The Fundamentals Have Changed - Again

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Includes: CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, GLD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TLT, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV, VXX
by: Macrotheme Capital Management LLC

Summary

The narrative has changed.

Geopolitical risks now outweigh pro-growth policies .

It is important to be heavily hedged now.

Since the US election in November, my market outlook was based on two themes: 1) the effect of Trump's pro-growth agenda, vs 2) the effect of possible Trump's protections policies. My initial stock market outlook (NYSEARCA:SPY) (NYSEARCA:DIA) (NASDAQ:QQQ) was very bullish, until about the time when it became less likely that the pro-growth policies would be implemented in a timely manner. More recently, my outlook turned bearish, leading to the Trump-Xi summit, where I expected "difficult trade" negotiations, and first concrete indications of the protectionism.

However, the Trump-Xi meeting took an unexpected turn, and as a result, now the fundamental picture has changed, again. Specifically, the US-China trade relationship now appears to be pegged to China's help with North Korea. Here is the specific Trump tweet on this subject:

I explained to the President of China that a trade deal with the U.S. will be far better for them if they solve the North Korean problem!

This is very important, as now the threat of protectionism and trade war with China has mostly disappeared - as long as China complies with the apparent geopolitical agreement. So, the major negative theme appears to be temporary gone.

So, this should be bullish for the stock market? Actually, not really. The stock market hasn't really paid any attention to possible protectionism anyway. On the contrary, the frequently quoted Shiller PE ratio on S&P 500 is as high as the 1929 pre-crash levels, which suggests that investors have been exclusively pricing the pro-growth theme and buying stocks at historically very rich valuations.

But more importantly, now the Trump Administration has imposed on markets a new theme - the geopolitical risk. The conflict with North Korea is very serious, to put it mildly. The narrative refers to a nuclear war. The threats from all sides refer to "immediate, unexpected" actions.

Unlike the protectionist rhetoric, the financial markets are actually not ignoring this new "negative". Since the Syria bombings and initial North Korea discussions, gold prices have risen (NYSEARCA:GLD), Treasury bonds prices have risen (NYSEARCA:TLT), VIX has risen (NYSEARCA:VXX), and most importantly the VIX Term Structure inverted, which is a clear indication of fear. The stock market has shown more volatility recently as well, although, it still remains remarkably resilient.

The protectionist rhetoric was likely interpreted as the "though negotiations", which would ultimately lead to an acceptable market solution - or simply call it a bluff. So, the market largely ignored this as a potential threat.

However, the geopolitical rhetoric can not be dismissed as a bluff. The "all talk but no action" policy on North Korea is now not an option, since it would essentially lead to a loss of US credibility. Further, the expected time frame during which the current geopolitical risks would play out is highly uncertain. As we have been warned, an adverse event could happen immediately, or the situation could play out over months, even years.

So, what to do now?

The fundamental narrative is now clearly more uncertain, as the geopolitical risks overweight the pro-growth agenda, and as a trade-war is possibly replaced by a real war. This additional uncertainty will lead to more volatility, but also it increases the risk of a "black-swan" event. Thus, in this new unexpected environment, it is very important to remain heavily hedged with put options, gold, and Treasuries.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.