Page 165

While we always know where the stock market has been and where it stands now, there is no way we can accurately predict where it is going. You may try your luck with fortune tellers, statistical analysis, or a sign from God, but there is no absolute telling the future for us Earthlings. Having said that, people have always tried various methods to at least partially predict a direction for the market in the short run. The S&P futures by far has been the best indicator to do that, but it certainly hasn’t been always right. The S&P futures contracts always have a premium to cash (the actual value of S&P 500) during market hours until that very moment when they mature (convergence). We have covered the concept of premium already in the futures chapter. It is the size of this premium which may tell the investors something about the future direction of the market.

During market hours the price of the S&P futures contract moves in sync with the S&P 500 and the time to maturity, among other things. The futures contract price basically reflects the value that the investors believe the S&P 500 will be at maturity which is generally higher than the current value. But there is also another subtle value based on the current S&P 500 futures price: fair value. The fair value of the contract is based on a lengthy formula which relies on the cost of borrowing the cash to buy the stocks that comprise the S&P 500 minus the dividends paid by those stocks. Let’s use an example. If S&P 500 is currently at 1,400, the S&P futures contract expiring in one month may be 1,420, and its fair value for could work out to 1,425. Again this is calculated using a formula, but it basically tells us that at current S&P level of 1,400 we can expect it to be at 1,420 within one month, but considering the cost of acquiring the stocks and collecting dividends it should be 1,425. Fair enough. If overnight the S&P futures value moves beyond 1,425, that could indicate a higher opening for S&P 500 and generally the stock market. If, however, it stands below 1,425 this could be an indicator of a weak opening. Even a value of 1,422, while it is 2 points …