Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto
Mutual Funds

Cramer: The Distortion of Common Stocks by Index Futures

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

The whole thing seemed ridiculous to me. I was sitting in my Corporate Finance class at Harvard Law School in 1982, reading the Wall Street Jour­nal as always, just trying not to disturb the zombies around me with my page-turning. I liked to hide in the back during class; that way it was much less likely that I would be called on, because I either hadn't read the material or didn't understand it. Plus, who could concentrate on the stock tables and take notes on a meaningless class at the same time? Bet­ter to have your priorities straight in order to get your money's worth for the $25,000 a year you'll owe in student loans at the completion of the exercise.

Anyway, there was an article in the paper that day about some stock index that was going to start on the Kansas City Board of Trade, an ex­change I thought just traded those agricultural products you didn't care about unless you were in the food business-you know, grains, winter wheat, whatever. Yet there it was. Some wise guy was putting together not a basket of grains or pork bellies but a basket of stocks, specifically a bas­ket of the stocks in the Value Line Index, which represented the same stocks as the Value Line Investment Survey, at one time the bible of all stock research for the home gamer and the professional alike. Those were the quaint days, when individual stocks were studied and owned, not the quant, or quantitative, world of today, when whole groups of stocks are charted and traded via machines that are supposed to tell you the op­timum purchase price and let you exercise the trade within the blink of an eye.

This newfangled package of stocks was meant to trade as a futures contract, meaning you would bet on the future direction of all the stocks combined in the index, except, unlike a grain index, at the future's conclu­sion you wouldn't have to deliver the stocks themselves. The prices would settle in cash, and you would be able to take your gains from where you first made your bet. And it was a bet, not an investment, because you weren't actually buying the individual stocks in the package. Just like a future, you could sell short the basket too, if you thought it was going to go down.

So if you thought the collective value of all the stocks in the Value Line Index was going higher, you bought a future that gave you the right to the gains at a specific point in time. If you thought they were going lower, you could short the index and then buy it back and pocket the dif­ference, if indeed it went lower, as you hoped and wagered. Of course, if you bought, thinking the index was going higher, and it went down, you had a loss of the portion of the money equal to the decline, just as you would with an individual stock.

After I read about this new index futures market, I asked one of my securities professors, "How can this be legal?" Stocks, I said, don't trade in lockstep. There's nothing in a group of stocks that is comparable to winter wheat, which is uniform and not meant to have any differentiating statis­tics or characteristics. Stocks trade on their own mettle. They have so little in common there could be no point in homogenizing them in an index. The repercussions could be huge. Stocks might cease being representa­tive of the enterprises behind them and take on the characteristics of an entire market, even as that market had little to do with the profits or sales of the individual companies. I said it was absurd and I couldn't believe the Securities and Exchange Commission would allow such an irresponsible grouping of stocks to trade together.