lowers interest rates and boostsbond and stock prices. Inflation worse than expected raises interest ratesand depresses stock and bond prices.
That inflation is bad for bonds should come as no surprise. Bondsare fixed-income investments whose cash flows are not adjusted for inflation. Bondholders demand higher interest rates to protect their purchasing power when inflation increases.Worse-than-expected inflation is also bad for the stock market. AsI noted in Chapter 11, stocks have proven to be poor hedges against inflation in the short run. Stock investors know that worsening inflationincreases the effective tax rate on both corporate earnings and capitalgains and induces the central bank to tighten credit, raising real interestrates.
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CENTRAL BANK POLICYCentral bank policy is of primary importance to financial markets. Martin Zweig, a noted money manager has described the relationship thisway:In the stock market, as with horse racing, money makes the mare go. Monetary conditions exert an enormous influence on stock prices. Indeed, themonetary climate—primarily the trend in interest rates and Federal Reserve policy—is the dominant factor in determining the stock market’smajor direction.3
Chapter 13 showed that four of the top five largest one-day ralliesin Wall Street history were involved with monetary policy. Loweringshort-term interest rates and providing more credit to the banking system is almost always extremely welcome by stock investors. When thecentral bank eases credit, it lowers the rate at which stock future cashflows are discounted and stimulates demand, which increases futureearnings.Chapter 11 showed that over the past half century, tightening bythe Fed was associated with poor returns over the next year while easingboosted the market. Although the impact of changes in the fed fundsrate on 3- to 12-month returns has not been as reliable in recent years asin the past, surprise intermeeting moves by the central bank are as powerful as ever. The unexpected one-half-point cut in the funds rate from6.5 to 6 percent that took place on January 3, 2001, sent the S&P 500 Indexup 5 percent and the tech-heavy Nasdaq up an all-time record 14.2 percent. A smaller, but still substantial response met the Fed’s decision tolower the discount rate on August 17, 2007, during the subprime mortgage crisis.The only case in which stocks will react poorly is if the central bankeases excessively, so that the market fears an increase in inflation. But ifthe central bank eases excessively, an investor would prefer to be instocks than bonds, as fixed-income assets are hurt more than stocks byunexpected inflation.
CONCLUSIONThe reactions of financial markets to the release of economic data are notrandom but instead can be predicted by economic analysis. Strong economic growth invariably raises interest rates, but it has an ambiguous3
Martin Zweig, Winning on Wall Street, New York: Warner Books, 1986, p. 43.
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effect on stock prices, as higher interest rates battle against stronger corporate profits. Higher inflation is bad for both the stock and bond markets. Central bank easing is very positive for stocks and has historicallysparked some of the strongest stock rallies.Although the most important monthly report for the markets isusually the employment data, the focus of traders constantly shifts. Inthe 1970s, inflation announcements took center stage, but after Fedchairman Paul Volcker shifted the focus to monetary aggregates, theThursday afternoon money supply announcements captured the attention of traders. Later, in the 1980s when the dollar soared, trade statisticswere given top billing. Employment and inflation reports are always important to the markets, and the central banks’ reaction to these data isprobably the most important factor that impacts markets.In the end it should be noted that this chapter focuses on the shortrun reaction of financial markets to economic data. Although it is fascinating to observe and understand the market’s reaction, investing on thebasis of these releases is a tricky game that is best left to speculators whocan stomach the short-term volatility. Most investors will do well to watchfrom the sidelines and stick to an investment strategy for the long run.
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PA R T
STOCK FLUCTUATIONSIN THE SHORT RUN
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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THE RISE OF EXCHANGE-TRADEDFUNDS, STOCK INDEX FUTURES,AND OPTIONSWhen I was a kid—a runner for Merrill Lynch at 25 dollars a week—I’d heard an old timer say, “The greatest thing to trade would be stockfutures—but you can’t do that, it’s gambling.”LEO MELAMED, 19881
Warren Buffett thinks that stock futures and options ought to be outlawed, and I agree with him.P E T E R LY N C H , 1 9 8 9 2
If someone were to ask what stock traded the largest dollar volume inthe United States in 2006, what would you guess? General Electric,Exxon Mobil, Microsoft? The surprising answer is a stock that was not in1
Leo Melamed is the founder of the International Money Market, the home of the world’s most successful stock index futures market. Quoted in Martin Mayer, Markets, New York: Norton, 1988, p. 111.2Peter Lynch, One Up on Wall Street, New York: Penguin, 1989, p. 280.251Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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existence before 1993 and does not even represent a company. The security with the highest dollar volume was spiders, the nickname given tothe S&P 500 Depository Receipts (SPDRs), an exchange-traded fund thatrepresents the value of the S&P 500 Index. In 2006, over 17.6 billionshares were traded, representing a value of over $2.3 trillion.
EXCHANGE-TRADED FUNDSExchange-traded funds (ETFs) are the most innovative and successful newfinancial instruments since stock index futures contracts debuted twodecades earlier. ETFs are shares issued by an investment company thatrepresent an underlying portfolio. They are traded throughout the dayon an exchange where the prices are determined by supply and demand.Most ETFs issued in the 1990s tracked only well-known stock indexes,but more recently they have been tracking new customized indexes andeven actively managed portfolios.The growth of exchange-traded funds has been explosive. At theend of 2006, ETF assets totaled $422 billion, and although this is only asmall fraction of the $10.4 trillion in standard mutual funds, ETFs havegrown more than 300 percent since 2002.Spiders were the first and most successful ETF, launched in 1993.But spiders were soon joined by others, with nicknames like cubes, a corruption of the QQQ ticker symbol given to the Nasdaq-100 Index, anddiamonds, with the ticker DIA, which represents the Dow Jones Industrial Average.These ETFs track their respective indexes extremely closely. That’sbecause designated institutions, market makers, and large investors,called authorized participants, can buy the underlying shares of the stocksin the index and deliver them to the issuer in exchange for units of ETFsand deliver units of ETFs in exchange for the underlying shares. Theminimum size for such an exchange, called a creation unit, is usually50,000 shares. For example, an authorized participant who delivers50,000 shares of spiders to State Street Bank & Trust will receive a prorated number of shares of each member of the S&P 500 Index. These authorized participants keep the prices of the ETFs extremely close to thevalue of the index. For the active ETFs, such a spiders and cubes, the bidask spread is as low as 1 cent.There are several advantages of ETFs over mutual funds. ETFs, unlike mutual funds, can be bought or sold at any time during the day. Second, an investor can sell ETFs short, hoping to make a profit by buying
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them back at a lower price.3 This proves to be a very convenient way ofhedging portfolio gains if an investor fears the market may fall. And finally, ETFs are extremely tax efficient since, unlike mutual funds, theygenerate almost no capital gains either from the sales of other investors orfrom portfolio changes to the index. This is because swaps between theETFs and underlying shares are considered exchanges in kind and are nottaxable events. Later in this chapter we will list the advantages and disadvantages of ETFs as compared to alternative forms of index investing.
STOCK INDEX FUTURESETFs are really the outgrowth of one of the most important trading innovations of the last 50 years—the development of stock index futures inthe early 1980s. Despite the enormous popularity of these new exchange-traded funds, the total dollar volume in ETFs is still dwarfed bythe dollar volume represented by trading in index futures, most ofwhich began trading in Chicago but are mostly now traded on electronicexchanges. Shifts in overall market sentiment often impact the index futures market first and then are transmitted to stocks traded in New York.To understand how important index futures were to stock prices inthe 1980s and 1990s, one need only look at what happened on April 13,1992. It began as an ordinary trading day, but at about 11:45 in the morning, the two big Chicago futures exchanges, the Board of Trade and theMercantile Exchange, were closed when a massive leak from theChicago River coursed through the tunnels under the financial districtand triggered extensive power outages. The intraday movement of theDow Industrials and the S&P futures is shown in Figure 15-1. As soon asthe Chicago futures trading was halted, the volatility of the stock marketdeclined significantly.It almost looks as if the New York Stock Exchange went “braindead” when there was no lead from Chicago. The volume in New Yorkdropped by more than 25 percent on the day the Chicago futures marketwas closed; and some dealers claimed that if the futures exchange remained inoperative, it would cause liquidity problems and difficulty inexecuting some trades in New York.4 Michael Metz, a market strategistat Oppenheimer & Co., declared: “It’s been absolutely delightful; it3
ETFs are exempt from the uptick rule that until recently restricted shorting stock when the price isfalling.4Robert Steiner, “Industrials Gain 14.53 in Trading Muted by Futures Halt in Chicago,” Wall StreetJournal, April 14, 1992, p. C2.
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FIGURE
15–1
When Stock Index Futures Closed Down, April 13, 1992
SOURCE: Bloomberg L.P.
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seems so sedate. It reminds me of the halcyon days on Wall Street beforethe program traders took hold.”5Who are these program traders that investors hear so much about,and what do they do? The floor of the New York Stock Exchange has always been alive with a constant din of people scurrying about delivering orders and making deals. But in the mid-1980s, just a few years afterindex futures were introduced, the background noise was punctuatedevery so often by the rat-tat-tat of dozens of automated machines printing hundreds of buy or sell tickets. These orders were almost alwaysfrom stock index futures arbitrageurs—that is, program traders who relyon differences between the prices of stock index futures traded inChicago and the prices of the component stocks traded in New York.The noise signaled that the futures market was moving quickly inChicago and stock prices would soon change accordingly in New York.It was an eerie warning, something akin to the buzz of locusts in biblicaltimes, portending decimated crops and famine. And famine it might be,for during the 1980s and early 1990s some of the most vicious declines instock prices have been preceded by computers tapping out orders emanating from the futures markets.In those days, changes in the overall level of stocks did not originateon Wall Street but on Wacker Drive at the Chicago Mercantile Exchange.Specialists on the New York Stock Exchange, those dealers assigned tomake and supervise markets in specific stocks, kept their eyes glued onthe futures markets to find out where stocks would be heading. Thesedealers learned from experience not to stand in the way of index futureswhen they are moving quickly. If they did, they might get caught in anavalanche of trading such as the one that buried several specialists on October 19, 1987, that fateful day when the Dow crashed nearly 23 percent.
BASICS OF THE FUTURES MARKETSMost investors regard index futures and exchange-traded funds as esoteric securities that have little to do with the market in which stocks arebought and sold. Many investors do very well trading stocks withoutany knowledge of these new instruments. But no one can comprehendthe short-run market movements without an understanding of stockindex futures and ETFs.5
“Flood in Chicago Waters Down Trading on Wall Street,” Wall Street Journal, April 14, 1992, p. C1.Today the proliferation of electronic trading has made it impossible for an incident such as the onethat crippled the Chicago exchange 15 years ago to happen again.
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Futures trading goes back hundreds of years. The term futures wasderived from the promise to buy or deliver a commodity at some futuredate at some specified price. Futures trading first flourished in agricultural crops, where farmers wanted to have a guaranteed price for thecrops they would harvest at a later date. Markets developed where buyers and sellers who wanted to avoid uncertainty could come to an agreement on the price for future delivery. The commitments to honor theseagreements, called futures contracts, were freely transferable, and markets developed where they were actively traded.Stock index futures were launched in February 1982 by the KansasCity Board of Trade using the Value Line Index of about 1,700 stocks. Buttwo months later, at the Mercantile Exchange in Chicago, the world’smost successful stock index future, based on the S&P 500 Index, was introduced. By 1984, the value of the contracts traded on this index futuresurpassed the dollar volume on the New York Stock Exchange for allstocks. Today, the value of stocks represented by S&P 500 futures tradingexceeds $100 billion per day.All stock index futures are constructed similarly. In the case of theseller, the S&P Index future is a promise to deliver a fixed multiple of thevalue of the S&P 500 Index at some date in the future, called a settlementdate. In the case of the buyer, the S&P Index future is a promise to receivea fixed multiple of the S&P 500 Index’s value. The multiple for the S&PIndex future is 250, so if the S&P 500 Index is 1,400, the value of one contract is $350,000. In 1998, a mini version of the contract (called an e-mini),with a multiple of 50 times the index, was offered, and it trades on theelectronic markets. The dollar volume of these minis now far exceedsthat of the standard-sized contracts.There are four evenly spaced settlement dates each year. They fallon the third Friday of March, June, September, and December. Each settlement date corresponds to a contract. If you buy a futures contract, youare entitled to receive (if positive) or obligated to pay (if negative) 250times the difference between the value of the S&P 500 Index on the settlement date and the price at which you purchased the contract.For example, if you buy one September S&P futures contract at1,400, and on that third Friday of September the S&P 500 Index is at1,410, you have made 10 points, which translates into $2,500 profit ($250times 10 points). Of course, if the index has fallen to 1,390 on the settlement date, you will lose $2,500. For every point the S&P 500 Index goesup or down, you make or lose $250 per contract.On the other hand, the returns to the seller of an S&P 500 futurescontract are the mirror image of the returns to the buyer. The seller
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makes money when the index falls. In the previous example, the seller ofthe S&P 500 futures contract at 1,400 will lose $2,500 if the index at settlement date rises to 1,410, while he or she would make the sameamount if the index fell to 1,390.One source of the popularity of stock index futures is their uniquesettlement procedure. With a standard futures contract, if you bought it,you would be obligated at settlement to receive, or if you sold it, youwould be obligated to deliver, a specified quantity of the good for whichyou have contracted. Many apocryphal stories abound about howtraders, forgetting to close out their contract, find bushels of wheat, corn,or frozen pork bellies dumped on their lawn on settlement day.If commodity delivery rules applied to the S&P 500 Index futurescontracts, delivery would require a specified number of shares for eachof the 500 firms in the index. Surely this would be extraordinarily cumbersome and costly. To avoid this problem, the designers of the stockindex futures contract specified that settlement be made in cash, computed simply by taking the difference between the contract price at thetime of the trade and the value of the index on the settlement date. Nodelivery of stock takes place. If a trader does not close a contract beforesettlement, his or her account would just be debited or credited on settlement date.The creation of cash-settled futures contracts was no easy matter. Inmost states, particularly Illinois where the large futures exchanges arelocated, settling a futures contract in cash was considered a wager—andwagering, except in some special circumstances, was illegal. In 1974,however, the Commodity Futures Trading Commission, a federalagency, was established by Congress to regulate all futures trading.Since futures trading was now governed by this new federal agency andsince there was no federal prohibition against wagering, the prohibitorystate laws were superseded.
INDEX ARBITRAGEThe prices of commodities (or financial assets) in the futures market donot stand apart from the prices of the underlying commodity. If thevalue of a futures contract rises sufficiently above the price of the commodity that can be purchased for immediate delivery in the open market, often called the cash or spot market, traders can buy the commodity,store it, and then deliver it at a profit against the higher-priced futurescontract on the settlement date. If the price of a futures contract falls toofar below its current spot price, owners of the commodity can sell it
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today, buy the futures contract, and take delivery of the commodity laterat a lower price—in essence, earning a return on goods that would be instorage anyway.Such a process of buying and selling commodities against their futures contracts is one type of arbitrage. Arbitrage involves traders whotake advantage of temporary discrepancies in the prices of identical ornearly identical goods or assets. Those who reap profits from suchtrades are called arbitrageurs.Arbitrage is very common in both the stock index futures marketand the ETF market. If the price of futures contracts sufficiently exceedsthat of the underlying S&P 500 Index, it pays for arbitrageurs to buy theunderlying stocks and sell the futures contracts. If the futures price fallssufficiently below that of the index, arbitrageurs will sell the underlyingstocks and buy the futures. On the settlement date, the futures pricemust equal the underlying index by the terms of the contract, so the difference between the futures price and the index—called a premium if it ispositive and a discount if it is negative—is an opportunity for profit.Arbitrage in the ETF market is similar, except here an arbitrageurmust buy or sell all the stocks in the index and simultaneously make anoffsetting transaction in the ETF in the open market. An arbitrageur in theETF makes a profit when the prices of the stocks that she buys to createthe ETF are less than the funds that she receives by selling, or creating, anETF. Alternatively if the prices she receives from selling the stocks in theindex exceed the cost of buying the ETF, the arbitrageur will buy the ETF,exchange it into its component stocks, and sell them in the open market.Index arbitrage has become a finely tuned art. The prices of stockindex futures and ETFs usually stay within very narrow bands of theindex value based on the price of the underlying shares. When the buying or selling of stock index futures or ETFs drives the price outside thisband, arbitrageurs step in, and a flood of orders to buy or sell are immediately transmitted to the exchanges that trade the underlying stocks inthe index. These simultaneously placed orders are called programmedtrading, and they consist of either buy programs or sell programs. Whenmarket commentators talk about “sell programs hitting the market,”they mean that index arbitrageurs are selling stock and buying futuresor ETFs that have fallen to a discount.
PREDICTING THE NEW YORK OPEN WITH GLOBEX TRADINGAlthough trading index futures closes at 4:15 p.m. Eastern time, 15 minutes after the close of the New York stock exchanges, trading reopens in
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index futures at 4:30 in an electronic market called Globex. Globex has nocentralized floor, and traders post their bids and offers on computerscreens where all interested parties have instant access. Trading inGlobex proceeds all night until 9:15 the next morning, 15 minutes beforethe start of stock trading in New York.6Index futures trading can be active just after the close of regular trading on the NYSE and Nasdaq. This trading is especially popular in theweeks following the end of a quarter when many firms release their earnings reports and give guidance about future earnings and revenues. Unlessthere is important breaking news, trading is usually slow during the nighthours, although activity can pick up if there is dramatic movement on theTokyo or European stock exchanges. Trading again becomes very activearound 8:30 a.m., when many of the government economic data, such asthe employment report and the consumer price index, are announced.7Market watchers can use the Globex futures in the S&P, Nasdaq,and the Dow to predict how the market will open in New York. The fairmarket value of these index futures are calculated based on the arbitrageconditions between the future and current prices of stocks.The fair market value for the futures contract is determined on thebasis of the current index value when markets are open and on the previous closing level when markets are closed. Because of the continuousstream of news, the futures price overnight will usually be either aboveor below the fair market value computed at the close. If, for instance, better-than-expected earnings reports came out after the market closed,then the futures price will trade above fair market value computed onthe basis of previous closing prices. The amount by which the futuresprice trades above or below its fair market value will be the best estimateof where stocks will trade when the exchanges open. Many financialnews channels post the overnight trading in the S&P 500, Dow, and Nasdaq futures to inform viewers of the likely opening of the market.The formula to calculate the fair market value depends on two variables: the dividend yield on stocks and the interest rate. If an investorputs a sum of money today in risk-free bonds, that sum will earn interestat the ongoing interest rate. If instead the investor buys a portfolio ofstocks and simultaneously sells a one-year futures contract that guarantees the price of those stocks one year from now, the investor will earn the6
In Chapter 13, we examined the reaction of S&P futures to the terrorist attacks on the morning ofSeptember 11, 2001.7In Chapter 14 we noted the dramatic fall in the S&P futures traded on the Globex that occurred inresponse to the strong July 5, 1996, employment report.
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dividend yield on stocks and be guaranteed a return on his or her stocksthat is the difference between the futures price and the current price.Since both these investments deliver a guaranteed, riskless sum,they must earn the same rate of return. That means that the futures pricefor stocks must be sufficiently above the current price to compensate theinvestor for the difference between the yield on stocks and the yield onbonds. In other words, the futures price must be above the current price(in percentage terms) by i – d, the interest rate minus the dividend yield.8
DOUBLE AND TRIPLE WITCHINGIndex futures play some strange games with stock prices on the dayswhen futures contracts expire. Recall that index arbitrage works throughthe simultaneous buying or selling of stocks against futures contracts.On the day that contracts expire, arbitrageurs unwind their stock positions at precisely the same time that the futures contracts expire.Index futures contracts expire on the third Friday of the last monthof each quarter: in March, June, September, and December. Index options and options on individual stocks, which are described later in thechapter, settle on the third Friday of every month. Hence four times ayear, all three types of contracts expire at once. This expiration has in thepast produced violent price movements in the market, and it is consequently termed a triple witching hour. The third Friday of a month whenthere are no futures contract settlements is called a double witching, and itdisplays less volatility than triple witching.There is no mystery why the market is volatile during double ortriple witching dates. On these days, the specialists on the New YorkStock Exchange and the market makers on the Nasdaq are instructed tobuy or sell large blocks of stock on the close, whatever the price, becauseinstitutional investors are closing out their arbitrage positions. If there isa huge imbalance of buy orders, prices will soar; if sell orders predominate, prices will plunge. These swings, however, do not matter to arbitrageurs since the profit on the future position will offset losses on thestock position, and vice versa.In 1988, the New York Stock Exchange urged the Chicago Mercantile Exchange to change its procedures and stop futures trading at theclose of Thursday’s trading and settle the contracts at Friday openingprices rather than at Friday closing prices. This change gave specialists8
If the dividend yield is more than the interest rate, then the futures price will be below the currentprice.
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more time to seek out balancing bids and offers, and it has greatly moderated the movements in stock prices on triple witching dates.
MARGIN AND LEVERAGEOne of the reasons for the popularity of futures contracts is that the cashneeded to enter into the trade is a very small part of the value of the contract. Unlike stocks, there is no money that transfers between the buyerand seller when a futures contract is bought or sold. A small amount ofgood-faith collateral, or margin, is required by the broker from both thebuyer and seller to ensure that both parties will honor the contract at settlement. For the S&P 500 Index, the current initial margin is about 5 percent of the value of the contract. This margin can be kept in Treasury billswith interest accruing to the investor, so trading a futures contract involves neither a transfer of cash nor a loss of interest income.The leverage, or the amount of stock that you control relative to theamount of margin you have to put down with a futures contract, is enormous. For every dollar of cash (or Treasury bills) that you put in marginagainst an S&P futures contract, you command about $20 of stock. Andfor day trading, when you close your positions by the end of the day, themargin requirements are significantly less. These low margins contrastwith the 50 percent margin requirement for the purchase of individualstocks that has prevailed since 1974.This ability to control $20 or more of stock with $1 of cash is reminiscent of the rampant speculation that existed in the 1920s before the establishment of minimum stock margin requirements. In the 1920s,individual stocks were frequently purchased with a 10 percent margin.It was popular to speculate with such borrowed money, for as long asthe market was rising, few investors lost money. But if the marketdropped precipitously, margin buyers often found that not only did theylose their equity but they were also indebted to the brokerage firm. Buying futures contracts with low margins can result in similar repercussions today. The tendency of low margins to fuel market volatility isdiscussed in Chapter 16.
USING ETFs OR FUTURESThe use of ETFs or index futures greatly increases an investor’s flexibility to manage portfolios. Suppose an investor has built up gains in individual stocks but is now getting nervous about the market. Selling one’sindividual stocks may trigger a large tax liability.
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But by using ETFs (or futures), a good solution is available. The investor sells enough ETFs to cover the value of the portfolio that he seeksto hedge and continues to hold his individual stocks. If the market declines, the investor profits on his ETF position, offsetting the losses of thestock portfolio. If the market instead goes up, contrary to expectation,the loss on ETFs will be offset by the gains on the individual stock holdings. This is called hedging stock market risk. Since the investor never sellshis individual stocks, he triggers no tax liability from these positions.Another advantage of ETFs is that they can yield a profit from a decline in the market even if one does not own any stock. Selling ETFs substitutes for shorting stock, or selling stock you do not own in anticipationthat the price will fall and you can buy it back at a lower price. UsingETFs to bet on a falling market is much more convenient than shorting aportfolio of stocks since regulations prohibit individual stocks from beingshorted if their price is declining, but ETFs are exempt from this rule.
WHERE TO PUT YOUR INDEXED INVESTMENTS:ETFs, FUTURES, OR INDEX MUTUAL FUNDS?With the development of index futures and ETFs, investors have threemajor choices to match the performance of one of many stock indexes: exchange-traded funds, index futures, and index mutual funds.9 The important characteristics of each type of investment are given in Table 15-1.As far as trading flexibility, ETFs and index futures far outshinemutual funds. ETFs and index futures can be bought or sold any timeduring the trading day and after hours