Global Macro Trading Journal

Some rough calculations that I did after the US election showed that a 0.125% improvement in real growth was worth a little over 150 ES points to the market. I'm referring to long-term growth here, not little pops in GDP. Since the 2008 crisis the US seems to have been trapped a 2% growth trajectory, that is lower than the historical 3-3.5%

Larry Summners, Paul Krugman and other folks seem skeptical that the Trump administration will succeed in getting out of this growth trap. But that is mostly because they don't have skin in the game and love to politicize issues. As a trader and investor I look at this differently.

The US will have a, likely, 8 year stretch where the President (with a much higher level of support from Congress that Obama had) will be doing everything he can to get that 2% structural growth level up. For every 12.5 bps that he suceeds (in terms of producing economic efficiencies that increase real potential GDP growth), he will squeeze the shorts by 150 ES points. It wont be a instant relantionship, this is more in terms of theoretical long-term valuation but I doubt this relantionship wont hold since people use Discounted Cash Flows to value stocks (and even the Gordon model sometimes). As the real growth shows up in the numbers, those DCF models will pick up and stocks will be valued more. So stocks will be favored more as/if Trump succeeds.
It doesn't take that much in improvement to send the market significantly higher

In fact, one could even say that the whole reason that the US market was so high in valuations (as measured by the CAPE ratio and other metrics) was because investors didn't really believe that the Secular Stagnation/New normal of 2% growth was sustainable, they believed it was going to be solved at some point and that higher growth was going to justify those valuations and even make stocks cheaper.

This is not too dissimilar to why currencies collapse when fiscal problems emerge in a country. While the current President might be trusted as to not print money to pay for the fiscal deficit, being long that currency is to also be exposed to every President for the next 50-100 years. At some point someone will get in there and they might print money. So therefore investors dump the currency up to a level where there is enough compensation to hold it.
 
As it turns out that market was correct about Secular Stagnation potentially being temporary. Now you have an administration that will all that it can to reverse it. If whatever plans they try, don't work, they will try other things. Trump run on helping out the average american, getting that growth higher is a big part of that. He also has that goal of 4% growth that I'm sure will come up in the next president election

So effectively, there is an administration that will try to make every one short ES or underweight stocks life's miserable for the next 8 years. And the relationship is for little improvements to produce significant losses for those short/underweight. Does it make any sense to short or to stay underweight for any significant (months or years) period of time in a market like this?
Only if your short is a NYT column, in the real world is just a horrible trade. In Fed's speak "the risks are to the upside"
 
The US CAPE ratio (Shiller PE) overstates a lot of the valuation in US equities because it includes the financial crisis (with huge accounting losses by AIG and other firms that distort the data as Jeremy Siegel shows) and then a period of low 2% growth where profit growth wasn't as good as it could be.

I rather look at the forward PE, which is at 18x right now. If you assume higher growth going foward, then pretty quickly this market starts to look quite cheap
 
Now, that said, I do see the point of trying some short trades during this Trump rally. Inaguration might start a profit taking period and Trump will say some crazy things once he gets there. Today stocks are gaping down and so I will be involved on the short side, just in case things tank in antecipation of inaguration. Key is to not risk a lot in trades like this. My risk budget is quite small
 
So I decided to re-run the numbers with the Gordon Model to see how much more are stocks worth when the growth rate rises.

Pre-election, lets assume a fair value of 2150 on the SPX. Thats where the price seemed to be hoovering around before the election got close and thing got wild. At that price, people were buying expecting to earn some kind of return (what financeers call the 'required return'). That term is used right along with 'cost of capital'. That's the minimum required to make an investment

The cool thing is that with data, we can find what the market 'wanted' by keeping SPX at around 2150. The math is as follows

Price of the stock = Dividend next year / RequiredReturnOrCost of Capital - Expected Growth Rate

2150 = 51.50 (expected S&P500 dividend next year) / RequiredReturn - Expected Growth

I extracted the expected dividend by looking at the yield (2.3%) to that 2150 and added a 4% growth (2% real 2% inflation)

What is the expected growth before Trump? Probably the Secular Stagnation/New Normal of 4% (2% real 2% inflation) plus some kind of probability that the Secular Stagnation will end and the growth will rise . Lets assume a 10% chance growth will go to 3% real 2% inflation. So that 4% (or 0.04 in decimal form) becomes 0.04 + plus a 10% of an additional 1%, or effectively 0.04 + 0.001 = 0.041

Plugging that into the formula it becomes
2150 = 51.50 / RequiredReturn - 0.041

Solving for X (Required Return) one finds that the market was holding stocks at 2150 with an 'expected return' of 6.49% (or 0.0649 in decimal form)
That's what makes the formula hold. And it seems consistent with REIT yields of 3-3.5% and 30y treasuries of 2.75% (stocks needed a premium over these assets)

So, what happens when the probability of the end of secular stagnation changes? Lets assume, it goes to 50%. How much is the SPX worth?
X = 51.50 / 6.49%(required return) - 4.5%(expected growth)

Why 4.5%? its the 4.1% from before (0.041) but with the additional chance of getting 1% growth. a 50% chance of 1% growth equals 0.5% growth
Solving that formula, the result is

SPX = 2587

With a 100% probability, the SPX becomes worth a staggering 3459!

And whats more, I'm only assuming the max upside is 1% in real growth (from 2% to 3%). The historical growth rate goes as high as 3.4% for some pretty long decades.

Even a small improvement of taking the growth rate from 2% to 2.35% produces an SPX worth 2406.

Point is, stocks are extremely sensitive to the long-term growth rate embedded on their cash flows. You talk about changing it (to the better) and its like offering cocaine to Maradona

What Trump and Co will do is to spend 8 years trying to make that 100% probability scenario become a reality. But whats worse is that if one shorts ES or gets underweight of it, you lose in many scenarios:
-Trump suceeds and the growth rate rises
-Trump eventually fails but the market thinks he will suceed so it rises a lot before it the fall. You get squeezed badly or you lag the market badly
-Trump fails in creating long-term growth but it suceeds in creating short-term growth (a party is thrown for 8 years), this creates a false boom that boosts stocks
-Other scenarios I haven't thought about

For that reason, I would caution anyone with fighting this market, unless its a day trade or swing trade done for tactical reasons (or you are just punditing around in the NYT), chances are it will be a bad decision
 
The Gordon dividend model is simply a rational way to value equities. Discounted cashflows show a similar kind of sensitivity to the long-term growth rate. To count on the market not realizing the obvious (more growth is good for growth driven financial assets) is very dangerous, very dangerous. There is a reason why stocks historically have done well in periods of rising growth, that's because people can see the obvious
 
Now, there are some complexities around profits driven from overseas. Not all of the growth will flow directly to the companies as they derive some revenues from outside the US so presumably, World GDP growth is more important than US GDP growth for that segment. But the numbers and the sensitivity is so extreme that one has to be aware of it, otherwise it might lead to some seriously bad decision making. Again in Fed's speak "the risks are to the upside"
 
Daal said:
The US CAPE ratio (Shiller PE) overstates a lot of the valuation in US equities because it includes the financial crisis (with huge accounting losses by AIG and other firms that distort the data as Jeremy Siegel shows) and then a period of low 2% growth where profit growth wasn't as good as it could be.

I rather look at the forward PE, which is at 18x right now. If you assume higher growth going foward, then pretty quickly this market starts to look quite cheap
More...

http://www.advisorperspectives.com/...ch-on-forecasting-returns-with-the-cape-ratio
 
DB_sezwhat said:
http://www.advisorperspectives.com/...ch-on-forecasting-returns-with-the-cape-ratio
More...
Pretty cool. If one looks at a range of valuation metrics like this guy's, Siegel NIPA CAPE, my Gordon derived estimate or Forward PE ratios, things aren't that bad at all.

To me a pretty big clue that the gloom and doom folks are wrong is to consider that stocks are real return assets. They tend to adjust things for inflation, so the dividend yield+the buyback yield is a real return.
Right now the dividend yield is around 2.3%, I'm not sure what the buybacks are but that will probably quite easily take the total yield to 3%. So 3% real plus a 2% expected long-term inflation, a total of 5%. And that 3% will growth as well, so its worth more than 3%. We are talking a about a total nominal return of at LEAST ~6%ish in a world of 2-3% bond yields so there is plenty of equity risk premium.

Expected equity returns are only bad when people use the, currently, flawled Shiller CAPE or if they use fuzzi math like estimating that valuations will drop and putting that into an expected return formula (like saying 2% from dividends + 2% inflation -2% in multiple contraction). That's a pet peeve of mine
 
I defended John Hussman in the past but that was only because I was still developing my ideas about stocks. Time has reveled plenty about the folly of his approach. But even less bad investors like Jeremy Grantham seem to be falling for things like predicting valuation contraction. Against this 'multiples will contract and that will come out of your pocket' I got the following:

-Multiples contracting can actually be a net positive to an investor. Anyone that has a lot of cash coming in (due income from a job or things like that) WANTS multiples to contract to acquire financial assets at lower prices. If you projtect 2 investors looking to retire in 20-30 years, the one with the chance to invest at cheap markets early, will retire a lot sooner. So we are talking about a begnin scenario that the fuzzi math gloom and doom folks are accounting for as negative
-No one knows where valuations are going, there is a certain element of 'collective inteligence' that has to be respected. Its possible that valuations will remain high for a really long-time as they are there due structural changes to the investment industry as I have argued here
https://www.elitetrader.com/et/thre...t-they-have-been-historically-forever.305894/
And indeed, if you look at the realized equity premium figures from Damodaran, the equity risk premium has come down in recent decades. Its quite possible that such development wont change

And what if I'm wrong? If that's wrong and multiples contract, that's a benign scenario where one gets to invest at cheaper prices. Its not a 'real' risk, its a fake risk
 
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