While we wait for the FOMC decision, I thought it would be an interesting learning experience to present a recent trade I’ve been apart of. The most interesting part about it is not the success or failure, but how it all played out in real time and surprised so many investors (including myself). In the future I will do more of these posts, regardless of whether they are winners or losers, which might help some of you with your own trading. I know that putting pen to paper (or in this case fingers on the keyboard) and reviewing my recent decisions & action definitely helps me.
Chart 1: Opened the short against US small caps on 19th of September
I cannot possibly cover everything that goes to my mind when executing trades, so I will keep it as brief as possible. On Friday the 19th of September, I was away on a trip and happened to be in Seoul, South Korea. Even though there are quite a lot of distractions there (haha!), I was keeping a close eye on the global equity markets, hold neither longs or shorts. I wanted to short the small caps index for awhile, due to its high valuation reading and deteriorating breadth participation (amongst other signals).
As I looked at the September edition of Merrill Lynch’s Fund Manager Survey, I noticed that funds held a very high exposure towards equities. At the same time we were approaching end of QE and volatility could pick up.
I also noticed the huge divergence between large and small caps like S&P 500, which at the day of my entry was at record highs. Furthermore, global breadth was thinning, as the actual correction started in June with Europe leading the way to the downside. Furthermore credit spreads and volatility was starting to rise, indicating some sort of financial stress in the system.
I opened my short on the Russell 2000 via IWM ETF at $114.55 with a very tight stop loss above the reversal candle at $116. I was prepared to risk about 1.2% on the small cap index and since the stop loss was very tight, to make the trade more powerful, I decide to use a lot of leverage (20 is to 1). A loss would only cost me couple of hundred basis point of my fund’s NAV, while a win could be a very handsome reward indeed.
Chart 2: Didn’t expect Russell to go straight down for next few weeks…
Once the trade is open, no one of us ever really know what comes next (regardless of how smart some of us sound). That is why a review of recent price events as well as my own thinking process is an interesting read in hindsight.
Following the short position, for weeks the Russell 2000 kept declining and under-performing larger cap stocks. The sell off started to intensify in early parts of October and various media outlets were puzzled as to why stocks were falling. I was in Singapore at the time and talking about my short position to a friend, who I regard as mentor. I was saying how media is blaming it on Eurozone, some blamed it on Ebola and others said that ISIS 9all the way in Iraq) is behind the declines.
At this point Russell 2000 already declined by about 10%, so media coverage started to focus on how small cap stocks were already in correction mode, giving it plenty of negative attention. As the ETF broke below $108, many technical analysts stated that the neckline of a “head & shoulders pattern” was triggered and that Russell 2000 could fall by at least another 10 to 15 percent… if not totally crash!
On Monday the 13th of October I noticed that something started to change. US small caps started outperforming their larger cap counter parts, with tape refusing to move lower. As the VIX dramatically spiked on Wednesday the 15th (usually a signal of capitulation), Russell 2000 barley budged lower. Then we saw Treasury Bond prices spike higher in panic buying as majority of bond bears realised that rate rises might not come as early. I decided to cover all my shorts and close my Yen long (safe haven play opposite to stocks).
I remember at the time talking to another friend in Singapore and telling him that my instinct & gut feeling is telling me at least a short term inflection point is at hand. Because I was heavily leveraged and the trade was a huge success making a mini fortune most people don’t earn in years, I decided to walk away at that exact moment.
Chart 3: …or to rebound crazy straight back up in a few weeks after that
Various bloggers I follow were certain that we were about to enter a waterfall decline, also known as a crash. They stated various indicators and analogues, dating all the way back to 1929. At the same time, extremely popular and ever so famous investing guru – Dennis Gartman – was on CNBC letting everyone know he was 100% cash and T-bills because a “huge bear market is coming and would last for months.” Little did we all know what would happen next.
The rebound in US equities has been quite amazing, as prices have now literally returned to the point from which they originally fell (especially seen in Chart 4 with S&P 500). It turns out that, if I held onto my shorts, as of last night I would pretty much be at a break even level. I would assume many bulls have been shaken out of their long positions, while many bears were sucked into believing that a downtrend is starting right before the short squeeze. Both sides are now scratching their heads…
After all, the job of the market is to thieve and steal as much money as possible, from as many participants as possible, in as many occasions as possible. And please do not think because I made a correct decision this time around (on the short term basis), that I am extremely smart or something. Personally, I have been humbled by the market on many, many, many occasions and I’m sure I’m awaiting my next punishment just around the corner!
Chart 4: US stocks have been a huge surprise for both the bulls & bears
So I leave you with this great quote: a wise trader once said that the stock market is a man’s invention that has humbled him the most. If you are not humbled, you haven’t been around for long enough or you are just delusional. Finally I would like to ask all the fellow readers of the blog and the newsletter to jump on the poll and vote on the question below.
In an article on Financial Sense website, Chris Puplava recently put forward various quotes by central bankers who recently expressed their view that ending stimulus right now could be slightly premature. Various dovish comments are most likely attributed to rebound in the stock markets from oversold condition back in middle of October. Let us focus on one of these comments below, by Fed’s Bullard:
Inflation expectations are declining in the U.S. …that’s an important consideration for a central bank. And for that reason I think that a logical policy response at this juncture may be to delay the end of the QE…
“We are watching and we’re ready and we are willing to do things to defend our inflation target,” Bullard said… A pause in tapering would protect against “downside risk” and bolster inflation expectations, he said. “We could react with more QE if we wanted to.”
Personally, I believe the up-and-coming FOMC meeting is one of the more important ones to pay attention to. The question is whether Federal Reserve will extend the QE for awhile longer or stop it this month as originally planned. This decision will impact the movement of equities, bonds, currencies and commodities.
Chart 1: Falling inflation expectations will have majority of Fed worried!
So, it is Mr Bullard’s comments that have me paying close attention to the bond market right now. I am looking at the same indicator Fed tracks, namely the 5 Year Forward Inflation Expectation Rate. As a matter of fact, by observing Chart 2, you will notice that every time inflation expectations fell to level we are currently at (or even lower), the Federal Reserve was not talking about ending stimulus… but actually hinting at starting or extending it.
During Jackson’s Hole meeting in August 2010, ex-chairman Bernnake hinted at QE 2. During the US Debt Ceiling Debate, various risky asset went through a major correction making the Fed concerned about deflation again. As a result, Operation Twist was started around that time.
By middle of 2012 various FOMC members and other central bankers started to hint at a possibility of a new round of QE, which was eventually implemented in November 2012. By middle of 2013 various assets, and in particular Emerging Markets, were affected by the talk of QE taper. Eventually, ex-chairman Bernnake pushed the taper out to year end.
Today, inflation expectations are once again very low, so I ask myself if it very wise to expect the Fed to end QE this month, as majority expect? Obviously, that is a hard one to answer and I wish my crystal ball could help me (but its broken). So just like always, I rather refer to the market instead of opinions by various analysts, economists, strategists and other experts. Let us look at the way investors are positioned for better clues.
Chart 2: If the Fed resumes QE, heavily shorted assets could benefit…
In the recent post entitled Currency Market Positioning, I discussed the fact that market participants hold a huge net long exposure on the US Dollar. Every man and his dog is bullish the greenback right now, and I am apart of it too. All of my cash has been held in US Dollars for months now, while I have been heavily short Gold and Silver since the July peaks.
From my own experience, it rarely pays to be on the side of consensus, so there is an above average probability that these trades could reverse and rebound (for at least awhile). Obviously, what is needed is some sort of catalyst. So I wonder if the recent stock market volatility, as well as the fall in inflation expectations, has scared the FOMC enough to extend QE.
If this was to happen, we could see a shake out of the Dollar bulls and fast short squeeze the bears of various assets such as Australian Dollar, Crude Oil and even Silver (refer to Chart 3). With a tight stop loss below $17 per ounce, a contrarian trader could bet on a PMs rebound right now. The trade would have very minimal risk at the current price level.
Chart 1: US market breadth has now rebounded from oversold levels
After a powerful week and half of rallying, we can clearly see in the chart above that various breadth readings have rebounded from short term oversold levels we experienced during middle of October inflection point. Firstly, we are now putting in more 52 week highs relative to 52 week lows, which is pushing the 5 day average of High Low Ratio back above the neutral levels. Secondly, advances are now dominating decliners and up volume is more present relative to down volume. Finally, the percentage of stocks with the S&P index trading above the 50 day moving average has rebounded back above 50%.
Chart 2: US stock market rebound has surprised just about everyone!!!
Two weeks ago, as the US equity market futures were trading around mid 1,800s, all I heard from various traders, analysts on TV and bloggers was how much “technical damage” was done to the S&P 500. Certain traders were even forecasting a waterfall decline and outright crash a.l.a 1929, as soon as we sliced through the 200 day moving average, concluding that we won’t trade above it again for at least a few years.
While I was watching CNBC and Bloomberg, various bulls were claiming that this correction was necessary and that it will go on for awhile longer. In other words, even the bulls weren’t bullish anymore. Well, as always the market does something completely opposite to what the consensus expects so we had a super strong US equity rebound, surprising just about everyone.
In my opinion, it is less about various indicators and technical damage, or the fact that volatility is so low and options are cheap. It has to do more with underlying conditions. It seems to me that this is where majority of investors, including me, go wrong most of the time. They fail to study underlying conditions. Once again in words of Jesse Livermore:
I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.
Chart 3: Rebound has been very uneven throughout the global markets
For example, let us observe Chart 3 more closely. Underlying favourable conditions come in many forms and are just some of the reason why during the recent correction, US stocks or Indian stocks didn’t fall as much as European or Asian counter parts, but rebounded much more quickly and vigorously.
Let us refer to India in particular, which is currently benefiting from optimism of its recent elections, while the Brazilian stock market is crashing in Asia trade, as elections there disappoint investors. Also of note is the fact that India is benefiting from lower commodity prices, especially Oil and Gold, as its trade deficit narrows (for at least awhile). At the same time a slowdown in China in impacting Australia and South Korea, due to these same reason.
Now, many readers usually mistake the studying of underlying conditions with fundamental analysis regularly seen on CNBC, where so called “experts” discuss backward looking economic data like Non Farm Payrolls. Since markets are a discount mechanism (looking ahead around 6 months from now), the most important skill set for an investor is his or hers ability to anticipate, and not just react like the rest.
We have been focusing on the equity markets quite a lot recently, due to a huge pick up in volatility. Let us now refocus our attention on currencies, as I discuss my own positioning as well as my views on future price action.
Chart 1: Majority of hedge funds are sitting pretty in the USD right now!
One could argue that majority of the current volatility could be attributed to Federal Reserves plan to end the QE program. As we have all heard in recent months, there is even talk about attempting to hike interest rates sometime in 2015. US Dollar has benefited from these policy changes against all the majors (and majority of the minors too), however this is now a very overcrowded trade.
That doesn’t mean the greenback won’t rise even further, but what it does mean is that majority of the easy gains have already occurred for now. We have a major resistance sitting right above at around 88 on the USD Index. If and when reached in coming weeks, I would assume the Dollar to finally take a breather for awhile.
There is a lot of excess cash in my fund right now, as I haven’t purchased any precious metals in a long awhile and all of it sits in US Dollars. I am also long the US Dollar by being short the Aussie (more on that later down).
Chart 2: Last weeks Yen rally & stock sell off squeezed half of the bears
Japanese Yen managed to rally during stock market volatility, as it once again benefited from the appeal of being a safe haven asset. I purchased the Yen above 109 against the US Dollar, as it became oversold in early October. As we can clearly see from the chart above, short bets reached close to $14 billion, which is one of the more extreme positions in history.
I was planning to hold this position for awhile, with the hope of a major short squeeze running its course. However, as the stock market corrected rather violently and VIX spiked swiftly, I was forced to close my Yen long last Wednesday just below 106 per US Dollar. Quite a profitable short term trade, however it wasn’t what I was after.
Looking at the COT futures positioning right now, I can see that positioning has been cut by almost a half in just one week, so there is a possibility for the Yen to keep declining. Right now, I am neither a buyer nor a seller of this currency. Having said that, if the Yen was to fall again, I would definitely have another crack at it. Such an overcrowded trade cannot last forever and eventually consensus will be squeezed.
Chart 3: Consensus has now positioned for even further Aussie declines
Regular readers of the blog would know that I have been short the Aussie Dollar since late 2012 around 1.05 per USD. I also added to that position with another large short bet in August of this year at around 0.94 per USD. I continue to hold both positions with a view that Aussie could still decline some more from the current support level of 0.8650 per USD.
Having said that, it seems that the market now agrees with me and my thought pattern has become consensus. That usually means one of two things. Either the decline in the Aussie will be more gradual and choppy from here onwards, with continual short squeezes. Or, the currency will now have a sustained relief rally from the current support level and all of us will be wrong for awhile. In other words, easy gains have been made and it will be a lot harder to short the Aussie from here.
Chart 4: Managers increasing bets on Gold but the price looks bearish!
Finally, we turn out attention to the precious metals sector. I believe that the long term secular bull market in this sector is not yet finished, especially the way central banks continue to act with currency devaluations. However, we need to respect the price action right now, which shows that we are currently in a cyclical bear market that was way overdue after Gold recorded 11 annual gains in the row.
In my view, as I have written many times on the blog, Gold will be breaking down into a final low soon enough. The up-and-coming selling pressure will most likely produce a proper panic which we failed to see in middle of 2013. The shake out should get rid of majority of perma-bulls, which refuse to give up on their optimistic Gold views. This is precisely why I have fully hedged my Silver holdings in early July (above $21), as well as executed short positions on Gold (above $1310).
While Silver has recently broken below its important support level at $19, Gold continues to hang in there (for now). However, I think this is soon about to change and Gold will follow Silver downward by breaking below $1,185. Hedge funds have recently been adding to Gold once again, but the price pattern remains quite bearish in my opinion.
Chart 5: Positioning in the Silver market is now becoming very negative
I have to apologise for the late post. I was meaning to do Part 3 of this article as soon as possible, but I have taken out my wisdom teeth (all 4) two days ago. I currently feel like my jaw is broken during a bar fight or something haha!
Chart 1: S&P 500 has rebounded from short term oversold conditions…
Over the last two posts, which started last Thursday morning Asian time, we concluded that the S&P 500 was short term oversold and had an above average probability of bouncing. Well, the index squeezed bears very hard as it retracted the whole fall in October. Unless you had a great entry point in middle of September (right at the peak), you are most likely not profiting from being a bear right now. In the comments section I wrote that:
I see many traders who refused to notice a spike in ETF volume and a spike in the VIX, staying short with average entry points. I also see many traders trying to re-short S&P 500 every single day since the rebound started one week ago.
In Part 2 of the article, I asked a key question connected to underlaying conditions and fundamental developments that should be on all investors minds right now. That question is – has the market just overreacted to Fed ending the QE program or is there a real slowdown occurring that could drag the global economy into another recession?
Personally, I believe that the market has overreacted to Fed’s plan of ending the QE program. The market has rebounded as soon as a few members of the FOMC stated that maybe it would be wise to extended the QE program for awhile. The bears seem to be super surprised at the recent rebound, so they must be failing to understand how addicted the market has become to liquidity. As soon as the punchbowl is taken away, emotions run wild like a little kid throwing a tantrum.
Chart 2: S&P has been through an amazing performance in recent years
However, the underlaying conditions aren’t that simple. Economic activity and financial markets are currently in divergence, but they do have a strong link. Assuming the Federal Reserve does decide to end the QE (at least for awhile), the market could once again begin to decline. If asset price valuations sell off more rapidly this time around, it could actually impact the confidence within the main economy.
Let us not forget that S&P 500 has gone through a tremendous bull market over the last five years. In Chart 2, we can clearly see that 5 year rolling compound return hit 2 standard deviations above mean over the last 140 years (data thanks to Robert Shiller). Bull markets in 1929, 1936, 1987 & 2000 achieved 3 standard deviations, then went through major crashes.
Whether or not we are in store for something similar is beyond my crystal ball powers, but my view here is that US equities will most likely suffer below average historical returns, after just going through above average historical returns. Assuming US equities underperform for awhile, where should stock investors go?
Chart 3: EM stocks trying to make a comeback after poor performance!
While US stocks don’t offer great value, that doesn’t mean all stock markets are made equal. Personally, I am closely following Emerging Market indices such as China. GEM equities seem to be going through a similar under performing cycle right now to what we saw during middle to late 1990s. Let me explain:
- The Asian Financial Crisis in 1997/98 crashed the MSCI EM Stock Index, which was followed by strong rebound before a period of prolonged under-performance. Eventually a breakout occurred and GEM stocks caught up with a powerful bull market.
- In recent years we went through a Global Financial Crisis in 2007/08, that also crashed the MSCI EM Stock Index. And in similar fashion, prices went through a strong rebound. Since May 2011, emerging markets have be under-performing.
Could a breakout in GEM stocks be around the corner? I am not so sure, but I am watching it very closely. A major risk here includes further appreciation of the US Dollar, which tends to put pressure on Emerging Market equities, as local currencies sell off. The other risk is a possible major top in the US equity market (refer to Chart 2), which would drag down all global stock markets one way or another.
Chart 4: Japanese stocks priced in US dollars are ridiculously cheap!!!
However, not all foreign stock markets feel the pressure as the local currency devalues against the greenback. One should consider the fact that a weak Yen could actually help propel Japanese stocks into a new secular bull market. This market is ridiculously cheap and has been under-performing for as long as I have been alive on this planet. One of these days that will change, so the question here is has the time finally come for the Japanese shares to shine? Keep a close out on this one!
Chart 1: Volume spikes during intermediate low as retail investors panic
- Volume has spiked on various ETFs, including one of the most traded: iShares SPDR SPY. Usually, a spike in volume is a signal of retail investor (dumb money) liquidation and tends to signal kind of an intermediate bottom.
Chart 2: Volatility has tripled over the last few weeks… too far too fast!
- The same is true for the volatility index, which has tripled since middle of September. During mid week, VIX index was almost 100% above both the 50 day and 200 day moving average. Historically, this has signalled some sort of capitulation (however, sometimes only for a brief rebound).
Chart 3: High low ratio has become oversold & should signal a bounce
- Bears have been in control of the current price trend, with some foreign markets under pressure since June. All of this has pushed breadth into oversold territory and the HL Ratio has now officially turned oversold for the first time since August 2011. Even during downtrends like 2008, this indicator does a great job of signalling a potential relief rally.
Chart 4: Percentage of stocks above 50 MA is also quite oversold now
- Same can be said about the other breadth indicator I frequently use – percentage of stocks above a certain moving average. In this case, we look at the percentage of S&P 500 stocks trading above the 50 day moving average and come to a conclusion that we are most oversold since May of 2012 (last time we saw a 10% correction).
Chart 5: Stocks are deeply oversold relative to bonds over the short term
- The Stock vs Bond Ratio indicator is very interesting (and comes to us from SentimenTrader website). While US stocks have fallen only a little bit in recent weeks, US bonds have rallied all year long and recently gone vertical. This makes stocks very attractive on relative basis. SentimenTrader reported that the last weeks Wednesday intraday movement betweens stocks and bonds got to almost 5 standard deviations oversold. Chart above shows what happens when stock bond ratio got to minus 3 standard deviations.
Chart 6: Some surveys have now entered fear levels & signal a rebound!
- There is no real capitulation or panic yet, that is obvious. Various sentiment indicators are still either complacent or neutral. Investor Intelligence bears remain stubbornly low. However, a few indicators have entered fear levels and one of those is NAAIM. Currently, managers hold under 10% net long exposure to US equities. Last instance we saw this was around August to October 2011.
Ok that was a quick indicator recap. We discussed the short term inflection point last Wednesday, so I am not lagging here. I was very quick to point this out in real time. In the short term, bears have been squeezed a bit, with S&P 500 futures rebounding close to 1900. Still, I do not think the volatility is over and by no means has the US stock market seen a major capitulation like we went through in early 2009 and late 2011.
Now, there is no rule book to say that we have to go through something as dramatic as the repeat of those two recent crashes. On the other hand, it might even be worse this time around. The key question here is connected to underlaying conditions and fundamental developments. How well can you read them…
Has the market just overreacted to Fed ending the QE program or is there a real slowdown occurring that could drag the global economy into another recession?
If you believe that the economy is starting to slow properly and earnings to be impacted on the downside, you are probably betting on the start of a new bear market and the indicators above won’t concern you much. On the other hand, if you believe this is just a short term panic, some of the indicators here are signalling oversold conditions right now. Maybe the correction could get a bit worse (10 percent plus), but you might be willing to be a contrarian soon enough.
We will continue with Part 3 coming up next…
Chart 1: The most volatile week since the Eurozone Crisis during 2011!
Very volatile week, so let us look at a basic grid of the most important Global Macro asset classes. Here are some interesting developments to note:
- For the most part, Developed Markets stocks have under-performed Emerging Market stocks in the last few weeks. MSCI World Index, together with S&P 500 and DAX 30, have all broken below their recent multi-year uptrends. Broad Chinese stocks have outperformed recently, as correctly predicted almost three months ago.
- Money continues to flow from the rest of the world towards United States – a reversal of the carry trade. All currencies have been under pressure as of late. Euro has failed to hold its support, while Yen and Aussie are trying to get a bounce of their respective support levels. If the Fed backs away from rate hikes, US Dollar could be in correction mode for awhile.
- We are going through a bit of a deflation scare once again. Crude Oil has been under major pressure, while Treasury Bonds have gone through an amazing rally in 2014, and recently rising almost vertically. To me, this looks like a major shake out of market participants that were betting on inflation and interest rate rises.
Chart 2: Global stock and commodity markets under pressure this week
While the ever-popular US large caps and the more neglected Emerging Market stocks looked like they were going to gift investors some decent returns this year (20% plus on annualised basis), it seems that 2014 is all about Treasury Bonds. Starting the year as one of the most hated asset classes, Treasuries have outperformed just about everything this year. Furthermore, on the total return basis, Treasury Long Bond is currently making record highs.
The other hated asset was Gold. However, I believe the yellow metal continues to look weak despite still holding on its major support around $1185 per ounce. A breakdown is most likely coming before a major bottom occurs, as Silver continues to lead the whole sector lower.
A lot of readers have asked me: what will it take for the US Dollar to finally top out?
As long as US Dollar remains strong, commodities & emerging market stocks might continue to under-perform. A crescendo would occur as a major deflation shock runs through global financial markets, making the US Dollar go vertical at which point the Federal Reserve would most likely reverse its current view of monetary policy by 180 degrees.
Chart 3: Annualised returns show Treasuries outperforming other assets
Chart 1: Federal Reserve has proven that we are now going to QE99…
Source: Internet / Unknown
Well… somebody has to tell the truth once in awhile, because you are not going to get it on CNBC or Bloomberg. This post has nothing to do with prices, fundamentals, trading, entry points, economic or technical indicators – all of which are commonly found on this blog. This post has to do with a basic observation of what is clearly happening today.
As soon as the Federal Reserve even attempted to take away the QE punch bowl, markets turned down very quickly and volatility spiked almost instantly. We can clearly see how addicted investors are to QE and how disconnected stock prices are to economic activity.
Now, keep in mind that the S&P 500 has declined between 7% to 9%, depending on the way one measures it. Unless you are a short term trader, this is nothing to even worry about. However, the Federal Reserve is already sending out signals that the QE exit might now be extended. This is just ridiculous!
And if the market goes through a short term bounce and decided to turn back down again in coming weeks or months, Federal Reserve will probably extended QE and scrap the whole plan of tightening.
Chart 2: S&P barley corrected & some of FOMC academics are in panic!
I am not saying without QE program S&P 500 would return back to March 2009 lows of 666 points, but what I am saying is that all the markets (including bond interest rates) need to be left alone, without constant intervention by central banks, to clear themselves and find fair and true value based on what the market deems to be current fundamentals.
We all understand markets aren’t perfect. But we should all also know that trillions of dollars by the private sector (billions of individuals who don’t work for the government), is a better decision making process then ten people locked up in a private room pulling levers on lagging economic data.
If I worked for the Federal Reserve, I would be ashamed of the policies that are currently in progress. I would also be embarrassed at the way FOMC caves in as soon as financial markets fall a little bit. This is not helping the local or global economy and the more juiced up & depended the system becomes, the larger the troubles will eventually be as Fed becomes forced to tighten. After all, you cannot stay at 0% interest rates forever…
Disclosure: I’m currently long US Dollars, short Australian Dollars and Gold, and fully hedged in Silver. The US Dollar bull market might go on for awhile longer, but it won’t last. At that point, you better own some Precious Metals in your portfolio.