Discretionary Recessionary Signals

Do you feel more optimistic than a year ago? Despite more negative headlines and political turmoil, bond markets are signaling more optimism surrounding future growth than a year ago.


Nominal yields around the world are much much lower than their historical averages. We actually see negative rates in some European nations. That being said, things are improving. Long-term growth expectations are heating up:


Since a year ago (See: Column “Delta One Year”), all yield curves have steepened, with the Italian yield curve steepening the most severely. In all cases, the 10-year yield rose/fell faster/slower than the 2-year yield. This signals more demand for short term bonds compared to a year ago. Since a month ago (See: “Delta One Month”), all yield curves, save for Italy, have flattened. This signifies more demand for long term debt than short term debt. See Table 1:


It seems sentiment has changed since a year ago. Within the last month, more investors have loaded into longer-term fixed income securities. This is a yield-seeking activity. There has been a global flight to longer term, higher yielding fixed income securities within the last month. This point of view describes investors preference for more yield (less long-term risk).

As yields rise, the opportunity cost of owning stocks rises. More investors will flock to bonds as yields become more attractive. This dynamic causes equity markets to follow bond markets. This point of view describes investors preference for more return i.e. more yield.


Dueling Pianos:

As the yield curve steepens, expectations of future long-term growth have risen relative to short-term growth expectations. As investors become more optimistic on the economy, more money will pile into riskier assets, i.e. stocks. I call this the Future Expectations argument. Under this argument, a yield curve steepening results in higher stock prices. This argument describes an investors preference for risk. More expected growth = more willingness to accept risk. Under this argument, bonds and stocks are inversely correlated.

As the yield curve steepens, yields rise and prices fall on the long end of the curve. As yields rise, equity investors looking for yield will sell equities in favor of bonds. As long term yields rise, equities will fall. This is the Opportunity Cost argument. Under this argument, a steepening yield curve will result in lower stock prices. This argument describes an investors preference for yield. Under this argument, bonds and stocks are positively correlated. (For more on Stock/Bond Correlation, see PIMCO).

Given today’s nominal yields & equity values:

Investors are yield-seeking at current nominal yields, thus the Opportunity Cost argument dominates the Future Expectations argument. When the yield curve flattens today, equities will rise tomorrow and when the yield curve steepens today, equities will fall tomorrow. As nominal yields rise, I believe the relationship will flip, and the Future Expectations argument will dominate.

In 12 out of those same 12 markets, yield curves have steepened over the last year. In 11 out of 12 markets in our sample, yield curves have flattened within the last month. Should this change of sentiment continue, yield curves will flatten and equities will continue to rise. However, I expect the long-term trend to prevail, with yield curves continuing to steepen throughout the next year.

When the ECB and BoE decide to stop QE and raise short term rates, I expect yield curves to steepen. As yield curves steepen, equity markets will fall as investors switch to bonds from stocks. Investors will flock to safety, rallying bond markets.

Watch the ECB and BoE for signals on bond markets. See German Bund Yields.

Thanks for reading,

– Tommander-in-Chief

Sauce: http://www.wsj.com/mdc/public/page/2_3022-govtbonds.html

Further: “What the hell are you talking about?”

A common measure of bond market sentiment is the different between the yield on a 10-year government bond and a 2-year government bond. For example, the spread below is 1.25%. (Note: not the actual yield curve below.)


Review: There are two types of yield curve steepeners: Bull and Bear. A bull steepener short term rates are falling faster than long term rates. This means the 2-year fell faster than the 10-year (and both rates fell); recall, prices rise as yields fall. A bond bull market is one where yields fall. A bear steepener is one where the 2-year rises less than the 10-year, and both rates rise. Prices on bonds fall as yields rise.



Why are Markets so Calm?

Valuations are stretched and economic data is cooling, yet markets are complacent. Why? The following are rationalizations of current market values.

1.) Massive movement from active management into passive strategies. Why pay someone to under-perform the S&P 500? Passive investing implies no trading, which means less volatility.

2.) Increased regulation has permanently caused a decline in the riskiness of markets. Insurance companies and financial institutions no longer have autonomy over what they can invest in. With more oversight comes less risk…

3.) Lower interest rates globally have caused investors to flood into riskier assets. With more investors seeking risk, demand is high, creating inflated but stable asset prices. Argentina, who has defaulted on Government debt SEVEN TIMES, just issued a 100-year bond at a 7.9% yield. Demand for the high yielding asset was strong.

4.) JPMorgan estimates that stock pickers account for just 10% of trading volumes, with 60% done by quantitative trading strategies and passive investing. With more trading done by ’emotionless’ quantitative algorithms rather than hot-blooded traders, market risk has declined permanently. We’re in a “new normal” of low volatility and interest rates. Sounds firmiliar… *cough* Tech bubble in 2000 *cough*

5.) “Stocks always go up.” 😉

6.) Quantitative Easing in Europe and Japan cause inflows to higher yielding assets. The Bank of Japan (BOJ) or the European Central Bank (ECB) pumps liquidity into markets through open market operations (bond buying initiatives). Sellers of the bonds use the Yen or Euros to buy US Dollars. They use the Dollars to buy equities and debt. QE by foreign governments is inflating assets prices. As they continue to ease, i.e. flood markets with liquidity, we should see the trend continue. However, we have seen the USD decline since December ’16. Keep an eye on foreign monetary policy moves. A sudden move by the ECB or BOJ might cause fluctuation in US asset prices.

SAUCE: https://www.bloomberg.com/news/articles/2017-06-27/markets-may-have-nothing-left-to-fear-but-fearlessness-itself

Thanks for reading.

– Tommander-in-Chief

Trouble in Yellen-Land

Bond markets and the Fed aren’t making sense.

The Fed (“Yellen”) rose the Federal Funds Rate (FFR) last Wednesday, June 12th to a range of 1.00% to 1.25%.

The Fed has two mandates: (1) to keep prices stable (i.e. keep inflation around 2%) and (2) to minimize unemployment. In other words, stabilize the economy by cooling it off when growth gets too fast and heating the economy up when growth slows.

The mechanisms to do this are two fold. The Fed can raise the “Federal Funds Rate” (FFR), making short term credit less available. The FFR is the lowest rate at which a financial institution can borrow. If you raise the lowest rate available in US markets, everything else should follow. Right?

Wrong. The FFR is a very short term instrument. Changes in the FFR only change short term interest rates. (See: Term Structure of Interest Rates). This brings us to our second weapon in the Fed’s arsenal: the Balance Sheet. The Fed can buy and sell securitized mortgages and government debt. They can hold assets on their balance sheet to synthetically alter the supply of debt at longer tenors.

Quantitative Easing (QE) by the Fed flooded markets with cash by purchasing bonds in the open market in order to promote lending (i.e. liquidity). The Fed’s balance sheet exploded… I mean EXPLODED. Check this post for relativity. In the most recent Fed statement, the Committee agreed it would soon be time to bring the balance sheet back to “normal”. This means they will no longer buy new treasuries or redeem matured securities.

Once balance sheet normalization begins, there will be less demand for Treasuries and yields should rise, ceteris paribus. Right?

However, longer term treasury yields have fallen while short term rates rose. This results in a flatter yield curve. Growth in the US and the world remains tepid; and inflation in the US remains under the 2% target rate, but the Fed sees fit to continue tightening monetary policy.

So what gives Janet? 

This morning, Lisa Shalett, Head of Wealth Management Investment Resources at Morgan Stanley, wrote: “… we believe the Fed has embraced a new narrative that extends beyond its mandate of full employment and 2% target inflation.”

The Fed isn’t raising rates because our economy is heating up; they’re trying to combat the next recession proactively. They’re ‘normalizing’ the FFR and the balance sheet back to levels where they can reasonably combat the next recession.

OK, but why the flatter yield curve?

A colleague of mine introduced the idea of relative interest rates as an additive theory. The risk/reward profile of US debt is one of the best in the world. For example, the 10-year government debt yield in Singapore is comparable to the same rate in the US. Would you rather have Singaporean dollars or US dollars given current market conditions? That being said, we have seen a sell off in the US dollar since the beginning of the year. Take a look at what has happened to the US dollar since President Trump took office:


The dollar has rallied and subsequently sold off since the election. In my colleague’s argument, the dollar should rise. If there is a high demand for Treasury bonds, we will see a rise in demand for dollars. You can’t buy US government debt with foreign currency; you have to convert it to US dollars first. More buying of USD pushes up the price.

The recent bond market rally on the long end of the yield curve has pushed rates lower. This could be from more demand as per my colleague’s point; or the bond market is calling bullsh*t on the Fed’s optimistic outlook for the economy because a movement from stocks into bonds signifies a move to safety. When the 10- to 2-year spread tightens, it signifies lower growth expectations in the future.


When Trump was elected, stock markets rallied. The so called “reflation trade” became all the buzz and a “risk-on” mentality became popular. Check out the pop in the 10 to 2 on November 8-10th. This was a spark of optimism that the US economy might see some fiscal stimulus. Since, the bond market has postulated that the current administration might not be able to meet goals in respect to healthcare and infrastructure stimulus, thus spreads have narrowed and expectations tempered.

To review:

The Fed says we’re growing at a healthy clip, with inflation rising. Their reflation narrative is weak, and the bond market isn’t buying it.The Fed is trying to stockpile ammo before the next recession.

What I’m watching:

An inverted (i.e. negative) 10- to 2-year spread has preceded EVERY recession in recent history. Check it out:


Keep an eye on the 10 to 2.

What I’m Reading:

Thanks for reading,

– Tommander-in-Chief


Disclaimer: there are SO MANY moving parts in finance. It’s impossible to point to any one factor because it’s always a combination of several or many factors that affects markets.

In the grand scheme of things, how big is Apple?

Apple, Inc., producer of the iPhone, announces quarterly earnings on Tuesday.

This WSJ article claims that the cash and cash equivalents on APPL’s balance sheet will exceed $250 billion dollars. I put this article together to give you some idea what that looks like.

Relative to the World:

$250 billion is about the same size as the nominal GDP of Venezuela, Pakistan, Chile, Bangladesh, or Finland. It’s about the same size as the combined GDP’s of the smallest 61 countries in the world. I repeat, Apple could afford to buy the smallest 61 countries in the world using ONLY CASH!!

Switching to revenue as a metric:

Apple, at $233.72b, would be the 47th largest country in the world, between Vietnam and Peru. For relativity, Toyota Motor produces $236.6 b in revenue each year. The largest company in the world is Walmart at $482.13 b in revenue. Walmart would sit between Poland and Belgium if you allow sales to be a metric compared with GDP. Walmart is bigger than Belgium, UAE, Norway, Hong Kong, South Africa, Denmark; the list goes on and on.

Of the top 15 largest corporations in the world (FORBES), six are commodity producers, two are automotive producers, two tech (Apple, Samsung), and two conglomerates, one is utilities, one pharma, and one financial. Apple makes up 6% of the revenue of the top 15 companies in the world.


In terms of Geography:

Five are USA based, four Chinese, and one from each of the following: UK, Germany, Japan, S. Korea, Switzerland, and Netherlands.


This is the world represented by the top 15 companies sorted by sales revenues. Note: Eight (8) countries represented.

This is the world represented by the top 8 economies sorted by GDP. Strangely similar eh?


Grexit: Should we be worried?

Without another bailout, Greece is set to default in June on yet another debt payment of $7.0b.  If Apple agreed to pay instead of the Greek government, it would represent just 2.8% of the cash on Apple’s balance sheet.

The entirety of Greece’s nominal debt in dollars is $375.6 billion. Apple’s total debt is around $100 billion. Apple’s total cash is around $250 billion. Apple could afford to buy two-thirds of Greece’s debt using ONLY CASH. It would only need about $125 billion in nehw debt to completely refi te whole country.

Remind me, why are we worried about Greece again?

Food for thought. Thanks for reading.

– Tommander-in-Chief


1.) http://statisticstimes.com/economy/countries-by-projected-gdp.php

2.) http://fortune.com/global500/list

3.) https://www.wsj.com/articles/apples-250-billion-cash-pile-enlivens-hopes-fuels-expectations-1493566748

Relative Performance: Equal or Market Capitalization Weighted Index?

Using SCHA and SCHX as proxies for Small and Large cap equity markets, I attempt to measure cumulative relative performance over one (1), two (2), and three (3) year time periods.

The S&P 500 is a market capitalization weighted index, meaning the biggest companies have the biggest weights in the index. The Dow Jones Industrial Average (DJIA) is a price weighted index. So companies with large stock prices are weighted heavier. (Example: Goldman Sachs at $230 has much more weight than Intel at $34). There are also equal weight indexes (Ticker: RSP). These weight each stock in the index equally, regardless of price or market cap. (Ex: 60 stocks, each gets 1/60th weighting.)

Investing your money in a market cap weighted index leaves you relatively more exposed to larger companies, where equally weighted indexes leave you more exposed to smaller caps. Price weighted indexes have very little mathematical basis, other than they’re easy to understand. Price weighted indexes are not good representation of changes in value of the stock market, thus we ignore them in this exercise.

Small cap stocks tend to exhibit more price movement, i.e. more volatility. More risk, more reward. On average, small caps will outperform in a bull market, but under-perform in a bear market. The strategy goes, overweight small caps when times are good, overweight large cap value (Walmart, Walgreens) when times go sour.

Here’s the relative cumulative performance of Small/Large Cap equities. A number above one (1) means small cap is outperforming, while a number less than one (1) means Large Caps are outperforming.



The above graph shows relative cumulative performance starting in March of each year. Example, blue line shows 36 month relative cumulative returns, while the green line shows the 12 month relative cumulative returns.

Since Trump took office in November of last year, we’ve seen a bump in small caps, then a subsequent sell off, relative to large caps. Small caps popped first, then large caps followed. However, small caps have outperformed relatively since last year, while large caps have performed better since three (3) years ago.

We need to compare this to an average ratio for each time period (far right column). Note: these are weekly returns (March thru March).


Large Cap have outperformed Small Cap over the last three years, pretty significantly, and under-performed over the last twelve (12) months.Thus, equal weight has outperformed over the past year as we see below. However, Large caps have made a *Huge* rally relative to small caps since February. Here we used RSP and SPY as proxies for equal and market weighted indexes.


Strategy: Large Caps were over valued last March, but Small cap valuations are catching back up. Buy equal weight for the 6-9 month time period, then re-evaluate relative performance. Note: Tax reform will help Small cap over Large cap, so watch for tax reform in late summer,early fall (LINK, Fortune).

Disclaimer: this article is designed to help you choose between Equal or Market cap weighted indexes; I’m not advocating specific securities. This is only one measure of relative valuation, do more research on your own before purchasing securities. I do own SCHA.

Supersize Me’s Effect on MCD’s Stock Price

Image result for mcd

I’ll save you the suspense: MCD’s stock price returns were affected by the release of Morgan Spurlock’s Supersize Me on May 7, 2004. However, MCD’s stock price returns were also unaffected by the release of Morgan Spurlock’s Supersize Me when measured differently.

If you just change how you measure the reaction, you can get the data to tell you what you want. In the business it’s called confirmation bias or data mining. The desire to produce a positive result incentivizes researchers to get the numbers to tell them what they want to hear.

In the example of McDonald’s stock price, we use an event study to gauge the average change in stock price before and after the ‘event’. Morgan Spurlock’s Supersize Me didn’t portray McDonald’s fares in the most appealing light, so I expected to find a negative change in the returns and volume of McDonalds stock, all else held constant.

Quick stats refresher:  A big t-stat implies rejection of the null hypothesis, in favor of the tested hypothesis. A small p-value implies significance. A p-value ranges from [0,1] with zero being the most significant and one being the least.

Using a simple t-test to compare average daily returns here’s my results:

Screen Shot 2017-03-08 at 4.51.39 PM.png

A small p-value, as we see above, implies significance. This means the average return on MCD’s stock was significantly different before and after the release of Supersize me! But check this out…

Screen Shot 2017-03-08 at 4.51.32 PM.png

Over the same time period, but at a weekly tenor, we see a different result. This p-value is huge, the average weekly returns were not significantly different from one another before and after the release of Supersize me.


Screen Shot 2017-03-08 at 4.49.49 PM.pngScreen Shot 2017-03-08 at 4.50.19 PM.png

This exercise goes to show you should be wary and inquisitive if a statistic doesn’t make sense or makes too much sense. The financial world is not a laboratory where everything works out the way it “should” according to the models. Statistical findings are useful tools to model and describe our world, but always take them with a grain of sand. (I’m never sure if its sand or salt…)

Challenge ideas, be inquisitive, and don’t get all your news in one place.

Thanks for reading,


Note 1: If you want the data, I’ll be happy to provide it.

Note 2: Time Period (Jan. 1, 2004 – Sept. 20, 2004)

Side note: Risk is a human made concept. If you can associate a probability with an uncertainty, you’ve created risk. If you can’t calculate a probability that an event will occur it remains an uncertainty, and is either over or underestimated depending on your past experiences. For example: you hear about a recent shark attack on the news and are planning a day at the beach. Because of immediately available information, you overestimate the probability that you’ll be attacked by the shark and spend the day building sandcastles rather than shredding the surf. The risks don’t match up.Your perceived risk and the probability that you’ll be gobbled up by a Great White are different.


Golf Options: An exersize in derivatives

In this article, I’ll try to explain derivatives using the price of a season pass to a golf course, the price of a gallon of milk, and from the perspective of a corn farmer.

Red Rocks Golf Club, in Rapid City, SD, sells season golf passes for $1,450 per adult, plus an additional charge of $525 for a single seat cart pass. An 18 hole round of golf at Red Rocks costs $59, excluding tax, with an additional $21 for a cart. Red Rocks is betting that patrons will golf 24.58 times over the course of the year, (1450/59). They’re also betting that you’ll use the cart 25 times over the year (525/21). By this measure, the cart pass is overvalued. The cart pass should be valued by the same metric as the golf pass; a club member should refuse to pay anything over $516.18 (plus tax) for the cart pass.

How is this a derivative?

The golf course is selling you the option to golf. Whether you use that option enough times, i.e. golf enough rounds, is completely up to you. I would venture to guess that the price of a golf pass at Red Rocks has outpaced inflation. Why? Perhaps people are golfing more. If the golf course sells the pass, and the golfer gets 40 rounds in throughout the year, Red Rocks loses money on the investment, but the golfer gains. The intrinsic value of the golf pass can be expressed as such:

IV(golf pass) = Price of Pass – (# of Rounds* Price Per Round)

Note: Price of Pass and Price per Round are both constant and known; the only variable is how many rounds of golf the golfer plays.

Black Friday:

The BF price implies the commercially saavy golfer will only play 19.66 rounds of golf. The BF price on a cart pass ($472.50) implies the golfer will use the pass 22.5 times. Personally, I don’t know many people who like to go to the golf course just for a drive. Why the discrepancy?

I would be curious to see how the rates have changed over time. I wonder if the number of rounds implied has changed over time or if the price is arbitrary. This is the type of problem for an actuary. Under a perfect price discriminatory environment and with perfect information, the club could sell to each patron at a price consistent with their past behavior. A retiree who lives near the golf course and golfs 80 rounds a year is exploiting the system, while someone who can only golf 15 times a year is getting hustled. Looking at a patron’s past should determine their rate, just like insurance.

“Golf is too hard,” some say. And rates of participation are showing it. Red Rock installed a defensive strategy into their rates. College students and millennials get a discount on their passes as a direct result. Supply and demand states that if demand drops so do prices. So instead of keeping a single sticker price on their passes and lowering it to compensate for the drop in participation rates, Red Rock split their pass into several age tenors after identifying who wasn’t buying passes. This is all guess work, but I’m sure this pricing scheme wasn’t conjured out of thin air. (Guardian)

Seniors also get a discount, as they are probably some of Red Rock’s most devout customers. They’re also less likely to tear up the course by duffing their tee shots and taking a ton of mulligans.


Financial options are similar, but instead of number of rounds being variable, it is the underlying spot price’s volatility. Options written on an underlying asset derive their value from the volatility of that asset’s price, for example, the price of a barrel of oil. Oil is a commodity that is highly traded and the price of oil is hotly debated. Big moves in the price of oil are much more likely that a big move in the price of milk; therefore, options on oil are more expensive than options on milk. The price of an option is called premium.

A call option is the right to buy the underlying asset at a certain price. For example, my view is that milk is undervalued, at $2 bucks a gallon. One option would be to buy 10 gallons of milk and hold onto them until the price rises. However, I’d have to store the milk, keep it cold, and also make sure it doesn’t go bad before I sell it. All these things cost money, and diminish my profits. By buying a call option on milk, I can eliminate these costs. I’m betting that the price of milk will rise. I buy a call on milk at a strike price of $2. This means I’ve just bought the right to buy milk at $2, sometime in the future. To buy this right, I will pay the seller premium. If the price of milk goes to $2.50 like I planned, I’ll exercise the option, buy milk at $2 then sell it at $2.50. My profit is:

Π = $2.50-$2.00-Premium

If the option goes unexercised, meaning the price of milk moves in the opposite direction, say to $1.50, then my option expires worthless and I’m only out premium. I don’t have an obligation to buy the milk at $2.00, just the option. Profit in this example would be:

Π = -Premium

Similarly, a put option is the right to sell the underlying asset at a certain price. Buying a put option is a bearish view on the underlying asset. If you believe the price will fall, you want to lock in a sell price for your asset. As a farmer of corn, you notice everyone’s crops seem to be doing particularly well, and this harvest is set for a record year. A rise in supply causes the price of the asset to fall. You believe this will directly affect your profits for the year. In order to protect against this, you buy an option to sell your corn at a certain price, thus capping your downside. If the harvest is weak, and the price of corn rises the option expires and you’re only out the premium. If the harvest is strong, as you expected, you have the right to exercise the option and sell your crop at a higher price than the rest of the market.

I hope this helped expand you’re knowledge of derivatives. Thanks for reading.

– tommander-in-chief