Cramer: The Distortion of Common Stocks by Index Futures

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

The whole thing seemed ridiculous to me. I was sitting in my Corporate Finance class at Harvard Law School in 1982, reading the Wall Street Jour­nal as always, just trying not to disturb the zombies around me with my page-turning. I liked to hide in the back during class; that way it was much less likely that I would be called on, because I either hadn't read the material or didn't understand it. Plus, who could concentrate on the stock tables and take notes on a meaningless class at the same time? Bet­ter to have your priorities straight in order to get your money's worth for the $25,000 a year you'll owe in student loans at the completion of the exercise.

Anyway, there was an article in the paper that day about some stock index that was going to start on the Kansas City Board of Trade, an ex­change I thought just traded those agricultural products you didn't care about unless you were in the food business-you know, grains, winter wheat, whatever. Yet there it was. Some wise guy was putting together not a basket of grains or pork bellies but a basket of stocks, specifically a bas­ket of the stocks in the Value Line Index, which represented the same stocks as the Value Line Investment Survey, at one time the bible of all stock research for the home gamer and the professional alike. Those were the quaint days, when individual stocks were studied and owned, not the quant, or quantitative, world of today, when whole groups of stocks are charted and traded via machines that are supposed to tell you the op­timum purchase price and let you exercise the trade within the blink of an eye.

This newfangled package of stocks was meant to trade as a futures contract, meaning you would bet on the future direction of all the stocks combined in the index, except, unlike a grain index, at the future's conclu­sion you wouldn't have to deliver the stocks themselves. The prices would settle in cash, and you would be able to take your gains from where you first made your bet. And it was a bet, not an investment, because you weren't actually buying the individual stocks in the package. Just like a future, you could sell short the basket too, if you thought it was going to go down.

So if you thought the collective value of all the stocks in the Value Line Index was going higher, you bought a future that gave you the right to the gains at a specific point in time. If you thought they were going lower, you could short the index and then buy it back and pocket the dif­ference, if indeed it went lower, as you hoped and wagered. Of course, if you bought, thinking the index was going higher, and it went down, you had a loss of the portion of the money equal to the decline, just as you would with an individual stock.

After I read about this new index futures market, I asked one of my securities professors, "How can this be legal?" Stocks, I said, don't trade in lockstep. There's nothing in a group of stocks that is comparable to winter wheat, which is uniform and not meant to have any differentiating statis­tics or characteristics. Stocks trade on their own mettle. They have so little in common there could be no point in homogenizing them in an index. The repercussions could be huge. Stocks might cease being representa­tive of the enterprises behind them and take on the characteristics of an entire market, even as that market had little to do with the profits or sales of the individual companies. I said it was absurd and I couldn't believe the Securities and Exchange Commission would allow such an irresponsible grouping of stocks to trade together.

I questioned whether this Kansas City Board of Trade idea would pass muster given how it might play havoc with how we value individual stocks. Surely the SEC would see the detriment and distortion a Value Line Index could cause down the road if it caught on. My professor, clearly oblivious to who the heck I was, as he would never have seen my face behind the front page of the Journal I read each day in class, informed me that there was nothing insane at all about this basket of stocks. This new index would be a risk tool for portfolio managers, just as the farmers needed risk tools for their crops. If someone owned a portfolio of stocks and wanted protection from events and feared the downside, he could sell a Value Line future against his portfolio, hedging that risk, just like a farmer or a grain buyer who might fear a drought or a frost. In fact, a stock future could work even better for a portfolio manager than it might for a winter wheat farmer. If the portfolio manager truly feared some sort of catastrophic event, he wouldn't have to blow out each individual stock, incurring all sorts of imperfections, commissions and time pressures. Instead, with one order, he could put a hedge on that would insure against the downside during a very specific period and then have that hedge taken off when the event concluded or was safely behind him.

If someone wanted to accumulate exposure to stocks, meaning he just wanted to bet that all stocks were going to go higher, my professor ex­plained, he didn't have to do all of the work on the individual stocks or tediously buy each one; he could just buy a future and get all the exposure to the stock market he needed in one immediate, seamless transaction. No hedging in this example, just an outright instant accumulation. The pro­fessor reminded me that many portfolio managers simply viewed stocks as part of a broader allocation of stocks, bonds, real estate and gold, and that this future simply gave the portfolio manager the chunk of stocks he needed to get the proper exposure to this one portion of the investment supermarket. It was a beautiful expedient, in his opinion.

I bridled. How could it not matter what the companies in the index do? What about all of the work people put in to discover or purchase an indi­vidual stock? What about the research process, the process of finding the best stocks, not just stocks themselves as one unit? Why would anyone want to own the bad stocks with the good? Who would want to check his stock-picking abilities at the door? The haughty professor lectured that perhaps I didn't understand what was about to happen to stocks, that portfolio man­agers were moving away from the futility of individual stock picking and into a "can't beat them, join them" strategy. They were just trying to equal a benchmark or try to slightly exceed it, rather than trump it. They simply wanted to put, say, 40 percent of their entire portfolio in stocks and, say, 50 percent in bonds, because they preferred bonds over stocks in general, and not specific stocks. That way they couldn't fall to0 far behind the stock mar­ket with their allocation and would be "truer" to that allocation than they would be otherwise. The stock future was the future, and he saw it coming.

But wouldn't the index influence the action of the stocks in the index itself? I persisted. The professor, who knew exactly what the SEC was doing (he was a corporate finance professor tied in to Washington), told me that the SEC was unconcerned because the government believed-and to a degree still does, by the way-that stocks themselves were much big­ger than the index and the index was a tail that could never wag the whole dog. The idea that an index could ever control a stock's particular move­ment was antithetical to the purpose of the hedge or the accumulation. No single portfolio manager or even a group of portfolio managers would ever be big enough to influence an index to the point that it would impact the stocks in the index themselves.

The certainty of that statement annoyed me, but I didn't make the rules. I realized that at one point in life I would have to live by them, as I already had my heart set not on practicing law but being a real-life stock-picking portfolio manager.

Thus, with one obscure index on one obscure exchange, the index future was born.

Two months later the much, much larger Chicago Mercantile Ex­change began trading futures on the Standard & Poor's 500, a sainted group of stocks, considered the best representation of the stock market since 1923, when it was first created. (Older, more desultory investors still seize on the Dow Jones Industrial Average as the benchmark, and I start each Mad Money show with how it fared that day, but portfolio managers compare their performance to the much more broad index that is the S&P 500, the benchmark that one must beat regularly to be considered a suc­cessful, or outperforming, manager.)

Pension funds, huge portfolio managers and mutual funds almost im­mediately took to the S&P 500 index futures as a cheap, low-commission way to get exposure to the market and yet not have to deliver stocks, as they would wheat or pork bellies, because the settlement, what happens when the future comes due, like the Value Line future, was in cash. One of these big institutions could put, say, $20 million to work in some S&P futures contracts that allowed it to get a gain six months out. If the S&P 500 rallied 10 percent in that period, the account stood to make $2 million at the time of settlement.

Not only were futures convenient, but the managers didn't have to put up the entire amount that they sought to buy or sell. In fact, they could borrow money and put up only a fraction of that $20 million in real money. Of course, the logic extends to large numbers: $20 million could get you $200 million in exposure in seconds. The rules for futures are very different from those for stocks. With futures you can use leverage and put up much less cash than with stocks and get much more bang for the buck-still another advantage for those who want to use these commodity-like instruments. Simple as that.

Too simple.

Almost overnight these contracts became a sensation as the big funds fell in love with them. They got to be so popular, at the same time that funds were growing ever larger as money flowed into the stock market, that within a few years the impossible had come true: they began to have a more powerful impact on stocks than anyone had dreamed, including the people who run the companies in the indices. I always felt they were too powerful, and I railed against them in the 1980s in the few press out­lets available to me. I suggested that they would one day cause a stock market crash because the futures could easily overwhelm the actual stock market, as the little amount of capital needed to control a stock future could turn millions of futures dollars into billions of stock dollars.

Sure enough, by 1987 they were so sought after that a bunch of finan­cial consultants decided that they could use the futures to hedge out all risk to stocks, no matter the size of the fund. They created a product called "portfolio insurance," and they peddled it to big institutions that owned a lot of stock. The consultants said that for a fee they could protect any fund from the downside because, as the market went down, the consul­tants could dynamically hedge out any losses using these S&P 500 futures.

The product initially worked terrifically well as the market drove ever higher through most of that year. Then, when the stock market started to crumble in August 1987, culminating in the crash of '87, portfolio insur­ance began to fail. It directly contributed to that record-smashing one-day 508-point decline as the consultants threw the equivalent of acetylene on that raging fire of selling by trying to short the futures ahead of the plummeting stocks. The Chicago-based futures had overwhelmed the New York-based stocks. The stock that came in for sale because of the S&P 500 futures sellers arrived too fast and in too large amounts, so that buyers couldn't be found. As a result, the stock market lost almost a quar­ter of its value in a day. The dynamic hedges, the insurance, failed to protect the portfolios properly, so the clients lost huge amounts and the consultants went under.

After that fateful day, it dawned on many market participants that the S&P 500 futures were now bigger than the stocks, and big sellers of fu­tures can knock down stocks with impunity, even if they didn't deserve to be knocked down.

A Treasury Department investigation of the crash identified the inter­action between the futures and the stocks themselves as a proximate cause of the precipitous decline simply because the leveraged selling of futures could impact stocks faster than buyers could be found to offset them. Just think back to that Stride Rite example to understand how speed can overwhelm volume; multiply that speed by ten, the approximate ratio of futures selling to stock buying on that fateful session. Rules were put in place after the crash to slow the futures-to-stock linkage on big price declines, but the whole portfolio-basket approach was already ingrained, and, being just a few years old, it was never even called into question as a possibly manipulative and pernicious entity.

Stocks eventually climbed back up after the crash, when it became clear that the whole episode was caused by a problem with the mechanics of stocks versus futures, and not with the underlying economy and its impact on stocks. The futures had simply caused the stocks to go haywire, but the economy never skipped a beat. Never again, though, did any of us have any illusions about how futures had changed the stock market. From then on, for many of the biggest funds, stocks might as well have been soybeans or corn or wheat. For many managers, it never again mattered what companies did. They decided to just trade the whole index as an asset class, regardless of the individual stocks that made it up.

From the birth of that now obscure Value Line Index until the present day, we know that perhaps the biggest influence on a stock beyond its sec­tor and its own business is whether it's in the S&P 500 index. And at times of real crisis, the S&P futures are a far more powerful influence than the fundamentals of any individual company. If the futures roar higher or plummet, your stocks will rise or fall if they are in the index. They react as if there is one giant buyer or seller of everything, from the tiny Stride Rites to the Exxons and Apples. The futures are so powerful in their influ­ence over individual stocks that a stock you own might get a real beat-down as part of an S&P futures sell-off, even on the day of a good earnings report or positive analyst chatter. It's just the way it is. I got used to it, even though I hate it, just as I hated the Flash Crash, which was very similar to the Great Crash of '87 in its speed and almost in its size.

You too have to get used to this reality, and you have to recognize that, as in the individual stock example I gave you, nothing a company does can stop the tide. The movement in the stock price simply has de-coupled from the underlying stock because of this financial innova­tion. The genie jumped out of the bottle three decades ago, and we have not been able to stuff it back in, no matter what the companies in the index try to do about it, including aggressive buybacks and even bountiful dividends.

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

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