Equity Indexes: CME Micro S&P 500 (
MES1!
), Micro Russell 2000 (
M2K1!
)
On August 26th, Fed Chairman Jerome Powell declared to forcefully fight the worst inflation in 40 years. He warned that the Fed would continue raising interest rates, even if it would cause "some pain" to the U.S. economy.
In an eight-minute speech at the Jackson Hole Economic Symposium, Chairman Powell said that higher rates could persist "for some time." "While higher interest rates, slower growth and weak labor market conditions will lower inflation, they will also cause some pain to households and businesses," he said. "These are the unfortunate costs of reducing inflation. But failure to restore price stability will mean even greater suffering.”
"Price stability is the responsibility of the Fed and the cornerstone of our economy," he said. "Without price stability, the economy doesn't work for anyone."
Stock market fell immediately in response to the Fed’s hawkish tone. By the end of the day, the Dow plunged over 1000 points, or 3.03%. S&P 500 and Nasdaq 100 tumbled 4% and 4.4%, respectively. Russell 2000 closed below the 1900 mark, down by 3.3%.
A New Game in Town
In the past decade, US capital market operated under the assumptions of low interest rate and low inflation rate. They have been effectively overturned. In addition, we also face heightened geopolitical risks in Europe and supply chain bottleneck in the aftermath of a global pandemic.
In a new investment regime, all financial assets would go through market repricing.
To navigate this new paradigm with rising interest rates and high inflation, we will launch a series on the repricing across major asset classes in this new regime. This week, we deep dive into the repricing of US equity index. Upcoming stories will follow up on interest rates, foreign exchange, energy, metal, agricultural commodities among others. We will also re-visit our previous trade ideas whenever appropriate in this series.
Equity Indexes Will Decline Due to Higher Cost of Capital
The discounted cash flow (DCF) pricing theory states that stock price is the present value (PV) of expected future cash flows discounted by the weighted average cost of capital (WACC).
Let me illustrate this concept using a $1 million payment, to be received in five years.
• For a company with excellent credit score, we could use Moody's Aaa Corporate Bond Yield as our WACC.
• Moody’s Aaa bond yield is quoted at 4.18% today, up from 2.52% a year ago.
• PV discounted by a 2.52% WACC is $883K. PV with a 4.18% WACC is $815K.
• When the cost of capital goes up, present value drops by 7.7%.
Fed rate hikes would raise borrowing cost for all US corporations. Therefore, stock prices across the market should decline due to a higher cost of capital, other things equal.
Last Thursday, in an interview with CNBC, St. Louis Fed President James Bullard claimed that his year-end target Fed Funds rate is 3.75%-4.00%. After Powell’s hawkish statement, I have good reasons to believe that Fed Funds rate would reach 4.50%-5.00% by the end of 2023 and stay at that level for at least a year.
Triple-A corporate bond yield is usually 200 basis points higher than the risk-free Fed Funds rate. Going back to our $1 million example, A 7% WACC would yield a PV of $713K. This represents a 12.5% discount from the current PV of $815K.
Of the 500 companies in the S&P index, only two have Triple-A rating. Nineteen are rated from AA- to AA+. And 119 are rated from A- to A+. This indicates that the borrowing costs for S&P component companies are higher than the Aaa bond yield. They could face a bigger hit in a stock market repricing.
Based on this logic, I expressed my view by shorting US stock index futures on June 22nd, as in my story titled Bear Market is Far from Over https://www.tradingview.com/chart/ES1!/FTF4pdAT-Bear-Market-is-Far-from-Over/.
What about smaller companies, such as those in the Russell 2000? They usually have lower credit ratings and higher borrowing costs. Moody’s Baa Corporate Bond Yield is 5.13%, nearly 100 basis points higher than the Aaa yield. One year ago, it was 3.31%.
If we assume an 8% WACC for Russell 2000 and go through the same exercise, the $1 million future cash flow will have a PV of $681K, down 13% from current level.
Up to this point, we focus on just one factor, a higher borrowing cost. In an economic downturn, companies would incur lower revenue and lower cash flow. Smaller companies could be impacted more significantly.
Let’s further assume that our $1 million in five years will be down by 10%, to $900K. With an 8% WACC, the PV is now $613K, down 25% from current level.
With double hit from higher borrowing cost and lower expected cash flow, Russell 2000 is more vulnerable to a repricing risk compared to S&P 500.
In addition, Russell 2000 is overpriced with a trailing price earnings ratio (P/E) of 66.78, compared to a 22.84 P/E for S&P 500.
I further expressed this view by shorting CME Micro Russell 2000 (M2KZ2), as in my story “A Tale of Two Americas” https://www.tradingview.com/chart/LE1!/hrOZOjHB-A-Tale-of-Two-Americas/ on August 7th. Friday, Russell fell 65 points (-3.3%) and closed below 1900 points.
With three more possible rate hikes before the December contract expires, there might be some room for the Small-Cap index to fall. My view on shorting Russell stands.
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.
MES1!
), Micro Russell 2000 (
M2K1!
) On August 26th, Fed Chairman Jerome Powell declared to forcefully fight the worst inflation in 40 years. He warned that the Fed would continue raising interest rates, even if it would cause "some pain" to the U.S. economy.
In an eight-minute speech at the Jackson Hole Economic Symposium, Chairman Powell said that higher rates could persist "for some time." "While higher interest rates, slower growth and weak labor market conditions will lower inflation, they will also cause some pain to households and businesses," he said. "These are the unfortunate costs of reducing inflation. But failure to restore price stability will mean even greater suffering.”
"Price stability is the responsibility of the Fed and the cornerstone of our economy," he said. "Without price stability, the economy doesn't work for anyone."
Stock market fell immediately in response to the Fed’s hawkish tone. By the end of the day, the Dow plunged over 1000 points, or 3.03%. S&P 500 and Nasdaq 100 tumbled 4% and 4.4%, respectively. Russell 2000 closed below the 1900 mark, down by 3.3%.
A New Game in Town
In the past decade, US capital market operated under the assumptions of low interest rate and low inflation rate. They have been effectively overturned. In addition, we also face heightened geopolitical risks in Europe and supply chain bottleneck in the aftermath of a global pandemic.
In a new investment regime, all financial assets would go through market repricing.
To navigate this new paradigm with rising interest rates and high inflation, we will launch a series on the repricing across major asset classes in this new regime. This week, we deep dive into the repricing of US equity index. Upcoming stories will follow up on interest rates, foreign exchange, energy, metal, agricultural commodities among others. We will also re-visit our previous trade ideas whenever appropriate in this series.
Equity Indexes Will Decline Due to Higher Cost of Capital
The discounted cash flow (DCF) pricing theory states that stock price is the present value (PV) of expected future cash flows discounted by the weighted average cost of capital (WACC).
Let me illustrate this concept using a $1 million payment, to be received in five years.
• For a company with excellent credit score, we could use Moody's Aaa Corporate Bond Yield as our WACC.
• Moody’s Aaa bond yield is quoted at 4.18% today, up from 2.52% a year ago.
• PV discounted by a 2.52% WACC is $883K. PV with a 4.18% WACC is $815K.
• When the cost of capital goes up, present value drops by 7.7%.
Fed rate hikes would raise borrowing cost for all US corporations. Therefore, stock prices across the market should decline due to a higher cost of capital, other things equal.
Last Thursday, in an interview with CNBC, St. Louis Fed President James Bullard claimed that his year-end target Fed Funds rate is 3.75%-4.00%. After Powell’s hawkish statement, I have good reasons to believe that Fed Funds rate would reach 4.50%-5.00% by the end of 2023 and stay at that level for at least a year.
Triple-A corporate bond yield is usually 200 basis points higher than the risk-free Fed Funds rate. Going back to our $1 million example, A 7% WACC would yield a PV of $713K. This represents a 12.5% discount from the current PV of $815K.
Of the 500 companies in the S&P index, only two have Triple-A rating. Nineteen are rated from AA- to AA+. And 119 are rated from A- to A+. This indicates that the borrowing costs for S&P component companies are higher than the Aaa bond yield. They could face a bigger hit in a stock market repricing.
Based on this logic, I expressed my view by shorting US stock index futures on June 22nd, as in my story titled Bear Market is Far from Over https://www.tradingview.com/chart/ES1!/FTF4pdAT-Bear-Market-is-Far-from-Over/.
What about smaller companies, such as those in the Russell 2000? They usually have lower credit ratings and higher borrowing costs. Moody’s Baa Corporate Bond Yield is 5.13%, nearly 100 basis points higher than the Aaa yield. One year ago, it was 3.31%.
If we assume an 8% WACC for Russell 2000 and go through the same exercise, the $1 million future cash flow will have a PV of $681K, down 13% from current level.
Up to this point, we focus on just one factor, a higher borrowing cost. In an economic downturn, companies would incur lower revenue and lower cash flow. Smaller companies could be impacted more significantly.
Let’s further assume that our $1 million in five years will be down by 10%, to $900K. With an 8% WACC, the PV is now $613K, down 25% from current level.
With double hit from higher borrowing cost and lower expected cash flow, Russell 2000 is more vulnerable to a repricing risk compared to S&P 500.
In addition, Russell 2000 is overpriced with a trailing price earnings ratio (P/E) of 66.78, compared to a 22.84 P/E for S&P 500.
I further expressed this view by shorting CME Micro Russell 2000 (M2KZ2), as in my story “A Tale of Two Americas” https://www.tradingview.com/chart/LE1!/hrOZOjHB-A-Tale-of-Two-Americas/ on August 7th. Friday, Russell fell 65 points (-3.3%) and closed below 1900 points.
With three more possible rate hikes before the December contract expires, there might be some room for the Small-Cap index to fall. My view on shorting Russell stands.
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.
