Market Pulse: Long Time No See

Discussing a populist presidential election's effect on markets, and other interesting market observations.

Hello! It’s been a while since the last FinanceTLDR issue. A month and a week to be precise.

I’ve been busy with personal life matters and decided to take a break (apologies for the absence!) but will try to get back into a regular pace of publishing starting from this issue.

Let’s start.

Here’s a little bit something from my personal life: I took this photo of Quebec City’s Chateau Frontenac hotel during a trip to the city last month.

The Big Picture

Earlier in the year, I was worried about geopolitical risks hampering the market.

Although there indeed were problems stemming from volatile geopolitics (e.g. Russia banning gasoline exports in March causing a major rally in oil prices), the global situation quickly cooled again.

The cooling of global tensions helped the market stage a massive rally in the summer with the S&P 500 climbing a whopping 12% since May!

Here’s my mental framework for what’s going on.

Everything stems from the fact that this year is a US presidential election year with high levels of populism.

Both sides of the political aisle think the other party will seriously damage the country.

When populism is high leading up to an election, the incumbent government is greatly incentivized to crank up the money printers to increase its chances of winning.

The stakes are high, you’re in control of the federal government and have the power to do so, so why not?

Populism + election = more money printing

This is exactly what we’re seeing happen this year:

1. First, the Federal Reserve announced a massive cut to quantitative tightening earlier this year, even as inflation remains stubbornly high.

   1. The change: reducing monthly treasury runoff from the Federal Reserve’s balance sheet from $60 billion to just $25 billion.

   2. In other words, the Federal Reserve is adding $35 billion in treasury buying demand per month. This is the Federal Reserve’s way of subtly but significantly cutting long-term interest rates.

   3. There’s no reason to cut interest rates now with inflation still above the 2% target. Yet, oddly enough, the Federal Reserve still feels compelled to do so. Perhaps this is why they’re opting to cut rates in a 'low key' way to avoid headlines.

2. Second, quasi-government agency Freddie Mac is on track to launch a program that will flood the financial system with potentially over a trillion dollars of new liquidity through “second mortgages”.

   1. This program aims to allow home owners that locked in low interest mortgages to access their home equity without losing the original mortgage’s low interest rate.

   2. As such, it can unlock potentially over a trillion dollars stuck in low interest rate mortgages that could then be put to use in the financial system.

   3. Freddie Mac was just cleared to launch a pilot program for this late last month.

   4. With inflation still stubbornly above the Fed’s 2% target, the broad economy growing nicely, and the stock market continuously pushing all-time highs, there is no need to do this. But they’re doing it.

Populism + election = stabilizing global geopolitics

On geopolitics, even though global conflict is at unprecedented levels in recent history, we shouldn’t discount the extraordinary power the US has in both igniting and cooling conflicts.

As the world’s largest producer of fossil fuels and the world’s preeminent military and financial power, the US can easily make problems go away if it wants to.

Perhaps the best recent example of this is how the US forced Ukraine to stop targeting Russian oil refineries.

Ukraine’s bombardment of Russian oil refineries took down an estimated 30% of the latter’s refining capacity. This caused a large spike in global oil prices from March to May that threatened to reignite global inflation.

On first impression, this move seems nonsensical. Russia’s energy revenues directly helps to finance its war efforts.

Wait… what? This headline sounds nonsensical on first impression.

Second-order thinking suggests this move is a symptom of a publicly unspoken but pivotal US government objective for this year: do as much as possible to keep global inflation down, even if this means protecting Russian energy revenues.

Why? We can only guess at the motives but it’s not a stretch to say that they could be election-related.

A Key Learning

As such, a key learning for me from this summer’s events is that if the powers-that-be want low inflation and a rising stock market, we need to not only become less bearish but also lean in and go with the flow.

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For the rest of this newsletter, I'll share a few interesting market observations and trade ideas.

Quantifying China Risk

The US stock market has been booming on AI hype and this entire nascent industry hinges on a continuous supply of top-end semiconductors from Taiwan’s TSMC factories.

As such, China is top of mind right now given the incessantly rising tensions in the South China Sea and China’s ambiguous rhetoric on the matter of Taiwan.

In fact, because of this risk, major hedge funds divested from Chinese stocks at a record pace last year:

1. Ray Dalio's Bridgewater, the world's largest hedge fund, liquidated nearly a third of its holdings in Chinese stocks in the second quarter of 2023.

2. Multiple U.S.-based hedge funds: Coatue, D1 Capital, and Tiger Global reduced their positions in Chinese stocks in the second quarter of 2023.

3. Berkshire Hathaway has been rapidly selling off its large BYD investment.

However, it’s not that useful to say that a black swan event could happen without quantifying the probability. I didn’t know how to do this in a rigorous way until I had a recent insight to use prediction markets.

The good news is that popular prediction market platform Polymarket has a market exactly for this called “Will China invade Taiwan in 2024?”. It’s currently trading at 10%; low but not low enough to be of no concern.

The most valuable opinions are ones where money is at stake so I really like the idea of using prediction markets to quantify event probabilities.

A Currency War in Asia

The Japanese Yen has fallen precipitously in the past few years. This trend continued in recent days.

Normally, US government officials would be up in arms accusing Japan of engaging in a currency war. This is a major faux pas in our “rules-based world order”.

For example, when Vietnam allowed its currency to devalue in 2021, Treasury Secretary Janet Yellen was quick to publicly accuse the Southeast Asian nation of currency manipulation.

Oddly enough, Yellen has been mysteriously silent now that Japan, an economy much larger than Vietnam’s, has allowed its currency to rapidly depreciate over the last 2 years (USD/JPY has fallen 28% since 2022).

I think we can interpret Yellen’s silence as a tacit approval of what Japan is doing. Japan is, in essence, conducting a currency war with China.

A weaker Yen increases the competitiveness of Japanese exports over Chinese exports. This hurts China’s export-heavy economy.

However, at the cost of its domestic economy, China has been reluctant to race Japan to the bottom since it wants to promote the Yuan over the US Dollar as a major currency for global trade. For this to happen, the Yuan’s value must be stable.

The headline is disingenuously oblivious. The unspoken motives are hiding in plain sight.

Japan’s ongoing rapid currency devaluation puts China in a tough spot.

Should China maintain the strength of the Yuan, which could hurt its own economy but support its long-term global ambitions, or should it allow the Yuan to weaken to ease short-term economic pressures?

Idea: Zillow

I’ve been interested in the Zillow idea for a while.

In line with The Big Picture narrative I discussed above, the US government seems keen on cutting interest rates (and has already started to by reducing QT) and stimulating the housing market (Freddie Mac second mortgages program).

Zillow, as a growth + technology + housing market stock, greatly stands to benefit.

Idea: GM

The market has long ignored GM and given it a tight valuation relative to Tesla. Now, the company is printing money and is taking matters into its own hands.

Did you know that GM earns 20% of its market cap every year? Yup, $10 billion in annual net income vs $50 billion in market cap. The company is now rightfully deploying its massive earnings to buying back stock. In Q4 2023, GM bought back $8.6 billion worth of its stock in an accelerated share repurchase plan and then bought back another $1.4 billion of stock this year. Last month, the board approved yet another $6 billion share buyback plan.

GM shares outstanding in the last 5 years. Note the massive drop in the most recent data point.

That’s $16 billion of share buybacks in a year, which is over 30% of the company’s current market cap.

This is equivalent to Apple buyback over $1 trillion of its stock in a year!

GM can do this because its printing cash. $10 billion of annual net income with a $50 billion market cap is nothing to scoff at and it can really force the market’s hand with these massive buybacks.

Idea: Intel

Here’s an interesting observation: Intel’s stock was pinned to $30 for two months! That’s very unusual price action. Only in the past week did it suddenly wake up and climb over 10%.

I see Intel as being well-positioned for a strong showing in the second half of this year.

Earlier in the year, the company announced $45 billion in US government grants to build state-of-the-art semiconductor fabs in the US and Europe.

$45 billion might sound like a lot but this is future money, money held behind specific milestones that the company must meet, and thus the market shrugged off the good news.

Intel predicts that this grant money will start to show up on its financial statements later this year and when it does, sentiment for the stock should improve significantly.

S&P 500 Prediction

In my last Market Pulse issue published on June 4th, I shared this prediction for the S&P 500.

Below is how the S&P 500 has moved since then. I’ve also added a new prediction (in blue).

Although I got the general direction right, the S&P 500 moved up a lot higher than I thought and continues to rocket upwards.

I anticipate that it will cool off a bit since its pushed past the top Bollinger Band. After some consolidation, the upward trend will resume as we near the presidential election in November.