Let’s ignore our discretionary outlook for a second. let’s focus solely on a our model.
Our model only focuses on the medium-long term and ignores the short term, with one exception:
When the very near term risk (i.e. a few days) is extremely asymmetric, switch from being long to being 100% cash.
This short term risk is always tied with a specific event/news. Our model tells us to switch to cash 1 day before the event. When the short term risk is very high, the risk-reward profile heavily skews in favor of the bears.
- If the outcome of the event is positive, then the market will at most rise 1-2% the next day. If the outcome is positive, then the model tells us to switch back to being long on the next day’s Open price.
- If the outcome of the event is negative, then the market will make a downwards mini-crash. In this case, we’ll go long when the market falls 5-6% (i.e. “small correction” territory).
That’s a 6-to-1 risk:reward ratio.
There were 3 examples of this in the past year:
Brexit was close to being a 50-50 tossup. We shifted to cash the day before Brexit.
The negative outcome came out, and we came close to picking the exact bottom on the Brexit trigger.
We didn’t think Trump would win, so at the time we did not see this as a market risk. Hence, we did not shift to cash. Nevertheless, the S&P futures instantly crashed 5.2% before reversing. We missed this opportunity.
April 23 French election
We shifted to cash because it was possible that Le Pen would win much more than expected in the first round. A positive outcome emerged, and it became clear that Le Pen would lose the second round. The S&P gapped up 1% on this news, and we bought back our position at a slightly higher price.
Comey’s testimony on Thursday, June 8
Comey is set to testify next Thursday. This is a real risk. We don’t know if Comey will reveal anything that will significantly broaden the Trump-Russia investigation. Right now, we think that the probabiliy of a negative outcome is slightly more than 50%.
- If a negative outcome arises, it’s likely that the S&P will fall 5-6%.
- If a positive outcome arises (i.e. Comey has nothing that can hurt Trump), the market will at most rise 1-2%. You can always shift back to being long after this trigger.
Right now, we are already sitting on 100% cash due to our discretionary outlook. We went against our model on May 13. But if we were following our model to the letter, we would be:
- Sitting on 100% long UPRO (3x S&P 500 ETF) right now.
- Shifting to 100% cash on Wednesday’s close (i.e. just before the Comey event).
- Shifting back to 100% long UPRO after the Comey event, depending on the outcome of the event.
Some discretionary notes
There are 3 things to note.
The Trump-Russia investigation is widening. Officials are being tight lipped because they don’t want to public to misconstrue an incomplete and ongoing investigation. However, it seems that the investigation now includes business dealings that members of the Trump investigation may have had in the past with Russia and Ukraine.
We still don’t think Trump colluded with Russia to win last year’s election. Instead, we think that Trump may have been involved in some gray area business dealings with Russia that he doesn’t want the public to know about. The details of this investigation will cause a media frenzy, but we still don’t think Trump will be impeached.
Disconnect between the economic data and the S&P 500
Some people are concerned about the recent disconnect between U.S. economic data and S&P 500.
Recently, the S&P has been soaring in the face of “bearish” news, while U.S. economic data has been missing expectations. Key indicators in housing and the jobs market missed expectations this month.
The Citigroup Economic Surprise Index has deteriorated to -40.
The disconnect between the S&P and economic indicators should not concern bullish investors.
- Historically, there is no solid correlation between small fluctuations in the economic data and the S&P. The economic data only impacts the stock market when the data deteriorates significantly. We aren’t even close to witnessing significant deterioration.
- The Citigroup Economic Surprise Index measures “the data vs. analysts’ expectations”. Investors should focus on whether or not the data itself is deteriorating (vs last month, last quarter, last year). Ignore the “data vs analysts’ expectations”.
- If the S&P makes a small correction, it won’t be because of the economic data. It will make a small correction simply because this “small rally” is too aged. We’re looking for a technical-driven correction. The fundamental “reason” is just an excuse for selling.
Why wage inflation has been so low
With the unemployment rate and initial claims so low, some economists are surprised that wage inflation has been so low over the past few years. They shouldn’t be surprised.
More than 1/3 of the jobs added in this economic expansion are low wage jobs (i.e. close to minimum wage). These jobs are in retail, fastfood, hospitality, etc. Low wage employees have little bargaining power over wages. As of 2017, we are seeing more and more high paying jobs being added (e.g. in healthcare). Hence, wage inflation should pick up this year and next year.