The enhanced investor weekly macro 6/4/17 by seitys

The Enhanced Investor Weekly Macro

June 4, 2017

ENHANCED INVESTOR WEEKLY WRAP & UPDATE Market Wrap-Up Hey Everyone, This week’s report is going to focus on three things: Last week’s movement and this week’s potential for volatility (see Comey’s testimony impact on Thursday), which provides a great segue into a report by our friend, Trey Taylor. Let’s get into it! Perhaps the most important item from last week was the Employment numbers released by the Department of Labor on Friday. Although the unemployment rate fell to a 16year low (4.3%), the U.S. economy added just 138,000 jobs in May, which was a notable drop from the 185,000 forecast. Remarkably, the low jobs numbers didn’t result in an adverse effect in the market and did little to diminish the expectations of the Federal Reserve to hike the overnight rates when they meet on June 13-14. Full employment is within the scope of the Fed’s mandate and, therefore, a rate of 4.3% warrants monetary tightening. As I’m sure a majority of you heard, Trump pulled out of the Paris Climate Accord. As a result, oil prices fell once again. From what my sources tell me in Washington, Trump has lost nearly all remaining support from House Republicans who are sponsored by Oil and Gas. Additionally, the Democrats, having fueled climate awareness since 1999, are now staging a group (nationwide) that spans fifty major US cities to approach the UN without the requirement of presidential approval to re-join the Accord. As such, Crude futures fell more than 1% on Friday, after the news broke as it sparked concerns that U.S. oil production could expand more rapidly in the absence of a stringent focus on curbing the use of fossil fuels. The Paris Agreement laid out a framework for countries to adopt clean energy and phase out fossil fuels such as oil, coal and natural gas. Gold continued its run following the lower than projected jobs number and growing concerns about the United States role in the global market. Once the Federal Reserve raises rates once more in June we’ll be able to deduce future positions in the metal following additional economic data and political shifts in D.C.

The Enhanced Investor Weekly Macro

June 4, 2017

Now that we’re all caught up, here’s what’s on tap for this week… Honestly, the EU is likely to set the tone for global financial markets this week, with the European Central Bank (ECB) policy meeting and British general election in focus. As I mentioned above, here in the US, we’ll be paying close attention to former FBI director James Comey's testimony before the Senate Intelligence Committee, in a hearing that could add to mounting issues for Trump. Finally, China is set to release monthly trade and inflation data amid recent signs of reduced output in the world's second largest economy. This has been expected for the past two months, so no worries here. European Central Bank Policy Meeting The ECB’s latest interest rate decision is due at 1145GMT (7:45AM ET) on Thursday. Most of the focus will be on Draghi’s press conference 45 minutes after the announcement. With economic growth clearly shifting into higher gear and political risks declining, investors will look for forward guidance on when and how the ECB could scale back its massive asset purchase program. It could also discuss dropping its so-called easing bias, a pledge to keep rates at their current or lower levels for an extended period and to increase the volume of asset buys if the outlook worsens. Removing the reference to further rate cuts could risk strengthening the Euro, which rose to a seven-month peak against the dollar last week. British General Election The UK will vote on Thursday, with voters set to elect 650 members to the Lower House of Parliament from which a government will be formed, despite some public calls for a postponement in the wake of the weekend terror attack in London which killed seven and left 48 injured. Much like the election in the US, the polls in the UK currently suggest the vote may be closer than the expected comfortable victory for the Conservatives, led by Prime Minis-

The Enhanced Investor Weekly Macro

June 4, 2017

ter Theresa May, with the Labour Party, under left-winger Jeremy Corbyn, closing the gap. However, British opinion polls have had a relatively poor track record recently, raising expectations that the election outcome could again spring a surprise. We saw this last year with BREXIT. A big parliamentary majority for May would ease uncertainty for companies and investors and pave the way for the Bank of England to raise interest rates sooner than markets expect. A failure to win the election with a large majority would weaken May just as formal Brexit talks are due to begin, while the loss of her majority in parliament would pitch British politics into turmoil. Comey Testifies Former FBI director James Comey is scheduled to testify before the Senate Intelligence Committee investigating Russia's alleged meddling in the 2016 U.S. election at 10:00AM ET (1400GMT) Thursday. In his first public appearance since Trump fired him on May 9, Comey is expected to be asked about conversations in which the president is reported to have pressured him to drop an investigation into former national security adviser Michael Flynn, whose ties to Russia are under scrutiny. Comey was leading the FBI's probe into the allegations, and his firing sparked a political uproar last month. The Justice Department and multiple U.S. congressional committees are investigating Russia's actions in the 2016 presidential election and questions about possible collusion between Russian officials and Trump campaign associates. The deepening turmoil surrounding the Trump administration have added to doubts that the president would be able to follow through on his campaign promises for tax cuts, deregulation and fiscal stimulus. China Trade Data China is set to release trade data for May on Thursday. The report is expected to show that the countryâ&#x20AC;&#x2122;s trade surplus widened to $47.8 billion last month from a surplus of $38.0 billion in April. The Enhanced Investor Weekly Macro

The Enhanced Investor Weekly Macro

June 4, 2017

Exports are forecast to have climbed 7% in May from a year earlier, following a jump of 8.1% a month ago, while imports are expected to rise nearly 9% after increasing 11.7% in April. Additionally, on Friday, China will publish data on May consumer and producer price inflation. The reports are expected to show that consumer prices rose 1.4% last month, while producer prices are forecast to increase by 5.6%. Chinaâ&#x20AC;&#x2122;s foreign exchange reserves for May due on Wednesday will also be in focus. Authorities in Beijing have been tightening requirements on financial stability risks and looking closely at credit in recent weeks, so May's figures will be of particular interest.

The Enhanced Investor Weekly Macro

June 4, 2017

Volatility and the Unknown - Trey Taylor June 4, 2017 It is not possible nor sensible to form predictions into the future. However, in times when current conditions present dubious forecasts, it is imperative to keep in mind our perspective. As Mark Twain pens in The Gilded Age: A Tale of To-Day, “History never repeats itself, but the Kaleidoscopic combinations of the pictured present often seem to be constructed out of the broken fragments of antique legends.” While Tulipmania or Black Monday will not identically reoccur, we can use such events to learn from the past and evaluate proper risk-return principles to develop our guide to current market conditions. Although the future is always unknown and unforeseeable, if we incorporate historical experiences with forward-looking expectations we may analyze such scenarios. Between 1950 and 1960, economists used adaptive expectations theory which formulated business and consumer expectations based on past experiences and suggested change will occur slowly. However, since people hold more information than just past data, adaptive expectations theory was relatively misleading. In response to such outlook, John Muth established an alternative, rational expectations theory, which forecasts expectations using all available information. In retrospect, any expectation can be put in one of two buckets; what was predictable and what was unpredictable even looking back. Anticipated events such as the Dot.com Bubble or 2008 Financial Crisis, while unforeseen events include Black Monday or the Flash Crash. However, we must also consider the third type of occurrence. As Donald Rumsfeld ex-Secretary of Defense famously said, “There are known knowns; there are things we know we know. We also know there are known unknowns; we know there are some things we do not know. However, there are also unknown unknowns – the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” While Rumsfeld might sound like a hyperbolizing politician, these events are relevant to risk. There are known risks which we can and cannot quantify, and there are also risks that are unknown that we can be able to quantify and but also cannot quantify. After the 2008 Financial Crisis, a new paradigm for pricing risk has developed, and the next unknown unknown is further eminent. While adaptive expectations have allowed for variable change and shifting expectations, predictions may also artificially create optimal estimates using goal seeking prediction models based on faulty conclusions. In fact, the rise of big data leading to the use of algorithms and fin-tech instruments have extended rational expectation theory. Such models have changed our perception of risk by hiding structural problems with imperfect models that remain untested during recent recessions. Attempting to understand recession probability is nearly impossible as evidenced by Graph 2 that even the Dallas Fed cannot properly model recessions probability. The Enhanced Investor Weekly Macro

The Enhanced Investor Weekly Macro

June 4, 2017

A recent article by investment management firm PIMCO, “Pivot Points” put forth their probability model to evaluate such future market conditions. The article announces, “if history is any guide, we believe the probability of a recession sometime in the next five years is around 70%.” If this is the case, we must consider such scenario. I analyzed three five-year time frames of growth, followed by two-year downturns. As depicted in Table 2, the years 1995 through 2000, 2002 through 2007, and post-2009 S&P 500 shows periods of boom. Conversely, during the Dot.com Crash of 2001 and 2008 Financial Crisis brought years of decline. The five-year growth during bull terms averaged 192%, while bull periods saw a negative 51% decline. From this boom-bust model along with the numbers presented by PIMCO, I project a mean expected return of negative 23% within the next five years. While this exercise uses imperfect past historical data, the results show if these modern scenarios duplicate past price action then this deserves our attention. Evaluating current expectations, we can theorize on miscellaneous macroeconomic shifters as well. In the next five years, United States fiscal policy should include tax cuts as well as increased spending. We can assume that the FED will begin to normalize balance sheet and increase interest rates. International concerns include Italian Banks, Greek debt, and continued Brexit fallout uncertainty. Concerns of Chinse economic collapse buoy in the horizon but Xi Jinping’s defect New Silk Road poses uncertain time horizons. Bilateral trade deals with China, Russia, and other nations project to widen trade policy as President Trump seeks to reduce the deficit. Again, the rise of the quants has also held an undeniable effect on markets. These models predict all known variables bridging the past, present, and future estimates and continue becoming more efficient. Skeptics argue that evidence using historical back testing will prove to be ineffective in the long run despite short-run profit due to underpinned structural risks. Indeed, these assumptions are not fact, but we can use such assumptions as macroeconomic expectations. Indeed, some tranches will fall flat, yet asset allocation contains the advantage of shielding risk from overweight market conditions and identifying markets that will outperform. Recent low volatility figures may provide a blueprint moving forward. The Volatility Index evaluates this differential between the perception of the world and as it exists. As evidenced in Graph 1, Volatility sits at its lowest point in years and dubiously mirrors 2007. Whether this represents an eerie lull or not, what is certain is the unknown market expectations have peaked. Unusually low volatility has paved the way for questions about unknown and unquantifiable events. What is unforeseen is real growing threats to our economy gone unpriced within the market. The riskreward paradox is critical when understanding that risk compensation for with reward one to one. Greater risk should see higher expected returns. However, this much has failed to come true in current markets. While a projection of a recession based on such problems is nearly impossible and timing, the market is a near fatal task. However, tacThe Enhanced Investor Weekly Macro

The Enhanced Investor Weekly Macro

June 4, 2017

tical asset allocation can take advantage of current conditions, good or bad. The role of such strategy is not to predict the future but to identify mispriced risk. To evaluate unknown conditions, we must prepare for unknown unquantifiable risks when evaluating what we can forecast. While charting unknown territory, the influence of adaptive versus rational expectations, understanding historical models within present day, and understand volatility as a metric are important considerations. Overpriced assets usually contain market identified risk and thus should include such compensation. As further evidenced in the volatility index and explained the scenario analysis, unknown and un-calculatable systematic risk are not being rewarded. Eminent geopolitical, economic, and unknown risks are peaking while the Volatility Index is flat. Rising concerns around debt and credit default are real drivers of uncertainty. Thus, mis-priced markets are evident. To reiterate Mark Twain's thoughts, history does not repeat itself, but it sure does rhyme. Although the next five years will contain an inevitable market shift, allocation and models should reflect pragmatic expectations. Uncertainty about the future will remain, but the answer is where risk fully reciprocates return.

The Enhanced Investor Weekly Macro

June 4, 2017

Graph 1

Table 1 Scenario!Anylasis!on!Modern!Bubbles!in!the!S&P!500 Time 1995-2000 2000-2002 2002-2007 2007-2009

Start

2009-2017 2017-?Bear Steady Growth Bull Market Recession

450 1500 808 1525

End 1500 808 1525 681

Return 233.33% -46.13% 88.74% -55.34%

681 2415

2415 1190

254.63% -50.74%

450

2415

18.99% 192.23% -50.74%

Event Er Bull Market Steady Growth Recession

Prob 1.92 0.19 -0.51

5% 15% 70%

Outlook Current 9.50% Bull Market 9.60% Steady Growth 2.85% Recession -35.52% Projection -23.07%

2415 2646.84 2483.83 1557.26 1857.93

M ean Er VAR SQ Dev M ean 0.10 0.33 0.11 0.03 0.26 0.07 -0.36 -0.12 0.02 -0.23 VAR STD

VAR 0.01 0.01 0.01 0.03 0.16

Graph 2

The Enhanced Investor Weekly Macro

June 4, 2017

The Enhanced Investor Weekly Macro

June 4, 2017

Works Cited Cole, Chris. "BULL MARKET IN FEAR." (n.d.): n. pag. 23 Oct. 2012. Web. "Federal Reserve Economic Data | FRED | St. Louis Fed." FRED. Federal Reserve Bank of St. Louis, n.d. Web. 30 May 2017. "The Gilded Age." Google Books. N.p., n.d. Web. 02 June 2017. Graham, David A. "Rumsfeld's Knowns and Unknowns: The Intellectual History of a Quip." The Atlantic. Atlantic Media Company, 27 Mar. 2014. Web. 02 June 2017. Richard Clarida, Andrew Balls, Daniel J. Ivascyn. "Pivot Points." Pacific Investment Management Company LLC. N.p., n.d. Web. 02 June 2017.

The Enhanced Investor Weekly Macro

June 4, 2017

Additional Info For any newcomers who don’t know me, I’ve been contributing via the Enhanced Investor Weekly Macro Reports under #WatchList for over a year now. I began the education portion of this newsletter back in November due to the market action at the time. My in-depth knowledge of bubbles relative to political shifts and global economics, emerging markets, and monetary/fiscal policy needed to be shared, so I decided that it was simply not enough for beginners, or even intermediate traders because in order to have the ability to synthesize what’s truly happening - you need to be operating at the MBA/PhD level. As I’ve noted before, unfortunately, some PhD’s forget the basics. Whether that’s due to moral hazard, or plain and simple hubris, I can’t comment on that. Anyway, as I said a few weeks ago, it’s not fair for me to assume that all of you have what those at investment banks call “financial sophistication”, but that’s why we’re working together here at Enhanced Investor. Monitoring Wall Street and Washington helps us gain the upper edge. It’s why we do this. Anyway, I am more than happy to help, so if for some reason I don’t receive a tag in the #mainstockchat, or you don’t direct message me on Discord, please feel free to email here adamwood@fas.harvard.edu or you can tag me on StockTwits @ EILeadMacroAnalyst. Don’t fear a bubble - ever. We do not fear bubbles here at Enhanced Investor. Why? Because we’re armed with the strategic, tactical, and historical knowledge of every major bubble that has ever occurred. From the Tulip Mania of 1637 to the Housing Crisis of 2008 and the current market conditions - we’re prepared.

The Enhanced Investor Weekly Macro