Sexier than sowbellies, simpler than soybeans and as speculative as anything Atlantic City or Las Vegas has to offer: a futures contract based on the Dow Jones average of 30 industrial stocks.
Massive opposition is being mustered against what was once considered a laughable proposal to let investors speculate on the Dow Jones average.
The Securities and Exchange Commission, the Federal Reserve Board and, perhaps most importantly, Dow Jones & Co., are aggressively attempting to squelch the plan.
Hardly taken seriously when it was proposed by the Kansas City Board of Trade a few months ago, the plan has become so appealing and so controversial that the Commodity Futures Trading Commission has scheduled two days of hearings on it Wednesday and Thursday.
Previously an obscure marketplace for trading futures contracts in hard dry red winter wheat, the Kansas City Board is trying to cash in on the booming futures business by creating what is potentially the most popular future of them all, one based on the Dow, symbol of the stock market.
Called the 30 Selected Industrial Stock Average future - because Dow Jones will not allow its name to be linked to it - the plan would let investors speculate on the future level of the popular stock market index just as they now speculate on future prices of corn, cocoa and other commodities.TKansas City's contract would be based on the expected level of the Dow average in March, June, September and December, and would be valued at 50 times the daily Dow quote. A $1 change on the average would mean a $50 change on the futures contract; the futures would be quoted at the Dow index price to make the investment easy to understand. At Friday's close of 838.10, the Dow futures contract would be worth $41,905.
W.H. Vernon, executive vice president of the Kansas City Board of Trade, contends the Industrial Average Futures would be used just as other futures contracts are - by hedgers who want to protect themselves against changes in the price of commodities and speculators who think the hedges are wrong.
Bank trust departments, investment bankers or anyone else with plans to buy or sell stock at some future date are potential hedgers in the industrial average futures, the Kansas City official contends.
An investor expecting the Dow average to increase by December could buy a portfolio of shares of each of the 30 stocks included in the index, or instead could buy a December Dow futures contract.
Buying the stock would require the investor to put up 50 percent of the purchase price under the stock purchase margin requirements set by the Federal Reserve Board. Buying the futures contract would require only a $1,500 down payment under the margin provisions proposed by the Kansas City BOard of Trade, providing a tremendous leverage advantage to the futures investor.
With the Dow at 800, purchasing the portfolio would require a $40,000 investment, $20,000 in cash. If the average rose to 900, the portfolio purchaser would make $5,000, a profit of 25 percent on the cash invested. In the same situtation, the futures contract buyer would gain the same $5,000 profit, but it would amount to a 333 percent return on the investment.
But the lever tilts both ways, and when the Dow plummets - as it did with record velocity this past week - the futures buyer with only $1,500 put up as margin could be wiped out quickly. Negative economic news pushed the Dow average down by 58.99 points in the last five trading days; a hypothetical speculator who invested $1,500 in Dow futures a week ago Friday after the stock market closed would have lost $2,949.50 by the time the market closed last Friday.
The value of the portfolio buyer's investment also would have declined in last week's mini-crash, but the losses would only be on paper and might be recouped if the average swings back up. The futures buyer, however, would have faced an immediate cash outflow.
Under the futures trading rules, margin buyers must maintain their minimum margin in the faces of losses. Each time their cash investment falls 30 percent below the minimum margin, they receive "a margin call" from the broker requiring the loss to be made up in cash. The only alternative is to liquidate the contract at a loss.
Last Monday alone, the Dow dropped almost 22 points. The hypothetical Dow futures buyer would have lost $1,100 and would have gotten a phone call from the broker demanding restoration of the margin minimum. As the average continued to skid during the week, the futures contract investor would have had to pour out more and more money to preserve the position. By the end of the week, the original contract would have required a total investment of $4,449.50 unless the speculator lost his nerve and sold out, as many do when the market turns down.
The speculative risks of an investment in which the customer can lose not only the original investment but additional money in a matter of days is one reason why the SEC has gone on record against the Kansas City Board of Trade proposal.
In a scathing 15-page letter written to CFTC Chairman William T. Bagley, SEC Commissioner Irving M. Pollack cited "the enormous potential of this proposed contract for purely speculative abuse." Added Pollack, "The purported economic purpose it is alleged to serve is yet unproven and, in any event, it is likely to be of limited utility."
Warning that unsophisticated investors may be touted on high-risk Dow futures by unscrupulous commodity salesmen, the SEC contends the stock index futures contract is so far removed from legitimate investment instruments that it violates gambling laws in many states, including Missouri.
The SEC - which regulates the stock market - contends the CFTC has no authority to approve trading in a futures contract involving stocks. While CFTC staffers assert their claims to the turf are well documented, the SEC potentially could move on its own against the Kansas City Board should the contract be approved.
The Federal Reserve is involved in the application because the Fed sets margin requirements for stock purchases. Fed staff members contend - in a staff study to be released Monday - that the low-money-down futures contract amounts to an attempt to circumvent the margin requirements. The agency's board of governors is expected to take a formal stand on the stock index future at its next meeting.
Further action also can be expected from Dow Jones. The business information firm, which publishes The Wall Street Journal and Barron's magazine, first compiled a stock market index in 1834 and, in the ensuring century, has made its industrial stock average synonymous with the general health of Wall Street.
Although the Dow Jones name already has been dropped from Kansas City's proposal - apparently at Dow Jones' demand - Robert Potter, a Dow Jones board member and counsel to the firm, said the company has warned the Board of Trade and the CFTC that it may take other actions.
The Dow Jones attorney said the company belives it not only can prevent use of its name but has a proprietary right to the formula used in figuring the average. Originally the widely quoted industrial index was simply the average price of 30 major companies traded on the New York Stock Exchange. But to compensate for stock splits, mergers and bankruptcies involving companies on the list, the formula has grown more complex.
Because the average is merely a mathematical equation, the Dow Jones future has one big difference from other commodity futures. CFTC officials estimated that 97 percent of all commodity futures trades are settled in cash, but theoretically the speculator who buys December corn futures is entitled to a boxcar of that grain come Christmas.
The Dow Jones futures buyer will be entitled to 35 shares of each stock included in the index, the Kansas City Board of Trade decided late last week after considering two other delivery plans.
The central issue to be aired in the hearings on the proposal probably will be the economic justification for inventing such a unique investment instrument. CFTC Commissioner David Gartner will be chairman of the hearings, which also are expected to produce new arguments about the general proliferation of futures contracts and the growth in futures trading.
Critics of the trend say highly leveraged futures contracts attract investment dollars that ought to be going into common stock, aggravating the shortage of investment capital and draining away investments in emerging companies that once were the speculator's favorites.
While the most outspoken critics suggest the Kansas City Board is only interested in generating new business for itself, some economists believe that any means of hedging against price changes adds stablity to the economic system.
The recent acceptance of trading in futures in home mortages and Treasury bills and the several dozen applications pending before the CFTC for additional futures contracts in commodities ranging from heating oil and foreign currencies to metals are cited as evidence of the demand.
One economist has advocated going even farther that any of the exchanges now suggests and trading a futures contract based on the consumer price index.
While researching the Kansas City Board of Trade proposal, economist Kurt Dew hit upon the idea of CPI futures as a way for everybody to hedge against inflation. A wage earner fearful of living cost increases could buy CPI futures to protect his or her earning power, Dew suggests.
Dew had been scheduled to outline his thesis at next week's hearing, but his appearance was cancelled Friday. Dew is on the staff of the Federal Reserve Bank of San Francisco, and Fed officials in Washington apparently did not want one Fed economist to go on record in favor of a proposal that the board itself was opposing.