There has been a sea change in investor sentiment this year, and the main reason for the strength of the rally has been the European Central Bank's (ECB) decision to flood the eurozone banking sector with cheap three-year loans via its long term refinancing operation, or LTRO.
Of course, the very fact that the ECB felt it had to pump an eye-watering €489bn (£414bn) of low-cost credit into the European banking system highlights what a perilous state the region's banking sector was in. That fragility was precisely what led me to point out a number of times last year that the eurozone's banking and sovereign debt crisis was in danger of bringing down markets like a house of cards.
The same fear of contagion spreading led me to advise readers to take out some form of portfolio insurance in mid-December, when the FTSE 100 was trading at 5520 and when a major bank failure was a significant possibility. At the time I showed how a purchase of 10,000 Royal Bank of Scotland's FTSE 100 covered put warrants, RJ24 at 80p each could be used to hedge an equity portfolio worth £50,000. The warrants have an exercise price of 6250, expiry of 15 March 2012 and parity of 1,000:1.
In the event, the ECB played its 'get out of jail' card at the 11th hour, which prevented the armageddon scenario that I had feared from panning out. The next tranche of funding is due shortly, with the smart money betting that a €1 trillion-plus line of cheap credit will be provided by the central bank this time round.
So, with the main index rising to around 5900, the RJ24 put warrants have fallen to 40p, but this is only part of the story. This was a hedge rather than a trade; so the rise in the market should have lifted the value of the equity portfolio you were seeking to protect. The worked examples I gave at the time assumed that your core portfolio tracked the FTSE100. But if it is concentrated outside the FTSE100, you may well have profited.
For example, a £50,000 portfolio stuffed full of FTSE Aim, small caps and mid caps in equal ratios - these account for over 70 per cent of all companies listed on the London market by number - and with a beta in line with these three indices, would have risen by an average of 17 per cent. That is a notional gain of over £8,500, which would completely wipe out the £4,000 loss on the RJ24 put warrants and produce a net 9 per cent return since mid-December - compared to a 6.8 per cent rise in the FTSE100.
That's because since equity markets started their multi-week rally in mid-December, the tiddlers have risen by more than the titans. The FTSE Aim index is up 21 per cent, the FTSE Small Cap is up 13.3 per cent and the mid-cap FTSE 250 is up 17.2 per cent. All of which has helped us do very well with the small-cap stocks I have written up this year; the Bargain Shares portfolio is off to a great start and there have been big share-price gains in recent recommendations such as Communisis and Moss Bros.
Short term volatility aside, it looks as if the 'risk on' rally has further to run. As stock market historian David Schwartz has noted, when the UK market rallies for six weeks in a row or more – as has been the case with the current winning streak – this is a significant event. In fact, a rally of this magnitude has occurred 79 times in the last half-century and a bull market was running on all but two of those occasions.
It's a similar story in the US when the Nasdaq 100 rallies for seven weeks in a row, a feat it accomplished on 17 February. Such a winning streak has happened 11 times since 1985 and on every occasion the index posted a positive return in the next six months. It was not insignificant, either, as the average gain was 15 per cent.
So, given the marked improvement in investor sentiment and the game-changing actions of the ECB, not to mention further monetary easing by the Bank of England and a pledge by the Federal Reserve to keep interest rates at record lows until 2014, I am minded to close out the portfolio hedge described above. In the weeks ahead, I will seek out further opportunities in small-cap stocks. To recap, my strategy is to identify hidden value that the market has missed. Other investors are far more likely to pounce on such mispriced gems - and so trigger the necessary re-rating - in the sort of risk-tolerant environment that is now prevailing. As the success of recent recommendations attests.
