Trade idea 2017: Short US Stocks

7:20 AM

Hey peeps! I am back from my holiday, had some time to think, so here is an idea from my reflections.

Summary
·         Shorting US stocks might be warranted
·         Rising Interest rate environment
·         Reflexive bubble potentially forming after the Trump rally


Are Trump Policies supportive for business environment?
So the Trump rally has underlined two expectations of the market, 1) inflation is going to increase (via fiscal spending) 2) tax cuts to help businesses. For the later of the two, as I have said numerous times, i do not believe this to be true.

Cost of funding based on the accounting principle of WACC is likely to increase dramatically. The Cost of Equity will be high due to high PE ratios, on the other side of the equation, the cost of debt is likely to be high due to increased interest rates and reduced tax shield.

However, some would argue that a tax cut would assist with this. And I am inclined to agree.

Except, upon reading Trump’s pre-election book, it is clear that he intends on isolating China effect of cost competitive goods and bring manufacturing back onshore. This could translate to increased cost.
There could be a possible drawback of this as well. China is switching from an export, trade-based economy to one that is driven by domestic demand. 

China thus has no reason to "kowtow" to the needs of the US, especially if terms do not benefit them. The second largest economy not buying, for example, Apple products could hurt US companies, especially those dependent on China for trade.

If this is so, PE expectation is unlikely to be met by the expected yield even after tax cuts.

Reflexivity (ala George Soros)

This reflexive argument here is similar to the conglomerate boom & bust cycle in the 1960s. A notable case study in George Soros book “The Alchemy of Finance”.

Simply put the companies expanded on the basis of low-interest rates, but when interest rates rose, the conglomerates could no longer support the high valuation and stocks fell. It is a feature, not an outcome of the Boom/Bust cycle, when it happens when we do not expect it.

With the rising interest rate environment which now stands at 3 times in 2017, which could land us in the ballpark of 1.25% - 2.00% depending on how much is raised, if PE ratios do not provide a premium return over these rates, especially forward projected PE, a fall could ensue.

Currently, PE ratios are at 27.68 higher than the 24.02 just before the 2008 crisis. 2000 period in the chart should be ignored due to the dot com bubble.


 Source: http://www.multpl.com/shiller-pe/

So why have prices gone higher through the post-Trump election? Soros explains this as self-reinforcing trends,

Part 1 – Virtuous Cycle
Prices are low and provide a good yield on investment. People buy and prices rally (virtuous cycle when stock prices are cheap and markets rally).

Part 2 - Vicious cycle
As more and more people buy, prices go up towards the point the equilibrium. But as outsiders see this rally, they think investing now is the “right time”, so they buy, prices go up.

Part 3 – The bust
The cycle is only met at its peak when the expectation divides from reality.


With so much passive ETF investing recently, some pundits have indicated that the rally was exaggerated by these passive investors throwing money into the market.

Will reality strike soon? Or will we reach a time of “irrational exuberance” and extended periods of low growth as made famous by Alan Greenspan and expounded by Robert Shiller.

Entries and timings

The system I employ is the Marcus Trifecta method so I will need sentiment and trend indicators to give an exact entry, however fundamentally I will look broadly at the below. 

Some may fall on analyst ratings to wait for an opportune time to find entries but I am skeptical, before the dot-com bust of 2000, most of those most badly affected still had a “Buy” rating, not even a “Hold” let alone a “Sell” rating. Not to mention their biases to give a good rating.

Possible Entry 1 - The next big earnings announcement period will be March, I will likely take a position then prior to earnings announcements, but will be extremely cautious if the rally continues. As the reporting period will be that of December 2016, we would still be in the Obama administration and tax reforms/increase interest rates have yet to take full effect.

However, the already lofty PE might not meet market expectations and this could be the beginning of the fall.

Possible Entry 2 – ISM manufacturing has been one of the macro trader greatest weapons in predicting the market. Raul Pal has a great YouTube presentation on this. A negative reading might be predictive in the future sales expectations of managers. A low enough reading would prompt an entry.

Possible Entry 2 – The next reporting period would be June, this may the first cracks that we see. Nonetheless, we have to wait and see beyond this point.

Instruments Expression

S&P and stock related such as the QQQ and DOW. For myself, the S&P500 or the DOW30 provide a better barometer for this expression.

The DOW30 the largest 30 industrial companies and Nasdaq100 might be less sensitive to the changes as PE ratios are slightly higher on the SP500.

Rallies will likely occur in fixed income as the FED model or also capital structure theory, under each tier of the capital structure brings you more risk. And with this risk, should come with higher return.

Fixed income instruments are ranked lower risk than equity. i.e. Bonds should return less than stocks.
Risks have been asymmetrical to the downside for a while, as told by Ray Dalio, but have yet to be realized.

Financial Gurus are normally very very patient, to the point of waiting over 3 years for a single thesis to become true. It is likely we will have to do the same.




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1 comments

  1. I was looking for something like this ,Thank you for posting the great content……I found it quiet interesting, hopefully you will keep posting such blogs…

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