Despite our many worries about the world, we think it quite probable that the S&P Index has not yet peaked. Indeed, we think that the US market could accelerate its rise. I outline three reasons why, and one way to trade it, below:
There’s more life left in this bull market
Most importantly, the US is enjoying one of its great historic bull markets. Since it bottomed in March 2009, the index has risen 270%. There remains much scepticism about US stock prices, especially from old-fashioned value investors (like us!). The history of big bull markets is that they often go on long after the old-timers say they’ve gone too far, and often end up rising at a fast rate as an increasing share of the population gets dragged into the bull market. With global interest rates remaining low and likely to stay that way for a bit longer, the chance of an accelerating, or even parabolic rise in the US market is quite high.
Trump is pro-business
Donald Trump is unashamedly pro-business. His stated policies include cutting taxes for rich people and corporations, allowing businesses much greater freedom to pollute, giving banks greater freedom and reducing protection for workers and consumers. These policies, if enacted, are great news for US investors, at least in the short term.
Self-interest could keep a lid on US interest rates
Several members of the US Federal Reserve board are due to retire next year, including its Chairman, Janet Yellen. As a property investor with large debts, it is in Trump’s interest to ensure that the Fed is led by governors who will keep US interest rates low and US monetary policy easy. If the Fed explicitly announced that it intends to do this for the next few years, asset markets would be likely to respond very favourably.
How to participate in this bull market with little risk
We’ve invested 2% of our fund in call options on the S&P Index that only have value if the index rises 10-15% over the next year. One option we own expires in June 2018 and is exercisable at 2800, 13% above the market’s current level. We recently paid 5 points for this option, or 8.6% implied volatility, which is close to a record low. Based on historic volatility levels, when we bought the options, there was a 30% chance that the index would rise over 13% over that time, and if that happens then we could expect to make over 30 times our money. That is to say, the option has an expected value of about ten times what we paid for it, based on historic volatility levels.
On the other hand, if current levels of volatility continue, then this option has only a 7% chance of having any value and we’ve made a bad investment.
Fred has worked in the stockbroking and funds management industry since 1981, starting in stockbroking in Sydney. From 1989-2003 he worked in London and Monaco as an investment analyst and fund manager. From 2000-2003, Fred ran the London office...
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Volatility is asymmetric - higher when markets are falling. Does it make sense to base the value of your call on increased volatility?
Interesting contrarian view, thanks.