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U.S. stock prices seem supported by a "smart-money" put.
Like the Bernanke Put, and the Greenspan Put of yesteryear, the smart-money put can be relied on to prevent stocks from falling too far. A put option offsets declines when associated securities fall, by allowing the owner to sell—"put" in options jargon—them to someone at a preset price.
Unlike the Bernanke and Greenspan puts, the smart-money put is harder to quantify, but it clearly exists, even if it wasn't minted by a central bank.
A key fact of the 2012 stock market is that many sophisticated investors—the supposed "smart money"—have missed the rally, which has boosted some stocks by more than 50%. Because the eyes of the sophisticates are fixated on Europe's economic problems, and their minds are searching for data to dispel evidence of a U.S. recovery, many of the funds and accounts they run are trailing their performance benchmarks. This most likely exacerbates some of the recent intraday volatility.
WHEN THE STOCK MARKET DECLINES in reaction to some data, the smart money trades futures contracts to pressure share prices. This crowd uses news and market commentary to paint a menacing picture worthy of Stephen King. Yet, at some point, even those nattering nabobs of negativity fill the bullish void in the options and stock market with buy orders. That helps stocks bounce higher.
What makes the smart-money put so powerful is that fund managers face real problems if they lag behind the performance of the stock market or their peers. The need to at least match—and ideally beat—performance benchmarks almost forces them to buy stocks. If they don't deliver good returns, they may find that their investors flee into the arms of better-performing managers.
The natural question: How big is the smart-money put? No one really knows because, unlike the Bernanke put, it represents many different managers. One way to size the put—and it is imperfect—is by gauging sentiment.
Consider this exchange on Twitter: A hedge-fund manager recently asked what it would take to get other managers off the sidelines to invest. The answer: "The Second Coming." His response: "Head trader at top hedge fund just texted me 'second coming will be a sell-on-the-news event.' "
SO, IF SENTIMENT IS SO NEGATIVE, it is no wonder that the so-called dumb money is ensconced in the supposedly safe environs of the bond market.
In totality, Main Street's love of bonds represents future support for stock prices in the form of a massive "knock-in option." At some point, individuals who are stashing billions of dollars in bonds will buy stocks when they hit some unknown milestone.
In March, according to data cited by Sandler O'Neill, fixed-income mutual-fund inflows totaled $34.4 billion, compared with $41.5 billion in February. The March figure was more than double the $15.9 billion pulled in a year earlier. Exchange-traded stock funds have clearly attracted some money, but stock mutual funds' net inflows came to $5.6 billion in March, down from $18.7 billion in February and $22.4 billion a year earlier.
Despite reasons to bullishly position for stocks, it always makes sense to look for hedges to offset any potential mistakes in logic—especially when something as fickle as investor sentiment figures so heavily in the analysis. Earnings season is in full swing, and the facts must be used to update the smart-money put thesis.
Bottom line: It continues to make sense to sell puts and calls to manage the risk of existing stock positions, and to enhance yield.
Comments: steve.sears@barrons.com http://twitter.com/sm_sears
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