Too many market pundits gloss over their mistakes, or even worse, pretend they never made the call in the first place. Although I trade in and out against my longer term view, I don’t want my daily letter to be a market timing service. It is too difficult to articulate short term trading in a once a day journal entry. Instead my goal is to hopefully give you something to think about, and to share my mistakes as I attempt to navigate this crazy market environment.
Keeping in that spirit, I have to come clean that I was not setup for yesterday’s face ripping rally. Although there were some shrewd traders that saw the buying wave building (RBC’s US head of equities Charlie McElligott, who appears on ZeroHedge from time to time, made a terrific call last week getting bullish), it is now obvious too many investors were either underinvested or full out short.
The real question is whether something fundamental changed which will bring about a resumption of the bull market, or whether this was merely a short covering rally.
Sticking to my view
For now, I am sticking to my view the status quo will cause lower risk asset prices. The global economy is being slowly starved of US dollar liquidity. Although the recent market disruption will most likely cause the FOMC to take a pass on hiking at the March meeting, Yellen & Co. seem to have a very different interest rate path in mind than market expectations (chart courtesy of Martin Enlund @enlundm at Nordea):
Until the indicators the Federal Reserve base their optimistic economic scenario upon roll over, or alternatively the FOMC changes their tune about nipping inflation in the bud and allow inflation to spike above 2%, then any sort of market stabilization will be met with a resumption of the overly hawkish policy from the Federal Reserve.
Risk asset rallies are almost self defeating. Rallies based on an easier Fed will only result in tighter policies.
How could I be wrong?
Although I think rallies should be sold, I have to always be aware of where I might be wrong. What keeps me up at night is the knowledge that someday, the velocity of money might stop declining, and might even increase.
Over the past decade as the velocity plummeted, the Federal Reserve was forced to engage in massive balance sheet expansion to offset the private sector contraction. Most investors now believe this decline in velocity is permanent. Some even believe demographics and other factors will cause velocity to fall even further.
This view is popular amongst the deflationistas. These investors believe deflation is inevitable and cannot be avoided.
I take a different tack. Absent government intervention, deflation is the natural state for the economy. But the Central Banks are desperate to stop this delevering. They have expanded the monetary base by absurd amounts.
Velocity is not some scientific variable that can be accurately forecasted. It is based on society’s desire to borrow money and spend. There are indeed trends which affect this desire, but at the end of the day, it is based on the whims of humans. Who knows what might trigger a change in attitude.
The only certainty is the fuel planted by the Central Banks is absolutely massive. If (and granted this is a big if), the velocity would tick higher, then the fire could be unprecedented.
At the back of my mind, this is what always scares me as a short seller. The potential for an explosion higher in all prices frightens the wits out of me. In this scenario I don’t think inflation will be limited to financial asset prices (as was the case from 2012-2015). All prices would scream higher, but stocks would most likely be dragged along.
This worry is why I own inflation breakevens. Recently they have traded right on top of equities, but I expect in an inflationary environment break evens blow stock returns out of the water.
Since I am short stocks, as long as breakevens are rallying as well, it doesn’t hurt too much. What would kill me is a return of a financial asset rally.
Obviously there is more to inflation expectations than just commodities, but this chart does a good job at showing the massive financial asset rally of 2013-15. Although one should never say never, I just don’t see this sort of outpeformance occurring again. We might get a reflation, but if we do, it won’t be solely good for only financial assets. In fact, I suspect the very opposite will occur.
I am still short US stocks, but I am making sure I have other longs that I believe will perform even better in the coming months. Inflation breakevens are just one. Emerging market equities have been left for dead and have just started to perk their head up. Long crude oil is another position that should rally more than equities (yes, I know choosing the instrument to play crude oil is difficult). And I have not even started about high yield debt. I own way too many busted bonds.
I would have preferred to have called this recent rally in US stocks, but I still believe there are a myriad of other better assets to own. Buying US stocks is a bet that the massive outperformance against almost all other asset classes over the past three years resumes. Maybe it does - after all Central Bank madness is at the heart of these crazy moves, so who I am to say it won’t get even more dumb? But I don’t want to chase US equities, and in fact, will continue to short into strength.
Until something changes, rallies are just short term positioning squeezes. Remember the most vicious rallies are found in bear markets…
One last thing
In what has become almost a daily occurrence, another large energy company used the improving tone in risk assets to issue a boat load of equity. Last night Weatherford International announced a public offering of 100 million shares. This was again done near the lows over the past two decades. The stock is down on the day, but the same can’t be said for Weatherford bonds:
I will leave you with my new slogan for energy company trading; no rush to buy the energy company equity, but tons of rush to buy their credit.
Thanks for reading,
PS: I received tons of great feedback/ideas about the USO outstanding share increase from yesterday’s article. I will follow up on the post tomorrow…