First Principles for Financial Asset Class Trading
Disclaimer: This content is for information only and reflects only my views. I am investment analyst at an investment bank (six years experience).
Macro /futures systematic initial design, stock frameworks: themes, single-stocks, weightings, valuation.
This post will explore the first principles for the valuation of select financial assets within a broader framework of capital movements. This will explore valuation of equities, bonds, and commodities (financial assets), in the context of economic activity and capital flows, synthesized (briefly) with currencies.
For background, the NAV of the portfolio (use to test these ideas) has now recovered nicely (now up 130% YTD from starting equity of 26K) as the losses June/July (admittedly sloppy risk management) were offset by some well-timed trade reversals in early August.
Central bank policy is the key driver of financial assets. Central banks set the base-line cost of money and in turn bond prices. These policies are set in the context of inflation and economic growth (targeting employment in the U.S.). Expectations for higher inflation historically means higher rates and lower bond prices. The cost of money is used to influence growth or increase / decrease transactions in the economy though capital creation.
Capital creation and economic growth. New capital (typically debt) often leads to more transactions (businesses that borrow cash to build new products leads to future sales transactions etc.) Central banks have historically lowered rates and cost of capital to stimulate more transactions (or vice versa). Central banks can also raise interest rates to reduce the growth of debt (by raising the minimum return). The creation of debt (and capital) is done at banks which the central bank supervises.
Today central banks are looking for higher inflation (most now have inflation “targets” and have recently signaled a commitment to sustaining the level of economic activity through lower rates. This suggest lower rates which has lead to the broad increase in bond prices across global markets and so I continue to hold the long U.S. bond position.
FX is another lever when interest rates are zero. More recently central banks have actively intervened in capital markets by directly buying bonds and other financial assets. This influences interest rates with increasing the price of bonds (actively buying and reducing supply) by lowering the value of currencies (using cash to finance the transaction). Hence gold (as a currency) continues to increase in value as central banks lower the value of currencies and I continue to hold the long gold position.
Currencies likely the new zone of capital flows. The free flow of money across adds an addiitonal speculative element to markets. Capital tends to flow to the highest return so as the Federal Reserve lowers the lowers the return on capital the dollar strengh is likely to ease. Hence I will continue to hold a small dollar short position vs. the Yen as the Bank of Japan has communicated that it will maintain (as opposed to ease) rates.
Key principles of equities bond and commodities.
Equities. Buying a share of a company means looking for a return from the future earnings (future generated cash) of the organization. This return can be expressed in yields (dividends or earnings as % of price). This yield be further broken down into a combination of a risk-free cash rate and a risk premium. This risk premium can be thought of as compensation for risk that there will be no earnings for the investor.
Equities are unique in that company will often invest those earnings (future cash) to grow the business (more earnings) and hence its value will tend to appreciate. The investor then will look to the growth of earnings. Earnings can be further analyzed by profitability (cost-structure of the company) and top-line or revenue trends (demand for the services or products). The latter is usually more important (it is difficult company “cut to greatness”). Taking demand to the macro-level, this demand is aggregated in economic activity or transactions (the metric GDP is literally a sum of transactions).
Given the lower cost of capital and potential for new capital formation U.S. equities represents a position for further U.S business invesment (particularly intellectual property) which should drive top-line and productivity, as well as continued growth of demographics (millenials increasing as % of workforce).
Bonds. Buying a bond means taking cash at a future date with the return provided in the interest rate. The yield (simply the interest rate in context of price) thus reflects the risk-free cash rate and an additional risk premium.The risk is that this future cash is worth less due, which can be from higher rates in the future and / or the cash is worth less vs. other assets (i.e inflation).
Given the premium for U.S. bonds is very small (20 bps for 30-year treasury over the risk-free rate) this position is simply a daily hedge fo the equity position and will appreciate if the Federal Reserve lowers rates further.
Commodities. These assets have no future cash flows associated so they reflect quite simply supply and demand dynamics. Supply is a lot more volatile than demand in commodities. For example, demand for oil tends to be mostly stable (transportation, heating, electricity) while supply is volatile (OPEC setting production targets). The mismatch tends to drive volatile price movements for commodities (booms and busts).
In the case of commodities futures, the future price an “interest rate” that reflects the cost of storage (cost of “carrying” the asset) as well as a changing risk premium that reflects more producers selling than investors buying.
I have no positions here since with global growth slowing and capacity continuing to be cut for many commodity industies it is difficult to see prices going either way for now.
