Foreword
This is a quick note, which tends to be just off the cuff thoughts/ideas that look at current market situations, and to try to encourage some discussions.
Inflation is near its highest in ~40 years, the Fed and almost all other central banks are aggressively hiking rates at an unprecedented pace, global supply chains are shaky at best, Russia and Ukraine at effectively at war, effectively disrupting two of the largest sources of both food and fuel for the world and Europe is facing an uncertain winter due to energy shortages. Sounds like a good time to check in on equities.
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
ERP
Equity risk premium, or ERP, is defined as the rate of return investors demand for equities over that of the risk free rate. Based on Yardeni Research, the current ERP is around 5.5%, slightly lower than the start of the year, and quite a bit lower than late 2019, early 2020 (pre-pandemic).
The lower the ERP, the more confident investors are generally said to be of equities — at the extreme, an ERP of 0% implies that investors view equities are interchangeable with risk free securities in terms of returns.
Which is to say, despite all the above, investors actually view equities more favorably than the start of the year, at least, based on the ERP.
Derp
The 3rd quarter just ended, and earnings season is upon us again, starting in earnest in about 2 weeks with the banks, followed closely by the big tech companies. By the end of October, we’ll have CPI for September as well as the Q3 earnings report from most of the largest companies in the US. Just in time for the Fed’s FOMC meeting on November 1st and 2nd.
Given that the ERP went down slightly compared to the start of the year, it seems like the market is expecting (at least with regards to the risk free rate) that the Q3 earnings reports will come in good, or at least in line with expectations.
That seems a little optimistic, given the financial situation around the world right now. In particular, it seems in my naïve view that
- Companies that depend heavily on sales made in foreign currencies are going to suffer from the strong US dollar.
- Companies that depend heavily on global supply chains are going to have issues with shortages.
- Companies that don’t have pricing power relative to their input costs are likely to get their margins squeezed.
On the other hand
- Companies that are allowed to export energy seem like they may do well.
- Companies that are able to adjust their prices based on inflation, while keeping their costs low, are likely to do well.
Positioning
For all the reasons above, I’m thinking seriously of shorting the stocks of those companies in the first list into earnings. As usual, this will be a small position (since I don’t generally like shorting and shorting is extremely hard to get right), mostly for fun, but also for personal validation.
As always, you can see the positions in one (out of 10+) of my brokerages with StockClubs (1), with a 1 day delay.
Footnotes
- Disclaimer: I am an investor in the app.
Janky Thoughts 