What We Expected
When the ball dropped in Times Square at midnight December 31st, we had very good reasons to cheer for Year 2022.
S&P 500 ended 2021 at 4,766.18, up 27%. In fact, the index was more than double in a 2-year bull market since the pandemic drove it down to 2,230 in March 2020.
U.S. Bureau of Labor Statistics (BLS) reported monthly growth of nonfarm payroll by 648K, 249K and 199K in October to December, respectively. U.S. regained 18.8 million jobs since April 2020. This accounted for 97.7% of the total job losses due to the pandemic.
BLS also reported the Consumer Price Index (CPI) at an annual rate of 7.0%. AAA regular gasoline retail price averaged $3.28 a gallon nationwide for the last week of December.
Fed Chairman Jerome Powell insisted that inflation was “transitory”. Firstly, this was due to the bottleneck in the global supply chain, which had been disrupted by the pandemic. But we were already coming out of the pandemic. Global trades would be normal again soon.
Secondly, Congress passed a $1.9 trillion stimulus bill in March 2021. Pumping money in the financial system obviously pushed demand and price-level up. After all, most of us could afford higher prices with the $1,800 stimulus check from the Trump Administration and $1,400 more thanks to President Biden.
Meanwhile, Fed Funds rate was at its lowest level in 0%-0.25% range. Thirty-year fixed mortgage rate averaged 3.11% at the year-end 2021, according to bankrate.com.
What Actually Happened
Fast forward to October 13th 2022. BLS reported a higher-than-expected CPI at 8.2% annual rate in September. The Core CPI, which excludes foods and energy, ran at 6.6%, its highest level since 1982.
When U.S. market opened, S&P 500 dropped below 3,500. While it posted a historic turnaround later in the trading session, it proved to be a “dead cat bound”. On October 14th, the S&P fell 2.37% and closed at 3,583.07. This is a year-to-date return of -25.3%.
Since March 2022, the Fed has engineered five consecutive rate increases. Fed Funds rate is up 300 basis points to 3%-3.25%. More rate hikes are expected at the November and December Federal Open Market Committee meetings. After all the rate increases have been completed, the terminal rate is widely believed to be above 5%.
Thirty-year fixed mortgage rate is now 7.73%, a whopping 4.63% higher compared to the end of last year. Home ownership is increasingly out of reach for young adults.
Central bank tightening has not yet cooled the runaway inflation. Reading the CPI data by category, you will find that everything went up except for gasoline and diesel. However, gas has bottomed in September and has been creeping up in the past three weeks. So has diesel. Without their offsetting, inflation is likely to stay high in the coming months.
We are on the verge of a recession. The question is not if, but when and how deep. The global economy faces strong headwinds:
• High interest rates
• High inflation
• A regional war that lasted eight months with no end in sight
• An energy: Russia turns off natural gas and OPEC+ cuts oil production
• Political uncertainties: US midterm election, new governments in the UK and Italy
Stock Index Trade Ideas
In the past five months, I discussed 20 trade ideas on TradingView, ranging from equity index to interest rates, foreign exchange, energy, metals, agricultural commodities, and cryptocurrency. Let’s revisit three ideas on stock indexes and see if they still make sense today.
“Bear Market is Far from Over” was published on June 22nd. I suggested that the S&P would test its support line at 3,383, its pre-COVID peak. Thursday’s low was within 100 points from reaching this level! Mindful that this occurs when the US economy is still growing. Imagine where the S&P would go when we are in a recession.
In “The Great Wall Street Repricing”, I used the Discounted Cash Flow model to illustrate why the stock market has to fall.
• High interest rate raises the weighted average cost of capital (WACC). It enlarges the denominator of the DCF equation and makes the present value smaller.
• High inflation increases the cost of goods sold. Higher price tends to reduce demand. The combined result is lower free cash flow and a smaller numerator of the equation.
Seven weeks after publishing this idea, I observe that both interest rate and inflation rate are higher than originally expected. So the repricing impact would be even bigger.
At “Tale of Two Americas”, I explained why Small-Cap index Russell 2000 could fall harder than the Blue-Chip S&P 500 during a recession.
• The component companies in the Russell 2000 have lower credit ratings and higher WACC
• Recession would have a bigger impact on the revenue and profit of smaller firms
• Russell has lofty P/E ratio. The bubble would burst in an economic downturn
Bearish Trading Strategies
Three strategies for your consideration: 1) Short the S&P 500; 2) Short the Russell 2000; and 3) Long the S&P-Russell Spread.
CME S&P 500 Futures (
ES1!
)
ES is one of the most liquid equity index futures contracts. It traded 3.3 million lots last Thursday. If you bark at its $10,000 initial margin, try the Micro E-Mini S&P (
MES1!
). It is 1/10 the size of ES and requires only $1,000 in margins.
When is a good time to short? I would wait for a bear market rally like last Wednesday. There will be many of them. Investors are hopelessly romantic with stocks. A better-than-expected company earnings, or a less hawkish tone from the Fed, could be interpreted as good news, even for a one-day wonder.
CME Russell 2000 Futures (
RTY1!
)
RTY traded 324,814 lots last Thursday. The index is more overpriced than the S&P and we could make a bigger payday shorting it. Initial margin is $5,500. Similarly, the Micro E-Mini Russell (
M2K1!
) is 1/10 of RTY and requires only $550 in margins.
As with the ES, I would wait for a rebound before putting in a short RTY position.
Long ES-RTY Spread
If you are not comfortable with an outright short futures trade, consider the spread between S&P and Russell index futures. I expect the price gap to get wider as the more overpriced Russell falls faster than the S&P.
What’s the appropriate long-short ratio? Initial margins for MES and M2K are $1,000 and $550, respectively. Long 1 MES and Short 2 M2K would do the trick.
Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. TradingView users already have access to delayed data. A Pro user could upgrade to real-time CME market data for only $4 a month, a huge discount at the time of high inflation.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
When the ball dropped in Times Square at midnight December 31st, we had very good reasons to cheer for Year 2022.
S&P 500 ended 2021 at 4,766.18, up 27%. In fact, the index was more than double in a 2-year bull market since the pandemic drove it down to 2,230 in March 2020.
U.S. Bureau of Labor Statistics (BLS) reported monthly growth of nonfarm payroll by 648K, 249K and 199K in October to December, respectively. U.S. regained 18.8 million jobs since April 2020. This accounted for 97.7% of the total job losses due to the pandemic.
BLS also reported the Consumer Price Index (CPI) at an annual rate of 7.0%. AAA regular gasoline retail price averaged $3.28 a gallon nationwide for the last week of December.
Fed Chairman Jerome Powell insisted that inflation was “transitory”. Firstly, this was due to the bottleneck in the global supply chain, which had been disrupted by the pandemic. But we were already coming out of the pandemic. Global trades would be normal again soon.
Secondly, Congress passed a $1.9 trillion stimulus bill in March 2021. Pumping money in the financial system obviously pushed demand and price-level up. After all, most of us could afford higher prices with the $1,800 stimulus check from the Trump Administration and $1,400 more thanks to President Biden.
Meanwhile, Fed Funds rate was at its lowest level in 0%-0.25% range. Thirty-year fixed mortgage rate averaged 3.11% at the year-end 2021, according to bankrate.com.
What Actually Happened
Fast forward to October 13th 2022. BLS reported a higher-than-expected CPI at 8.2% annual rate in September. The Core CPI, which excludes foods and energy, ran at 6.6%, its highest level since 1982.
When U.S. market opened, S&P 500 dropped below 3,500. While it posted a historic turnaround later in the trading session, it proved to be a “dead cat bound”. On October 14th, the S&P fell 2.37% and closed at 3,583.07. This is a year-to-date return of -25.3%.
Since March 2022, the Fed has engineered five consecutive rate increases. Fed Funds rate is up 300 basis points to 3%-3.25%. More rate hikes are expected at the November and December Federal Open Market Committee meetings. After all the rate increases have been completed, the terminal rate is widely believed to be above 5%.
Thirty-year fixed mortgage rate is now 7.73%, a whopping 4.63% higher compared to the end of last year. Home ownership is increasingly out of reach for young adults.
Central bank tightening has not yet cooled the runaway inflation. Reading the CPI data by category, you will find that everything went up except for gasoline and diesel. However, gas has bottomed in September and has been creeping up in the past three weeks. So has diesel. Without their offsetting, inflation is likely to stay high in the coming months.
We are on the verge of a recession. The question is not if, but when and how deep. The global economy faces strong headwinds:
• High interest rates
• High inflation
• A regional war that lasted eight months with no end in sight
• An energy: Russia turns off natural gas and OPEC+ cuts oil production
• Political uncertainties: US midterm election, new governments in the UK and Italy
Stock Index Trade Ideas
In the past five months, I discussed 20 trade ideas on TradingView, ranging from equity index to interest rates, foreign exchange, energy, metals, agricultural commodities, and cryptocurrency. Let’s revisit three ideas on stock indexes and see if they still make sense today.
“Bear Market is Far from Over” was published on June 22nd. I suggested that the S&P would test its support line at 3,383, its pre-COVID peak. Thursday’s low was within 100 points from reaching this level! Mindful that this occurs when the US economy is still growing. Imagine where the S&P would go when we are in a recession.
In “The Great Wall Street Repricing”, I used the Discounted Cash Flow model to illustrate why the stock market has to fall.
• High interest rate raises the weighted average cost of capital (WACC). It enlarges the denominator of the DCF equation and makes the present value smaller.
• High inflation increases the cost of goods sold. Higher price tends to reduce demand. The combined result is lower free cash flow and a smaller numerator of the equation.
Seven weeks after publishing this idea, I observe that both interest rate and inflation rate are higher than originally expected. So the repricing impact would be even bigger.
At “Tale of Two Americas”, I explained why Small-Cap index Russell 2000 could fall harder than the Blue-Chip S&P 500 during a recession.
• The component companies in the Russell 2000 have lower credit ratings and higher WACC
• Recession would have a bigger impact on the revenue and profit of smaller firms
• Russell has lofty P/E ratio. The bubble would burst in an economic downturn
Bearish Trading Strategies
Three strategies for your consideration: 1) Short the S&P 500; 2) Short the Russell 2000; and 3) Long the S&P-Russell Spread.
CME S&P 500 Futures (
ES1!
) ES is one of the most liquid equity index futures contracts. It traded 3.3 million lots last Thursday. If you bark at its $10,000 initial margin, try the Micro E-Mini S&P (
MES1!
). It is 1/10 the size of ES and requires only $1,000 in margins. When is a good time to short? I would wait for a bear market rally like last Wednesday. There will be many of them. Investors are hopelessly romantic with stocks. A better-than-expected company earnings, or a less hawkish tone from the Fed, could be interpreted as good news, even for a one-day wonder.
CME Russell 2000 Futures (
RTY1!
) RTY traded 324,814 lots last Thursday. The index is more overpriced than the S&P and we could make a bigger payday shorting it. Initial margin is $5,500. Similarly, the Micro E-Mini Russell (
M2K1!
) is 1/10 of RTY and requires only $550 in margins. As with the ES, I would wait for a rebound before putting in a short RTY position.
Long ES-RTY Spread
If you are not comfortable with an outright short futures trade, consider the spread between S&P and Russell index futures. I expect the price gap to get wider as the more overpriced Russell falls faster than the S&P.
What’s the appropriate long-short ratio? Initial margins for MES and M2K are $1,000 and $550, respectively. Long 1 MES and Short 2 M2K would do the trick.
Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. TradingView users already have access to delayed data. A Pro user could upgrade to real-time CME market data for only $4 a month, a huge discount at the time of high inflation.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
