My 1st Million At 33 - yes, you can do it too

I took up the challenge from Prof. Peter Navarro on his macro-trading challenge (Feb 23rd, 2008). It was a very interesting mental exercise. I must say that it took longer than I expected to complete it. You can see the answers here if you can’t find it at Peter Navarro’s site. My own answers are in parenthesis if they differ from Peter’s.

Before I go further, I misunderstood that Navarro meant only 3 Neutral per scenarios, instead of a total of 3 Neutrals. Therefore, I ended up with less neutrals than I would like. Here was my email sent to Peter Navarro for my tradings:

I only had 1 college class in economics, but I’m going to give a try on competing for your book. My answers are at the bottom. I will probably write up a blog post on this competition linking back to your own site:

Explanation for trades:
LONG in Energy/Metals if Asia growth does not abate. Due to inflation in scenario #2 & #3, I will also be long in commodities in general. I will be SHORT in commodities for scenario #1, due to a potential outsized correction at the current “lofty” price of commodities.

Long in US bonds if in a global recession. Neutral in a decoupling scenario due to a potential devaluation of $US. Short in US bonds for stagflation, since bond yields will go up.

On US real estate, it will be highly dependent on the long term interest rate/credit availability at today’s price, and somewhat dependent on US growth. So I will be SHORT in scenario #1 due to recession, NEUTRAL in scenario #2 due to a low US interest rate, and SHORT in scenario #3 due to interest rate.

On stocks, it’s dependent on growth and inflation. Mild inflation is actually good for stocks which is an inflation hedge. Since US growth stocks tend to be companies with significant international sales, they would benefit from Asia and Europe growth. Therefore, in scenario #1, I will be SHORT in all stocks. In scenario #2, I will be SHORT only in US stocks, but NEUTRAL in US growth stocks, and obviously LONG in foreign stocks. In scenario #3, I will be SHORT in stocks in all developed countries (US & Europe), while SHORT (to NEUTRAL) in Asia/US growth stocks due to inflation factor. Since I can only have 3 NEUTRAL, I decided to stay SHORT in Asia/US growth stocks.

On currency, it is dependent on the strength of economic growth and also potential interest rate levels. US interest rate is highly dependent on economic growth and always skewed towards growth side. Therefore, in recession, US interest rates will be LOW. Europe has a more balanced growth profile. Asia on the other hand has a problem of (imported) inflation, and they will NEED to raise the currency exchange rate to tamper down inflation effects (especially since their absolute income in $US is lower relative to US/Europe). Therefore, in scenario #2, the currency strength should go from Yuan, Euro, $US. In scenario #3, $US is probably the worst, while Euro/Yuan may be skewed towards Yuan or on par. In scenario #1, Euro vs $US probably will have a positive carry-trade, and therefore I expect to SHORT in Dollar/Euro. Dollar, a senior currency, tends to get more respect in a recession, especially since Yuan needs to stay low so that China won’t have a serious unemployment problem due to US recession. So I will be LONG in Euro/Yuan, and LONG in Dollar/Yuan.

Post-review of the differences between mine and Navarro’s:
1. I’m longing energy and base metals, while Navarro is shorting. I guess the difference lies in that I personally believe that inflation force will overpower recession, while Navarro believes in the other way, especially given the current potential episode of stagflation.

2. I tend to believe a much weaker $US than the regular scenarios that Navarro presented. Therefore, my currency trades tend to short $US, and long Yuan, and then long Euro.

This is an interesting exercise. I encourage everyone to take up this challenge. My own prediction for the current unfolding economy is that it will resemble scenario #1 (global recession) first for maybe 3 to 9 months, and then go into scenario #2 for about 1.5 to 2.5 years, and then go into scenario #3 and possibly hyper-inflation afterwards for possibly 5+ years. However, stocks may not necessarily be a short, because under hyper-inflationary scenario, stocks will rise in nominal values too. The coming decade obviously is going to be very tough on regular investors.

Frugal at 1stMillionAt33.com