As for the S&P 500, the lowest-cost way to short it would be to sell short SPY, the S&P 500 ETF. If you’d rather use options to short the S&P, you can buy “at the money” or slightly out of the money puts on SPY. I’d stick to further expiration dates.
 
The S&P 500 is overvalued. It would take a resumption of investor fear to drive it down to, or below intrinsic value. Despite recent weakness, we’re not yet seeing much fear — at least not as much fear as we should be seeing, considering the horrible economic and regulatory environment. The vast majority of investors still think we’re in a new bull market.
 
The best estimates I’ve seen put the S&P 500’s intrinsic value somewhere in the range of 800 to 900. This range should go up over time assuming economic growth, and the “survivorship bias” of the index (i.e., companies like GM and Citigroup, whose market caps get obliterated, get lower weights, while successful companies like Apple get higher weights as they rally).
 
But for now, considering valuations, profit margins, and risk premiums, the S&P is likely overvalued by 25%. The S&P could easily fall to that range by 2010, 2011, or 2012 but there’s no way of knowing when.
 
2. Can I buy and sell put options from my online brokerage account, or do I need to use a broker?
 
Dan: Every good online brokerage offers options trading. You’ll just need to open a margin account. Your online broker should have all of the available educational tools. E*TRADE has worthwhile links to free educational resources on options trading here. The basics of the simplest options trades are not complicated. I like to keep recommendations simple.
 
3. Is there a minimum amount of money a person needs to short stocks?
 
Dan: From my experience, there is no minimum amount. Most likely, the minimum amount would be your broker’s minimum for opening a margin account. You need a margin account to sell short. Another way to limit the amount of money you commit to shorting would be to buy put options instead. You can get the same exposure as shorting, but with much less money involved. Each put contract gives you exposure to a short sale of 100 shares of stock.
 
For example, if you shorted 100 shares of a $20 stock, you’d have to borrow $2,000 from your broker in your margin account (the amount borrowed depends on your level of equity in your margin account), sell the stock at $20, and have the obligation to buy it back in the future. Your profit is the difference in the stock price between when you sell it short and buy it back, multiplied by the amount of shares you sold short.
 
If you used a put option with an asking price of $2 per contract, you can short the same value of shares ($2,000), but only risk $200 ($2 per contract times the right to sell 100 shares of the underlying stock). Profit potential is much higher, but so is the risk of loss. The way we deal with this in Strategic Short Report is to find stocks that we’re highly confident are overvalued, and look for put options with high strike prices and distant expiration dates. If the thesis isn’t developing as we expected after a few months, we cut our losses.

4. Is there still opportunity to short BP, what do you think is the best way to do this?
 
Dan: I would not recommend shorting BP at today’s price, because it’s likely undervalued. The only thing powerful enough to drive it much lower would be endless class action lawsuits, without any sort of negotiated cap on damages.
 
That’s not an outcome I would bet on. It’s certainly possible, but not likely. The U.S. government has an interest in keeping BP alive and functioning normally, so it can fund cleanup costs damage claims out of its future cash flow. The value of BP’s future cash flows — after adjusting for spill-related costs — is likely much higher than the current stock price (especially if over the next decade, average oil prices are north of $100 per barrel, which is very possible).
 
That being said, if you want to bet on the government and lawyers tearing the company apart in a foolhardy manner (which wouldn’t necessarily surprise me), it would be much smarter to buy puts rather than sell the stock short, because with puts, you can limit your risk of losses.

Regards,
Dan Amoss
Whiskey & Gunpowder

June 17, 2010

How to Short the Market Right Now was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Their initial stake, as a 2002 research paper noted, increased five times over. Now that’s real money!

But roll forward 10 years, and the total return on the S&P 500 was actually negative for the decade ending on 30 June 2008.

Yes, you read that right. For the 10 years to last week, the S&P index delivered less than zero. That’s even after accounting for dividends (good) as well as inflation (bad).

U.S. equity buyers just suffered a “Decade of No Returns” in short. Looking back to the late Nineties from the late Noughties, it barely seems possible.

The S&P enjoyed two strong bull markets during that time. The first added nearly 50% in the 18 months following July ‘98; the second delivered more than 87% in the five years to Sept. ‘07. All told, the S&P rose in 69 months out of 120 — and yet anyone holding the 500 stocks included in Standard & Poor’s Index just wound up with a total return of sweet fanny Adams.

Whatever happened to holding stocks for the long term?

“[The Noughties] are well on the way to being the worst decade for stocks since 1930-40, back when things were really messy,” says the Wall Street Journal. It cites a note from Richard Bernstein, chief investment strategist at Merrill Lynch, who spotted this Decade of No Returns last week.

Even “the somewhat more-bullish Tobias Levkovitch, chief U.S. strategist at Citigroup, pointed out recently that the S&P 500 returned just 1.66% from 2000-2007,” the Journal goes on.

“He notes that all of the returns so far this decade have come from dividends; price return is slightly negative.”

Dividends remain crucial to stock market investing, in short. Ever more crucial, in fact…and perhaps more crucial still than either Bernstein or Levkovitch dare guess:

It should surprise us little. But while U.S. equity investors saw the S&P’s valuation rise more than four times over during the 1990s, its 500 constituent stocks didn’t actually pay out four times as much in dividends each year.

Indeed, the capital gains enjoyed by NASDAQ and S&P owners between Jan. 1990 and the end of 1999 came at the cost of decent yields offered to new stock-market buyers. That decade saw dividend yields on the S&P fall in half, according to data from Robert Shiller at Harvard University — down from 3.3% to below 1.15% per year.

Any wonder the derriere eventually fell out of the “Long Boom” at the start of this decade? By way of comparison the long-run historic average sits nearer 4.3%.

That’s the long-run average running back 120 years and starting in January of 1888.

The equity bull market of the 1990s, in other words, stands out as something of an aberration…an “outlier” event as dramatic in its own way as the stock-market wipe-out of the 1930s. But while the Great Depression took stock prices so low, dividend yields shot up towards 14% per year, the vanishing yields of the 1990s needed the bear market of 2000-2003 to set things right.

Only, of course, it didn’t. Yields slumped and stayed slumped as the tech crash drowned financial, industrial and retail stocks in its wake. S&P dividends fell lower right alongside stock prices. Even at the low of Oct. 2002, the dividend yield offered by America’s 500 biggest corporations remained well below 2.0%.

Fast forward to mid-2008, and the gap between what you might now earn in dividends and what investors have traditionally expected remains very nearly as wide as it was throughout the 1990s. The upshot? Unless things really are different this time, and investors are willing to buy stocks that pay less than half the rate of inflation — and less even than U.S. Treasury bonds! — then the current bear market might be expected to roll on for a while longer yet.

Why? Because to push this decade’s dividend-yield back toward the long-run historic average, the annual pay-out from S&P stocks would need to reach a staggering and never before witnessed 19% — and stay there — for the next 18 months.

Short of market-wide “earning surprise,” you can guess what that would mean for stock prices, currently offering a little over 2.1% per year in dividend yield.

Either investors had better hope and pray earnings rise sharply…or inflation in their cost of living goes negative…before stocks look to be a good income-paying asset class once again.

If not, they’re likely to continue swapping stocks for other investments until the return offered by equities gets somewhere near to its historic average — more than twice the current level today.

Regards,
Adrian Ash
BullionVault
July 11, 2008

Negative Gains from the SP 500 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.