JS Global Macro Notes

[darkhorse]

Global Macro Notes: High Voltage

And you ask me why I like to play
I got to get my kicks some way…
- AC/DC

Ladies and gentlemen, it’s time to prepare for some high voltage rock n’ roll.

The theme, as articulated a ways back, continues to be “Sunny With a Chance of Earthquakes.” Bullish bottom up forecasts are being rudely and repeatedly disrupted by violent top down tremors.

In January of this year, fears of China slowdown gripped the markets, sending equities into a tailspin. Then, a few months later, the Greek meltdown, the euro zone debt crisis and the May 6th “flash crash” hit.

The bulls overpowered these setbacks on the strength of resilient earnings beats. But earnings season is over now — after a somewhat middle of the road final tally — and the top down hits just keep on coming. As nicely summed up by FT Alphaville, the latest round of data points was brutal...

Read full comment here

 

[Optionpro007]

Great article and thank you for sharing what I consider is well thought out 3- tier analysis.

Do you have a target on Pot or running a trailing stop?

 

[Ghost of Cutten]

Quote from darkhorse:

Feel free to get the ball rolling, as you clearly have an opinion here...

The first devil's advocate question I would ask is, which blue chip franchises do you see at an 8-10% yield, and if the case for value there is as compelling as you suggest, why are investors falling all over themselves to lend to IBM at 1% and McDonald's at 3.5%.

Also, how about Hussman's take on misvaluation via questionable forward operating earnings estimates, coupled with his assertion that, by more reliable historical measures, stocks are ~ 40% overvalued.

Re, expected long run returns, I would have to ask, expected returns for whom and regarding what strategy? The viewpoint of a swing trader, for example, will be very different than that of a long-term investor... as will the viewpoint of someone with a "fully invested" mandate versus another who is comfortable using rapidly-deployed leverage and switching in and out of cash...

Also, whether the macro headwinds are "temporary" or severe and lasting seems a major debate of the day, and not something trivial in the least... if China turns out to be a potemkin village, for example -- or at least a grossly overhyped / overinflated one -- then it could be a very rough couple years ahead for the global economy.

Well, let's start with a simple proposition - fundamentals matter, but relative to price/market expectations. A bear item at S&P 1200 is a bull item at S&P 800. The idea of a double dip, whilst surely not entirely priced in, is not exactly a fresh news item anymore. With the S&P off 12% or so, clearly some chance of it has been priced in.

We also need to look at outright valuations. We have stalwart high quality stocks like JNJ, PG, KO, AAPL, GOOG, MSFT, MCD selling in the 10-20 PE range, hardly bubble territory, and with the 'E' coming out of a painful recession, it's not like 1929 or 2007 with precarious margins or balance sheets. Reasonable dividend yields for some and nice growth prospects for others suggests their valuations are not overvalued and quite possibly attractive - not just in absolute terms but relative terms also. Hussman's point doesn't apply here because these are historic non-adjusted earnings - and the companies have serious pricing power and 'moats', we are not talking about some cyclical auto or commodity business.

Given that backdrop, it's quite possible that even if *all* the bad macro news comes to pass, these stocks might hold up better than the S&P on the downside, and rally more on the upside. The S&P could fall maybe 10%-15% and that's it. A move like that would complete a moderate 6-9 month 20-25% bear market, and surely after two 50% bears in a decade, and the worst bear for 75 years just having been completed, the odds of another secular bear market starting now are pretty small.

China having a bust and the EU having a debt crisis are relevant more for being long Chinese and EU equities, and a few exporters and commodity plays, then the US blue chip multinationals. Remember 1998 where the whole of Asia, not just China, had a depression, not a recession, and the S&P had a 3 month burp and then was at new highs before the end of the year. The USA is not Hong Kong or Britain, the vast majority of GDP is generated from domestic activities not foreign trade. Foreign problems may hit asset markets further but short of a new war or another 9/11, they are unlikely to derail US underlying fundamentals for long.

Besides, if that is your scenario (and I think it's a decent odds play), a portfolio short China and EU-dependent stocks, and long attractively valued high quality US franchise stocks, should perform far better relative to risk than a pure short in the stock market. I just don't see the kind of skewed index short risk/reward that was there in 2007 or early 2008, where prices were considerably higher than they are now.

 

[darkhorse]

Quote from Optionpro007:

Great article and thank you for sharing what I consider is well thought out 3- tier analysis.

Do you have a target on Pot or running a trailing stop?

Thanks -- two stops, half the position close in, the other half a little wider. Monitoring the situation as it unfolds more so than committing to an expectation.

 

[darkhorse]

Quote from Ghost of Cutten:


Besides, if that is your scenario (and I think it's a decent odds play), a portfolio short China and EU-dependent stocks, and long attractively valued high quality US franchise stocks, should perform far better relative to risk than a pure short in the stock market. I just don't see the kind of skewed index short risk/reward that was there in 2007 or early 2008, where prices were considerably higher than they are now.

A reasonable and well articulated view -- your entire post I mean, not just the para quoted above.

I see no real need to argue with your points, other than perhaps a minor quibble or two. With that said, I do think there are some philosophical differences between our approaches that are subtle, but important to articulate.

First and foremost, it is my goal to preserve a stance of extreme flexibility at all times. What this means is that ANY forecast -- no matter how strong -- is merely one possible scenario among a wide range of scenarios.

In practice this means that, if someone asks "What do you think is going to happen," my response will be along the lines of gaming the highest probability scenario. There is no scenario that is "my" scenario, strictly speaking, because the market script can change quickly and dramatically, and I am happy to change along with it. Even an 80% likelihood misses the mark one time out of five.

Then too, there is the striking importance of fat tail risk (and fat tail reward). Fortunes are often won -- and lost -- on the occurrence of the broadly unexpected.

Consider, for example, two extreme outlier scenarios:

* Within the next five years, the S&P goes to 3,000 (a triple).

* Within the next five years, the S&P goes to 350 (two thirds decline).

Neither are likely, obviously, but both are hypothetically possible.

What is more interesting to me than the targets -- as both are intentionally outrageous -- is the means by which one or the other could come to pass.

For example, for the S&P to triple, we would probably need some sort of Zimbabwe style "controlled hyperinflation" environment, in which Ben Bernanke turns into Gideon Gono, paper assets enter a fiat devaluation vortex, and nominal equity values melt up even as real values decline.

For the S&P to fall by two thirds, in contrast, we would need a combination of the mother of all liquidty traps -- the deflationary bond bulls' darkest predictions -- and a protectionist downward spiral reminiscent of Smoot Hawley in the 1930s, probably centering around fallout from competitive currency devaluations. (Note Chuck Schumer's demand that China revalue the yuan vs. the relative impossibility of that demand, given razor thin export margins, not to mention that Germany is arguably as mercantilist as China.)

Again, I'm not so much interested in predicting the future -- not interested in that at all really -- as being aware of various scenario possibilities so that I can get out my surfboard and ride the waves properly.

By thinking about the full range of scenarios, including the extreme ones, I maintain the advantage of an open mind and the ability to quickly assimilate potentially game-changing information. If we do not get the extreme "Zimbabwe" forecast, for example, but certain factors unfold as such to suggest markets are leaning that way, I may have a strategic edge by way of having worked out the possible catalysts and drivers beforehand, and so on.

Then, too, there are differences in competitive strategy that make general "best portfolio" comparisons impossible -- like a land predator trying to compare hunting strategies with a sea predator -- but that's a topic for another time.

 

[darkhorse]

Weekend Comment / Links Roundup: Requiem for an American Dream

China officially leapfrogged Japan in the week that was, but the story was in some ways old hat -- an inevitable result made official by an accounting blip, more indicative of Japan’s woes than China’s strengths.

Instead, the meme with the most psychological resonance these days seems to be the death of a dream... the American dream, that is.

As the unemployment graphic from Spiegel notes, America is reaching new and frightening levels of joblessness. Bootstrap efforts are failing. A creeping sense of resignation has all but suffocated the V-tinged optimism that temporarily prevailed.

Some Americans are responding with purchases of metal detectors and lottery tickets. Others are abandoning equities and hoovering up long bonds. Many are simply hunkering down, unsure of what to do next.

Hope for the future looks hard to come by. As a McKinsey chart illustrates, the hot job sectors of tomorrow — Biotech, Semiconductors, Clean Technologies — collectively represent a tiny 1.1% of the U.S. jobs pie.

Meanwhile, the job sectors under bloody siege — construction, financial activities, and retail — count as more than 22% of the total...

Go here for the 08-22 links roundup

~

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[Gabfly1]

Quote from darkhorse:

...First and foremost, it is my goal to preserve a stance of extreme flexibility at all times. What this means is that ANY forecast -- no matter how strong -- is merely one possible scenario among a wide range of scenarios.

In practice this means that, if someone asks "What do you think is going to happen," my response will be along the lines of gaming the highest probability scenario. There is no scenario that is "my" scenario, strictly speaking, because the market script can change quickly and dramatically, and I am happy to change along with it. Even an 80% likelihood misses the mark one time out of five.

Then too, there is the striking importance of fat tail risk (and fat tail reward). Fortunes are often won -- and lost -- on the occurrence of the broadly unexpected...

Hmm. Seems to me an argument can be made that you could survive, and possibly thrive, on a diet of price alone. I'm reminded of the story about the guy who explained to his friend the division of labor between him and his wife regarding household responsibilities: he worried about the economy and politics, while she cooked, cleaned, washed, ironed and managed the bils.

 

[darkhorse]

Quote from Gabfly1:

Hmm. Seems to me an argument can be made that you could survive, and possibly thrive, on a diet of price alone. I'm reminded of the story about the guy who explained to his friend the division of labor between him and his wife regarding household responsibilities: he worried about the economy and politics, while she cooked, cleaned, washed, ironed and managed the bils.

The highest echelons of discretionary trading are all about selective aggression, which is a function of relative conviction level and opportunity awareness, which in turn are functions of something more than price.

You can't position size off of price, and you can't use price alone to identify, isolate and target tremendous opportunities in which the reward to risk profile far surpasses that of the standard trade. It is not just knowing when to bet, it is knowing when to bet big, and price in and of itself does not speak to this.

Though yes, an argument can certainly be made

 

[Gabfly1]

Quote from darkhorse:

The highest echelons of discretionary trading are all about selective aggression, which is a function of relative conviction level and opportunity awareness, which in turn are functions of something more than price.

You can't position size off of price, and you can't use price alone to identify, isolate and target tremendous opportunities in which the reward to risk profile far surpasses that of the standard trade. It is not just knowing when to bet, it is knowing when to bet big, and price in and of itself does not speak to this.

Though yes, an argument can certainly be made

I agree that your point is sound in theory. And it is hard to argue with the success of those who employ such an approach. However, the point is that if your thesis is supported by price, then you will move forward with your thesis. And if your thesis is not supported by price, then you will seek an alternate thesis supported by price. The question arises, at the end of the day, who is pulling whom by the nose? Especially against the backdrop observed by Keynes that "Markets can remain irrational longer than you can remain solvent."

(Hey, it's Sunday and I'm bored. I'm just making conversation.)

 

[darkhorse]

Quote from Gabfly1:

The question arises, at the end of the day, who is pulling whom by the nose? Especially against the backdrop observed by Keynes that "Markets can remain irrational longer than you can remain solvent."

(Hey, it's Sunday and I'm bored. I'm just making conversation.)

Well, we aren't in disagreement as to the critical importance of price.

My stance is that price confirmation is a necessary, but not sufficient, condition for action. It is less about one factor "leading" and more about a confluence of factors coming together -- like the components of an engine.