Studying Soros

It was reported that more than 10 per cent of the notional value of the portfolio was invested in put options on the S&P 500 and that this position had been significantly increased during the quarter.

This news leads to two obvious questions. Firstly, does the existence of the large put position mean that Soros is bearish on the US stock market? Secondly, if so, what justifies the negative outlook?

My answer to the first question is ‘not necessarily’. A put option is a derivative that delivers money when the price of the underlying asset on which it is written falls to a level below a predetermined exercise price. Thus, in this case, the put position will deliver money when the S&P 500 drops below the exercise level. That immediately sounds bearish, right? Well, not exactly. One cannot look at this position in isolation from the rest of Soros’s portfolio. If the rest of the portfolio has positive exposure to the US stock market, then the put position starts to sound like a classic hedging strategy.

Essentially, Soros may just be buying insurance against the possibility of a fall in US stock markets. Let us assume that, excluding the put, Soros’s portfolio is net long the US stock market.

Indeed, the 13F filing that informed us of the put position also shows some chunky long positions in US stocks. Then if, for whatever reason, the US stock market was to drop, the put position would tend to deliver positive cashflow at precisely the same time as the rest of the portfolio was likely to be delivering negative returns. In the event that the US stock market rose, the put option would expire worthless and the rest of the portfolio would deliver positive returns. So the put hedges the downside stock market risk while not eliminating upside potential. This is exactly the same strategy homeowners pursue when buying insurance against their house burning down (that is, they spend a small amount of cash today such that, in the event of a disaster, some or all of their losses are mitigated). It is also worth noting that the put may be used to (imperfectly) hedge other risks that are positively correlated with US stock market risk.

So the answer to our first question is that it is not clear that the existence of the put position means that Soros believes the US market is due for a drop soon. But, let us put this point aside for now. Let us assume that the negative exposure to the US stock market that the put delivers is larger than the positive market exposure of the rest of his portfolio such that, net, he has indeed taken a negative view on the US stock market. Add to this the fact that the put position has been increased so dramatically quarter on quarter and it seems worth devoting some time to thinking about factors that might cause one to be bearish about US stock markets.

Let us start with the observation that US markets had a stellar 2013. The S&P 500 was up around 30 per cent for the year and the Dow Jones Industrial Average delivered similar performance.

Benchmark

Does this observation, in itself, tell us anything? Well momentum investors might tell you that it means a good 2014 is more than likely, while contrarians will say the opposite and that ‘what goes up must come down’. I would suggest that to make any judgement, you need a benchmark. You need to be able to ask whether the market is currently high or low relative to some measure of fundamental value.

A popular way of looking at the value of a stock market relative to a benchmark is to compute the market’s cyclically adjusted price-to-earnings ratio (or Cape). This measure, popularised by Yale academic Professor Robert Shiller, is really just the ratio of the current level of the market to the average level of market earnings over the most recent decade. Mr Shiller, among others, has argued that high levels of the Cape tend to forecast disappointing stock market returns.

So, in terms of Cape, where are we now? Mr Shiller’s own computations give us a Cape for the US stock market of around 25. Is this large or small? Well, again using data provided on Mr Shiller’s website, one can show that the current Cape is in the largest 10 per cent of values ever recorded. Cape has only been significantly larger than its current level during the 1929 stock market crash and around the much more recent dotcom bubble. If history is a good guide, then current levels of the Cape suggest that during the next decade or so we should expect subdued US stock market returns.

So does this mean we should all be running for the hills and moving our money into cash? Should we all be buying put options on the S&P 500? Probably not. The Cape is a decent forecaster of long-horizon returns but a much less good predictor of short-run (for example, quarterly) returns. Therefore, the current strength of the Cape probably justifies a more defensive long-term allocation across stocks and bonds, rather than just dumping the stock market today. Of course, if you are so inclined, you could layer other reasons to be defensive (if not outright negative) on top of this. For example, you might be concerned that tapering in the US has come too soon and might lead to renewed US macro weakness.

So all in all, there are some indications that there may be a little too much froth in the US stock market at present and that a long-term defensive view is warranted. It is hard to suggest that this is behind the Soros put, though. Much more plausibly, the put position is a hedge that seeks to insure the portfolio against short-run stock market fluctuations to the downside. This is what hedge funds do. They bear risks that they think will generate excess returns and hedge the risks that will not.

Richard Payne is professor of finance at Cass Business School

Key points

■ There has been a lot of attention to the large hedge against the S&P 500 placed by Soros Fund Management.

■ The 13F filing that revealed the put position also shows some chunky long positions in US stocks.

■ The hedge could easily have been an insurance policy against short-run stock market fluctuations.