Yesterday I argued that the market was overestimating the certainty that the economy is rolling over as opposed to just pausing. Although the odds do indeed favour a continued deterioration in the world economy, there is a better than anticipated chance that the economic growth will return after this slight hiccup.
I mentioned that if this was the case, shorting bonds and buying real assets will most likely be a better trade than buying stocks.
Today I want to explain my thinking.
During a usual economic cycle, the initial tightening period where the economy is gathering momentum but the Fed is still behind the curve is often a period of consistent stock market strength. The reason the stock market rises is due to the fact that profits grow faster than the rate at which the earnings are discounted rises. This is the sweet spot at which rates are not rising that fast, yet profits are rushing upwards as economic growth fuels profits. As the economic cycle progresses, investors continue to pay less and less for a dollar of earnings as a combination of rising interest rates and investors anticipating the inevitable economic slow down cause the P/E ratio to shrink.
The reason that I think this time is different (and right there you should take what I am saying with a big, no I am mean huge grain of salt) is that I am skeptical that even if the economy improves that corporate profits are going to be able to grow enough to outpace the rise in yields.
I have two reasons for this skepticism. The first is that I think that there is a decent chance that if the economy does become self sustaining with money velocity stopping it’s seemingly never ending plummet lower, then the bond market is going to have a big accident. If the economic growth somehow does become self sustaining, then the massive amount of fuel that the worlds’ Central Banks have heaped on the fire is going to cause a massive bond market accident. The bond market is going to have a dramatic repricing downward (higher in yield). Therefore even if the earnings manage to grow, I don’t think they are going to grow anywhere near as fast as interest rates rise.
The second reason is that I am skeptical is that I can’t see this trend of corporate profits as a percent of GDP growing dramatically.
Corporate Profits as a percentage of GDP</a> </div>
As is evident from this graph, corporate profits as a percent of GDP exploded higher in 2000. Although it had risen during the Dot Com bubble, it went vertical in 2000 as Greenspan lowered interest rates to absurdly low rates. Then during the 2008 credit crisis these profits quickly evaporated, but we have managed to steadily return to the pre-crisis highs.
In my mind, to be bullish on the stock market, you need to believe that this ratio can at least stay elevated, with the GDP growing and yet interest rates staying low. I just think that an awful lot has to go right for this to work.
The stock market bulls seem to cheer for economic growth, but if I were them, I would be careful for what I wish for.
I think that if we get an economic recovery it is going to surprise a lot of market participants with a declining stock and bond market.
I recall reading a book about a fellow who was addicted to drugs. He wasn’t a “hanging out in the crack shack homeless” drug addict, but more like a “somewhat fully functioning productive member of society” addict with a massive drug problem. He would buy his drugs in bulk with the idea of piecing it out over the course of the month. It was like going to Costco for drug addicts. I am sure you are seeing where I am going with this – inevitably he would do the whole months’ worth of drugs in an insane binge. But this is the part that I like best about the story. He came up with the ingenious idea of buying himself a safe that opened with a key. He would take out a few days of drugs and then stick the rest of his stash in the safe. At that point, he would mail himself the key so he couldn’t get at the drugs until the key returned by post a couple of days later. Although he was smart, he was after all a drug addict and not that long after implementing his great system, even though he knew that the key was due to arrive in the mail in a couple of days, he couldn’t help himself and proceeded to take a sledgehammer and blow torch to his safe to get his drugs out where he promptly did the entire month’s supply in one night.
And just like the drug addict couldn’t help himself, I can’t help myself from trying to pick a top in some of these stupid crazy mo-mo stocks. Yesterday I succumbed to the desire and bought some puts on Facebook and Tesla. I know it is stupid. The chances that I am able to pick the top is pretty close to nil. I know that the odds favour the bubble continuing and that trying to short these names is a mugs game. But I can’t help myself. My only defence is that I am not yet a true addict and have kept these purchases strictly recreational. I have bought so little that it is barely to going to move my P&L. I also did not short, but bought puts to ensure that my risk is limited. I am embarrassed – but I can’t stop myself and getting a little taste will hopefully quell my craving for trying to be a hero and picking a top. But then again, isn’t that what all addicts say?
Update: Long a tiny position of puts on TSLA and FB. Just for shits and giggles. Conviction 1. Stop – none: when they go to zero the market will do it for me.
Short US 5 Year Treasury Futures. I expect the Fed to continue to withdraw stimulus aggressively. Conviction 3
Short US 2 Year Treasury Futures. I think the downside is a move from 31 bps to 25 while the upside is a move up to 50 bps. Conviction 4
Short Euro. Added to this trade into the recent rally. Conviction 5
Short Nasdaq 100 futures, short Eurostoxx futures, and short Nikkei futures. I entered the trade last Wednesday with idea that the Fed is going to taper until something breaks and that the bulls are pushing their luck. Conviction 4. No stops for now
Short European stocks via ESTX50 index vs Long S&P 500. I continue to believe that the ECB is too tight relative to the Fed and the BoJ, and that this will translate into relative weakness of European equities. Conviction 5
Short Yen. Establish short Yen last week. Now I will sit tight and wait. Conviction 4
Short JGB futures. I can’t call myself a macro trader without this widow maker on the sheets. Small position for now, but will add aggressively at the first sign it is working. Conviction level: 2. No stop.
Long Yen volatility. I believe we are entering a period of increased volatility for the FX pair. Conviction: 3
Long 30 year US treasury volatility. Swapping half of this position into Yen volatility. Conviction 2
Long various deferred crude oil futures contracts. I own a variety of different expiries in years from December 2014 all the way to December 2020. Conviction level: 5. No hard stop.
Long precious metals smorgasbord. Long gold, silver and platinum futures. I also believe that the closed end ETFs (CEF.A CN Equity or PHYS US Equity) which are now trading at discounts versus years of trading at a premium are a good way to play this idea. Conviction level: 5. Using the year end lows as a stop for half the position.
Long grains. Long deferred corn, wheat and soybean futures. Although this trade has not worked at all, I really like it long term. Conviction level:6. No stop period.
Long Ithaca Energy IAE CN Equity. See previous posts. Conviction level: 5
Long Input Capital INP CN Equity. I have not yet written this up, but I really like this story. More to come in coming days. Conviction level: 5