Money Guide | S&P 500 implied probabilities
Also: Indicators, World Watch, Quick take, Weekly Agenda, News, Musings, Opportunities
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In this issue: Interest rates, Cooler inflation, Euro recession, Canada immigration, Whale stock-selling, El Niño, Bitcoin ETF, Chinese apps, Amazonian charcoal, and a few thoughts on S&P 500 implied probabilities
Indicators
The Money Guide Indicators provide you with a macro overview at a glance of financial markets and more detailed information when you zoom-in
Do you want to know more about its components and how are they evaluated?
Part 1: How to read the Indicators from Money Guide
Part 2: Inflation Rates, Central Banks' Rates, Sovereign Bonds, Currency Exchange Rates
Part 3: Commodities, Stocks, Crypto
World Watch
The Money Guide World Watch provides you with a macro overview at a glance of the main situations that can negatively influence economic and financial markets
Do you want to know more?
2023 Threats
2023 Threats’ status updates
My Quick Takes
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Colored circles in Money Guide refer to estimations of possible economic and financial impact:
🟢=positive mid-term forecast
🔴=negative mid-term forecast
⚪=neutral mid-term forecast
Weekly Agenda
All times are US ET (UTC-4)
Monday, June 19
US Markets closed
21:30 🔒 AU RBA Monetary Policy minutes
Tuesday, June 20
--
Wednesday, June 21
02:00 🔒 UK Inflation Rate
(Previous: ***, Expected: ***)
10:00 🔒 US Fed Chair Testimony to Congress ⚠️
Thursday, June 22
07:00 🔒 UK BoE Monetary Policy decision
(Previous: ***, Expected: ***)
10:00 🔒 US Fed Chair Testimony to Congress ⚠️
19:30 🔒 JP Inflation Rate report
(Previous: ***, Expected: ***)
Friday, June 23
03:00 🔒 EU/US Purchasing Managers’ Index reports
⚠️Probable high volatility when information is released to the public
(Click here to read about the usual market behavior)
*🔒 Forecasts, analysis and additional information locked in the previous sections are available only in the premium edition of Money Guide for paid-subscribers
News
📰 🟢 US Fed leaves interest rates alone for now, as inflation cools | On Wednesday, the US Fed announced that it would pause and not raise interest rates for what would have been the 11th time in a row since March 2022. The short term federal funds rate will stay put at a range of 5% to 5.25% (link)
📰 🟢 US Inflation rose at a 4% annual rate in May, the lowest in 2 years | All the numbers were in line with consensus estimates. The Consumer Price Index increased just 0.1% for the month, bringing the annual level down to 4% from 4.9% in April (link)
📰 🔴 Eurozone slips into recession as revised data shows two quarters of falling output | The 20 countries that use the euro fell into a mild recession around the turn of the year, as high inflation discouraged consumer spending and governments tightened the purse strings (link)
📰 🔴 European Central Bank hikes interest rates to highest level in 22 years | The European Central Bank raised interest rates by a quarter of a percentage point Thursday and signaled another hike to come next month. The latest move takes the benchmark rate in the euro area to 3.5%-4.00%, the highest since May 2001 (link)
📰 🟢 China makes surprise rate cut as economic recovery loses steam | The cut to the 7-day reverse repo rate will boost liquidity in the banking system and make short term loans cheaper. The rate will drop to 1.9% from 2% (link)
📰 🟢 Mass immigration experiment gives Canada an edge in global race for labor | At a time industrialized countries around the world are confronting declining birth rates and aging workforces, Canada is at the forefront of betting on immigration to stave off economic decline (link)
📰 🟢 Intel to build in Israel as chipmakers move beyond East Asia | Intel confirmed the company’s “intention to expand manufacturing capacity in Israel,” where it is already active, but didn’t specify the terms or provide other details (link)
📰 🔴 Companies, big investors sell shares at fastest rate in years | There have been more than $24 billion of ‘follow-on’ share sales since the end of April, boosted by the rebound in stocks (link)
Musings
💭 🔴 The US Fed is taking a break in hiking interest rates. Here's why | After raising rates from zero to 5% in 15 months, the central bank is pausing to assess the economic impact of monetary tightening (link)
💭 🟢 Yellen on US-China trade: "decoupling would be a big mistake" | US Treasury Secretary Janet Yellen said it is in the United States’ best interest to maintain ties with China, though she said documented allegations of human rights abuses in China and questionable trade policies need to be “addressed” (link)
💭 🔴 El Niño could take a $3 Trillion bite out of the World Economy | That estimate is based on damages inflicted by El Niño in previous years, plus forecasts pointing to a potentially supercharged event this year (link)
💭 🟢 BlackRock May Have Found Way to Get SEC Approval for Spot Bitcoin ETF | The asset management giant included a surveillance-sharing agreement in its proposal, which could eliminate the risk of market manipulation related to bitcoin (link)
Opportunities
💡 Bond bulls shred 2023 playbook after favorite trade backfires | Wagering that short-term yields would decline relative to longer-term ones seemed a sure bet with the US Fed expected to finally stop its aggressive hiking cycle and pivot to cuts later in the year. Now, after the central bank upped its projection for interest rates this year by a half-point, the once-popular yield-curve steepening strategy is being abandoned (link)
💡 Hong Kong’s $1.9 Trillion stocks await boost from Yuan trading | The initiative holds a lot of promise: it can draw more buyers by minimizing exchange-rate risk and solidify the yuan’s growing status as an international currency. The influx of capital may also provide the next catalyst for Hong Kong shares, helping extend a rally this month thanks to hopes of new stimulus measures (link)
💡 Yalla, Lark, and other Chinese apps succeeding overseas | TikTok and Shein are household names, but Yalla, Lark, Bigo Live, ShareIt and CamScanner are on the rise (link)
💡 Ancient Amazon charcoal seen as next big thing in carbon markets | A type of charcoal first used by Amazonian tribes thousands of years ago is becoming a key component of net-zero goals set by blue chip companies eager to offset their carbon emissions (link)
💡 GBTC Discount Narrows After BlackRock’s Filing for Spot Bitcoin ETF | The discount is currently at around 40%. This is the lowest level since mid-May, down from 44% earlier this week, but still significantly higher than the 35% level it reached earlier this spring (link)
💡 ToolsGPT by ByBit | ToolsGPT is an artificial intelligence (AI) bot based on the GPT-3.5 model (link)
A few thoughts on…
S&P 500 implied probabilities
Flip a coin and there is a 50% chance that it will land on one of its two faces. If you and I were to flip a coin, betting $5 each, you would expect to get a $5 payout when winning, since each of us has a 50% chance of winning. If I offered you a $6 payout instead of $5, you would probably take the bet (on a purely mathematical basis), because you would effectively be risking only $4 for the same 50% chance of winning $5.
When we know the odds (probabilities) of every possible outcome with certainty, the math for determining our bets is pretty straightforward (using the Kelly criterion, for example).
What happens when we don’t know the odds? Can we estimate them? Sometimes we can’t do that by ourselves, since we lack enough information. Could we derive that information and the probabilities from someone else that knows much more than we do? We could, but first we would have to find a source. Who has enough information?
I have talked before about the wide-held belief that efficient markets “aggregate” (or “discount” or “price in”) all the information that may, positively or negatively, impact valuations, through the consensus of all buyers and sellers representing all the possible postures. If that is correct, we can turn to Options markets in our search for implied probabilities.
”Call” and “Put” Options are, in simple terms, bets. And the prices of those bets reveal the implied probabilities behind them. Can we trust the accuracy of those prices? Since derivatives markets are mainly used for hedging (defensive) purposes and not for mere speculation, there are clear incentives for every participant to act on its best interest and, if the Options markets are large and efficient enough, the prices will have a greater degree of accuracy.
Using the prices of Put and Call Options for the S&P 500 Index and calculating the costs and maximum payoffs (profits) of multiple “Butterfly spreads” at a series of specific strike prices, we can obtain the Implied Probabilities for each strike price (dividing the cost of the Butterfly spreads by the maximum payoffs), adjust for the time value of money, and then combine them to plot an Implied Probability Distribution graph. (Methodology)
In January, we made that exercise for the Standard & Poor’s 500 index. The S&P 500 index aggregates the weighted stock prices of the 500 biggest US public companies. It is the most commonly followed equity index, and is considered the most adequate index for historic economic performance benchmarking. Implied Probability Distributions for the S&P 500 are useful to understand the aggregated market views of how the US Economy (and the World Economy, by extension) will behave for a specific period.
The S&P 500 Index closed last week at 4415. In January it opened the year at 3845 and reached a high of 4452 last Friday, after the expiration of Options contracts for this quarter.
At the beginning of the year, our Implied Probability Distribution graph for the first 6 months of 2023 looked like this:
I wrote at the time:
-The Options markets implied probability for the 3150-3550 range is around 14%, assigning over 70% probability to the upside and less than 15% to the downside.
That means 6-to-1 odds that Earnings-per-Share don’t change much from this year AND the market prices it at 16x earnings-The Options markets implied probability for the 3550-3950 range is around 22%.
That means 4.5-to-1 odds that Earnings-per-Share don’t change much from this year AND the market prices it at 18x earnings-The Options markets implied probability for the 3950-4450 range is around 35%.
That means 3-to-1 odds that Earnings-per-Share don’t change much from this year AND the market prices it at 20x earnings
(Click here to read the full piece)
In January, the S&P 500 Index was at 3850, and market participants were predominantly predicting the index would be in the 3950-4450 range for the next six months. The 3850-4450 range had a 40% implied probability, 2.5-to-1 odds. Their prediction turned out to be spot on.
I want to repeat the exercise and see what market participants are estimating for the upcoming 6 months (for the December 15,2023 expiration). Let’s find out:
For Price-to-Earnings ratios (P/E ratios), I’m considering a range of $210-$230 S&P 500 Earnings-Per-Share (EPS), which is close to the $220 EPS of 2022. The long-term average P/E Ratio for S&P 500 companies is close to 16x.
(For more on P/E ratios, see Big-Tech valuation bets)
As you can see in the graph, according to my calculations, the Options market Implied Probabilities for the upcoming 6 months are:
Above 4400: 59%
Below 4400: 38%
3350-3750 range: 6% (16-to-1 odds) that Earnings-per-Share don’t change much from the previous year AND the market prices the index at 16x earnings
3750-4150 range: 12% (8-to-1 odds) that Earnings-per-Share don’t change much from the previous year AND the market prices the index at 18x earnings
4150-4650 range: 30% (3.3-to-1 odds) that Earnings-per-Share don’t change much from the previous year AND the market prices the index at 20x earnings
4650-5050 range: 35% (3-to-1 odds) that Earnings-per-Share don’t change much from the previous year AND the market prices the index at 22x earnings
5050-5450 range: 6% (16-to-1 odds) that Earnings-per-Share don’t change much from the previous year AND the market prices the index at 24x earnings
At the moment, I don’t know what is the reasoning behind such positioning beyond “everything goes up” and “AI, AI, AI”. Maybe market participants are expecting a huge growth reflected on Earnings-Per-Share (EPS). If that were the case, the P/E multiples for each range would be smaller.
I still believe that buying above 16x P/E multiples is expensive, and even more so in the current global economic reality (see Big-Tech valuation bets).
In the meantime, this exercise gives us a clearer picture of the current market sentiment.
take care, have fun, be chill
-SM
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