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Heading Dow-n

Created:

22 June 2009

Updated:

23 June 2009

Written by:

Simon Thompson

If the consensus among economists is right, the US could come out of recession in three months' time. That would clearly be good news, although the risk of a 'double-dip' recession should not be underestimated, especially given the imbalances in the US housing market and the fact that the process of de-leveraging has a long way to go.

However, the stock market is already pricing in much of the likely uplift from the recovery. Let's assume that earnings for the S&P 500 index as a whole fall another 30 per cent from their current level of $43. Then, let's assume that earnings bounce 60 per cent from their lows, as they often have done in the past. That puts the S&P 500 on a multiple of 'mid-cycle' earnings of 18.5 times.

Compared to history, such a multiple is not great value. Nor does it factor in the possibility that the US economic recovery could be anaemic as a result of the headwinds affecting the US housing market, the pressure on the all-important consumer and scope for a margin squeeze on US corporations (Price and Value, 15 June 2009).

Also, as I noted two weeks ago, not once since 1950 has the S&P 500 managed to surge more than 40 per cent in advance of the recession ending. On average, it rallies around 20 per cent from its bear market lows by the time economic growth turns positive. That's an important statistic because the S&P 500 is currently 39 per cent up from its March bear market low of 666. So, even if the recession were to end in September, nearly 60 years of stock market history suggests that the S&P 500 will be lower, not higher, than its current level of 922.

It is worth noting, too, that in the past, by the time the index was up over 40 per cent from its bear market low, the US economy was not only not in recession, but was on average nine months into its recovery.

Research from Standard & Poor's also suggests that the stock market is overdue a correction in the months ahead. In past bear markets, when a final bear market low is in place, the S&P 500 typically corrects back 7 per cent from its interim post trough high to test that low, but the decline is closer to 14 per cent on average after a severe downturn like the one we have seen between October 2007 and March 2009. That would take it back to around 800, a 50 per cent retracement of the up-move from the March lows. And given the high correlation between the S&P 500 and Dow Jones Industrial Average, a similar retracement would take the Dow (which looks the weaker index) back from its current level of 8555 to 7700.

So, if like me you expect some summer turbulence in the US equity markets, one way of playing this trade is to buy covered put warrants on the Dow, such as Société Générale's SW35, which have an exercise price of 9500, expiry of 18 September 2009 and a parity of 1000:1. (Full details on the SG website)

With the warrants trading at 72p, and £1 worth $1.645, we are paying the equivalent of 1184 points to short the Dow at 9500, so would need the index to fall to 8316 by mid-September to recoup our warrant premium. However, if the Dow falls back to my 7700 target by mid-September, then the warrants would be trading at around 109p - a 50 per cent premium to their current price.

This is a medium-risk trade with warrants geared 5.6 times to movements in the underlying index. The stop loss is set on a move above 8900 on the Dow, its recent high.

[Editor's note: since this article was written, the warrants have risen in price to 83p, the DJIA closed yesterday at 8,339 and the S&P 500 at 893.04 - so a drop to Simon's target level of 7,700 on the DJIA would yield a 31 per cent profit]