Just to rehash, in the wee hours of November 9th, when it became clear that Trump would win the Presidency and likely have a super-majority in Congress, rates, U.S. dollar, commodities, and stocks all reversed from multiple percentage point losses to gains and embarked on a multi-month rally that spoke to a newfound optimism for economic growth buoyed by the prospect of deregulation, infrastructure spending and tax and healthcare reform.
Five months into the new regime, three of the four risk asset classes have nearly roundtripped the entire move from the election. While U.S. stocks remain within striking distance of their all-time highs, with the S&P 500 (SPX) up 14% from their November 8th close, the yield on the 10 year Treasury note is a few bps above its Nov 9th close, but almost 20%, or about 45 bps above its 52 week highs made earlier in the year. Crude Oil is below its Nov 8th close and more than 20% from its 52-week highs made post-election. And lastly, the U.S. Dollar Index (DXY) is back below its Nov 8th close and 6.5% from its 52-week highs made in January.
While Treasury Yields, U.S. Dollar and commodity prices all trade on their own fundamentals, they are often a function of one-another. When the U.S. Fed embarked on ZIRP and QE their intent was to obviously lower rates, but it also weakened the dollar, which caused commodity prices to plunge. The initial response to the recognition that Trump would win the election all of the above saw weakness, at some point in the hours that followed the financial powers that be came to the same conclusion that the new political world order would be good for risk assets. Three pillars of that thesis have fallen, and interestingly the last, and most resilient U.S. stocks’ bull case is, for the most part, strengthened by the weakness of the others. Low rates make it easier for U.S. corporations to borrow to spend on r&d and capex, cheaper to refinance existing debt, or borrow to buy back stock. Most importantly for investors, low rates make stocks look more attractive for those starved for yield. Low commodity prices lower input costs for corporations, which should be passed onto consumers, and lower prices at the pump or on consumers’ energy bills should create greater discretionary spending. And lastly a weak dollar should make U.S. manufacturers’ wares that much more attractive to foreign buyers.
So for the most part, all these ingredients are bullish for stocks, which might explain why the S&P 500 is within 1% of its recent all-time highs. But I caution those who would disregard the weakness in the prior three asset classes and place greater emphasis on equity strength on what it means for the state of our economic recovery and the near-term return potential for U.S. stocks.
There is no reason why stocks and bonds can’t go up together, they have done that for years in the post-financial crisis era. But the only problem is that at this stage of the recovery, as the U.S. Fed has embarked on a path to normalize rates by raising them, and letting swaths of fixed income holdings roll off their balance sheet as opposed to reinvesting them, rates and the dollar were not expected to go down in this environment. Which leads me to believe that investors crowding into U.S. stocks might be committing new capital to the asset class for all of the wrong reasons. Now this might have been able to be said at any point in the last year, and I did say it, especially in the lead-up to the election as it was my belief that the election of Trump to the White House would quite possibly be one of the most destabilizing forces for U.S. economic growth given his nationalist/ protectionist rhetoric during the campaign, U.S. geopolitical stability given his incoherent and erratic take on foreign affairs and what was likely his inability to bring a very polarized nation back together. Since the election, I have been wrong on many of the reactions that I expected in the markets, but not wrong on my take on the man and his form of governing. It is my belief that the roundtrip of rates, dollar and commodities is a referendum on Trump by the smart money, while the resilience in U.S. stocks is basically fake news, or the new money in the market clinging to whatever hope they have left.
What’s clear to me, fair or not, is that Trump’s presidency for at least the balance of the year, will be marred by investigations, that have largely escalated by his own doing. It is also a good bet that 2018 will be marked by his own party turning on him as his disapproval ratings increase and as representatives in the House and Senators go into survival mode as they look to get reelected. I am not expecting any real talk of impeachment until 2018 (only if the House flips), but I suspect that whether or not the initial cause for a special counsel to investigate campaign collusion with the Russian proves to be false, there have been no shortage of actions since by those in the White House that are likely to snare some close to the President into at least obstruction of justice charges. This will not be a good result for getting through his supposed pro-growth legislative agenda, will likely cause some cabinet members like Wilbur Ross at Commerce and Rex Tillerson at State to resign as they will no longer choose to have their reputations tarnished and make the midterms a referendum on the President with big losses and a lame-duck status. Lastly, this Healthcare Bill. I believe it to be no-win for Republicans. If they push it through, without any public debate, no Democrat support and wavering support from the far right and a group of Republican moderates, then this just makes next year’s midterms that much more difficult for them. If it fails and they move on to other legislative initiatives then it is just another reason for Trump to turn on his own party, which also makes it much harder for Rs in the midterms. It is my view that Rs, and most importantly Trump and his close advisors have sorely misjudged the course in which to embark on their legislative agenda, the process, the support from their own party and the increasingly polarizing effect they are having on the country. This will result in losing the supermajority at the midterms as it did in 2010, 2006, and 1994.
Maybe some wish-casting here, but I have never felt as strongly as I do now that this scenario is far more likely than not.
My worst fear is that we see some sort of shock, like a domestic terror attack, and instead of the country coming together, we see scapegoating that further divides our country.
U.S. stocks speak to a sense of stability that I do not believe exists in the current investment environment, while Treasuries, dollar, and commodities relay a level of fear that we have not seen since U.S stocks were at much lower levels and valuations.
The largest sell-off in the SPX since the election was about 3.5% from March 1st to March 27th. We are now 5% higher than those levels, and up 9% on the year.
With the SPY at $243, the Sept 243 straddle (the call premium + the put premium) is offered at about $9, or about 3.7% of the etf price, if you bought that and thus the implied movement between now and Sept 15th expiration, you would need a move above $252, or below $234 to make money, which seems pretty fair. Either a breakout to new all-time highs or a breakdown to the mid-May lows, the last real bout of volatility in the broad market, which happens to be a nice intersection of the uptrend from the pre-election lows in early Nov:
At this point, SPY put spreads out to mid-September look like an attractive way to hedge a portfolio of large-cap stocks, or a vol and dollar cheap way to make long premium directional bets.
So What’s the Trade?
Buy the SPY ($243.50) Sept 240/215 put spread for 2.60
- Buy 1 Sept 240 put for 3.20
- Sell 1 Sept 215 put at .60
Breakeven on Sept expiration –
Losses up to 2.60 between 237.40 and 240, with max loss above 240
Profits up to 22.40 between 234.40 and 215, with max profit of 22.40, or about 10% at 215 or lower.
Rationale – As either a directional trade or a hedge vs a portfolio this is a dollar cheap put spread out til September, for just over 1% of the underlying price. It targets near the money participation to you got it, very near Nov election levels. The thought here is that most other risk assets have round tripped those moves since November. If equities were to follow that’s the spot to look towards with defined risk. Vol is obviously low so this is cheap historically.