When I lived in the Midwest, phone calls home back east were always an hour off. If I called at 9pm, my family would receive the call at 10pm, which was their local time. On one occasion, my sister lamented that I was living in the past. Well, big sis, I just took my first step to living in the future.
Today, I executed my first futures trade, by shorting one June12 E-mini S&P 500 contract at 1,336. By satisfying the original margin requirement of $5,000 per contract (I have beyond the minimum excess cash to back this), and paying the $8.65 commission, I shorted the market with an equivalent exposure of $66,800 (-1 contract x 50 unit move x $1,336 market price).
Such an exposure can be justified on several levels. First, even though I’m exposed to $66.800, that amount represents a levered figure. The reality is that if the market rises by 10% (falls by 10%), my loss would be 10% (gain would be 10%) of the $66,800 figure, or $6,680. This is a much more tolerable figure, albeit still a lot to lose on the downside.
Portfolio Hedging
Second, from a portfolio perspective, the short position is heavily offset by my long positions. Recall last month, I had a $21k position that shorted the market to primarily hedge my long positions. When the broker ran out of shortables, futures became the method of choice. With a net negative position going forward, I can deploy more funds toward long ideas. Overall, my long positions will be hedged with this trade.
Human Capital Hedging
Third, though not as imperative as my other arguments, my future human capital has a high positive correlation to the US market. That is, my future income will likely be tied (directly or indirectly) to the advances of S&P 500. Empirically, as the equity market advances, so too will my future salary advance. This statement is true for most MBA folks and Wall Street types.
Now for the fun part… Irrespective of portfolio hedging and human capital, here are reasons to be speculatively bearish:
Valuation – Profit margins remain elevated, and in my opinion, P/E multiples on a forward basis are quite lofty. Moreover, we know that higher profit margins are predictably related to weak subsequent earnings growth. Jeremy Grantham of GMO also shares this opinion that the S&P500 is overvalued.
Recession – This risk is likely undervalued by market participants. The team at Economic Cycle Research Institute has been pitching (and reaffirming) this for a few months now. Furthermore, John Hussman argued yesterday that year over year real personal consumption growth, at current levels, ‘has never been observed except in connection with recessions.’ Moreover, the Banking Notes portion of his write-up should humble, or at least question, economic optimism. Although I encourage the read, the quick interpretation is that banks look okay on paper now at a significant expense later.
From my own economic lens, I have yet to see real, meaningful contributions that would increase gross domestic product. Capital will continue to be depressed as interest rates press against the zero, total labor participation (year over year) has barely budged (while the participation rate has fallen), and productivity (efficiency) has a small gain. On the banking front, I am concerned that much of what caused the financial crisis in 2008 still remains in play. Banks still hold bad assets on their books (some of them marked well above market value), the nationwide housing inventory is still too high, and lenders have an incentive to take excessive risks given the safety net of a bailout (debt holders need to be able to lose invested capital).
The current situation reminds me of a Fortune excerpt from Howard Marks (Oakmark Capital) 5/7/10:
Number one, that the economy is highly reliant on the government stimulus programs. What happens when they’re withdrawn? Number two, the economy is reliant on artificially low interest rates. What happens when they rise to normal levels? Number three, there are still a lot of problems to be worked out in commercial real estate, and a lot of banks still hold a lot of commercial mortgages. Number four, the main source of energy in the economy over the prior twenty years has been the consumer, who did his part by spending more money than he made. Where does growth come from in the next five years if the consumer doesn’t go back to doing so?
Catalysts
Easy answers: Any negative news coming from Europe, China, or the US; reduced profit margins, and inflation creep (via high oil prices, headline inflation, etc.). A more straightforward answer, the market is overvalued, and I wanted a big down day to initiate the position. I would be lucky if today was the turning point, but even if it is not, I can continue to roll the position over subsequent quarters.
With regard to the Top Five page, given this trade, I adjusted the formula to reflect net dollars exposed instead of dollars committed. The difference is apparent with this trade as my dollars physically committed is only $8.65 (the commission) whereas exposure is $66,800, a significant amount more.
