SPX: Generational Short Selling Opportunity (SPX)

Shorting the S&P 500 has proven to be a disastrous strategy over the long term, as long positions on the S&P 500 Daily Inverse Index have lost 92% of their value since 2009. It is not surprising, therefore, that short interest in shorting the S&P 500 The S&P 500 has proven to be a disastrous long-term strategy. US stocks have collapsed to their lowest levels in years. However, there have been periods when shorting the market has been very profitable and there may be another such period. From the market peak in 2000 to the trough in 2009, short positions gained 125%, thanks to the combined effect of higher returns on cash relative to dividend yields and lower valuations, which outweighed the effect of higher earnings and dividends.

The conditions that led to such strong returns for short sellers In 2000 it came back into place again, with cash returns far greater than stocks and valuations at or near all-time highs. Additionally, deteriorating macroeconomic conditions should lead to weak earnings and earnings growth, reducing fundamental headwinds for short sellers. Although short bets may not be suitable for most investors due to the theoretical risk of unlimited losses and the risk of margin calls, these risks can be mitigated using daily reversal indicators, such as the one tracked by the ProShares Short S&P500 (Sh).

Get paid for selling

When investors short the S&P 500, they receive income of one form or another. When you short sell through a brokerage account on margin, the brokerage typically pays interest on the cash deposited, minus any brokerage fees and borrowing fees. Instead, the SH ETF participates in swap agreements and holds Treasury bills that generate interest, while also charging expense fees. In either case, the short seller must subtract from these cash proceeds the dividend yield paid by the S&P 500. In certain circumstances when interest rates are high and the dividend yield is low, short selling can be cash flow positive. This is the situation in which we currently find ourselves.

The chart above shows the performance of the daily inverse S&P500 index and the price of the inverse S&P500, which was revalued to 100 in 1990, with the spread tracking the income spread between the cash rate and the dividend yield. As you can see in the chart below, the S&P 500 Inverse Index tends to outperform during periods when the federal funds rate is higher than the dividend yield, and vice versa.

Betting on the return of the equity risk premium

The fact that investors are now getting paid for short selling is certainly a bonus, but more important is what it says about the equity risk premium, which is the expected excess return on stocks, relative to cash and/or bonds because the former is higher. Level of risk and volatility. Since 1990, the S&P 500 has averaged approximately 9% more annual returns than cash, while this figure has fallen to 6% when measured since 1970. This reflects an average of 5% annual returns on cash. And 11% on stocks, which can be broken down into a 6pp contribution from earnings growth, a 3pp contribution from dividend yield, and a 2pp contribution from rising valuations (lower dividend yield).

If equity investors expect excess returns on stocks of 6% relative to cash over the long run, with stocks now returning about 4% less than cash, this would require annual earnings growth of 10% in an economy trending at a nominal growth rate of 4%. . Assuming dividend growth of 4% in line with its long-term trend of tracking nominal GDP growth, this would lead to total excess returns on the S&P 500 of about zero. In other words, the dividend yield required for investors to generate returns in excess of 6% on cash, assuming interest rates currently remain at 5.5% levels and dividend growth at 4%, would be a staggeringly high 7.5%. Given that the yield is currently just 1.3%, this would require stock valuations to decline by 83%.

To be fair, interest rates are widely expected to fall, and I think it’s also fair to assume that the equity risk premium in the future will be lower than it has been in the past. However, even if the cash yield falls to 4% and the equity risk premium falls to only 3%, the dividend yield would still have to rise to 3% assuming dividend growth of 4%, which would require a rate of 57%. % prices drop.

The high equity risk premium fully explains why the S&P 500 performed so poorly from 2000 to 2009. At the peak in 2000, the dividend yield was just 1.1%, while 10-year Treasury yields showed a It was expected to be about 6%. Over the next nine years, dividends grew at a staggering 7% per year, but a four-percentage-point rise in dividend yields depressed stock valuations by more than 14% per year.

Earnings growth is likely to lag GDP growth after years of outperformance

Arguably, dividends per share will be able to grow more strongly than my 4% assumption. The S&P 500’s dividend payout ratio is just 33%, which is low by historical standards as the largest companies have been using retained earnings to reinvest, rather than returning them to shareholders. Doubling the payout ratio to 1990s levels could allow dividends to grow at high single-digit rates, justifying the current low dividend yield.

However, the low dividend payout ratio is not primarily a result of low dividend payouts, but rather due to the companies’ very high profit margins. The following chart shows dividends related to earnings, EBIT and book values. The lower payout ratio reflects higher profit margins, caused primarily by lower interest and tax expenses, which, as I said here, have nowhere to go but up.

While I only have access to sales and pre-tax profits for the S&P 500 going back to 1990, economic data goes back some time to the 1940s and shows that economy-wide dividend payments are high, relative to profits, and very high, relative to profits Before taxes, free cash flow, and GDP. It should be clear to see that dividends cannot continue to outpace the growth of the economy indefinitely, and it seems more likely that they will grow more slowly over the coming years, with profit margins themselves declining. Amid the continuing decline in savings rates in the United States.

Another factor that enhances short returns

I noted above that the returns on the daily inverse S&P500 tracked by the SH ETF tend to outperform what one would expect, based on the performance of the S&P500 alone during periods when there is more cash than stocks. While it’s true that income spreads play a big role, there appears to be another factor at play in driving returns on the S&P 500 Daily Inverse Index. The chart below shows the year-over-year change in the daily performance of the S&P500 Inverse Index, compared to the price of the S&P500 Inverse along with the federal funds rate spread over the dividend yield. What is notable is that although the two are closely related, they are not the same, indicating that there is another factor driving the returns on the inverted S&P500.

It turns out that the daily inverse S&P500 index underperforms what would be expected based on the S&P500’s performance during periods when volatility is high, and outperforms when volatility is low. I suspect that this variation in performance reflects the effect of daily rebalancing of the inverse index, although perhaps readers can shed more light on this phenomenon.

summary

Shorting stocks isn’t for everyone, but for those who want to bet against the market, this appears to be the most attractive setup since the peak of the bubble in 2000. While there is nothing stopping stocks from rising further than their current extremes in the short term Short sellers are now getting big money betting against it, and from a long-term perspective, all it takes to make big returns is an equity risk premium. To rise from nearly zero to just a fraction of its historical average.