Global Macro Trading Journal

"I believe we are mired in a slow-growth economy. Regarding the strong dollar, 44% of S&P 500 revenue comes from overseas. Non-U.S. profits are about 20% to 25% of the total"
http://www.barrons.com/articles/stocks-could-post-limited-gains-in-2017-as-yields-rise-1484376687

So my Gordon estimate might be off by that 20-25%. Still, by and large the relationship I estimated is likely to hold. It is just that instead of 1-1 the ratio will be 1 to 0.75 ratio (assuming corporate profits dont fall as a percentage of GDP). I actually think corp profits might rise as a % of GDP under Trump but lets not assume that. There is a substantial of upside risk to those short or underweight equities
 
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I recalculated the Gordon model to take into account that 1% rise in GDP is only likely to lead to a 0.75% growth in profits. The final output was this

upload_2017-1-18_8-16-43.png


a 0.1% rise in GDP leads to a 3.23% to a 4.36% gain in the index. There is a total of 39% of upside in the market. That upside is in ADDITION to the natural updrift of 3-7% that stocks do every year. It's a sort of 'valuation gap' that depends on the delivery of the better GDP growth.
If anyone thinks there is a flaw on these numbers, I'm all ears

The market is up 117 SPX points since my pre-election figure of 2150. But ~32 points of that could be considered the natural updrift that stocks have, not really a 'Trump rally'. Assuming a 6% natural updrift for 3 months (part of Oct, Nov, Dec and part of Jan 2017) then only 85 points were a "Trump rally". And the total upside of the market is 843 points.
So when people say that the Trump rally is crazy, that 'there is so much priced in here'. I can't help but to wonder how are they arriving at those conclusions. It looks like the market only priced in 10% of what could be priced in
 
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My figures will almost certaintly turn out to be off, I dont think they are that important. I think what's more important is the 'valuation gap' RANGE thesis. So maybe I'm wrong and there is no 39% valuation gap, perhaps it is 20% or 30% or 35%, point is, the way equities are valued, IF there is better growth (or a perception of better growth, probability of better growth), equities will respond dramatically

So in addition to the natural updrift of 3-7% that stocks have every year, there will be a 2nd updrift related to this valuation gap. Given that the market is only really up about 80-90 points due to Trump, one has to assume a really tiny valuation gap upside to think that the market is 'ahead of itself'
If anything it might be the opposite. I dont expect the market to close this gap quickly or to even enthusiatically antecipate a lot of growth. There will be skepticism on the way up and Trump's mouth and twitter account will create some volatility and this means the whole thing will take time. But the point is that the natural updrift+valuation gap updrift means that equities are likely to be the best performing asset class in the coming years by far
 
I think there is probably a 50% chance they achieve a 0.5% improvement in long-term growth. Of which 75% would become profit growth
So SPX would be worth
X = 51.5/0.0647-0.04375
X = 2458

I think that's a resonable target, get the market there without Trump delivering anything and I will talk about how the market is getting head of itself. And of course, I would have to adjust for that natural updrift. Lots of pundits dont do that

I'm assuming the requiredreturn/cost of capital remains constant but I think that is alright because:
-If risk free rates rise it will be due to inflation and the Fed fighting it. inflation will show up as even higher growth. The Fed is likely to match 1 for 1 any inflationary component of the Trump policies. But not the real growth, the Fed is unlikely to try to kill real growth (long-term) so no hikes are needed (and if they are needed, they are temporary)

-The required return could actually go down if people start to like equities more, this would make the market even more valuable and support the thesis even more
 
So when people get scared that bond yields are rising and that could kill the stock market, they need to consider why they are rising
-If its because of inflation, it isn't such a big deal given that stocks will get even higher profit growth coming from that inflation. If the burst in inflation is huge, that COULD hurt stocks if they can't pass costs to consumers (that is, profit margins fall). But we are talking about a move from 1.5% expected inflation to perhaps 2% or 2.25%. That shouldn't be hard to pass it along
-If bond yields are rising because of higher expected GDP growth, then stocks go ballistic if the growth shows up. Stocks are a lot more sensitive to growth than bonds
 
If inflation does pick up, there is one bad element to this that's the Fed will hike 1-1 any increase in inflation (so an extra 0.5% in risk free rates for any 0.5% increase in inflation) but the growth might only show up in that 1-0.75 ratio. So for every 0.5% increae in inflation, US profits would grow by 0.375%. So in theory, it could hurt the market. The Gordon formula would call for a higher required return (to reflect a higher risk free rate) but the growth rate would not be rising 1-1 with the required return. That's a risk

But I think that might not be such a big deal because:

-Trump's inflationary policies are likely to produce temporary inflation that the Fed will match with hikes, reverse that inflation and eventually bring rates down to the previous level. Its only persistent inflation that its a problem
-The required return might not rise 1-1 with the rise in risk free rates. If you consider that US risk free rates are a 100% domestic asset and that the US stock market has a 'foreign asset' component to them (given that 44% of revenues and 25% of profits come from outside the US), in theory, the required return shouldn't correlate 1 for 1 with the risk free rate.

That said, the Fed is a risk. Both short-term (as people love to freak out for any reason) and long-term if Trump produces a lot of inflation (specially if its coming from fiscal problems)
 
There is also the supply side argument that better GDP growth in the long-term is disinflationary. As a long as the US achieves a way out of Secular Stagnation, equities will be worth a lot more. Even if to achieve that, there a pop in inflation that the Fed hikes to counter it. Those hikes are "cyclical" hikes that get averaged out in the long-term, while getting out of Secular Stagnation is a long-term improvement that is worth a lot to the US!
 
A $18 Trillion economy is worth
$25.920 Trillion in 20 years compounded 2% real growth
but it is worth
$28.551 in 20 years compounded at 2.5% real growth
a 10% real difference
 
Daal said:
A $18 Trillion economy is worth
$25.920 Trillion in 20 years compounded 2% real growth
but it is worth
$28.551 in 20 years compounded at 2.5% real growth
a 10% real difference
More...
And of course, after 20years, this doesn't stop. You continue to collect those benefits. The effect of compounding is geometrical. That explains why stocks are so sensitive to growth rates
 
The Fed's 'longer run' projections are

Fed funds: 2.5% - 3.8% (2.8% - 3% is the 'central tendency')
Inflation: 2%
GDP:1.6% - 2.2%(1.7% - 2% is the central tendency)

So the Fed is down on the Secular Stagnation thesis. A good way to monitor if the Fed will kill the stock market is to look at the difference between the long-run Fed funds minus inflation. The real long-term interest rate. Right now the mid central tendecy real rate is 0.9%. Thats the stable long-term rate that the Fed thinks will keep inflation controlled. If the Trump policies lead the Fed to think there will be waste/fiscal issues, etc. The Fed will bump that up to 1% or more. That would be bad for stocks as it directly affects the 'required return'. It offsets improvements in GDP growth

The path of short-term hikes is irrelevant (except for day/swing trades). The few will pop rates, cut rates all through the cycle. What matters is where they will keep interest rates for the long-term (the actual risk free return one will get after averaging out all cycles)

So I'm going to monitor that from now on. The meetings with economic projections. Then I will see if there is a bump on the long run needed Fed funds to stabilize inflation. also its important to see the Fed's long-term GDP projection. That will show how much they like or hate Trump's policies
 
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