445 Capital: Post Election

Probable (improbable) happens less (more) frequently than I care to admit. Perhaps this validates the fact that my version of reality does not precisely resemble the real one. In the path integral formulation, Feynman postulated when a quantum particle travels through spacetime, it “probes” all possible paths before reaching its destination. This theoretical construct can be applied in our interpretation of reality and such a mental exercise forces us to think in terms of probability:

1. What probabilistic scenarios are unanticipated and/or mispriced by the general public?

2. How to construct a portfolio that would benefit under such conditions?

Bond

It is quite fascinating to observe how frantically prices of investment securities adjust to incorporate new information. This is especially true when a high-impact, low-probability event gets quickly priced into liquid financial markets. Global bond values (Graph 1) plummeted and lost over $1 trillion (Graph 2) as president-elect is expected to implement expansionary fiscal policies through infrastructure and defense spending spree.

While the magnitude of the curve shift was amazing (Graph 3), the steepened yield curve also signaled how investors and traders are forecasting future interest rate environments. The contango steepened (Graph 4) and expectations for two further hikes in 2017 have more than doubled to 27.8%. While some investors see no end in bond market woes, I think Treasury’s sell-off is largely done for the time being. Even if there are scarce investment opportunities in this domain, we can still extract meaningful information about pending fiscal policies by reverse-engineering the post-election price movements in the global bond market.

Equity

All-time high! What an addictive phrase. While it’s premature to call it the Big Rotation, rising yields in the bond market were mirrored by adrenaline-filled spikes in the equity market. My previous NASDAQ hedge against the pharmaceuticals companies (BMY & Seres: MCRB) worked quite well. The election result boosted the two pharmaceutical companies (up 9% & 7% since the election), but placed pressure on tech stocks – this helped me to liquidate the hedge with a profit and replace it with short DIA. I expect to exit the pharm-Dow index spread exposure in the near future. On the financial side, the MS (long)-GS (short) spread position ​​was liquidated at flat. Short SWK was liquidated at a profit of 4%, leaving HD long exposure only (down 5%). Long-term investments of WIX ($41.61), GOOG ($758.39) and XOM ($85.69) were purchased. Lastly, CVX was bought ($100.55) and sold ($106.18).

FX

Dollar index rose to 14-year high (Graph 5) and the dichotomy between Treasury’s sell-off and dollar index is quite noticeable. I do expect dollar to weaken in the short term, but am staying away from FX for the time being.

Commodities

As mentioned in the previous writing, elevated natural gas prices were largely driven by forecasts for a colder-than-average winter. It doesn’t look like a cold winter will materialize soon and natural gas prices crashed (Graph 6) as a result. Even options market is indicating the likelihood of further price deterioration (Graph 7) and tamed volatility from full storages, but I believe a good entry point for natural gas is not too far ahead. In the oil complex, a much anticipated production curtailment lifted the WTI active contract over $50, but it quickly cratered and is currently trading around $45. With ballooning deficits, OPEC members will face a difficult time agreeing on terms for production curtailments. While I do not have an economically efficient mechanism to place this bet, I suspect WTI and Brent prices (Graph 8) to diverge (WTI to outperform Brent) within a year - oh boy, was I wrong (exact timing, a wrong directional bet as of 07/25/2017. Domestic production outstripped my initial forecast).