Way back when in a former life, I knew this great fellow who was the head floor trader for our firm. He was fond of a saying I still remind myself of today:
“Slay your dragons while they are small…”
As I was writing yesterday’s post, I realized I was much more bearish on fixed income than I was on equities. Do I think stocks are overbought and might go down? Sure. But there is still a ton of bearishness out there. I could just as easily see stocks explode to the upside.
Yet I do not feel this same ambivalence towards the fixed income market. Although anything can happen, I am much more confident that bonds are headed lower rather than stocks. I have always said the next big crisis will occur when the bond market finally takes away the keys, so why am I trying to trade the second derivative?
The short side of the stock market sure seems tempting, but in some ways, that is the “easy trade.” In the current environment, few pundits will make fun of you for preaching caution, or even recommending going short.
Dave Lutz from Jones Trading summed it up perfectly in a recent note:
Every Technical Analyst is negative on the market. They all hate the rally – 95% of the street needs a pullback to try and get above waterline for the year. The “Pain Trade” is due north…
Could all those technicians looking for a roll over be correct? Yup, you betcha. The stock market is so far away from fundamental value, there are few “real” bids below. But when so many investors are looking for the same outcome, it rarely happens.
I think there are much easier trades out there. I covered my short stock punt from the other day, and will let others try to top tick this rally. My dragon was still small enough that it was relatively easy…
Think back to January. At that time the Federal Reserve was stubbornly leaning massively hawkish. This was causing an inordinate amount of US dollar strength, which translated into a vicious deflationary self reinforcing loop. The Federal Reserve’s hawkish policies caused credit to be destroyed, which forced the US dollar even higher, which then caused commodities and other US dollar denominated assets to fall in price, which created even more economic and financial stress, which only caused the cycle to accelerate.
At the time I argued all of the pain was self inflicted by the Federal Reserve. All they needed to do was ease up on the overly hawkish policy and let it breathe. But they took too long. In the process they created an overwhelming change in investors’ mindsets. Have a look at this article from the Telegraph. Note the date:
Investors became convinced deflation was about to take hold. I think allowing psychology to ever reach that point was absurdly stupid on the Federal Reserve’s part. It created an abnormally large reaction by other Central Banks as they tried to compensate for the US dollar liquidity withdrawal. The global economy didn’t need negative rates in Europe and Japan. What was needed was more US dollar liquidity. Yet because the Fed was so blind to this need, too many other Central Banks put the monetary pedal down way too hard.
In some instances, these desperate actions backfired. The BoJ’s move to negative rates definitely created more harm than good. But there can be no denying that there has been an extraordinary amount of monetary stimulus thrown onto the global economic bonfire.
Once the Fed finally eased up on the hawkish tightening, the vicious circle was broken. So now we have a situation where all this extra liquidity is making its way through the system, and the Federal Reserve is no longer offsetting it through an overly aggressive tightening bias.
The Fed was holding down the brake, so everyone else slammed on the gas. For a while we weren’t going anywhere, but now that the Fed has pulled off the brake, we are flying forward. Instead of just gently guiding the economy forward, the Fed has created a much more vicious stop / jump forward situation.
Yet most investors are still convinced the Fed will be back with the brake pedal:
This deflationary mindset is still all too prevalent with investors. They are hiding in fixed income with severe underweights in risk assets. Last year the Fed was worried about speculative bubbles. Well, they don’t need to worry about that any longer. The only bubbles are amongst their other Central Bankers’ balance sheets. Investors are amazingly pessimistic about everything except long duration safe sovereign bonds. Too many listened to RBS’ “sell everything” call. They have barely started to get back in.
I still think shorting German/Japanese/US fixed income is the best risk reward trade out there. Too many investors are hiding in these absurdly priced assets.
Earlier I said that shorting stocks was the “easy trade” and those rarely worked. Well, I think shorting bonds is the “hard trade.” No one thinks bonds will ever go down again… Not me, I think they will be the worse performing asset for many years to come…
Thanks for reading,