“Of course after a while, I heard a lot of calamity howling and the old stagers said everybody - except themselves - had gone crazy. But everybody except themselves was making money. I knew, of course, there must be a limit to advances and an end to the crazy buying of A.O.T. - Any Old Thing - and I got bearish.”
With the inauguration in the books and the craziness that is the Trump and Melania memecoins ($Trump and $Melania) on many minds, perhaps it’s only fitting that earnings will be the highlight of the week. I say fitting because clearly there is a lot of money that has gravitated to ‘investments’ that have no earnings.
At least as it relates to equities, in theory there should be a relationship between GDP and equity returns. That relationship is one where higher economic growth translates into higher earnings per share (EPS). There is a model called the Grinold-Kroner model that provides a relationship between nominal GDP to expected equity returns. Essentially higher growth provides higher earnings growth, higher dividend yields and research also indicates higher P/E ratios, as investors are willing to pay more for each dollar of earnings in a growing economy. Of course the relationship between GDP growth and EPS can be strengthened and weakened by dilution. Another popular model is the “Fed Model”, popularized by Ed Yardeni. While that model doesn’t explicitly tie valuations to nominal GDP growth it focuses on the inverse of the P/E ratio, or E/P, the earnings yield of the stock market. The “Fed Model” compares the earnings yield of the stock market to the 10-year yield on government bonds. A positive value indicates the stock market is under-valued, and vice versa. The valuation spread is seen as equivalent to the expected ERP (equity risk premium). If you consider earnings tied to nominal GDP growth, then you can see how stocks can be more attractive to bonds in a situation where earnings are growing and bond yields are stable. Whether that is the environment we’ll find ourselves in, I have no idea.
I mention all of this because on Friday the IMF upgraded their growth forecast for the U.S. by 0.5% to 2.7%.
We could spend the week talking about equity valuations, shitcoin valuations, speculations and scams, but we’ll start with a topic that continues to get a decent amount of press and that is the stock and bond correlation, which falls under the concept of diversification.
The basic idea of diversification as a core investment principle is that you can reduce risk by spreading investments across different assets that are not perfectly correlated. Bonds typically provide a way to diversify exposure to stocks because they often move in the opposite direction of stocks, an inverse correlation that is often seen during crises when investors seek “safe havens”. One of my favorite research articles was a work called "When Diversification Fails” by Sébastien Page and Robert A. Panariello. The paper highlights that diversification often disappoints when investors need it most, as correlations tend to rise during certain downturns. While bonds can often be the best diversifier during traditional “flight to safety” crises, there are certain macroeconomic environments where bonds may not live up to their expected role, one of which is when inflation and interest rates drive market volatility. During periods of high inflation both bond and stock prices may decline simultaneously, think 1970s and 80s and 2022. Central bank policy can also impact the correlation, think about policies during the GFC, etc. There was also a period during the Covid crises where investors were forced to sell safe bonds to fund margin calls, leading to losses on bonds and stocks at the same time. The point is that the correlation between stocks and bonds appears not to be static and can be somewhat regime dependent.
Over the last couple of decades there has also been somewhat of an increasing chorus of certain investment minds who believe that investors should largely eschew bonds and focus entirely on equities. A recent paper, "Safe Equities: An Alternative Allocation to Bonds" by Stephen Penman and Julie Zhu argues that a portfolio of carefully selected equities, identified through fundamental analysis as having low risk to future earnings, can offer a viable alternative to bonds for diversifying a portfolio and mitigating downside risk, particularly during equity market drawdowns. The paper draws on empirical evidence that bonds have failed to provide negative correlation to stocks during periods of drawdown and contend that “safe equities”, those with low downside beta and positive skewness can be a better alternative to bonds as a diversifier. Interestingly the way the authors believe safe equities should be used is that investors should short safe equities to fund a long position in risky equities, creating a zero-net investment strategy. Using “safe equities” as the “hedge” results in a lower return when equities rally, as compared to long-only risky equities, but the losses on the short position in “safe equities” will mitigate some of the losses on the “risky equities” in down markets. It’s a strategy that seems to be predicated on some differences in “beta” of the two equity baskets and a belief that this cost of insurance is better than that of using a traditional 60/40 portfolio. I’ll have to give it a deeper read and more thought, but I thought it was an interesting concept.
In the week ahead it’s really earnings as the focus with a light week for data.
Thursday will bring jobless claims, Friday will bring S&P manufacturing PMI’s and the final read of the UofM sentiment survey. We also get the BoJ rate decision, an expected hike.
Of course Trump’s policies will be front and center….for the next 4 years.
We enter the week with the 10Y at 4.63%, the 2Y at 4.30%, the DXY at 108 and the S&P 500 at 6,022.
XTOD: Southern Taiwan hit by 6.4 magnitude quake, TSMC evacuates some factories http://reut.rs/3PInlpm
XTOD: Senior Trump Advisors have reportedly prepared between 100-200 Executive Orders that President-Elect Donald J. Trump is expected to sign on Monday at the U.S. Capitol immediate following the Inauguration, and then at both Capitol One Area and the White House later in the Afternoon. The Orders are expected to cover many Campaign Promises made by Trump, possibly including:
-Delaying the TikTok Ban for up to 90 Days
-Tariffs of up to 25% on Products coming from Mexico and Canada
-Declaring a National Emergency on the U.S-Mexico Border
-Closing the U.S-Mexico Border
-Directing the U.S. Military to construct additional Infrastructure on the U.S-Mexico Border
-Designating the Mexican Cartels as Foreign Terrorist Organizations
-Reinstating a Ban on Transgender Military Service
-Rescinding any DEI Policy put in place by the Biden Administration
-Repealing several Policies on Electric Vehicles
-Repealing several Polices related to the Green New Deal
-Remove certain limits on Offshore Oil Drilling on Federal Land
-Declaring a National Emergency on Energy
-Orders on the Mass Deportations of Illegal Immigrants
-Ending Birthright Citizenship
-Reestablishing the “Remain in Mexico” Program
-Pardons for Hundreds if not a Thousand of those who participated in the January 6th Protest and Riot
XTOD: From my Surprises for 2025 on @thestreetpro .... * An extremely leveraged cryptocurrency market represents potential systemic risks. It is my view that cryptocurrency is "the mother of all bubbles" perpetuated by a number of factors (including the rejection of fiat money) and developing digital narratives -- many of which have a weak foundation of logic. The absurd notion that the limiting of supply of bitcoin is as stupid as it is damning -- as there is no limit to the supply of other cryptocurrencies. To us, the sheer market size of Bitcoin and other cryptocurrencies is a manifestation of the risks. When the cryptocurrency markets implode, which is my baseline expectation, the contagion effect will likely be pronounced on all of the capital markets.
XTOD: "You have a part that only you can play; and your business is to play it to perfection, instead of trying to force fortune. Our lives are not interchangeable. Equally by aiming too high and by falling too low, one misses the path to the goal. Go straight ahead, in your own way."
https://x.com/Reuters/status/1881432800575869203
https://x.com/sentdefender/status/1881138348062040476
https://x.com/DougKass/status/1881137666395164732
https://x.com/TheEudaimonist/status/1881012683824300408