I wondered whether I should short US equities. The answer was no.

Summary

Is the US equity market in the wrong place?

FOR

  1. Europe is improving: Spain has its banking bailout and work on a single bank supervisor is ongoing; Greece is presently compliant.
  2. China is improving: relatively subdued inflation allows scope for easing.
  3. US growth continues and data are improving at the margin.
  4. Real interest rates around the world are still falling in spite of being well into negative territory.

AGAINST

  1. The Fed is unlikely to act with the data flow improving and the Fed Index rising, BUT the One Great Variable is improving without Fed support on the back of the improvements in Europe.
  2. Breakeven inflation is already quite high. BUT it could edge higher and any improvement in earnings expectations on the back of economic data could temporarily buoy the market. [Is this right? Breakeven inflation and SPX have been highly correlated.]
  3. US leading index has declined for a couple of months BUT this is in its early stages and could be a blip, and the index has a long lead time.

CONCLUSION

  1. If anything, there is an argument for being long equities rather than short. But I could not go long at current levels.

RISKS

  1. Israel/Iran
  2. Ongoing European recession could get still worse.

Discussion

Why would you consider shorting SPX?

Economic data are worse than when SPX was at its may levels. Leading index is heading downward (although it hasn’t been for very long). On the other hand, economic surprise has been increasing for the past month.

Breakeven inflation has got to a level — but it has been higher recently. The argument that it cannot rally any further becomes an economic-data argument.

Equities are pretty much where they should be given the level of earnings and credit spreads. Credit spreads are tightening on an improvement in the European situation and would presumably tighten a bit further if the Fed did QE. I think the chance of QE is receding. I suppose that means that equities should not rally unless there is an increase in earnings — which leaves the market vulnerable to any economic-data-driven earnings pessimism.

However, if the economic data were to deteriorate then QE would be back on the cards and that would be a reason to buy equities — a Bernanke put.

Thus a short on equities today is a bet on their remaining range-bound — i.e. that economic data will remain anaemic.
Hence, if economic data were to improve, it would not be logical to be in the trade. That seems to be happening — consumer data for July are improving, and economic surprise is starting to tick up. Is this enough to kill the trade? It is, after all, a short-term phenomenon.

Thus the question becomes: is the recent improvement in the economic data flow after some months of disappointment enough to push earnings expectations above their March levels? That seems a stretch. The acceleration implied by retail sales in July is not enough to turn the tables on the “slow-growth” picture for consumers, and the equity market clearly doesn’t buy it yet. On the other hand, the equity market clearly IS buying something, and the Treasury market, far from being disappointed about a lack of Fed action, is rallying on the improving economic picture (especially initial claims and payrolls).

Are things bad enough to justify the short, then? One would tend to think not. No trade.

What about the slowdown in global trade — i.e. China and Europe? That is all very well, but Europe is on an upward track and China is easing. I think this would be the time to take profits on my post-Greece long IF ONLY I had traded SPX and not NKY.

In summary — things are indeed looking worse than in March, but at the margin, things are improving. Markets respond to the second derivative. So I am not sure that the market is in the wrong place, and it might even be that a stop above the March highs would get hit.

Are these points the salient points? When it comes to equities, earnings and credit spreads are what matters. Credit spreads are the OGV. The OGV is moved by global crisis risk as much as anything — at at present that is falling.

Israel/Iran is, of course, the wildcard.

Also, the European recession is ongoing — surely that will have some kind of effect?

And what about the short-term rollover of the US leading index? Probably meaningless in the short term; significant if it continues. The same goes for the yield curve and PCED.

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