Friday was a really interesting day. The US unemployment numbers were released and they came in pretty well spot on consensus.
Even though the numbers were what the market would have been expecting, the trading reaction to the release was completely out of line.
For the first hour the stock market was relatively well behaved. The stock market futures slowly grinded higher, with the S&P 500 future opening up 8 points from before the unemployment number release. But once the stock market opened, the selling began. And it was relentless.
NDX futures (white line) and S&P 500 futures (yellow line)</a> </div>
It was quickly clear was that the Nasdaq was leading the move lower. Many times during the morning it looked like the S&P 500 was going to stabilize and attempt to move higher, but then the large selling in the Nasdaq returned and overwhelmed any hope of a rally in the rest of the market.
There is only one reason for this terrible action – the hedge funds and other aggressive portfolio managers were way more over levered to the high flying momentum stocks than I thought. I have previously spoken about this over exposure and I even started selling naked calls on these stocks, but I was wrong in assuming they would simply trade “on the heavy side” for the next few months.
I underestimated how much speculation was occurring in these names, and therefore did not discount correctly the possibility of a large hedge fund liquidation.
And make no mistake about it – it is the hedge funds leading this charge lower.
Although I was by no means long, I have not being nearly short enough. I have made my usual mistake and misjudged how much the aggressive trader types were stuffed to the gills with this shit. I thought that the liquidation would be more of a rotation than a full blow sell off.
And it is not like there haven’t been signals. Last week Todd Harrison (from Minyanville) and Jason Goepfert (from Sentiment Trader) highlighted a chart that showed for the first time ever, the S&P 500 hit a 52 week high at the same time the Smart Money Index hit a 3 month low. The SMI (Smart Money Index) measures the difference of the Dow Jones return for the first 30 minutes of trading versus the last 30 minutes trading. Traditionally a healthy market is filled with more buying towards the end of the day as opposed to the beginning. The SMI index usually just tracks the S&P fairly closely.
SMART (in white) vs SPX (in yellow)</a> </div>
However, over the last month the two indexes have gone in completely opposite directions.
Same chart – just zooming in</a> </div>
No one knows what to make of this sort of action because it has never happened.
Whereas a month ago, these hedge funds were falling all over themselves with bullish prognostications (one newsletter I read summed it up as you needed to be long anything that was a “gifted and talented” camp as the sky was the limit for these type of people), my research and twitter feed are now filled with these aggressive traders leaning quite hard on the short side. I am not one known for being slow to switch sides, but even I find it amazing how quickly they have all jumped to the other side of the boat.
And herein lies the real question that you need to ask yourself. Is this decline in the last month the start of something more ominous, or is it simply a much needed correction in the high flying names that were bid up too high?
I unfortunately don’t have the answer. The sheer amount of these hedge funds makes determining the answer to this sort of question extremely difficult.
I have already made a mistake in selling calls in the high flying names instead of buying puts. Given the massive correction on Friday, I would have been much better off being long volatility. I underestimated the amount of pain that these hedge funds were feeling and their desperation for getting these names off the sheets.
This morning, I am leaning long – for a trade only and I am not going to put it into the position sheet because it is not a long term holding. There are a fair amount of studies that I follow that show a long edge this morning. However, I must confess that I am scared to be leaning long.
I am always cognizant to the fact that the Monday morning of the 1987 crash we opened down, which many professionals bought. However, the selling only intensified and anyone who dug their heels in was crushed. The current stock market environment is like the final stages of musical chairs. At the beginning of the game, your chances of getting a chair was fairly high, but now that we are approaching the end, and the removal of a chair means an increasingly higher percentage chance of not finding a chair to sit down on.
My only salvation is that this morning, I see that many aggressive traders are puking, with even the “legendary” Dennis Gartman reporting that he reduced his stock market exposure to neutral given the fact that “risk happens quickly” and now Gartman sees the need for safety.
Gee, wasn’t this the same “legendary” Gartman who was just a week ago advocating “aggressive” long positions in equities? Thanks for that insight about risk happening quickly. It happens especially quickly today when all you hedge funds take the same side of every trade.
I am not nearly as smart (or “legendary”) as Gartman, but I think that he is a perfect barometer for the hedge fund community.
And although I am not suggesting that you should aggressively get long equities, I think there is a good chance that this latest correction is not nearly as ominous as they all now think, and is instead just a cleansing of their over leveraged positions. Remember – the current environment is akin to a bunch of hedge funds sitting around in a circle shooting at the market. If they are now hugely bearish, at the very least you want to avoid climbing aboard their crowded train.
Postscript: As I write this there was an article crossing the Bloomberg about all the losses at the top hedge funds for the 1st quarter of 2014. There was some real pain at these shops. They were obviously stuffed even more to the gills with crap than I would have ever imagined. Here are some stats from Bloomberg:
Jones’s $13.5 billion Tudor Investment Corp. fell 3.2 percent in its Tudor BVI Global fund in the first three months of this year, according to clients, who asked not to be named because the returns are private. Bacon’s Moore Capital Management LLC, which runs about $15 billion, slid 2.8 percent through March 27 in the Moore Global Investments fund, an investor said. Novogratz’s Fortress Macro fund lost 5.5 percent in the quarter, according to investors in the fund. New York- based Fortress Investment Group LLC oversees about $4 billion in macro strategies.
Modelling up a trillion
On Friday, the ECB let leak that they had modelled up a $1 trillion QE program.
There is no doubt that the ECB has a real problem on its hands. When compared to the world’s other major Central Banks, they are by far the tightest. Their inability to aggressively expand their balance sheet is causing the Euro to march straight upward. Although the problem is being offset with lower interest rates throughout the Eurozone, they are quickly descending into a Japanese style deflation.
Many within the ECB, including Chairman Draghi, understand this problem and have desperately tried to talk down the Euro. However, the market is increasingly skeptical of these comments bringing any action due to the intransigence of the Germans.
And so once again, the market has once again dismissed this latest leak as the desperate attempt to talk down the Euro without any chance of the program actually being in acted.
Although I am not sure if the program is going to come tomorrow, next week, next month or next year, I think the market is being overly pessimistic about the chances that Germany relents and allows the ECB to expand. If you have a look at the German 10 year rates, you will notice that the recent deflationary dip has caused even the German real rates to move up into the positive territory:
German 10 Year Yield (white line) vs EU CPI (yellow line)</a> </div>
It will be increasingly difficult for the Germans to argue that monetary conditions are too loose as their real yields firmly trade in the green.
The current conditions will cause deflation to continue, and eventually, even the Germans will cry uncle.
For that reason, I think it is time to short German 10 year bonds. If you look at the yields versus the US bonds, you will notice that we are at recent all time wides:
German 10 Yr Yld (white line) vs US (yellow line)</a> </div>
I know that many will think – if the ECB is about to institute QE, why would you short Bunds?
Remember – QE is inflationary. And what is a bond investor’s worst nightmare? Inflation!