The past couple of months have been tough on the hedge funds. As a group, they were much too long the high flying momentum stocks. When the turn came in these names, the exit door was not nearly big enough. The selling started to snowball and before you knew it, stocks like Twitter and LinkedIn were almost cut in half.
The losses from this sector caused many hedge funds to curtail risk. Since these guys use so much leverage, any loss forces them to cut back on risk quickly. This selling caused a general decline in risk assets. Again, that selling attracted more selling, and it appeared that stocks might roll over into full fledged correction mode.
All the while, the combination of the continuation of the tapering of QE3 along with the terrible winter weather, gave lots of excuses for market players to be pessimistic about the future outlook.
When you add in the fact that seasonality entered a typically bearish period for the stock market, there is very little positive news to hang your hat on.
Yet, stocks are busting to new highs.
Let me take that back. Quality large cap stocks are busting out to new highs.
Have a look at the 5 year chart of the S&P 500 versus the Russell 2000 small cap index:
S&P 500 (white line) vs RTY (yellow line)</a> </div></p>
I have argued that our current environment consists of a series of rolling mini-bubbles. A particular asset or sector captures the investing public’s imagination and given the insane monetary policy, a bubble is quickly formed. However the lack of retail investors makes the bubble shorter in time frame than other bubbles like the 1990s dot com bubble.
I recently stumbled upon this terrific BofA Merrill Lynch chart that shows the increase in assets under management for various assets since the start of 2008:
Although the recent social media frenzy is not listed in the chart above, it also followed a similar pattern. The market becomes enamoured with a theme and inevitably overdoes it on the upside.
Now don’t get me wrong – I misjudged the recent stock market correction. The rout in high flying names definitely felt like the start of something bigger. It was easy to imagine it spreading to the other sectors of the market. But it didn’t. And the large cap quality stocks have actually completely shrugged it off and jumped to new highs.
Since 2008 the end of the other mini-bubbles didn’t stop the general reflation of risk assets, so I am beginning to think that neither will the popping of the high flying momentum stock bubble.
One of my main theories is that nothing will dramatically change until the bond market decides to take away the punch bowl. The Federal Reserve and other Central Banks don’t have the political will to usher in a deflationary slowdown. There is simply too many people with too much debt. Therefore the trend of ever increasing monetary stimulus to counter economic slowdowns will only increase until finally one day the bond market revolts. I am willing to bob and weave in my trading book while this theme plays out, but I steadfastly stick to the belief that no Central Bank will be able to withstand a deflationary collapse. Without such a collapse, our hugely over indebted economy can only reset one other way – by inflating.
I had taken a short position in the US stock market as I felt that the seasonal tendency for May to September to be weak along with the general inflated level of stocks offered a compelling risk reward to the downside. But I also touched on the fact that although the Federal Reserve was on tapering autopilot, the other three major economies needed to take the stimulus baton and run with it. Without them expanding, the markets were going to roll over.
However, it looks like two of them have picked up the baton and it is only a matter of time before the third does as well.
Yesterday I covered all my short stock market positions and replaced it with a long put position. I try not to be easily embarrassed as the key to survival in trading is to remain flexible (although I was a little embarrassed when Mrs. Macro Tourist insisted I dress up as a Centaur and take some family photos).
MacroTourist and this family</a> </div>
As Keynes noted, if the facts change, then you should also change.
So what happened to make me tone down the short stock market trade?
I felt that the ECB was the least likely of the three other Central Banks to put their foot down on the accelerator. As usual, the market gods decided to make my call look as foolish as possible. At the recent ECB press conference Draghi indicated that the ECB was ready to act if conditions warranted. I still think that the ECB will drag their heels and do too little too late, but right now the market has decided to err on assuming that it will be enough. We are in the process of pricing in a European QE program. Even the Germans are giving signals that they are comfortable with an ECB ease. I have decided to completely abandon my short European stock market trade as this repricing works its way through the system. At some point I will re-enter it, but I am heading to the sidelines for now.
The second country that seems to be getting ready for acceleration is China. Although the Chinese leaders continue to say that there will be no grand stimulus package, the market has recently taken the other capital reforms as good news.
From Dow Jones:
Copper prices jumped to the highest level in two months Monday after China unveiled a blueprint for reforming its capital markets, a move that investors hope will spark economic growth for the world’s largest consumer of the industrial metal.
I have been fortunate to have switched some of my precious metal position into copper as I felt that the market was overly pessimistic about China.
Yesterday copper broke out to two month highs:
Copper trading</a> </div>
When it comes to China it is more important to watch what is happening in the markets as opposed to what they say. Chinese officials do not telegraph their moves, but instead just enact them. The prices will move first, the reason will come later. The fact that the markets associated with Chinese growth are looking for excuses to head higher is an indication that the Chinese authorities are loosening up.
Which leaves us with Japan. Although they have not yet blinked, it is only a matter of time before they do so. The economic news continues to be grim. Some market pundits will say that the failure of Abeconomics to create growth will be reason it should be abandoned. There is very little chance that this will happen. The Japanese are going to double down on their policies – not abandon them. I expect to see the announcement before the start of the summer.
Therefore we will very soon have a situation where the other three major economies will be taking over the roll of liquidity provider from the Fed. It will be a mistake to focus solely on the Fed. The end of QE3 might not be nearly as ominous as many market participants worry.
I am no longer going to fight the rising stock market. I thought that the weak seasonal tendency and the lack of action from the other three major world economies was enough to send it lower. But the sell in May and go away is by no means an original trade. And now with the other two countries showing signs of expanding, there is no real edge.
I am going to keep a long S&P 500 put position though. Yesterday the VIX ticked at below 12.
VIX Index</a> </div>
Protection is super cheap. Given that I am long lots of risk assets, I need to have some shorts. I decided to buy September and December ATM (at the money puts) as a hedge. It is not as much a directional bet as simply cheap insurance.
I am quickly running out of time, but the last thing I want to highlight is yesterday’s trading action. Over the past couple of months, I had been celebrating the return of some decent intraday moves – both up and down.
However yesterday the old frustrating pattern of a quick move higher followed by a steady grind even higher returned.
S&P 500 trading yesterday</a> </div>
It was the first day in a long while that we didn’t roll over after the move higher. Something changed yesterday.
I am no longer going to fight the rise… for you shorts that have been waiting for the all clear sign to increase your position – there it is!