Economic Commentary: The Melt Up Trade

I've been thinking more about the possible bullish scenario I described in my last commentary on the tails of the Trump and GOP victories. In addition to the possible bullish effects of corporate tax repatriation, fiscal stimulus, and reduced regulation, there is also a technical element; we're seeing increased retail stock buying, which is pushing price-to-earning ratios above long-term institutional resistance levels. The combination of higher P/E ratios with higher corporate earnings could bring the S&P 500 50% higher over the next 2 years as underinvested money managers chase the rally attracting ever greater retail flows. 

Such a rally would be a bubble, and an excellent shorting opportunity, but I'm not going to wait to play it from the short side. Because of the substantially negative call skew in US markets, we can buy out of the money calls on the S&P 500 extremely cheaply (13.5 implied volatility for 20% OTM 2 year options). I'm taking 5% of the value of my entire portfolio and spending it on December 2018 SPY 260 call option premium (and some similar calls on other indices). If SPY ends up anywhere between down 100% and up 18%, I'll lose my 5% premium. My breakeven point is a roughly 20%* rally from here over 2 years, or 9.5% annualized.If markets end 30% higher after 2 years I'll make a 5x return on that 5% notional for a 25% total portfolio return.If they end 40% higher, 10x on the investment and 50% to the portfolio. With markets 50% higher ,15x and 75% etc.

Most likely these calls will expire worthless, but I think it's an excellent opportunity in terms of expected value, reward per unit of risk, and as a way to keep up with a potential raging bull market with minimal exposure to the downside. Given the wide range of possible economic outcomes ahead of us, this seems like an exceptional alternative to owning equity directly today.

A related alternative is to buy Eurozone equity calls and currency hedge them with a short EURUSD position; I'm dividing the bet about 2/3 in US equities, 1/3 in currency hedged European equities.

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