Peak Hour?

Caesar was warned about the Ides of March. For sharemarket investors, most scary are the Ides of October. Even Mark Twain was moved to comment that October was "one of the peculiarly dangerous months" to speculate in stocks. "The others," he wrote, "are July, January, September, April, November, May, March, June, December, August and February!"

So what is it about October that scares investors so? The bad reputation probably springs from field evidence, such as the 1929 and 1987 market crashes. The one-third market declines in October of those years are the worst month declines on record. And there have been other black Octobers. I can remember the mini-scare of 1989, and the 1997 Asia crisis climaxed, to the day, on the tenth anniversary of the 1987 crash.

October, however, is not the worst month of the year for Australian share investors. Many studies reveal September as the month of the worst capital returns. The many reasons for this market uncertainty range from dividend payments in the September/October period (Australian shares having generally high yields) to the psychological ("fear of October").

In the northern hemisphere, the onset of winter may dampen investors' moods, and certainly October is a bad month for concerns about winter food supplies. The good news is that studies show many corrections actually climax in October, thereby offering great buying opportunities '” for those with enough nerve.

With October not far away, commentators are again expressing concern about market outlooks, partly in reaction to the tremendous rise in the Australian sharemarket since March 2003 (63 per cent). During that period there has been only one significant correction '” the 13 per cent fall in March-May this year. Now there are two new concerns: the substantial rise in US interest rates over the past year, with the prospect of more to come; and the relentless rise in the price of oil in the same period.

US INTEREST RATES

The US Federal Reserve Bank has raised the US funds rate from 1 per cent in June last year to 3.5 per cent. Most commentators expect it to be 4 – 4.25 per cent by year's end. The chart shows that, 12 months ago, when the rate was 1 per cent, US real interest rates were negative 2 per cent (meaning the consumer price index, measuring inflation, exceeded the Fed funds rate by that amount).

In fact, real rates had been negative for nearly two years, and it can be argued that the source of the US housing bubble and the global commodities bubble can be traced back to this time. It was the longest period of negative US interest rates in at least 15 years. Now the Fed is aggressively raising rates, and by year's end the real rate is likely to be about 1 per cent. Although not extraordinarily high, it is very different from what the markets have gone through since March 2003.

Note that the past year has seen the sharpest rise in the Fed funds rate since 1994, which was a very difficult year for the stockmarket.

OIL

Since July 2004, the oil price has risen more than 80 per cent. Although it is true that nominally the oil price remains below the all-time peak levels of 1980, it is sobering to remember that they are above 1974 nominal levels by a massive 75 per cent. The 1974 oil shocks led to a nasty recession and a substantial stockmarket decline.

ALTERNATIVES

Even if all this makes you a little queasy, I do not recommend wholesale selling. But it may be time for fine tuning or tactical shifts in your portfolio. Three suggestions:

· Switch from speculative to blue chips
· Sell "calls" (the right to buy shares)
· Buy "puts" (the right to sell shares)

SELL CALLS

Selling calls against existing individual stock holdings is a good way to generate income. By selling a call, you give the right to a buyer to acquire your shares at a preset (strike) price at some later date.

For example, you can sell December 2005 Telstra calls today with a strike price of $4.91 for about $0.05 per share. If Telstra rises above $4.91 between now and December, the stock will be called away. At that point, your exit price is effectively $4.96 ($4.91 plus the $0.05 premium). In the meantime, you have also probably picked up the $0.20 Telstra dividend, giving you a total exit price of $5.16, compared with today's Telstra price of $4.70 share.

Of course, if Telstra stays below $4.91, you pocket the premium (and the dividend). The disadvantage to this tactic is that it doesn't provide further protection if Telstra shares continue to fall.

Stock options allow the holder to exercise them at any time. Normally a call option would not be exercised unless it was trading above the strike price.

Selling calls is a good way to generate income on stocks that an investor might be reluctant to otherwise sell. There may be any number of reasons for this, but one obvious one is that selling a stock crystallises tax consequences.

Selling calls might also be considered for stocks that have run too hard and look expensive. Or, in the case of Telstra, selling calls is a way of generating additional income while waiting for a turnaround.

The sell-call tactic might also be deployed for stocks that an investor wishes to sell but would like a higher exit price. The risk in the latter case is that the call is not exercised and the stock remains in the portfolio.

BUY PUTS

Investors can buy puts over certain (generally large-cap) individual stocks or over the market. Buying puts over the market is a better way to protect your entire portfolio than selling calls over individual stocks. A put, the opposite of a call, gives the owner the right to sell something at a preset (strike) price.

For example, investors can acquire December puts over the All Ordinaries index with a strike price of 4400 for about $0.70c. Each point of the strike price is worth $10. So the underlying value of this contract is $44,000 (4400x$10). And the cost of the put is $700 (10x$0.70) plus brokerage. If the market remains above 4400 on 15 December (expiry date), the investor loses the premium ($700 plus brokerage) paid; however, if the market falls to 4300, the investor pockets $1000 (100 points x $10) less brokerage. Index options can only be exercised on the expiry date.

The disadvantage of buying puts is that you may lose your entire premium or, as in the case above, just get your money back. The advantage is that, if the market falls precipitously, the portfolio has some protection assuming its value moves in step with the market.

So, for example, if the market drops to 4000 by mid-December, our hypothetical investor receives $4000 on every contract bought, thus providing him with some offset against the decline in the value of the underlying portfolio.

SWITCHING

Another tactic to consider is to switch from smaller, perhaps more speculative and risky stocks, to blue chips. In a market correction, all stocks are likely to fall, but blue chips are more likely to recover faster, or fall less than, other more risky stocks. This might be an ideal tactic in the oil-and-resource sector, where specs have run harder than blue chips. In a lower, or falling, commodity price environment, the specs might have no future at all.

An alternative to switching out of specs into blue chips is to just sell the specs outright and hold your cash for investing later. This course assumes excellent market timing skills, which few of us have. Regardless of whether you switch out of riskier stocks in your portfolio, or sell them outright, investors need to consider the tax consequences.

CAVEATS

For those of you who cannot afford a capital loss, or don't have the time to hang about for a market correction, then perhaps the sharemarket is not the place to leave your capital.

A correction may be imminent, but many studies show the sharemarket historically has provided returns superior to every other asset. I expect this to continue. I'm old enough to remember the Australian sharemarket peaking in September 1987 at 2300 and bottoming a month later at 1300. The market today is up 91 per cent from the 1987 peak and 238 per cent from the 1987 bottom. Even for those who bought in September 1987 and held on to their shares, the market has still provided a capital return of about 3.2 per cent a year compound and a dividend yield of about 4 per cent. Thanks to franking, the yield also has tax advantages.

These tactics are designed to finesse investors' portfolios. The market is not expensive on a P/E (price/earnings) ratio of 14x2006 earnings (yielding around 4 per cent) and with strong global commodity prices. I said October has often provided a good market entry point. I think this is more than likely again this year. If I'm right, any correction is a buying opportunity.

Perhaps Mark Twain should also have the last word on sharemarkets:
"There are two times in a man's life when he should not speculate: when he can't afford it, and when he can."

It's a good thing Eureka Report members are not speculators.

Leading stockmarket analyst Mike Mangan previously worked for Deutsche Bank. The author has sold some of the riskier stocks in his portfolio, sold calls against specific shares and bought some puts.