The U.S. stock market has been on a tear over the last four years. The S&P index has risen over 150 percent since 2009, and the question is: how come?
The major reason has been the access to cheap money that the Federal Reserve has provided through its management of the country’s monetary policy.
Consider that real interest rates have hovered at close to zero as a direct consequence of the Fed purchasing $85 billion in monthly Treasury securities, and this almost unprecedented intervention in the economy has driven investors to the stock market.
Antti Ilomanen, a managing director at AQR Capital, a firm that manages $80 billion in assets, stated recently that, “Monetary policy has dominated the equity markets more than earnings growth. The low discount rate boosts all asset prices and is the main reason that stocks have performed so well.”
Given the announcement by Ben Bernanke in June that the Fed may start reducing its bond purchasing program later this year and could eventually eliminate the program by the middle of 2014, it seems inevitable that stock prices will be headed south in the near future.
The second reason that the stock market has performed so well in recent years has been the spectacular increase in U.S. corporate profits.
Since the beginning of 2005 through the beginning of last year, the earnings per share of the companies that compose the S&P 500 have grown 50 percent.
The lukewarm economy hasn’t really added much to that growth figure, but the fact is: with only modestly higher revenues, companies have been able to reduce their costs, and this cost-cutting has increased profit margins.
Consider that in 2012, the S&P 500 earned $820 billion in profits, or 60 percent more than in 2004. This profit number was achieved with only 10 percent more employees than were employed in these companies in 2004.
Time out for a brief lesson in monetary policy: when interest rates are low, investors migrate to the stock market in an attempt to generate greater returns than are available in the bond market.
In the period since the Fed chairman announced his intention to cut back bond purchases, the yield on 10 year treasury notes has jumped from 1.63 percent to over 2.5 percent, an increase of over 40 percent.
Treasury bonds now look much more appealing to investors, since investing in Treasury securities carries zero risk.
So, what is an investor to do? I recommend revisiting your investment allocations. Now may be the time to think about increasing your fixed income portion and decreasing your allocation in the broad stock market. Another technique is to hedge your bets, by the judicious use of options.
The manner in which you would proceed would be to purchase put options in, for example, SPY, an exchange-traded fund whose allocations exactly match the composition of the S&P 500.
As of the 24th, SPY was selling at $169 per share. So you would purchase a 6-month $150 put option, which would allow you to sell your SPY anytime during the next 6 months, and limit your losses to 10 percent.
If your portfolio was precisely $170,000, you would buy 100 options for $3500. But wait, virtually simultaneously, you could sell $175 call options in SPY that would expire in 6 months, and you would receive $3.50 for each contract. So, if you sold 100 contracts, you would receive $3500 upon completion of the sale.
If the SPY were selling for $175 or more by the end of the six month period, you would have to sell your shares, for $175, which would represent a gain of 3.6 percent.
This strategy is referred to as collar, and may not be for everyone, but it can be an effective way to protect your portfolio by limiting your losses to 10 percent, while capping your possible gain from this collar at 3.6 percent.
If you are nervous in volatile markets (and this one may become very volatile if Mr. Bernanke follows through with his plan), check with your broker and get his/her opinion.
The idea for this column came from two articles in the most recent edition of Fortune magazine.
Got a financial planning question for Greg? You may email him at email@example.com.
Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience.