Bullets and Bazookas

I’ve decided to cut risk today by around 15% (I still remain very long and very bullish). The general risk reduction applies to my entire portfolio, but I’ve largely undone the extra EUR short that I put on on the 22nd (risk/reward seems lower here + I’m tired of waiting for actual ECB action). This is in light of the decrease in positive “tail risks” that I see. I’m going to target roughly 2 – 3% in daily volatility into the New Year (and will adjust accordingly if vol increases). I’ve also reduced gamma on near-dated options to prevent theta burn.

Positive Pressures

  • Earnings drift – US earnings growth will continue to be a positive going forward. Annually (assuming constant multiples), that means roughly ~4-5% of nominal appreciation.
  • Global QE flow-through – Implementation of QE & balance-sheet expansion actually matters (not just the announcement). This will cause a constant pressure up in the next year or so.
  • Continued buybacks & corporate action – This will serve to lower the “duration” of stocks (if we think about stocks as a CF stream). Perhaps it also means less sensitivity to rates and implied risk premium.
  • Seasonal effects – Everyone loves turkeys and Santa.
  • Short-term cheap oil – In the near-term (and through the holidays), the cheaper oil should have a non-trivial effect on spending. Perhaps it’ll be a retail bonanza this year.
  • Low interest rates forever – At this point, I’m solidly in the “global deflation export” camp. We’re going to be getting cheap capital from around the world in perpetuity. Sadly, it’s up to us to carry the world.

Negative Pressures

  • China “Harder Landing” than expected – Market news has been remarkably quiet about China in recent months. Everyone seemed to shrug off the weaker GDP and PMI numbers. So far, the PBOC & the Chinese government have the situation under control. But I’m a bit worried about this one… quite worried.

China Housing

  • Bazookas fired & bullets expended – For now, it appears that the Central Banks of the world have run out of bullets to fire. We’re still anticipating some “great action” by the ECB but that might be a story for next year. Until then, though, everyone is in wait-and-see mode. The PBOC still has bazookas to fire, but will likely only use it if some drastic event happens.
  • Perceived “bubbles” & extended multiples – I don’t believe the S&P is overvalued. In fact, with certain assumptions, we might even be undervalued (See this old gem by Damodawan). However, given the 5-year bull market, we’re seeing stronger calls by bears. The fear is there, and will potentially result in repricing of risk. However, this is not the global top (if a top at all).
  • Eurozone In-action (but more bucket kicking) – I have little hope of any real change in Europe until shit really hits the fan. Their system is in more gridlock than Republicans & Democrats. More indecision there (coupled with any more negative growth news) will add negative pressure.
  • Sustained low oil prices – I don’t actually expect this to happen. But a lot of “bad things” can happen if oil prices remain too low for too long. Sure, we’ll have positive flow-through to the US consumer, but we’ll also damage one of the main growth sectors in our economy. Perhaps more worrying, I foresee massive tail-risks from the collapse / weakening of oil-dependent nation (particularly Russia & Venezuela).
  • “Stronger” dollar – will be bad for multi-nationals. But might lower input prices for some.

Bullets Expended

  • Draghi’s jawboning – I don’t know how much longer he can jawbone markets without actual significant intervention. He’s promised a lot, and we’ve priced in a lot. Plus there appears to be some real drama at the ECB.
  • More US QE – It’s possible, but only if we double dip or the recovery stalls. However, we shouldn’t expect more QE into growth. Again, Yellen Straddle (no longer Put).
  • Ebola “Hype” Recognized – The scare is over. Ebola was never a “real” threat to the US. But judging from the impact, you’d have thought 9/11 happened again (airline stocks dropped ~30% in September / October!).

AAL Drop

Bazookas Fired

  • Japan seems to be executing the ultimate Hail Mary. They’ve decided to sac the Yen in a last-ditch effort to bolster the economy. I have my doubts, though, given lingering structural issues. One positive, however, is that pension rule changes will likely add a massive tailwind to global equities (mostly the US). Will also cause continued pressure on JPY.

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