Evaluation: SP500 Short trade

4:04 AM

So my big thesis for 2017 seems to be off to a bad start. Markets have moved 100 points up. In Part 1 i will evalute the fundementals of my thesis in Part 2 i will discuss why the market has moved against me. (hint: based on the below book)


So does this trade look more attractive?

The thesis surrounds the conglomerate bubble between August 1962 - December 1970.

I see it as the same due to rising interest rates over the equity premium. Reality hit only when earnings did not manage to keep up.

How has this shaped up? Time to take a look.

 1) Valuations 
There are many metrics that we can use to discuss if the market is expensive. For my purposes, i am only interested in 2.

Modified "S&P Alpha" = (SP500 Earnings Yield) - (risk-free rate/5yr treasury rate)
2008 = 7.24% - 5.59% = 1.65%
Today = 4.86% - 1.92% = 2.94%

Lower Earnings Yield
Earnings yield as a metric will remove tax implications and repatriation effects. This removes two very big thrust people are depending on.

- The Fed says interest rates will to go up. I.e. cost of funding.

- "America First", will likely increase cost of production and lower exports. I expect the earnings yield to come down.

Some argue this will be offset via fiscal spending. IMHO, it will only assist in a select group of companies.
One of the reasons for the valuations seen in 2000 was the trouble with tech firms. How do you value a company that has no assets?

Not that we no longer have that issue (Google has never issued a dividend despite its large earnings). But lessons from that mean we are unlikely to see the Equity Premium we saw in 2008.

Interest rates increase
If interest rates were to hike once in March, the effect is likely to have a multiplier effect. For e.g. in the last rate hike, the yield for the 5yr Treasury increased from 1.78% to 2.08% or 0.3%.

This may not sound like a big difference. But consider that we are looking at 3x rate hikes this year.
The difference is between 0.75% and 0.90%. On our valuations, this is a lot.

On the flip side, the increase in funding will likely affect finance costs to companies. This will reduce earnings yield.

2) Shiller PE ratios.
The second metric we will use is the Shiller Ratio. This is important because inflation expectation increases expected return.

Before the 1998 crisis, the inflation rate was 4.1%. Today, in 2006 this was 2.1%.
PE valuations in 1998 was 32.86 and they are only 29.31 today doesn't sound too bad.

Inflation is likely to increase on higher interest rate and protectionist policies.

If earnings move lower and inflation increases, we are looking at the same conclusion. The market is expensive.

From initial trade till today, nothing has changed about the above inputs or their underlying assumption.

So thesis still remains intact.

I have no evidence that lets me speculate the market will trend higher.

Fed Minutes coming out tonight, i believe, will argue for a rate hike in March. If so, the market could see a slight correction.

So why has the market gone higher due to? Stay tuned for part 2 coming out either tomorrow or Friday.

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