Market Corrections: am I missing something?

In the last week or so there has been a correction downwards of about 10%.
I hear various commentators sagely saying this was well overdue the market was ahead of the economic recovery etc., and those of us who saw paper losses should not be surprised.

This puzzles me greatly, but being new to this I am happy to be shown the error of my ways.

If I put my money in my cash account I think we were getting 3.5%, I suppose today we are getting 3.75% after the rise.
I want my money to be where it is earning the highest yield after tax, but take into account the different level of risk investing in a share rather than cash.

So therefore the acceptable return to me is if a share dividend grossed up for it's franking credits is greater than the cash rate of 3.75% plus the cost of a 1 year put option to protect the capital and make it a safe as cash. Then I am in front.

From this I am able to calculate from dividend forecasts a price at which the share is starting to become overpriced. Obviously this is a moveable feast as the interest rates go up it lowers the price at which the share becomes too expensive.

I update my spreadsheet daily and share prices I was monitoring were no where near being overpriced by that calculation.

So what is the rational for the correction being well overdue and expected.

Cheers

Gary

Re: Market Corrections am I missing Something

snabbu said:

So therefore the acceptable return to me is if a share dividend grossed up for it's franking credits is greater than the cash rate of 3.75% plus the cost of a 1 year put option to protect the capital and make it a safe as cash. Then I am in front.

Click to expand...

If you do this you may not be entitled to the franking credit.

Shares in any given company must be held for a minimum of 45 days at risk (without the put option) to be entitled to the franking credit where the taxpayer's total franking credits exceed $5000 for that year.

http://www.ato.gov.au/print.asp?doc=/content/8651.htm&page=4#P24_3913

There is the risk that dividend payments/franking levels don't live up to expectations.

Re: Market Corrections am I missing Something

drsmith said:

If you do this you may not be entitled to the franking credit.

Shares in any given company must be held for a minimum of 45 days at risk (without the put option) to be entitled to the franking credit where the taxpayer's total franking credits exceed $5000 for that year.

http://www.ato.gov.au/print.asp?doc=/content/8651.htm&page=4#P24_3913

There is the risk that dividend payments/franking levels don't live up to expectations.

Click to expand...

I don't actually place put options it's just a way of valuing the risk.

I understand that dividend payments might not live up to expectations.
But if you look at the dividend stability, and keep watching the forecasts, surely the forecasts and or market conditions for a share would have to change for them to become overvalued. Nothing has dramatically changed in the last week that I can see.

As a side question I think Westpac issued installment warrants capital guaranteed have a put option included in the bundled product and their PDS says you are entitled to the franking credits. I would have thought the share and the option are two different things as far as the at risk rule issue is concerned. The shares themselves are at risk. The options would be just an insurance policy.

Cheers


Gary

Re: Market Corrections am I missing Something

snabbu said:

I don't actually place put options it's just a way of valuing the risk.

I understand that dividend payments might not live up to expectations.
But if you look at the dividend stability, and keep watching the forecasts, surely the forecasts and or market conditions for a share would have to change for them to become overvalued. Nothing has dramatically changed in the last week that I can see.

As a side question I think Westpac issued installment warrants capital guaranteed have a put option included in the bundled product and their PDS says you are entitled to the franking credits. I would have thought the share and the option are two different things as far as the at risk rule issue is concerned. The shares themselves are at risk. The options would be just an insurance policy.

Cheers


Gary

Click to expand...

Instalment warrants are pretty options that include the dividend. There is very little downside protection. The cost of an option to protect yourself against falls for a year far outweigh the divvie.

Re: Market Corrections am I missing Something

snabbu said:

I don't actually place put options it's just a way of valuing the risk.

Click to expand...

I see what you are saying. Rather than actually doing it you are looking at it purely as a valuation tool.

snabbu said:

I understand that dividend payments might not live up to expectations.
But if you look at the dividend stability, and keep watching the forecasts, surely the forecasts and or market conditions for a share would have to change for them to become overvalued. Nothing has dramatically changed in the last week that I can see.

Click to expand...

The recent fall has only been small in comparison to the rise in the past 6 months or so.

snabbu said:

As a side question I think Westpac issued installment warrants capital guaranteed have a put option included in the bundled product and their PDS says you are entitled to the franking credits. I would have thought the share and the option are two different things as far as the at risk rule issue is concerned. The shares themselves are at risk. The options would be just an insurance policy.

Click to expand...

It's a fair bet the $5000 limit on the franking credits is buried somewhere deep within the fine print.

Insurance is itself a form of risk management.

snabbu said:

If I put my money in my cash account I think we were getting 3.5%, I suppose today we are getting 3.75% after the rise.
I want my money to be where it is earning the highest yield after tax, but take into account the different level of risk investing in a share rather than cash.

So therefore the acceptable return to me is if a share dividend grossed up for it's franking credits is greater than the cash rate of 3.75% plus the cost of a 1 year put option to protect the capital and make it a safe as cash. Then I am in front.

From this I am able to calculate from dividend forecasts a price at which the share is starting to become overpriced. Obviously this is a moveable feast as the interest rates go up it lowers the price at which the share becomes too expensive.

I update my spreadsheet daily and share prices I was monitoring were no where near being overpriced by that calculation.

So what is the rational for the correction being well overdue and expected.

Cheers

Gary

Click to expand...

I'd like to see your figures for this rationale.

While I agree in premise, there is nowhere near enough risk premium to make this stand up.

Divvies would have to be in the teens.

snabbu said:

If I put my money in my cash account I think we were getting 3.5%, I suppose today we are getting 3.75% after the rise.
I want my money to be where it is earning the highest yield after tax, but take into account the different level of risk investing in a share rather than cash.

Click to expand...

UBank (Backed by NAB) offer 5.11% pa.

Alternatively, if you have a mortgage with an offset account, the money in the offset account will effectively be earning you the home loan interest rate. You also don't pay tax on the "interest" since it is simply reducing your non-tax deductible expense (assuming it's for your primary residence and not an investment property). The downside, is that the full bells and whistles mortgages that offer offset accounts, usually have a slightly higher interest rate. There are several Credit Unions that offer this facility though.

P.

wayneL said:

I'd like to see your figures for this rationale.

While I agree in premise, there is nowhere near enough risk premium to make this stand up.

Divvies would have to be in the teens.

Click to expand...

I guess this is coming to the heart of the matter.
The risk premium.
How big should it be in the current economic climate?

That is going to depend on the share, I understand that.

It is also going to depend on your time frame as well, but let’s assume you have enough cash or bonds in your portfolio so that if the market goes into meltdown like it did a year or so ago you can wait out the madness without selling.

If we Take CBA and shares of that class. Can we say a multiple of 1.5 times the cash interest rate is a fair risk premium?

If we take TAH or SIP would a multiple of 2 times be OK.
I don't think not meeting market estimates is such an issue unless economic conditions change dramatically. This is handled by diversification one share underperforms the market expectation the other over performs.

Before the correction CBA and the like grossed up were at double the cash rate TAH and SIP three times the rate.

So we come back now to the commentators saying it's an overdue correction
share prices had risen too much.

They did rise a lot quite quickly but that could be because Australian shares fell too much in anticipation of a recession that just didn't happen.


I suspect there's a chart somewhere that says every time the market goes above a certain line by too many points, there will be a correction.
And this is what they base their comments on. I also suspect this chart is a self fulfilling prophecy

Cheers

Gary

zzaaxxss3401 said:

UBank (Backed by NAB) offer 5.11% pa.

Alternatively, if you have a mortgage with an offset account, the money in the offset account will effectively be earning you the home loan interest rate. You also don't pay tax on the "interest" since it is simply reducing your non-tax deductible expense (assuming it's for your primary residence and not an investment property). The downside, is that the full bells and whistles mortgages that offer offset accounts, usually have a slightly higher interest rate. There are several Credit Unions that offer this facility though.

P.

Click to expand...

This is a good point.
I am restricted as to where the cash can be, and the trading platform I use.
Due to electronic SMSF reporting.

However what I should concider for valuing cash is what is the maximum others can get for their cash, rather than what I can get for it, which is probably paying down your domestic home loan.

Which I suppose on average is going to return or save you 6.3% after tax.

So perhaps this is the return I should be applying my risk factor calculations to.

Redoing my calculation with that base would probably justify the correction.

Regards

Gary

Re: Market Corrections am I missing Something

drsmith said:

I see what you are saying. Rather than actually doing it you are looking at it purely as a valuation tool.


The recent fall has only been small in comparison to the rise in the past 6 months or so.


It's a fair bet the $5000 limit on the franking credits is buried somewhere deep within the fine print.

Insurance is itself a form of risk management.

Click to expand...

Yes those capital guaranteed installments are probably aimed at those investors with less than 180K to invest in equities so they would not be affected.

I think I wasted a good couple of days of my life learning about warrants but that's another subject.


Cheers

Gary

snabbu said:

I guess this is coming to the heart of the matter.
The risk premium.
How big should it be in the current economic climate?

That is going to depend on the share, I understand that.

It is also going to depend on your time frame as well, but let’s assume you have enough cash or bonds in your portfolio so that if the market goes into meltdown like it did a year or so ago you can wait out the madness without selling.

If we Take CBA and shares of that class. Can we say a multiple of 1.5 times the cash interest rate is a fair risk premium?

If we take TAH or SIP would a multiple of 2 times be OK.
I don't think not meeting market estimates is such an issue unless economic conditions change dramatically. This is handled by diversification one share underperforms the market expectation the other over performs.

Before the correction CBA and the like grossed up were at double the cash rate TAH and SIP three times the rate.

So we come back now to the commentators saying it's an overdue correction
share prices had risen too much.

They did rise a lot quite quickly but that could be because Australian shares fell too much in anticipation of a recession that just didn't happen.


I suspect there's a chart somewhere that says every time the market goes above a certain line by too many points, there will be a correction.
And this is what they base their comments on. I also suspect this chart is a self fulfilling prophecy

Cheers

Gary

Click to expand...

I think the typical market risk premium for Aussie shares would be 6-7% from various finance textbooks. To get the risk premium for specific stocks you can just multiple the 6-7% by the stock's beta.

Assuming your maths is correct... you still need to consider transaction costs when comparing the theoretical value of share return vs cash rate. Another important factor is the spread on interest rate... while the deposit rate is 3.5% or whatever, the borrowing rate is 6-7%. Due to this there can be no arbitrage (i.e. borrow money at cash rate to buy shares and buy put option) unless you are a bank.

Or may be that's what the bank's been doing... and hence their very high trading profits in the last 6 months.

skc said:

I think the typical market risk premium for Aussie shares would be 6-7% from various finance textbooks. To get the risk premium for specific stocks you can just multiple the 6-7% by the stock's beta.

Assuming your maths is correct... you still need to consider transaction costs when comparing the theoretical value of share return vs cash rate. Another important factor is the spread on interest rate... while the deposit rate is 3.5% or whatever, the borrowing rate is 6-7%. Due to this there can be no arbitrage (i.e. borrow money at cash rate to buy shares and buy put option) unless you are a bank.

Or may be that's what the bank's been doing... and hence their very high trading profits in the last 6 months.

Click to expand...

Aha, light bulb moment
This now makes sense and is quite surprising I have attached my spread sheet to check I have got the math right. What is a huge surprise to me doing this is that CBA is still over priced. SHV appears overpriced but it actually isn't because there is a dividend in there that they held back due the timbercorp fiasco. The others are all underpriced which is as I expected.
There are no transaction costs in this, however these are not for trading unless of course they become grossly over priced.

Thanks

Cheers

Gary

snabbu said:

Aha, light bulb moment
This now makes sense and is quite surprising I have attached my spread sheet to check I have got the math right. What is a huge surprise to me doing this is that CBA is still over priced. SHV appears overpriced but it actually isn't because there is a dividend in there that they held back due the timbercorp fiasco. The others are all underpriced which is as I expected.
There are no transaction costs in this, however these are not for trading unless of course they become grossly over priced.

Thanks

Cheers

Gary

Click to expand...

I think you are interpreting your calculations incorrectly. Market risk premium is a number that's backed out from the current valuation of the shares. It is not a number that you enter as an assumption in share valuation. You probably also need to input some dividend growth assumptions into the future... say 2-3% in line with long term inflation. This will change the valuation substantially.

Ultimately your spreadsheet is a very elementary version of what every investment bank analysts do... and we all know that analyst reports and valuations are typically only accurate for the previous quarter.

Now what happened to the put option idea in your original post? That showed good thinking put your spreadsheet has nothing to do with that idea.

skc said:

I think you are interpreting your calculations incorrectly. Market risk premium is a number that's backed out from the current valuation of the shares. It is not a number that you enter as an assumption in share valuation. You probably also need to input some dividend growth assumptions into the future... say 2-3% in line with long term inflation. This will change the valuation substantially.

Ultimately your spreadsheet is a very elementary version of what every investment bank analysts do... and we all know that analyst reports and valuations are typically only accurate for the previous quarter.

Now what happened to the put option idea in your original post? That showed good thinking put your spreadsheet has nothing to do with that idea.

Click to expand...

Hi Skc
What I am trying to do is come up with a reasonable price that a share can be, relative to the yield and level of risk. So that I can understand corrections. So my initial approach was to work out the cost of removing the capital loss risk. Which was the put option idea, and then assume the stock was held for two years, for the brokerage cost. When I misinterpreted your 6-7 % risk premium I thought this is an easier way to do it. Now I think you're saying take that percentage multiplied by the beta off the current price and all things being equal that is the likely volatility, in $ from the current price.
Is that the concept?

The rational being, if I feel something or everything is too expensive I need a measure for when I should consider getting out of a stock and sitting in cash pending getting back in at a lower price.

This is not a decision making tool, it is an alert, to go through and read all the announcements and the forecasts again, pound the calculator and make a decision based on that. It could also assist me in monitoring when I should be changing horses within a sector. So because it is an alert it doesn’t have to be too sophisticated to meet my needs.

In addition this is not intended even after I read the entrails of the goat, to make me right all the time, or even more than 50% of the time. It is an issue of justifying my investment decisions to myself. Because if I have done something for a good and valid reason and it goes south it is not going to bother me. But if it’s because of neglect or stupidity that would be an issue for me.

So for that purpose if I use the amount after tax $ someone could save by paying down their mortgage, add the premium of a put, add the brokerage (in and out) amortised over two years. Then make an allowance for capital gain over the two year period based on inflation forecasts.
Will that tell me approximately what the market should be prepared to pay for a share? What is a fair and reasonable price? If I do the same calculation based on my cash situation, that will tell me what it’s worth to me.

In regard to Put options, some of the shares I buy do not have these available, is it valid to use the price of something else in the same sector as a guide?

I can’t physically protect my CBA shares with a put option as I understand they are sold in contracts of a 1000, and I for diversification sake, don’t have that much money invested in any one share.
A lot of shares I have don’t have options written against them anyway.
Could we say if I took my most volatile stock, the one with the highest beta, and if I did want to protect myself over my whole portfolio from a general market downturn, bought put options for that share, balanced to the overall value of my portfolio. Would this be a valid strategy, if I was nervous about a correction, or simply wanted to go bush walking for a month and not look at the screen?

Cheer

Gary

If you are going to use options to minimise risk in your spreadsheet to compare returns of shares to cash, then you need to take the full position into account.

This being not just the purchase of a put, but the sale of a call as well, creating a synthetic short position to match your long share purchase.

While this will look good on paper, in the real world the bid/ask spread and commissions will kill such a strategy on Aussie stocks.

Comments Wayne?

brty

brty said:

If you are going to use options to minimise risk in your spreadsheet to compare returns of shares to cash, then you need to take the full position into account.

This being not just the purchase of a put, but the sale of a call as well, creating a synthetic short position to match your long share purchase.

While this will look good on paper, in the real world the bid/ask spread and commissions will kill such a strategy on Aussie stocks.

Comments Wayne?

brty

Click to expand...

This is far beyond me.
I have no comprehension of why I have to place a call to value to cash.
All I wanted when I started my question was the discounted dividend formula (DDF) only I didn't know what I was asking for.
I have now found it myself.
As well as what it is called.

Which is a good thing

I take it from your comment if I want to take a month off I need to sell everything as there is no way of protecting your capital while you are taking a break.

Cheers

Gary

I have no comprehension of why I have to place a call to value to cash.

Click to expand...

Ok.

A synthetic position is one where using options has the same risk profile as a stock position. For example buying a call and selling a put gives you the same risk/reward as buying the stock, but at a fraction of the cost/up front money.

By same risk profile, I mean that you lose lots if the price tanks (the value of your sold put goes up), but you make plenty if the price rises (you keep the put premium and the value of your call goes up).

In your case, by trying to have a risk free position after buying stock, you have to use the synthetic short with options, buying the put is only half the game. By selling the call option you recover much of the cost of the put and have a 'risk free' position. If the stock goes up you make money on the stock, but lose it to the call buyer. If the stock falls, you lose it on the stock but make it on the put (while keeping the call premium). Effectively, theoretically, you make nothing on the stock or options, yet keep the dividend.

However in the real world the spread and commissions kill you, unless you get real fancy and start using the greeks, but I'll let Wayne explain those.

brty

zzaaxxss3401 said:

UBank (Backed by NAB) offer 5.11% pa.

Alternatively, if you have a mortgage with an offset account, the money in the offset account will effectively be earning you the home loan interest rate. You also don't pay tax on the "interest" since it is simply reducing your non-tax deductible expense (assuming it's for your primary residence and not an investment property). The downside, is that the full bells and whistles mortgages that offer offset accounts, usually have a slightly higher interest rate. There are several Credit Unions that offer this facility though.

P.

Click to expand...

Most of the major banks will offer these kind of deals on PPOR mortgages, typically you will pay 3 or 4 hundred dollars a year to get this. They tend to be called 'Professional packages'

ANZ call theirs Breakfree, you get 0.7% off std variable and 100% offset & up to five loans (IP & LOC etc) for no extra costs, so if you have a mortgage any cash in the offset is effectively earning you money at lenders interest rate and its not taxed at the moment at typical 40% tax rate, its worth about 7 or 8% pa

NAB do a similar deal, i think this one is called 'Choice'

Hang me out to dry if I'm wrong

My favourite W word is waiver.

brty said:

Ok.

A synthetic position is one where using options has the same risk profile as a stock position. For example buying a call and selling a put gives you the same risk/reward as buying the stock, but at a fraction of the cost/up front money.

By same risk profile, I mean that you lose lots if the price tanks (the value of your sold put goes up), but you make plenty if the price rises (you keep the put premium and the value of your call goes up).

In your case, by trying to have a risk free position after buying stock, you have to use the synthetic short with options, buying the put is only half the game. By selling the call option you recover much of the cost of the put and have a 'risk free' position. If the stock goes up you make money on the stock, but lose it to the call buyer. If the stock falls, you lose it on the stock but make it on the put (while keeping the call premium). Effectively, theoretically, you make nothing on the stock or options, yet keep the dividend.

However in the real world the spread and commissions kill you, unless you get real fancy and start using the greeks, but I'll let Wayne explain those.

brty

Click to expand...

OK Now I get it.
Thanks

Gary