Well this is a little embarrassing. Not quite as embarrassing as when, after conceiving the MacroTourist out of wedlock, my parents decided to get married with me as as the ring bearer – but embarrassing nonetheless.
The MacroTourist at 2 years old</a> </div>
After writing a post about how I was going to do my best Jesse Livermore impersonation and go for the big money by “sitting for a while”, the market immediately embarked on one of the more volatile, confusing and just plain strange days in quite some time.
Yesterday morning I was feeling pretty confident that I had my book well set up to take advantage of the release of the extremely dovish FOMC minutes. However by lunch, I realized that something was amiss, and that my previous plan should be tossed out the window.
It was as if the Market Gods had read my post about sitting tight for the big money and just laughed in my face.
Now to be fair, I had said that I was going to piece out the Nasdaq calls that I had been lucky enough to ride higher the previous day, but I felt that I could piece them out over a couple of days. I would love to tell you that I realized first thing in the morning that the rally wasn’t going to continue, but I can’t. It took me to lunch to realize that something had changed and that the previous day’s rally was just a head fake.
At that point, I decided that discretion was the better part of valour, and even though I had just written this post about sitting tight, I immediately dialled down risk. Although I was kicking myself for not having made any sales of my Nasdaq calls in the morning, I made up for it by selling the entire position at lunch. Actually, when I went to hit the bid, the spread was 4 dollars wide as my calls had previously moved well into the money, and instead of selling them, I shorted futures on a one for one basis – creating a synthetic put. I also sold my EEM position and put on a big short S&P to hedge my other “risk on” positions. Finally, I bought back my Yen and the short German bunds in an attempt to just “clean up” my book.
Why did I feel so strongly about dialling down risk? I hate to say this, but the action was simply terrible. There was no super secret signal. There was no special sauce alert. What I had expected to happen was not happening, and the time came to protect my book instead of fighting with the market.
Let’s have a look at a chart of yesterday’s trading:
After Wednesday’s relief rally, the selling returned and was relentless. There was simply no bounce at all.
Even though the market sold off hard, what was strange was that the VIX barely rose.
I have written about how VIX is not the best way to play a market decline, but even I am surprised at how little the VIX moved up during yesterday’s sell off. I can’t construe this as anything but bearish. We need some fear to make a bottom. That move up in VIX is hardly the stuff of bottoms.
So why did we sell off so hard? The Fed’s dovish FOMC minutes should have sent the market higher.
I actually think that the Fed has very little to do with this sell off, and that the real reason for the decline lies with Japan, China and Europe.
Although the Fed is winding down QE, on a relative basis the US economy is the best performing of the major economies. There is plenty of debate on whether after the removal of QE the US economy will be able to stand on its own two feet, but for now, the US is chugging along.
The real problem lies with the other major economies.
Let’s go through them one by one.
Europe is currently skating by through lower borrowing costs, thereby pushing their problems off into the future. But their economy is mired in a deflationary vicious circle. Many within the ECB understand this, but are powerless to do anything to stop it due to political realities. The market keeps hoping that the ECB will loosen their monetary policy, but after 3 or 4 failed attempts by the ECB to talk down the Euro without backing it up with action, the market is now realizing that absent a severe deflationary crisis, the ECB is all bark and no bite. Disappointment number one for the market.
Now let’s move to Japan. Over the past year, many market participants held much hope for Prime Minister Abe’s bold reforms. However the benefits from the Yen devaluation seem to be wearing off with only drawback of higher import prices remaining. The much hoped for economic rebirth of the Japanese economy seems to be stalling. When you combine this with the recent increase in the consumption tax, there is increasing concern that Japan is about to slip back into the economic morass of the previous couple of decades. Markets had assumed that Abe was going to aggressively ease at the first sign of slowdown, but over the past few days there has been many signals out of his administration that no such increase in monetary stimulus is coming any time soon. Disappointment number two for the market.
And finally, we come to the most important of the countries – China. It used to be that market analysts would talk about how when the US got a cold, the world would get also get sick. The US used to the economy that drove the entire globe. This is no longer the case and today the fortunes of China often dictate the direction of global growth. Recently China embarked on a rebalancing of their economy – trying to move away from the infrastructure and export dependant economy of old, towards a more balanced one that includes more internal consumer consumption. This restructuring is not easy and is going to result in some painful readjustments. As these readjustments occur and growth in China slows, many market participants are hoping that China will abandon their rebalancing and return with a stimulus akin to the 2008 program. This week, even as the Chinese economic numbers continued to show decreasing growth, the Chinese government reaffirmed its commitment to the rebalancing and reiterated that there will be no stimulus. Disappointment number three for the market.
Even though the past couple of weeks has shown the Fed to be way more dovish than the market had feared, this slight change in nuance about the Fed’s interest rate policy path is insignificant compared to the major disappointments that are plaguing the other three major economies. Yes, maybe the Fed isn’t going to raise rates as quickly as the market feared two weeks ago, but that isn’t going to mean much if the global economy rolls over hard due to overly tight European, Japanese and Chinese policies.
When you combine the US stock market’s bubbly valuation with the potential for economic accidents in the these three other major economies, you realize that the US stock market is way ahead of itself. So when the stock market rallied Wednesday due to the Fed dovish minutes release, it was used as a rally to sell into. The big picture did not change and the Fed’s more dovish bent is not going to be enough to save the global economy.
As I mentioned, yesterday I significantly dialled down risk. Although I acknowledge that we are increasingly oversold on a short term basis, I am worried that the market is still hoping for Europe, Japan or China to blink and turn on the stimulus taps. I suspect there will need to be much more pain before it brings about any action, and I don’t want to be one of the longs hoping that it gets so bad that they have to deal with it. I believe that we have most likely entered into a bear market, and that rallies should be sold. I am leaning slightly short, and trying to stay nimble.
As I mentioned, yesterday I sold my EEM long. Although the developed markets have had a tough couple of weeks, the emerging markets have defied this slump and headed straight up. Have a look at the chart of the EEM vs the SPY:
Much of the recent underperformance of EEM has been made up with this massive rally. There seems to be a lot of hedge funds that were short emerging market against long US stocks, so I attribute some of this strength to that trade winding down.
Although I still like EEM more than any other stock market index, I think the time to step aside is upon us. I have sold the position and will wait for another opportunity to re-enter. Maybe it will get down under $40 again and we can look at it then. For now, the sidelines is where I want to be.
GM vs. Toyota
I am a pretty terrible single stock analyst. Many of my theories are more big picture in nature as opposed to digging through balance sheets type analysis. Therefore take the next idea with a big grain of salt.
Over the past couple of years, General Motors and Toyota have traded together in a surprisingly tight correlation.
GM (in yellow) vs Toyota (in white)</a> </div>
I am going to take a flyer and bet on this correlation breaking down and here’s why:
Both companies are suffering from news about safety issues and recalls. However, although Toyota seems to have gotten a lot of bad press, they didn’t actually ever kill anyone with their problems. GM on the other hand is probably responsible for many deaths that could have easily been prevented. I am far from a legal expert, but I expect that GM’s problems aren’t going away easily and that Toyota can solve all of their problems with money.
But here is the real kicker. What do you think is the most popular stock amongst the hedge funds?
Yup – you got it! GM.
And you know how much I think that popular positions within the hedge funds are disasters waiting to happen.
Finally, in terms of the macro picture, although I don’t expect it to happen soon, the first of the governments to blink will be Japanese government. The Japanese government has no choice but to ease aggressively. By this summer, the Japanese government will be panicking and expanding their QE dramatically. This will only help Toyota.
I am buying Toyota and shorting General Motors. I am going to trade it small and let it cook for a few months.