I am not afraid of looking like an idiot. I look like an idiot all the time.
Macrotourist family portrait</a> </div>
(I was a little disappointed that this family portrait didn’t capture our family’s essence, but I am not that upset about looking like an idiot.)
So as I make the following prediction, I realize that I am making it when most people are going to think I am an idiot. But I am not scared…
I believe that the time has come to get aggressively short the stock market.
I have been negative for quite some time, taking stabs on the short side, but not fighting the rising tide for too long. I have been lucky enough to have been neutral on this latest move higher, but I think the time to remain on the sidelines is over.
I recognize that from a technical point of view stocks have broken to new highs and that only idiots short new highs.
S&P 500 – breaking to new highs</a> </div>
However, don’t forget – I am not afraid of being an idiot.
The S&P 500 is breaking to new highs, yet most other indexes are still struggling to regain the highs made earlier in the year.
The Nasdaq still hasn’t broken out:
Nasdaq 100 – no new highs yet</a> </div></p>
The smaller cap Russell 2000 is nowhere near new highs:
Russell 2000 – no where new highs</a> </div>
So although large cap stocks are ticking at all time record highs, the rest of the market is not performing nearly as well.
Maybe it is foolish to fight the rise, but I would rather short into strength than to try climbing aboard a down bound train.
Everywhere I look signs of risk are piling up. Most professionals recognize the danger signs, but have given up fighting the tidal wave of money flowing into the stock market.
We have reached a point of extreme complacency regarding the recent rise.
One of the most peculiar things about financial markets is that the demand curve for an asset is positively influenced by upward price action. Price rises often increase the demand for an asset instead of the more logical decrease in demand at the higher price. Therefore as traders, you need to be constantly on the lookout for this self reinforcing feedback loop. However, blindly climbing aboard this feedback mechanism is a recipe for disaster. Eventually the positive feedback loop fails as prices reach levels that long term sellers overwhelm any extra demand from the positive price action. At that point, the selling is made all the more severe because of the short term longs that were only buying it because it was going up.
We are currently in an environment where the positive feedback loop is pushing prices higher. Traders that have attempted to short the rise have been frustrated by the seemingly unrelenting monster bid to the market. In my opinion most traders are either long (and feeling a little too smug), or they shorted into last month’s hole and are in the process of covering into this surprising strength. (ignore all the perma bears or perma bulls whose opinion never changes)
There are precious few traders that aren’t already short that are suggesting that this rally is the point to strap on the short risk.
This is why I think the time has come…
Trading isn’t easy – if it was, everyone would do it. Most often the best trade is the hard trade. And for me, that is why this breakout is time to strap on the short risk. Outside the perma bears, I feel like I am all alone in calling this a great spot to short.
Most of the guys who would usually be with me have already sold.
I am not just shorting because I don’t see anyone else writing any pink tickets (although that is certainly a big part), but also because the action in the other asset classes are screaming caution.
The yields on bonds are plunging lower. At the beginning of a usual market cycle, declining bond yields are a positive for the stock market. However, this is far from a usual market cycle. The recent declining bond yields are signalling that deflation has re-emerged as a real concern.
S&P 500 (yellow line) vs US 10 Year Yield (white line)</a> </div>
You might argue that given the distortions caused by the Fed’s QE programs that this is not a fair comparison. I don’t buy that, but I will go along for a bit.
How about the shape of the curve then? Although I will concede that the old yardstick about an inverted yield curve being the best signal for an imminent recession is now as relevant as 5 disc CD changers, I still believe that the direction of the slope of the curve is a very useful clue.
The curve has been collapsing for the last 5 months:
US 2/10 spread (white line) and US 5/30 spread (yellow line)</a> </div>
I understand the argument that bonds are rallying because of the repricing of confidence in the Fed’s forward guidance. But at the end of the day, if the bond market was confident of future growth the curve would be steepening. It isn’t. The bond market is screaming caution.
Many market participants dismiss gold as an ancient relic that does not really help in forecasting macro trends. I don’t buy that. Although I admit that gold moves on some unique factors, I think that at the end of the day it is a financial asset that helps understand the global liquidity situation.
Gold staged a big rally after the 2013 year end puke. It went from sub $1200 to almost $1400. However, since then it has slumped back down to $1250.
Gold trading</a> </div>
Although many traders will look at the gold market and claim that it doesn’t offer any predictive value, I think the recent slump is another danger sign.
The last month has been an unusually difficult one. Many macro funds are getting tagged. The market moves seem to be making less and less sense. I have long argued that the preponderance of hedge funds makes the situation all the more difficult. Combine that with Central Banks’ increasing domination of financial markets, you are participating in a game that is increasingly difficult to understand.
But this is all the more reason why you need to take the loneliest trade.
I feel like I could go on and on about all the different worries that are creeping into my consciousness. But they have been there for a while, so the question is; why short now? What makes this the point where you should be strapping on the short risk?
I can best describe it by explaining that;
- I was expecting the economy to enter into a self reinforcing economic recovery.
- This was going to make the taper a non-event.
- The mistake was going to be that the Fed did not raise rates fast enough and inflation takes off.
But I would say that this forecast is looking increasingly wrong.
Even though I had hoped for the economic recovery to become self reinforcing, the action in the bond market is suggesting otherwise. The action surrounding the taper is looking more and more like the end of previous QE programs. Although everyone thinks that QE programs are bond bullish, I continue to argue just the opposite. But I do agree that QE programs are universally bullish for stocks.
S&P 500 (white line) vs Fed’s Balance Sheet (yellow line)</a> </div>
As the Fed continues to taper, the stock market is going to struggle. This is especially true if the bond market is rallying due to deflation concerns.
Absent an ever increasingly accommodative Fed, financial risk assets are going to sag. I had hoped otherwise, but the warning signs are piling up that this is the case.
Six months ago there was significant doubt about the Fed’s resolve to taper. I argued that the Fed was going to taper until something breaks. I had hoped nothing was going to break, but the signs are piling up that the Fed’s withdrawal of liquidity is going to cause a problem.
I haven’t even touched on the problems that might arise if the ECB disappoints or the Japanese carry trade comes unhinged. These are just more nagging worries that make me all the more bearish.
Although the stock market price action is not yet confirming my bearishness, I am going to take the unusual view that higher prices are more attractive to sell than lower prices. Given the crazy low implied volatilities in the option market, I see no reason to short outright delta as buying puts is so cheap.
I am buying a variety of long dated puts in the S&P at various strikes that will establish a sizeable short position. I am also trimming some of my long stock positions. I am about as bearish as you can reasonably be in the face of a rising market. It is important to be aware that the trend can continue longer than you ever imagine, but at the same time, trading is never easy. By definition, the best trades you are going to be all alone. At a certain point, you just need to pull the trigger and go for it…
As the hockey great Wayne Gretzky said, “you miss 100% of the shots you don’t take.” I am taking a shot on the dark side with an aggressive long put positon.
Gold continues to get hammered
Gold continues to get hammered like a red headed step child. I had promised a write up on my theory on why gold is going down, but then I pulled the trigger on my big short stock position, so I felt that post was more important.
I will follow up tomorrow with more on gold, but I will leave you with a chart of the gold/stock ratio. Something to think about…
Gold/S&P 500 ratio</a> </div>