Towards the end of yesterday’s post I mentioned that I was returning to the short side of the stock market. My plan is to ease into it. I started the position on Tuesday and added to it last night after the Apple euphoria caused the Nasdaq to rally 50 handles.
Why have I returned to the dark side?
Longer term I am skeptical of the US stock market valuation. I just don’t believe that corporate profits can grow fast enough to justify the current stock market level. I also am convinced that QE is winding down, but even if the Fed does indeed pause their taper – that is no reason to buy stocks.
Stocks have benefited from the TINA paradox (There Is No Alternative). However just because the Fed has forced everyone out the risk curve does not mean that you need to join in. Their easy monetary policy has created a very unstable situation and the time to lean on the short side has returned.
Long term I am very confident that in real terms the stock market is priced to deliver sub-optimal returns. In case you don’t believe me, have a look at what exceptionally smart shops like GMO forecast for future returns:
At these elevated stock market levels, GMO has forecasts for negative long term real returns for US Large and US Small cap stocks. In fact they have below average real returns of all asset classes. The Fed has chased everyone out the risk curve and almost all financial assets are fully priced.
This sentiment is echoed by other investing legends – like PIMCO’s Bill Gross who tweeted:
All risk asset prices artificially high.
This short and sweet tweet is a condensed version of his beliefs:
“Those who expect double digit returns going forwards are going to be severely disappointed,” said Bill Gross, CEO of bond giant, PIMCO.
“The transition from a levering, asset-inflating secular economy to a post bubble delivering era may be as difficult for one to imagine as our departure into the hereafter,” said PIMCO managing director, Bill Gross, the world’s largest bond manager.
But as most things in life – timing is everything.
Why is it time to start leaning on the short side? And why am I taking a couple of weeks to ease into the trade?
The reason I started my position this week is that we have entered earnings reporting season. Over the past 5 years this period has resulted in lack lustre returns for the market. Have a look at his great chart from Bespoke Investments:
Almost all the returns of the S&P 500 have occurred during the off season. On the whole, this is a low risk period for shorts.
Then when you have a look at the seasonality, you will notice that we are approaching the end of the strong period for stocks. The old adage “sell in May and go away” exists for a reason.
Again from Bepoke:
March and April have traditionally been strong months. Then May and June really drop off with the returns being minimal. There is no guarantee that this pattern will repeat, but at the margin this seasonality gives the bears an edge.
And the final timing trigger is the fact that in terms of the Presidential Cycle we are entering the worst couple of months of the whole cycle:
These three long term timing indicators indicate that the odds do not bode well for stock market returns over the next few months.
Given the over stretched valuations I think that the risk reward favours a short position. This is a longer term trade, so I am in no rush to put it all on today. In fact what I would like best is for the stock market to rally into new highs so that we can establish a short at higher levels.
The “Trash Crash” of last month caught a lot of hedge funds off side. The selling was intense and for a few weeks – relentless. Last week that selling ended and the stock market has since rallied.
NDX trading over the past few months</a> </div>
There is a chance that this respite in the selling is just a pause. And that is why I am starting my position before the end of the quarter. I am worried that the bigger trend is now lower and that this week’s rally was merely a small counter trend recovery.
Regardless of whether the rally rolls over this week or if it shoots to new highs, I want to take the next couple of weeks to establish a larger stock market short. I will ease into it using a combination of triggers of both time and price.
I am using Nasdaq futures as my preferred vehicle. A couple of days ago David Einhorn admitted that he had created a short “bubble basket” to take advantage of the extreme valuations in the “cool kid” stocks. I don’t have the luxury of creating a capital efficient “bubble basket”, so I am left with shorting Nasdaqs.
Remember – this is a longer term trade. Use the recent strength from the Apple split news to sell into. Don’t be one of those guys selling the hole and buying the rips. And save some ammo for when we break to new highs!