Why I Am Flipping To The Short Side

Followers of my twitter account (@JulianMarchese) would know by now that I have switched from the long side in stocks, gold, bonds, and euros, to being short stocks, oil, and euros. My initial long positions were essentially based on the expectations of further central bank easing/accommodation, and the expected move did come to fruition, at least in gold, euros, and bonds. However I began to notice a structural shift in the financial markets, as expressed in my latest Seeking Alpha article here. I noticed how central bank easing trades in stocks were unwinding, and the newly freed capital was being put into more depressed markets. This shows a slight loss in confidence of market participants, as they were less comfortable in holding stocks, or in other words, the first sign of a major market shift (and now as I write this, the dow is down 125).

Tomorrow Federal Reserve Chairman, Ben Bernanke, will speak at Jackson Hole regarding the topic of potential further quantitative easing by the U.S. central bank. The question we must ask ourselves at this point, is a new QE appropriate at this point in time? To me, the answer is no, and I do not believe that the market will buy into more promises by the Fed.

-S&P 500 near new 4 year highs.

-Oil near $100 a barrel.

-Strength in the United States job market and housing market returning.

With these current factors (and more), I do not see the Federal Reserve launching, or rather announcing a new program tomorrow…it just wouldn’t make sense. We would need to see a larger stock market decline due to a waning global economy in order to justify another QE.

I believe that lingering problems in Europe will be the main contributor to the stock market decline I expect to see later this year. The problem that certain southern European countries face is simply irreversible. You cannot fix a structural issue with bailouts. Europe at this point needs to accept the hard times ahead and focus on growth from the bottom up. However this view is not popular with the political environment in Europe and so inevitable resurgences will occur.

Trading Notes for August 29th

Below is an example of note-taking I do every day to get a sense of what is going on around the world. It is extremely important to condense as much information as possible especially with the huge amount of information exchanging hands every day.

Economic Data Releases

 

Technical Notes:

-Market correlations continue to break down as stocks try to rise with the dollar along with oil and metals falling.

-Bonds are lower along with stocks.

Economic Notes:

United States

– Gross domestic product climbed at a 1.7 percent annual rate from April through June, up from an initial estimate of 1.5 percent, revised Commerce Department figures showed today in Washington. The figure followed a 2 percent first-quarter pace and matched the median estimate in a Bloomberg survey. The revised data also showed companies invested in new equipment at the weakest pace in almost three years.

– The index of pending home resales climbed 2.4 percent, exceeding the 1 percent gain median forecast of 39 economists surveyed by Bloomberg News, figures from the National Association of Realtors showed. The gauge rose to 101.7, the highest since April 2010. HOUSING RECOVERY

– Consumer spending, about 70 percent of the economy, climbed at a 1.7 percent annual rate, the weakest in a year and revised from a 1.5 percent initial estimate. Purchases added 1.2 percentage points to growth.

– Wages and salaries in the second quarter rose by $56.1 billion, less than the $56.4 billion initially reported. That compares with a revised $133.5 billion first-quarter gain that was bigger than the previous estimate of $123.3 billion.

– At the same time, consumers’ purchasing power eased, with disposable income adjusted for inflation rising 3.1 percent from April through June after a 3.7 percent gain in the first quarter. The saving rate in that period climbed to 4 percent from 3.6 percent in January through March.

– The revision reflected the biggest gain in spending on services since the fourth quarter of 2006. The largest contributor came from more spending on electricity and gas as temperatures across the country approached record highs.

– On the business side, today’s report offered a first look at corporate profits. Before-tax earnings rose at a 0.5 percent rate, after falling 2.7 percent in the prior period. They climbed 6.1 percent from the same time last year.

– Investment by businesses slowed last quarter. Corporate spending on equipment and software rose at a 4.7 percent pace, the weakest since the third quarter of 2009. The second-quarter pace was less than the previously estimated 7.2 percent rate and compared with a 5.4 percent increase in the previous quarter.

– International trade held up in the second quarter, indicating weaker global growth had yet to slow demand for goods produced in the U.S. Net exports, which initially subtracted from growth, contributed 0.32 percentage points to GDP, the revision showed.

–Bernanke may shed light on monetary policy in a speech to central bankers on Aug. 31 in Jackson Hole, Wyoming. The U.S. economy expanded more than previously estimated in the second quarter, reflecting an improvement in the trade deficit and a pickup in household spending on utilities. Americans signed more contracts to purchase previously owned homes in July, a sign housing will keep strengthening in the second half.

– Trucking companies are failing to show the kind of growth typical of an expanding U.S. economy, according to Christian Wetherbee, a Citigroup Inc. analyst.

Europe

–Italy’s credit is as good as it has been in three months, according to a decline in 10-year bond yields. Short-term rates have fallen too. Monti’s Treasury sold six-month bills today at the lowest rate since March. “Monti’s arguments have more force when yields are spiking in spite of the fact that his government has implemented a number of credible reforms,” said Mujtaba Rahman, an analyst at Eurasia Group in New York. “It is at this moment when his argument carries more thrust with the Germans.”

– Monti said he may request bond buying to bring down funding costs, while seeking to limit any conditions the European Union would try to impose.

-The pressure on Monti has eased since July thanks to pledges of support for future EU bond-buying efforts from Draghi and the German government’s diminishing opposition to bond- market intervention by the central bank.

-Italy sold 181-day bills at 1.585 percent today, down from 2.454 percent at the last sale of similar-maturity debt on July 27. Investors bid 1.69 times the amount of bills offered, up from 1.61 times last month. Italy sold 3 billion euros of zero-coupon 2014 debt yesterday to yield 3.064 percent, down from 4.86 percent at the previous auction on July 26, as investors bid for 1.95 times the amount offered, compared with 1.78 times last month.

-INVESTORS FEEL COMFORTABLE SPECULATING IN SHORT-TERM ITALIAN DEBT

-The ECB may use its funds to lower yields if Italy and Spain request such aid, Draghi has said. The central banker is expected to give details of the bond-buying plan and possibly lay out what type of conditions the ECB would demand in return when the GOVERNING COUNCIL MEETS ON SEPT. 6.

-Still, Bundesbank President Jens Weidmann this week reiterated his opposition to ECB bond buying, saying in an interview with Der Spiegel that it “can become addictive like a drug.”

–Bringing down funding costs is critical for Italy, which has a debt of almost 2 trillion euros ($2.5 trillion), the euro- region’s second biggest in nominal terms after Germany.

– Today’s 9 billion-euro auction of six-month bills precedes the sale of as much as 7.5 billion euros of five and 10-year bonds tomorrow.

– Merkel was persuaded at a June 28-29 meeting of euro-area leaders to allow Monti’s push to grant the region’s bailout funds more flexibility in coming to the aid of nations like Spain and Italy, who are bringing down their deficits and still facing high financing costs.

Support for Merkel has been increasing in Germany as European leaders prepare for what the chancellor called a “decisive phase” in their crisis fighting efforts.

– German Chancellor Angela Merkel said Thursday she is confident that Italy’s reform drive will help push down the country’s borrowing costs, but underlined her resistance to another idea that could drive them lower — giving the region’s permanent rescue fund a banking license.

– Parties in Greece’s coalition government have reached broad agreement on a major new austerity package demanded by the country’s creditors but are still negotiating over the fine print, the country’s finance minister said Wednesday. Yannis Stournaras said officials from the three parties in the conservative-led coalition would hold further talks to settle remaining “technical” issues.

The Short-Term Gameplan

For anyone following my twitter (@JulianMarchese) you would notice that I am currently long risk assets, through a bullish stance on equity and the euro. I am also long gold and bonds for very similar reasons. The reason I have such positions is simple… expectations for Federal Reserve & ECB liquidity injections. At the very same time, I hold the opinion, along with many others, that the Federal Reserve will not launch a QE3 in the short term for a multitude of reasons (U.S. economy is still doing quite well, stocks are at highs, oil running up, etc.). Although it is unlikely that the Federal Reserve with launch another program the September, it most certainly does not suggest that we will not see a QE3 over the next year. I think the reason for the recent rally is simply the fact that market participants and investors are familiar and used to the Central Bank Put, and have decided that they might as well purchase stocks now rather than later. Also many market speculators are on the other side of my trade, thus fuelling the short covering rally that made up a large part of this rally.

I will continue to hold a bullish stance on equity and a bearish dollar view until September when volume and trading activity returns to the market place. At that point in time I will re-evaluate my positions and decide what opportunities present the best probability and reward to risk.

Market Correlations Outta Wack?

As I write this article, U.S. equities (S&P 500) are down sharply from overnight highs, off 15-20 or so handles, while oil is up on the day, the euro is strong, and gold is higher. What is the deal with this action? In the past we have definitely seen shifts in market correlations, and in most circumstance these shifts bring a large general market movement in the markets affected. In this case, one of two things need to occur for this situation to rectify itself. These 2 solutions are:

1. Stocks need to rally to catch up and properly express what the U.S. dollar is pricing in easing.

2. Currency markets and commodities need to reverse to express what equity market participants are perceiving.

At this point I think the first solution is going to occur, and so I am still holding my long position in U.S. equities. The reason for this is because I believe the major selling we saw was basically profit taking from the huge rally we have seen this summer. Investors and traders are basically booking profits after the FED released its minutes yesterday. I am also starting to notice some bearish sentiment on twitter, even though we have hardly seen a move with much conviction to the downside. At this point I continue to expect higher prices in the euro/usd, gold, equities, and bonds. The long equity and bond trade continues to work nicely.

FOMC Meeting Minutes Today; What I Am Expecting

Nothing. 

In my opinion, along with many others, I believe that any action or hints to action by the Federal Reserve is quite unlikely at this point. The recent rise in risk markets, including U.S. equities to new highs, will most likely limit the U.S. central bank from doing anything meaningful, except continue repeating previously mentioned subjects. Over the past month or so, we have also seen a “strengthening” United States economy, with a better job picture, housing market, and retail sales. This recent strength most likely does not warrant any further action by the Federal Reserve through a program such as QE3 at this point.

Currently it does appear that risk markets may have actually priced in further Fed action with the recent price movement higher we have seen. If this is the case, I would not be surprised if we do move lower on the Fed minutes. In my opinion, a move lower on the Fed reaction would be a buying opportunity, as I still strongly believe that risk markets will continue to rise in this low volume environment until September, as more European and political news surfaces.

Stocks & Bonds: A Great Macro Trade?

The above chart shows us what would be our return if we purchased the S&P 500 ETF (SPY) proxy, and an equal amount of 20+ year maturity treasury ETF (TLT) proxy shares after the major stock market correction in 2011 (August). Holding these two positions would have yielded us roughly 40% solely from price appreciation, with dividends adding another 4% or so.

There is no question that there is a short-term inverse relationship between stocks and bonds… risk-on speculative positions are usually expressed through purchasing stocks and other risky assets, while simultaneously selling safe havens such as treasuries. However, in the longer run this does not have to be the case… there are certainly instances where stocks and bonds can fall and rally together over a certain period of time, and this has been the case for the past couple of years. Purchasing stocks on the lows on 2009 and holding to present would have returned us 100% through price appreciation, while during the same, bonds would have returned us 25%.

Why is this Occurring?

The reason for this longer-term rally in both stocks and bonds has been documented by myself in the past. Let’s explain each market separately. Money continues to flow into the treasury markets for basically three major reasons:

1. Global economic pressures force investors to flee into safer, low-yielding assets.

2. Financial institutions are eating supply as the gap between deposits and lending widens.

3. The Federal Reserve continues to support the treasury market to lower yields and promote risk-taking.

The continued flight to stocks on the other hand is supported by similar reasons:

1. Global economic pressures, specifically in Europe and Asia, force investors to look for risk in safer geographic locations, with the United States being the preferred choice.

2. Low yielding safe haven assets force investors to search for yield in the U.S. stock market.

3. The Federal Reserve continues to provide liquidity to the economy and promotes risk-taking in stocks, further providing confidence and increasing demand in stocks.

These reasons explain clearly and in a simplified fashion for why purchasing stocks and bonds together seems to be a great macro trade. Investors simply are forced to invest in U.S. bonds and stocks, and this relationship should continue in the near future. At the time of this writing, I am bullish both stocks and bonds.

Capital Flight In The Eurozone

The last couple of trading weeks have brought subdued movement and a slow grind higher in U.S. equity, commodities, and a sell of in quality through the treasury market. Central Bank confidence has kept investor fears to a minimum as the S&P 500 is less than 1% away from a 4 year high. European banks have also seen a massive rally over the past couple of days. Everything seems to be quite fine!

This market phenomena (central bank confidence rallies) can continue on for potentially weeks to even months, even with significant downside risks outside of the United States (can we say “Europe”). However the structural flaws of the Eurozone and the major threshold stress levels that have been passed should be obvious that Europe’s problem is far from over.

The Structural Flaw of Europe

It should be obvious that the major problem with Europe is that it was built as a monetary union, but without a fiscal union and banking union. By not having a fiscal union, it takes much more time to make important decisions, usually when it is too late. However the real plague is having a monetary union without a banking union. Why?

It is quite simple really, when worsening Eurozone countries such as Greece, Spain, & Italy begin / are experiencing capital flights, deposits are immediately exported out of the country in trouble, into stronger Eurozone countries. This capital flight essentially does not devalue the currency as deposits are NOT transferred into another currency. In a real capital flight from a country with their own currency, the selling of that currency would devalue the currency, and thus in the end make the country more competitive and attractive for investment. This does not occur in the Eurozone as banking systems are separate per country along with the monetary union.

In other words, Europe’s problems aren’t going anywhere. Although we will probably see a rally in risk in the coming weeks due to capital coming out of quality, central bank support, and low volume trade, be sure to be nimble for the reversal should come!

Reward to Risk in the Stock Market Today

As I have expressed countless times on my blog, youtube, and twitter, a huge portion of my trading strategies derive from one simple concept. Probabilities. Whenever you enter a position, whether it be a long term investment, or a very short term speculative activity, you are subject to simply random chance and probabilities. So with this realization, as successful market participants, our goal should be to put the probabilities in our favour. How do we accomplish this? The best way to do so in my opinion is by initiating positions with favourable reward to risk ratios. Essentially, whenever we make a trade or investment, we need to make sure that what we stand to lose is less than what we can potentially make from the position. Consider this: if we were to take only trades that are accompanied with a 4:1 reward to risk ratio (we risk $1 to make $4), we can be wrong 70% of the time on market direction, and still make money in the end. Observe some of the greats in the financial management/hedge fund industry. You will notice that this simple concept is present in their successes.

Utilizing this Concept in the Market Today

Currently, the stock market has seen what would be called a “volatility crush”. A volatility crush is when a market’s volatility basically contracts significantly in a very short amount of time. Large contractions in volatility usually come before a large volatility expansion, typically caused by some outside shock to the financial marketplace. The beautiful  aspect of a volatility contraction is that when we take a position in the “crush” environment, we know very quickly when we are wrong (the market will move very powerfully out of these ranges). This allows us to have a smaller stop, long or short, with a larger reward.

At this point in time, it is safe to say that the stock market has effectively priced in global central bank accommodation to risk-markets, as expressed by the recent rise in stock prices and volatility contraction (indicating market participants feel “safe”). Due to this “pricing-in” of global events, with a bias to the upside, an external shock to the downside would most likely cause a much larger move lower as the majority of the market is long at this point (traders who are long will need to liquidate). With this in mind, we can assume that a move lower will see more movement, and more potential.

Based upon this information, the better reward to risk trade in my opinion right now is to be short equities, and long volatility. Have a different opinion or would like to add to the discussion? Comment below!

Market Dissapointed

Once again, Federal Reserve Chairman, Ben Bernanke, has disappointed the market by offering no hint of QE3 (stock market crack), and stocks so far as of writing this (10:15EST) are selling off as a result. The chairman did mention however that the Fed is prepared to act as appropriate. But is this enough for the short-run? I don’t think so…

Market Theme

The U.S. equity market constantly has a long side bias and skew as the Bernanke put remains in place. Everyone knows that whenever the market starts selling off hard, or the economy begins to slow down or contract, (which the U.S. economy is starting to do) the federal reserve will be prepared to bring confidence and support the market, whether it be through QE or Operation Twist extensions. Other risk markets such as commodities and currencies, are not as directly affected, and so they seem to be the better shorts at this point in time.

U.S. Economy Discoveries

Yesterday’s retail sales number were horrible, coming in at -0.5% MoM, lower than the most bearish forecast. Many banks and institutions are revising their GDP expectations lower, and the U.S. manufacturing sector continues to contract. The job picture remains bleak as less and less jobs continue to be added for the past few months. Should this continue, the fed will have to act at some point.

Bottom Line

With no support from the fed in the short-term, I expect the dollar to continue rising, sending risk markets lower. However if the economy continues to slow around the world, specifically in the U.S., I would be looking to buy stock 10%+ lower with the Fed’s back.

Market Theme Discussion! Market Update for July 16th 2012!