Market concept of D.C. Put explained

Chas Craig, BridgeTower Media Newswires

We first introduced the market concept of the Fed Put when we commemorated the 30-year anniversary of Black Monday in October 2017. Two years on we wrote another column opining that the Fed Put was alive and well. Then, earlier this summer we discussed how this concept influences stock market valuations and that, since nobody wants to be this generation’s Herbert Hoover, more recently the Fed Put has morphed into a D.C. Put with the rollout of enormous fiscal stimulus.

However, a family member and longtime reader recently told me that she understood that government bodies have become increasingly inclined to backstop markets, but she struggled to fully understand the significance of the concept because she didn’t know what a “put” means. I realized then that I had made the mistake of not beginning at the beginning.

When you hear someone comment on the Fed Put or the D.C. Put, the word “put” is in reference to a put option. If one owns a stock and purchases a put option to match it, something known as a “protective put,” they have effectively purchased an insurance policy on their stock position. We are in no way advocating for readers to implement such a strategy, we’re simply explaining a concept.
Importantly, this concept of a put option as an insurance contract becomes adulterated when a put option is purchased without owning the underlying stock, something known as a naked put, which is a speculation that the share price will decline.

The “D.C. Put” that has expanded meaningfully in this current crisis effectively results in the government acting as an insurer of sorts of markets and, by extension, private enterprise. The likely result of this is for the expected rate of return on all long-term financial commitments to more closely resemble that of long-term U.S. Treasury bonds going forward. Within bonds, this line of thinking posits that the extra yield investors receive for owning non-Treasury bonds that have credit risk, on average, will be less than it otherwise would have been. For stocks, the primary transmission mechanism for lower expected rates of return is higher stock valuations, on average. Please note that there is an astronomically wide variance of opinions regarding what average business and market conditions will be going forward and how close we are to that state now.

The valuation issue is a double-edged sword. Obviously, we lament the reduced future return prospects we perceive. On the other hand, we have benefited mightily from the D.C. Put-induced valuation uplift recently. Further, while prospective returns on risk capital are probably going to be lower than historically normal, they are almost necessarily so because of the reduced risk owing to the implicit government insurance. Bottom line, we do think long-term stock market returns from today’s starting point are likely to be lower than they have been historically. This, however, is not the same thing as saying stocks are wildly overvalued.

Does this mean that share prices will march ever upward? Of course not. However, it does seem reasonable to think that market cycles will continue to be longer than was historically typical, be colored by periodic material, but not catastrophic declines that are cured by accommodative policy and then punctuated by very large losses when financial and economic imbalances become too extreme for policymakers to keep them at bay. Also, for the foreseeable future, structurally looser fiscal and monetary policy are likely to remain. However, even if unlikely, it is possible that, at some point, policymakers of the future will move to reduce the market’s insurance coverage. Ironically, market forces may someday determine that such aggressive government support is no longer sustainable and force the issue.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).