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Stock market call options to make money from inflation [ClearOnMoney]
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Stock market call options to make money from inflation

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Commentary

Stock market call options to make money from inflation

20 Feb 2013 by Jim Fickett.

The basic idea is this: A call option gives you the right to buy stocks (in the case considered below, an index fund of the Japanese market) at a certain price. You buy options for a level that seems completely out of reach – say 4 times current prices. When very high inflation comes, nominal stock prices rise much more than that – the analyst quoted below suggests, for the Japanese market, over 6000-fold. So you exercise your option, buy at 4x, and immediately sell at 6000x.

Many people have pointed out that the Japanese government budget – with extremely high deficits and a large fraction of the budget devoted to interest – is unstable, and likely to lead at some point to rising rates, more money printing, and inflation. The order and timing of events is unclear (my favorite scenarios are described in past commentary listed on the Reference page Japan government debt; another scenario is described below), but the bottom line is that high inflation in Japan is quite likely in the next few years.

So how does one invest on the supposition of high inflation?

Mebane Faber had a nice post last week in which he points to a 2010 newsletter from Dylan Grice at Société Générale, the French bank. Grice points out that call options for high nominal stock market values are quite cheap, and could pay out handsomely in case of high inflation. Here is the rationale:

Japan is no Zimbabwe. Neither was Israel, yet from 1972 to 1987 its inflation averaged nearly 85%. As its CPI rose nearly 10,000 times, its stock market rose by a factor of 6,500 … Regular readers know that I don’t generally make forecasts, but that every now and then I do go out on a limb. This is one of those occasions. Mapping Israel’s experience onto Japan would take the Nikkei from its current 9,600 to 63,000,000. This is our 15-year price target. …

Despite the Japanese government paying a mere 1.5% on its bonds, interest payments amount to a hair-raising 27% of tax revenues. …

Any meaningful repricing of Japanese sovereign risk would push yields to a level the government would be unable to pay. Moreover, since the domestic financial system is loaded up to the eyeballs with JGBs, a crisis of confidence there would soon transmit itself beyond the public sector.

So the path of least political resistance will presumably be to keep yields at levels which the Japanese government can afford to pay, and to stabilise JGBs at levels which won’t blow up the financial system. This will involve the BoJ buying any/all bonds the market can no longer absorb, probably under the intellectual camouflage of “a quantitative easing program” aimed at breaking Japan’s deflationary psychology. Economists might applaud such a step as finally showing the BoJ was “getting serious about Japan’s problems”. In fact, it will be the opening chapter of a long period of inflation instability. …

Japan’s tax revenues currently don’t even cover debt service and social security, persistent and growing fiscal burdens. Therefore, once the BoJ is forced into monetisation of government deficits, even if only with the initial intention of stabilising government finances in the short term, it will prove difficult to stop. When it becomes the largest holder and most regular buyer of JGBs, Japan will be on its inflationary trajectory. …

Japan is an advanced economy, a developed democracy and certainly no Zimbabwe. But Israel was all of those things too. It simply found itself politically committed to a level of expenditure – military and social – which it couldn’t fund. Instead of taking the politically unpalatable course of cutting that expenditure, it resorted to the tried-and-tested tactic of buying time with printed money. Between 1972 and 1987 Israel’s CPI rose by a factor of nearly 10,000. Inflation averaged around 84% and peaked at an annualised 500% in early 1985.

In real terms equity prices fell, failing to keep pace with the rise in the CPI. But in nominal terms they exploded rising by a factor of around 6,500 over the period, in keeping with experiences of nominal share indices in Argentina, Brazil or Weimar Germany during their inflationary crises. …

if Japan was to follow a similar trajectory to Israel’s, the Nikkei would trade at around 63,000,000 (63 million) by 2025. How much do you think 15y 40,000 strike call options would cost? I’m not sure either (though I’m sure I could get interested parties a quote), but call options are generally cheap, and “melt-up” calls especially so, and I’d be surprised if you couldn’t buy that risk for a few basis points a year. Is there a cheaper way to hedge Japan’s coming inflation?

This is an attractive idea for two main reasons.

  1. Although direct ownership of equities is, on the whole, a good inflation hedge, equities often perform poorly at first and require a long wait to recover (Some practical investment thoughts from Jeremy Grantham); furthermore, in a high inflation, it is impossible to avoid significant losses to taxes, outside of tax-advantaged accounts (Preservation of capital in the face of high inflation requires tax-sheltered gains); so you really need high returns, not just preservation of capital, and this strategy does provide high returns
  2. Oddly, the vast majority of participants in the market cannot think quantitatively and so, even if many people know inflation is a risk, they simply cannot imagine stock indices being several times higher than currently; hence Grice's comment that the required call option would probably be very cheap

The main danger in the proposed trade, it seems to me, is counterparty risk or chaos in the markets. That is, if the call option was sold to you by a Japanese bank, it is quite likely that in a very high inflation the bank would go bust and be unable to pay. Similarly, if inflation were really very bad, settlement on a Japanese exchange might be hindered by emergency changes in the rules. If one were to pursue this strategy, it would probably be best to buy a call issued by a European or Canadian counterparty. This point is probably behind a concise remark in another source quoted by Faber: “Buying 40,000 strike Nikkei calls with a ten- year maturity, with a payout in a strong currency can be done for around 40bps per year.” (emphasis added).

Buffett made a somewhat related bet in selling long-duration equity index put contracts, i.e., insurance against the stock market being lower in 15-20 years. This approach avoids the exposure to turbulent times, since Buffett is being paid annually now. It does have some genuine risk of having to pay out in the event of a market fall, but inflation and normal growth make that risk very small.

There are difficulties in long-dated options, but the approach is definitely worthy of attention.