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S&P 500 could collapse by 50%

When the stock market bubble bursts and recession sets in — Wall Street veteran

Paul Dietrich pointed to a highly overvalued market and cracks in the economy

The S&P 500 could be cut in half when the stock bubble bursts and the U.S. economy plunges into recession, Paul Dietrich believes.

“I believe that the upcoming recession will lead to a deeper decline in the stock market than in 2000 and 2008,” said chief investment strategist B. Riley Wealth Management in his latest monthly commentary.

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A graph of the stock market decline and recession. Stocks could collapse by almost 50%, and a recession could come as early as this year, says Paul Dietrich of B. Riley. Yuichiro Chino/Getty Images

Dietrich described in detail the warning signs indicating that stocks are highly overvalued and close to correction. For example, he pointed to the price-earnings ratio in the S&P 500 and the inflation-adjusted Shiller PE ratio, which, excluding past recessions, are at multi-decade highs, as well as the index’s historically low dividend yield of 1.35%.

He also noted that the recent market growth was driven by investor enthusiasm for several stocks, such as Microsoft and Nvidia, and their hopes that the Federal Reserve would lower interest rates later this year, rather than fundamental factors such as rising corporate earnings.

Indeed, Dietrich compared the huge hype around AI to the Internet mania during the dotcom bubble. He also drew attention to the Buffett indicator, which rose to 188% this year – close to the 200% mark, when buying shares, according to Warren Buffett, would mean “playing with fire.”

In addition, the strategist noted that over the past year, the price of gold has jumped by about 20% to record highs. He explained this by saying that institutional investors are buying this safe haven asset because they expect “a serious correction or collapse of the stock market due to wildly inflated stock prices and a slowdown in economic growth.”

As for the economy, Dietrich argues that decades of excessive budget spending and artificially low interest rates have pushed back the recession.

He predicted that rates would remain raised for many years to combat persistently inflated inflation, and the government would be forced to raise taxes to solve the problem of bloated budget deficits, which would lower prices for assets such as stocks and houses and cause an economic downturn.

“No one seems to notice that the economy is cooling, and there are risks to it everywhere,” he said. “I still think there is a high probability that the economy will go into a mild recession this year.”

Dietrich noted that the S&P 500 typically falls by about 36% during a recession, and the index will have to drop 12% from its current level of about 5,450 points to return to the 200-day moving average. Thus, he warned that the index could fall by 48% to 2,800 points – the lowest level since the collapse of Covid in the spring of 2020.

The Wall Street veteran is one of several leading forecasters predicting a worsening stock market and an impending recession. But it is worth noting that Dietrich has been sounding the alarm for several months, but neither the market nor the economy have faced serious problems.

Moscow Exchange

Moscow Exchange will launch two new futures for US stock indices in January

The Moscow Exchange already has futures for the S&P 500 and NASDAQ 100 indices.

The platform will expand this line with contracts for the Dow Jones and Russell, which will also be settlement. The exchange is also eyeing futures on the Chinese market.

In January 2024, the Moscow Exchange will launch two new futures on ETFs, which repeat the dynamics of US stock indices, Maria Patrikeeva, managing director for the derivatives market of the trading platform, told RBC Investments. Currently, futures for ETF units are already traded on the Moscow Exchange, the benchmark of which is the S&P 500, NASDAQ 100, Hang Seng, Euro Stoxx 50, Nikkei 225 and DAX indices.

“In January 2024, ETF futures will be launched that replicate the Dow Jones and Russell indices,” she said, emphasizing that these will be settled contracts that do not involve delivery of the underlying asset. “Investors can make money on price movements in a foreign market without the risk of owning the underlying asset,” Patrikeeva explained.

Previously, she said that the site would launch futures for the indices of Brazil, India and Turkey within six months. Now she added that the range of contracts for foreign indices could be expanded by other countries, in particular China.

“We have worked on this topic quite well and now we understand that there will be coverage of more than the three countries that we announced earlier. Also on top of this list we are thinking about China. We see a truly growing demand from participants for foreign assets,” Patrikeeva noted.

The Moscow Exchange also plans to begin trading in new perpetual contracts. “Next year we plan to launch new perpetual futures on foreign assets. We are currently doing a lot of analytical work. These will be very interesting instruments. We plan to start launching them in the first quarter of 2024,” said a representative of the exchange.

A perpetual futures contract differs from a traditional delivery contract in that it does not have an expiration (settlement) date. Expiration, that is, the date when the instrument expires, occurs every quarter – on this day the futures position must be closed. Otherwise, delivery of the underlying asset will take place. Perpetual futures do not have this feature – it is a one-day contract, every day it is automatically extended by one day. In fact, a perpetual futures is a convenient analogy for a spot instrument.

The first perpetual futures appeared on the Moscow Exchange in April 2022. Currently, the Moscow Exchange trades three perpetual futures for currency pairs (dollar, euro, yuan), a one-day contract for gold and the Moscow Exchange index.

 

Futures. Definition and types of futures

Futures are one of the types of derivative financial instruments (derivatives), a futures contract that fixes the obligations of the parties to conclude a deal in the future on agreed terms. This definition may seem confusing to many retail investors and private traders. However, in fact there is nothing complicated here.

Let’s imagine a situation that a potential buyer would like to purchase a batch of 1000 units of goods. At the same time, he assumes that in six months, when he needs this product, its price will increase significantly. Therefore, he is interested in paying current prices. There is a seller on the market who is satisfied with the current price for this product. However, it still needs to be produced and a batch of the same 1000 units will be ready in just six months. These participants can enter into an agreement among themselves, under which the seller undertakes to supply and the buyer to pay for the goods, indicating in its terms:

  • completion date – in six months;
  • batch size – 1000 units;
  • calculation at the price fixed at the time of conclusion of the contract.

In fact, such an agreement is a futures contract.

Thus, it becomes possible to explain what futures are on the exchange in simple words. These are contracts (agreements) under which the buyer and seller obliged after a certain period of time (that’s why it is called urgent) to make a transaction on the terms specified at the time of conclusion of the contract.

All that remains to be clarified is the concept of a derivative instrument. Here, in principle, there is nothing complicated either. The contract is concluded regarding some asset, for example, wheat, precious metals, energy resources, shares, etc. This asset is called the underlying asset. Accordingly, a futures is a trading (exchange) instrument produced, or rather, derived, from the underlying asset.

In trading on world markets, contracts with future execution are widely practiced. Such agreements are concluded among themselves, for example, by producers and consumers of goods such as wheat and other agricultural products, oil, gas, metals (i.e., commodity market assets). Futures, in comparison, have 2 main differences:

Forwards are settled “here and now”, at the time of conclusion of the contract, and delivery is made within the agreed time frame. Futures are settled and delivered at the time of execution (expiration) of the contract.
Forward contracts are concluded outside of an exchange, can have any characteristics and, as a rule, are one-time or renewable. A futures contract is an agreement with standardized parameters, concluded on an exchange that guarantees the fulfillment of obligations by the parties, and is repeatable (multiple).

Futures characteristics and specification

Futures is a standardized futures contract for which the following characteristics are established:

Performance (expiration) period is the duration of the contract. In the practice of exchange trading, weekly, monthly, quarterly, semi-annual and annual futures are used. In addition, there are so-called One-day (or “perpetual”) futures, which are valid for one trading day and are automatically extended the next. Such contracts are traded mainly on centralized cryptocurrency exchanges. In 2022, on the Moscow Exchange (for the first time in the world on a traditional exchange platform), 3 such contracts were put into circulation at the US dollar-Russian ruble, euro-ruble and yuan-ruble rates.

These and other characteristics are specified in a document called a contract specification and fully describe the exchange instrument. The specification includes the characteristics already described, as well as:

Contract name and codes. For example, the “perpetual” futures for the dollar ruble on the Moscow Exchange is called “One-day futures contract with auto-extension for the US dollar – Russian ruble exchange rate” and has the code USDRUB.

  • Its type is delivery or settlement;
  • The units in which quotations are presented, for example, gold futures are quoted in US dollars per troy ounce;
  • Price step and its cost;
  • Guarantee provision (GS).

Collateral is one of the features of exchange futures, which is associated with the settlement procedure. It is said above that settlement of futures contracts is made at the time of execution (expiration). Thus, at the time of concluding the contract, it is not necessary for the buyer to have the entire amount in the account to pay for it. Similarly, it is not necessary for the seller to have the entire volume of the underlying asset at the time of selling the futures.

But to guarantee the fulfillment of obligations, certain amounts or volumes of assets are reserved in their accounts, which cannot be involved in other transactions. They are called guarantees. As a rule, the GO is from 10 to 20% of the value of the underlying asset at the time of purchase/sale of the futures.

As a result, for a trader, futures trading is analogous to unsecured margin transactions. This ensures high profitability of futures trading, but at the same time significantly increases its risks.

Types of futures

As stated, the specification of futures contracts indicates their type. There are two of them:

Deliverable futures. It assumes that at the time of expiration the underlying asset is delivered from the seller to the buyer. For example, when one futures contract for Gazprom shares is concluded on the MICEX, upon execution, the seller transfers 100 shares (1 lot) to the buyer, and the buyer pays for them at the price fixed at the time of purchase of the futures. By the way, all stock futures on the Moscow Exchange are deliverable.
Settlement. In this case, the underlying asset is not delivered, and the buyer and seller pay for it in money. Those. if a gas futures was purchased, and the gas price has risen, at expiration the seller pays the buyer the difference in prices at the time of execution and purchase of the contract. The seller suffers a loss, the buyer makes a profit. If the price of gas has decreased, the buyer will pay the seller the difference in prices and will be at a loss. The seller will receive a positive financial result.

How to trade futures

Futures trading is not much different from transactions with other exchange assets. The trading participant must have a brokerage account with access to the derivatives market. In Russia, contracts are traded on the Moscow Exchange derivatives market (FORTS). Not all brokers provide access to it for private clients; the possibility of trading needs to be checked. In addition, some brokers require a separate account or sub-account for trading in the derivatives market. In this case, they will have to be opened. If a broker, such as Finam, allows trading contracts directly from a brokerage account, no additional action is required from the investor. The latter option is much more convenient, since it allows you to use any liquid assets accounted for in a brokerage account as GO.

After all preparatory operations, the trading participant can place orders to buy and sell futures. The main requirement is that there must be enough funds in the account to reserve the guarantee collateral. More detailed instructions, as well as futures trading options, are provided here.

The guarantee of fulfillment of obligations under futures contracts is the exchange. In most cases, it acts not so much as an intermediary, but rather as a central counterparty for such transactions. This means that the exchange guarantees each trading participant the conclusion of a transaction, acting as a buyer for the seller of the contract and a seller for its buyer. This also allows you not to wait for the contract to expire, but to make a reverse transaction at any time.

However, in futures trading, the liquidity indicator is of great importance. To reduce risks, it is recommended to trade only highly liquid contracts. For example, the most liquid futures on the Moscow Exchange for different types of underlying assets:

  • for shares of Gazprom, Sberbank and VTB;
  • on the RTS, Moscow Exchange and S&P 500 indices;
  • for exchange rates – yuan-ruble and dollar-ruble;
  • for commodity assets – natural gas, gold and Brent oil.

In general, futures are highly profitable instruments, trading on which is available to all private investors without restrictions. Due to the high risk, non-qualifiers will have to undergo testing to conclude the first deal. The contract trading technology itself is practically no different from operations with assets on the spot market.

(RU) Фьючерс. Определение и виды фьючерсов

Фьючерс – один из видов производных финансовых инструментов (деривативов), срочный контракт, фиксирующий обязательства сторон заключить в будущем сделку на оговоренных условиях. Многим розничным инвесторам и частным трейдерам такое определение может показаться малопонятным. Однако фактически здесь нет ничего сложного.

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