Friday, July 15, 2016

Summer 2016 Part Two: Short S&P500

Last summer, the S&P500 ended a six year bull-run which started in early 2009 and entered into a defined trading range, which we'll call a lower-bound of 1,800 and an upper-bound of 2,500. Historically, equity prices have exhibited an upward bias, so it's easy to guess which direction the S&P500 will be heading in over the next three years. The direction over the next three months however, is not so easily deciphered. The bull-run that ended coincided with the burst of global economic activity concentrated in the emerging and developing markets. The S&P500, which earns a large percentage of its revenues from outside the United States benefitted from the international growth, as well as universally accommodative monetary policy, and multiple rounds of quantitative easing by the Fed.

Fast-forward to summer 2016, and the S&P500 no longer stands to benefit from further systemic increases in financial market liquidity, and the current environment of global economic uncertainty will shift safe haven positioning by international investors out of equities and into government debt. This appears to be the underlying trend playing out in most developed non-commodity exporting economies, where mid to long-term interest rates are considerably low, with no signs of support from inflation. The overall effect will be upward pressure on the US dollar, filtering through to upward pressure on long-term bond prices keeping interest rates low. The shift in investor sentiment will also exhort downward pressure on US equities, and to an extent global equities.

Furthermore, with it's first (albeit arbitrary) interest rate increase, the Federal Reserve is attempting to communicate that financial market stability does not dictate the course of monetary policy. That first step has effectively removed the implicit guarantee to support equity markets in the short-term. Without the artificial supports of Large Scale Asset Purchases as they were by the Fed, the US equity market now has to realign with the underlying macroeconomic reality. A reality where long-term inflation expectations may be beginning to shift lower than the long-held central bank targets, and both financial and real asset prices over time must reflect their underlying fundamentals.