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Tom Armistead
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I'm a well-informed retail investor and formerly posted on SA in order to expose my thought process to critical examination and comment from readers. It made me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that... More
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  • Tranching The S&P 500 4 comments
    Nov 6, 2013 7:45 AM | about stocks: SPY

    Tranching has lost some respectability in the wake of the blow-up in structured finance. But logically it makes sense: when looking at a stream of income from multiple sources, there is some portion of it that is virtually risk free. And there's an equity tranche, speculative and calling for much higher rate of return.

    Suppose we view the earnings of the S&P 500 in that light. What is the basket of stocks worth, tranching and applying rates of return consistent with risk?

    When last I looked, as reported earnings for the index were projected at $97.83 as of 12/31/2013. Consulting Shiller's irrational exuberance data, inflation adjusted 10 year average earnings for the index stood at $64.06. That's the E in CAPE.

    Consulting history, I find that the largest ten year decrease in inflation adjusted 10 year average earnings was 37%. Reasoning from this fact, I conclude that the risk free portion of S&P 500 10 year average earnings is $64.06 X 63%, or $40.36. Capitalizing that at 2.66% (the ten year treasury rate), it's worth $1,577.

    The remaining portion of the $64.06 is $23.70. Capitalizing at 5.28% (Moody's Baa), it's worth $449.

    As for the final or equity tranche, it amounts to $33.77 ($97.83 - $64.06). Capitalizing that at 15%, on the grounds it's wildly speculative, it's worth $225.

    Adding together the three tranches, the income stream from the S&P 500 is worth $2,191. That is to say, the index would be fully valued at 2,191.

    Supposing currently low interest rates revert to the mean? Using 4.5% for the 10 year and 7.5% for Moody's Baa, the index would be fairly valued at 1,438, according to this line of thinking.

    You can see where I'm heading with this one. It all comes down to the question, how long can the Fed keep interest rates at these levels? Or, on a more fundamental basis, how long will the forces of supply and demand keep the 10 year at current levels?

    There is talk that the Fed will revise the unemployment cutoff point to initiate the taper down to 6%, from 6.5%. The FOMC seems to be doing a delicate dance with fiscal policy as implemented by the dysfunctional band in Washington. The fiscal stimulus that will not be forthcoming, and the fiscal drag that is more probable, will be offset by lax monetary policy well into the future.

    What about profit margins? Forget Corporate Profits as a % of GDP. S&P provides quarterly revenue and earnings data for the index, enabling the computation of margins. Currently the profit margin for the index stands at 8.2% compared to highs of 8.6% in 2007. Margins of S&P 500 companies have room to go higher.

    If this line of thinking is correct, there is considerable room for financial engineering here. With stock prices in the aggregate below the value of the earnings (or cash flow) streams involved, buying back shares with cheap borrowed money makes sense.

    Obviously this can't end well. But it could go on for a very long time.

    Disclosure: I am long SPY.

    Stocks: SPY
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Comments (4)
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  • Tom, good thought piece.

     

    Why don't you create a security based on your analysis. I will buy the senior tranche from you at a coupon calculated as the current 2.66% plus an annual inflator of, say, 3.5% (which I would guess is what the "risk free" component will increase from here over time taking Hussman's projections and goosing it upward a touch to reflect his relentless pessimism). Of course if earnings fall below the $40.36 level you calculate as risk free may coupon would be reduced as necessary.

     

    Sound good? What is your fee haha.

     

    If I had access to repo rate borrowing (say 65 bps) I would then lever up the trade maybe 5 to 1 but buy the SPY $85 Dec 2015 puts as a hedge. I think I would earn about 7% assuming my total investment in the senior tranche was hedged out dollar for dollar by the notional of the puts.
    6 Nov 2013, 11:16 AM Reply Like
  • Author’s reply » Robin,

     

    Some day when you have some time, go to the SEC website and look at GS 424b filings. They are borrowing money based on various schemes that diagram just like options, against indexes to include the S&P 500.

     

    I'm pretty sure they could cook something up. I would just be a little careful buying, if they were selling, and vice versa.
    6 Nov 2013, 11:31 AM Reply Like
  • I think you are right about everything you wrote but I KNOW you are right about the last sentence!
    6 Nov 2013, 11:40 AM Reply Like
  • Very interesting perspective. Thanks for another article worth reading.
    6 Nov 2013, 12:23 PM Reply Like
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