Thursday, February 02, 2006

A lot of fear out there...but not of the market keeping on going.

I just bought some June 2006 calls on the S&P 500...current market on
the future is 1274, I just paid 11.12 points in £100 a point for a 1350
call (ie. risking £1112). TO save you reaching for your calculator, that
requires the market to move up ~6.8% for me to get into the money.

My reasoning behind the trade:

1. The highs back in March 2000 for the S&P were just over
1500...assuming GDP growth over the last 6 years has been 3.5% (i've not
looked up the number but its probably about that), then 1500 at 3.5%
growth a year is equivalent to a 23% increase = 1845. So, that makes S&P
high's in today's "money" 1845.

Now...back in 2000, long term interest-rates were over 7%...today they
are below 5%...so since the value of equity is just the discounted value
of the future cashflow stream, discounting back at sub-5% gives a (much)
greater value than at over 7%. Even if you take the equity duration to
be only 5, then discounting 200bps (old rates - new rates) times 5 =
10%...so making the REAL old high 1845*110% = 2029.

Now, the economy seems to be ticking along nicely, unemployment is very
low, credit markets are not far off all-time tights (so also signalling
strong economic conditions), inflation is well-contained, commodities
are at all-time highs on global demand, so equities could get back to
their "highs" (which as i've explained is well above the absolute levels
they reached 6 years ago).

So a MASSIVE rise in equity prices is not crazy (although yes those old
levels in 2000 were a little bubbly). If the market did reach 2029,
that would be a 59% rise FYI.

Jun '06 was the longest call I could buy on IG Index, or I'd maybe have
gone further out.

Hope you made it through all that, would be great to get some comments
back!

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