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!

Market Update & Current Positions for August 16th 2012; Julian Marchese @JulianMarchese

The difference between gr…

The difference between great people and others is largely a habit— a controlled habit of doing every task better, faster and more efficiently.

-William Danforth

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!

When the market is moving…

When the market is moving and money is flying, it’s easy to forget that it’s the basic that ultimately produce success.Even after trading everything from exotic over-the-counter options to plain vanilla Dow stocks, I still need to constantly and obsessively evaluate every single trade, every single day.

-Jonathan Hoening

There is no place in the …

There is no place in the modern world for the unskilled; no one can hope for any genuine success who fails to give himself the most complete special education. The trained man has all the advantages on his side; the untrained man invites all the tragic possibilities of failure.

-Richard D. Wyckoff

I will not allow yesterda…

I will not allow yesterday’s success to lull me into today’s complacency, for this is the greatest foundation of failure.

-Og Mandino

 

“There is nothing new o…

“There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion that always gets in the way of human intelligence.
Of this I am sure.”

-Jesse Livermore

I learned to avoid trying…

I learned to avoid trying to catch up or double up to recoup losses. I also learned that a certain amount of loss will affect your judgment, so you have to put some time between that loss and the next trade.

-Richard Dennis