classes in which a U.S. based retail investor can readily invest without worrying about such things as local clearing systems (I once made a considerable amount of money, relatively speaking, in a Spanish domestic closed end mutual fund, shortly before the 1986 entry of Spain into the European Union. I was very lucky, in that I had a young but very capable London stockbroker, who was prepared to devote a considerable number of man-hours to making sure I got paid when the shares were sold. Regrettably, that broker is now very successful, much richer than me, and only accepts clients with a net worth about 100 times mine.) If Pakistan, for example looks good, but there is no way to buy Pakistani shares through the U.S. markets, by means of mutual funds or American Depositary Receipts, it is an opportunity that a U.S. retail investor should let pass, and the UPI Portfolio will do likewise.
If the next few years are ones of enormous strength in the U.S. stock market, focused particularly on the tech sector, and with valuations being almost irrelevant (as were 1996-2000, and indeed the short period since the market bottomed in March) then the portfolio will not be successful. Such a period is inevitable eventually. But I don't expect it soon.
To make the portfolio interesting, rather than attempt to buy a large number of individual shares (which in any case, I'm not very good at, although if basic equities such as General Motors come back into vogue, we will be there) I will focus its investment on up to five investment tranches, with roughly $20,000 in each tranche, and in the first few periods will invest one tranche per article, ending up fully invested at the end of the fifth article. If I then think the five investments chosen remain optimal, the portfolio reviews will become a bit boring for a while, as there will be no more money to invest until something is sold. Such is life; as I said, the purpose is to try and make "money" and demonstrate how this might be done, rather than to entertain readers with vacuous and unnecessary portfolio churning.
OK, to the first investment. In my "Bear's Lair" column three weeks ago, I stated that I considered the bond market to be overvalued, with interest rates likely to rise. That has indeed proved the case, with the yield on the 10 year U.S. Treasury note rising from 3.34 percent at the time of the article (and a low of 3.10 percent) to 3.97 percent at Friday's close. Probably more to go for there, but the bond markets may take a breather first.
The stock market hasn't however reacted to the rise in interest rates (which will have a huge knock-on effect on the housing market if it doesn't reverse, once it's worked its way through in about 4-6 weeks.) It's still close to its high for the year, with the S&P 500 Index closing Friday at 993.32, up 1.18 percent on the day. In spite of fairly weak earnings during the week, and a number of forecast downgrades, the market is still priced as if corporate profits are about to rebound sharply in the second half of 2003 (and even then, its valuation is very rich by historical standards.) If you assume instead, that the current level of profits is about what we can expect going forward, allowing for inflation and some modest economic growth (which I do expect to resume in the long run, after a lengthy Japan-style "rolling recession" of low or no growth) then the S&P 500 Index should be trading no higher than the 500-600 range.
The other question is then how long it's going to take to get there. Here I have no crystal ball, and am no trader, so I really can't tell, which means we need an investment that won't severely damage us even if it takes time to go right. My "best guess" however is that the decline in mortgage refinancing which we can expect to begin in the weeks ahead (resulting from the move that's already happened in long term bond yields, not any future moves) will make consumer spending soften around the end of the summer, and cause a weak market by September-October. But as often happens I'm less sure about the timing than I am about the direction.
It's difficult to invest in the short side of the stock market. The traditional way, to sell shares "short" that you don't own, is very dangerous, even with notional money, because if the shares unexpectedly rise your goose is cooked. Much better is to buy put options, possibly on individual shares but better on a broad based share index such as the Dow Jones Index, the S&P 500 Index or the NASDAQ 100 Index (which represents 100 large capitalization shares on NASDAQ -- there appear to be no tradable options on the NASDAQ composite index, that most commonly quoted.) I propose that the UPI portfolio will invest in a mixture of all three, in out of the money options, of the longest maturities possible. Out of the money options because they are cheaper, in terms of the option value as a percentage of the stock value you've got an option on (so, these being put options, I will invest in options that have a strike price LOWER than the current market index.) Long maturities for two reasons. First, I don't know when the drop will happen, so I want to give it plenty of time to do so. Second, the only value in out of the money options is their "time value," -- if you exercised them today you would make a loss. This decays incredibly fast when they're close to maturity, but much more slowly when they still have a long life left. So, the longer the better.
One other feature of out of the money puts is that their price varies according to the expected volatility of the index -- if share prices are jumping up and down, the options are worth more. In practice, expected volatility depends more on investor fear or complacency, rather than on actual price movements, so it's currently quite low -- the S&P 500 volatility Index (VIX) closed Friday at 21.26, close to its 12 month low, as investors are currently complacent rather than fearful. If the market drops, therefore, we should make extra money from a rise in volatility.
These options are quoted on the Chicago Board Options Exchange, and can be bought and sold through any broker, although you have to sign a separate agreement with the broker saying that you know how options work. On the Dow Jones and S&P 500 Index there are "Leaps" -- options with maturities longer than the usual 6-9 months, to June 2005 (Dow Jones) or December 2005 (S&P 500) so these are what we'll buy.
Of the $20,000, therefore, let's put $5,000 in Dow Jones puts (symbol - DJX), $5,000 in NASDAQ 100 puts (symbol - NDX) and $10,000 in S&P 500 LEAPS puts (symbol - LSX.) S&P 500 puts are relatively the cheapest (lowest price to underlying share value ratio) but the NASDAQ 100 index is more volatile, while the Dow Jones Index looks to be more overvalued than the S&P 500 Index on long term comparisons.
The Dow Jones Index closed Friday at 9,188.15. Since the June 2005 puts are very new (less than 1 month since they started trading) rather expensive and illiquid (because there are yet few contracts outstanding) I'll go for the December 2004 puts, which still gives us 17 months to get it right. December 2004 puts with a strike price of 80 (equivalent to an 8,000 Dow) are currently trading at $4.50, or $450 per contract (contracts are always on 100 "shares" and here a "share" is 1/100 of the Dow.) Let's buy 11 contracts, for $4,950. Vanguard's brokerage service (the one I use, cheap but not the cheapest) charges $30 per trade plus $1.50 per contract, or $46.50. Total $4,996.50, which has bought us put options on 8,000 x 11, or $88,000 of the Dow Jones Index, at a strike price of 80.
The NASDAQ 100 Index closed Friday at 1,259.91 (up from 804 at the low in October 2002, and down from about 4,500 in March 2000 -- this is a much more volatile index.) The longest contracts here are March 2004. Since I don't want the things to expire worthless, we'd better buy fairly close to the current level of NASDAQ, say 1,100, at which there is a March 2004 put option costing $54.80, or $5,480 per contract, plus commission of $31.50 is $5,511.50. Slightly above budget there, but the contract "share" is a full NASDAQ, so prices per contract are high, and "lumpy." We've bought the right to sell $110,000 of the NASDAQ 100 Index, but only for 8 months.
The S&P 500 Index closed Friday at 993.32. Here we'll go for the December 2005 contract, which has been trading since last December, but go further out of the money -- we have more time to be "right" so let's speculate that in 29 months the market will indeed move as far as we think it will. Here the contracts with a 70 strike price (each "share" is 1/10 of the S&P 500 Index) are priced at $2.90 and the 60's are priced at $1.60. Let's go for 20 of each, which costs us $5,800 plus $3,200, plus $120 brokerage, for a total of $9,120. We've bought the right to sell $140,000 of the S&P 500 at 700, and $120,000 of the S&P 500 at 600.
In total, we've bought the right to sell $458,000 of stock indexes, all of them out of the money, in the following form:
-- 11 Dow Jones strike price 80 December 2004 put option contracts, cost $4,996.50
-- 1 NASDAQ 100 strike price 1,100 March 2004 put option contract, cost $5,511.50
-- 20 S&P 500 strike price 70 December 2005 and 20 S&P 500 strike price 60 December 2005 put option contracts, cost $9,120
-- Total Cost: $19,628, just under our $20,000 target. We have $80,372 in cash left.
You can follow the prices of these contracts on the CBOE Web site, on quote.cboe.com (prices 20 minutes delayed.)
Let's see how we do. Remember, options are very dangerous, you can lose all your investment, so do NOT try this with anything other than "mad money." This is NOT your retirement savings!
Martin Hutchinson was a capital markets banker for 25 years. He may from time to time buy, own and sell securities discussed herein (and does in fact own index put options similar to those discussed above.)
