Gold, interest rates and the stock market have a very interesting relationship. Normally, declining interest rates are good for business and bad for gold. Post 9/11 and housing bubble, zero interest rate policies (ZIRP) created an artificial situation that fractured this relationship rendering it virtually useless over the last decade. This began to change last summer when the Federal Reserve Board stated that they would begin slowing the stimulus they’ve provided to the economy thus allowing interest rates to gradually rise. These relationships have begun to sort themselves out over the last three quarters and may actually be telling us something about the current pricing in the gold market.
This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.
Since the stock market’s dramatic sell off on May 6th, it has traded sideways to lower. The market has made new lows twice since then while each rally attempt has been capped by resistance roughly half way back to the top. Technically speaking, this is called consolidation and consolidation usually means continuation. The idea of an object in motion remaining in motion goes back as far as Isaac Newton and it still holds true to this day. This motion is what trends are made of and that is why consolidation is viewed as a pause in the existing trend’s general direction and in this case, the trend is down.
Over the last two months of consolidation we’ve also seen volatility increase to the downside. There have been twice as many big down days as there have been big up days. The largest down day came as the result of June’s monthly unemployment report, which resulted in a sell off of 4.5% to nearly 6%, depending on the stock index. Additionally, this month’s unemployment report comes out Friday, July 2nd. The national rate currently stands at 9.7% while Ohio is full a percent higher at 10.7%. Furthermore, several leading economists feel that our unemployment situation has yet to peak. Finally, July through October is typically, the seasonally weakest period of the year for the stock markets.
Clearly, there are no guarantees as to the future direction of any market. However, it is unwise not to take into account the current weighting of pros and cons when making financial decisions. That being said, what actions are available to someone who has owned a stock like General Electric for so long that the dividends and splits of the stock have left them with a cost basis of virtually nothing? Therefore, any sales of the stock would be subjected to substantial capital gains taxation. The typical response in this situation is one of helplessness. Just ride it out. The stock market comes and the stock market goes.
There is an active alternative to this feeling of habitual helplessness. That alternative is the calculated use of the futures markets. The construction of a futures contract is based on the agreement to either make or, take delivery of a given contract by the contract’s future delivery date. This is the basis of the old cliché, “Where do you want your load of pigs?” The reality is that less than one percent of the futures contracts traded are ever delivered and those delivered, are by design. Every trade in the futures market requires a buyer and a seller. The usefulness of futures is that it doesn’t matter how you initiate the trade. You can create a new position as either the buyer or, the seller and exit the trade prior to the delivery date thus, eliminating delivery issues.
Lets walk through a real world scenario using the General Electric example above. The owner of the General Electric stock wishes to protect their investment without having to pay the capital gains taxes on a lifetime or, generations of accumulation. Assuming the expectation of the stock market is lower, an appropriate amount of stock index futures can be sold to create a new position. This is called a short position and it makes money if the market declines in value. The portfolio has been protected by, “selling high.” If the market does decline or, the perspective on the market changes, the futures trade is offset by buying back what has been sold. This is, “buying low.” The cash difference between what has first been sold high and then covered by, buying low, is the profit accrued on the trade. This profit can be used to offset the loss in Cedar Fair on the broad market’s decline.
This same strategy can be used to generate protection or, profit in any market that is expected to fall. These include agricultural contracts like corn, soybeans or, cattle and also include things like the U.S. Dollar or gold and silver. The commodity markets were designed from the beginning to be used as a tool to hedge risk. This tool is available and applicable to a wide range of individuals and their respective needs. Furthermore, we can track the professional’s trading positions through the Commitment of Traders Report and use it as guide to time the entr4y of a short position. The next time a market is expected to decline don’t just sit there helplessly and watch the market value of your holdings – stocks, cash, precious metals, grains, etc. decline with it. Once educated, ignorance is no longer an excuse.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.