STILL ONE OF MY FAVOURITE TRADES
2017-09-27 5pm EDT | #Europe #SX5E #Canada #real estate
This summer, did you happen to catch the story of the Reading man who was flattened by a bus? It was all caught on camera (click here to watch it). He got smacked, thrown for a loop, and then in true English fashion, dusted himself off, and headed to the pub for a pint. Well, often that’s how my trading feels these days.
But some positions don’t cause me quite as much stress, and I want to talk about one of those today.
Over the weekend, the Germans went to the polls, and Angela Merkel did not fare quite as well as the market had hoped. Although she still won, it’s not as clean as previous elections. Forming a coalition government will be more complicated, and most importantly, hopes for a move towards a more unified Europe now appear much more difficult.
This has had a predictable effect on the euro.
Suddenly, investors are once again worried about the rise of anti-Euro parties. Spain, Italy - all sorts of separation scenario situations are now on traders’ minds.
And yeah, I understand the concerns. I certainly wouldn’t want to be stuffed full of peripheral European debt. And I know the initial reaction might be to sell all European assets, yet I think that is the wrong response.
This might seem trite, but the scariest thing in today’s market is currency strength. No one wants it. No one can afford it. And at least on a short-term basis, it is probably the most difficult adjustment for the various global economies. Take the United States. Would raising the overnight Fed Funds rate by 50 basis points hurt the American economy? Probably not nearly as much as the accompanying rise in the US dollar. It’s the secondary affects that are the real concern. Countries’ ability to vary monetary policy has become neutered as FX has become the escape valve for differing policies.
Europe’s biggest problem over the past six months has been a strengthening Euro. As investors have recognized Europe’s relative economic strength, they have bought the currency, causing a rally, but most alarmingly, creating a self-defeating economic headwind that has dampened the reason for buying the Euro in the first place.
Going forward, Euro weakness is therefore more important than anything else. Seems absurd, but that’s the world we live in. So although many European stock market bulls might take pause at the recent developments in Germany, as long as it sends the Euro lower, that’s all that matters. You can moan and wail about it being stupid, but how much sense does buying the Yen on North Korean escalations make? None, but that’s what happens. You can fight it, but I would rather take advantage of it.
And I think some European angst that helps the Euro sell off will be welcome.
Now let’s just hope this isn’t a case of “be careful what you wish for, you might get it - good and hard.”
One of my favourite trades.
I haven’t spoken about it lately, but owning super-long-dated Eurostoxx calls is still one of my favourite positions. They definitely have a Hotel California air to them, but for a guy like me that trades too much, the illiquidity is sometimes a godsend. It forces me to hold them for the long haul.
I originally wrote about this trade a year ago, Pretty Sure I am alone in this Trade, and I don’t want to repeat the same argument, but I did want to take the time to highlight an interesting aspect of this trade.
Usually, most equity options are short dated enough that the rho (sensitivity to interest rates) is quite small. But much to my delight, the Europeans list options on the Eurostoxx Index (SX5E) as far out as December 2026! Yup - you read that right! 2026 - nine years from today.
Let’s have a look at the farthest expiration. I chose the 3600 call. It settled at roughly 418, which represents 12.4% of the index. Putting aside option pricing theory for a moment and thinking about this logically, if you asked me whether I would be willing to bet that sometime in the next nine years the Eurostoxx index would be up a lot more than 12.5%, I would reply - darn tooting yes! I contend it’s a good bet to say that within that period, the index will at least double - but I am a little bit of a they-will-inflate-this-sucker-to-the-moon disciple.
Here is the interesting part. Assuming that everything stays the same, if interest rates rise, then the value of the options should also rise. And the amount is not immaterial. A 100 basis points move in the interest rate adds 100 points to the 442 price of the option.
One of the reasons that these long-dated call options are so attractive is that negative European rates are embedded in this price. Think about it for a second. How do you calculate the forward value of a stock index? It’s the interest rate minus dividend yield. In the old days, interest rates were most often larger than the dividend yield, so forward future contracts would trade at premium to the underlying index. Today in the S&P 500, they are approximately equal, therefore the curve is fairly flat.
But that’s not the case in Europe. There, interest rates are negative and substantially lower than the dividend yield.
That is why the futures curve trades at increasingly discounted levels. If rates were to rise, then the far month futures would have to also rise. That’s why the call options have positive rho.
I am a huge bear when it comes to European bonds. German rates are especially ridiculous and represent one of the best trade setups that I have ever seen. The trouble is that I can’t bet it all on red. Owning long-dated European equity index calls is a good diversifier. Sure, in a true crisis they won’t offer any benefit, but I am worried about the possibility the ECB keeps rates pinned lower for longer than I expect. In that case, I hope European equities would rip, and maybe I could eventually win on both trades.
Either way, I am not fussed about the German election results. Some euro weakness is welcome, and the currency move will be more important than the increased perceived political risk. And what better way to play it than super-long dated Eurostoxx calls? Just remember, you can check in, but you can never check out…
Oh Canada revisited
Last week I included a chart of the Household debt to disposable income (net of health cost) for both Canada and US.
Brad Parkes from www.economisms.com took that idea one step further and created a chart of the price of Canadian and US housing versus their respective disposable incomes. All I can say is that I wish I had thought of that! Brad has kindly helped me track down the relevant statistical information (you don’t want to do this yourself, you have to get a portion from the Institut de la Statistique Quebec), but we have now created the chart.
You can clearly see the 2007 US housing bubble. But when you look at Canada in this light, it doesn’t seem nearly as scary. Sure, it’s elevated, but the rise of the past two decades might have been the closing of the gap between Canada and the US. Don’t forget, Canadians might get taxed at a slightly higher rate, but they don’t have to pay for medicare. That ends up being a much larger influence than many of the Canadian real estate bears admit. Wouldn’t it be something if Canada were to disappoint those Canadian real estate bears by just boringly tracking US real estate from here on out?
Here is a link to the chart. As I mentioned the data was difficult to get, and then I found the FRED database series for the Canadian real estate index did not reflect the crazy market of the past few years properly (it didn’t seem high enough), so in 1999, I switched the data over to the more reliable Teranet-National Bank Home Price Index. It’s not perfect, but I think it is still important to think about. Maybe Canadian real estate isn’t so crazy after all…
Thanks for reading,