Markets in the Medium Term

This week was unusual for me in that I had three institutional investor friends come a-calling here in my sleepy little hamlet. Always great to see old friends who speak the same language. Lots of good discussion.

The upshot is that it forced me to distill my thoughts for the next six months or so. You will have already picked up on them in bits and pieces if you’ve been tracking @Behavioralmacro tweets closely over the past month or so. And I insert here the usual caveat that what I’m about to say could turn out to be totally and utterly wrong. But, all of us need a base case, so here’s what I boiled mine down to:

I call it the ascending triangle scenario.

The shock and pain of the January-February selloff forced everyone to take a deep breath and reassess the backdrop. We now need to wring out that extreme reading of euphoria, digest the rate hikes that we had been shrugging off, and recognize that growth is much more likely to have a run rate with a two and than a three handle. In short, market and growth expectations have to continue the process of coming off the January boil

In a sense, the shock created a mini disaster myopia dynamic. This process often plays out in an ascending triangle type pattern (if you can conceptualize one for growth expectations as well). And it resolves to the upside once the oscillations decline in magnitude, volatility dies down, and the January shock starts fading in our memories.

This is what an ascending triangle looks like:

 

We are entering the “bad” season for risk taking, many are licking their wounds from Q1’s volatility, and fundamental and technical consolidation referenced above needs time to play out.

The implication is while we can expect to return to the highs, it’s hard to imagine us getting anywhere meaningfully beyond them until this rough triangle plays out and risk appetite is replenished, which I’m guessing would likely be sometime this Fall.

To set up for this period, I added to discounted fixed income products to increase carry, taken the overall beta of the Investment book down, and increased in selected sectors like US home builders, which, in my view got hit too hard out of overdone fears of higher rates and higher wage inflation. I also like names that have a secular growth story–to the extent one can find them and get good entry points.

I have not changed my views on EM, but I do expect it to under-perform over much of this upcoming period. In part because its relative strength is no longer a surprise to anyone, and in part because any decent USD rally would shake out EM investors who came to the party late.

Hope this is helpful. Good luck.

The Three Books

I get asked often about what books I would recommend for getting a better handle on behavioral finance, markets, macro, pattern recognition, etc.

Back in 2012 I posted The Book List that covered a lot of ground–especially on the behavioral side. But I got asked again today, and I boiled it down to three books, one on behavior, one on central banking, and one on patterns and markets. This is where I recommend someone start.

Subscribers Only

Access all of BehavioralMacro's premium content and the private Twitter feed via Premo

Validate Twitter

Not a subscriber yet?

Subscribe

Powered by

Validation unsuccessful.

Please subscribe to access the premium content.

Here are the books:

On the behavioral side, Thinking Fast and Slow–help you realize the extent to which our judgements are thoroughly damaged by emotions/cognitive biases. If you haven’t been exposed to Daniel Kahneman, it will blow you away. You’ll understand how there is no way markets can be rational or efficient–not even in the aggregate.

On central banking, Angel Ubide’s Paradox of Risk really gets you into the heads of the major CBs in the crisis and past-crisis period. You don’t have to agree with all of his prescriptions for this book to help you get past cynical market myths and aphorisms to see how CBs really think about equities, inflation, moral hazard. It also has excellent color on the debates the major CBs had at critical points in time. Angel has spent enough time in both policy circles and markets to see the whole picture in way few do. (Sorry, Jim Grant.)

On patterns/markets, Stan Weinstein’s Secrets For Profiting in Bull and Bear Markets. Ignore the old and cheesy cover, it’s a great introduction to patterns and stock cycles. Yes, the world has changed since then, but basic building blocks of patterns and cyclical tendencies have not.

Happy reading!

Guesses as to where we are in this correction

We’ve sold off very sharply in a short period. Many investors—probably the majority—think this is mostly technical and the basic global fundamentals have not changed. This group will be buying this dip. Others are worried that so much stimulus on a fairly full-employment economy will lead to inflation the Fed will have to stamp out, and, more concretely, fear the January Average Hourly Earnings number triggered a broader market realization of this. This group sees maybe a bounce, but more trouble ahead now that global central bank normalization is unambiguously on.

Behaviorally, after such a long, strong run, the BTD crowd is the more likely to prevail. The muscle memory is fresh. Traders like successful retests. And the overall case for this selloff being predominately technical is pretty strong. I’d cuff 75% odds that Friday was the bottom of this correction. And if that’s the case, it’s almost a certainty that we’ll be shocked at how fast market sentiment toggles back to the bull case.

Obviously, if this is wrong, the next leg down would likely be panicky and painful once investors realize it wasn’t.

However, if Friday was indeed the local bottom, my guess is that we rally back to or near the previous market highs. And it would be in the run up to those previous highs where we start looking for divergences to gauge the strength of the bounce. At least, this is the road map I am running with unless/until thing change.

For divergences, you’d want to look primarily to market internals. Advance-decline lines, new highs vs new lows, momentum indicators, these are the kinds of things you want to track. Vol needs to work it’s way lower too.

If you want to add risk here and are in a position to do so, I would recommend, as a general guideline, the sectors and names that held up best in the correction, not the ones that sold off most. It’s counter-intuitive for many of us, but strength tends to beget strength—even if constitutionally some of us are hard wired to shop for ‘laggards and bargains’.

Whatever you do, make sure you get your sizing and your stops right to manage that risk. Good luck.

Update on Bitcoin $XBT $BTC

I wanted to follow up briefly on the bitcoin post from December. 

To me it still looks like a bearish pattern has to finish playing out.  Just going by the pattern–and bitcoin has been textbook both on the way up and on the way down–it looks like there’s at least one good down-leg left.

The reason bitcoin has adhered so well to textbook stock patterns is because there are no fundamentals and the emotions run very high. Basically it gives you an exceptionally clean read on sentiment.

If you’re short, though, remember to keep your size in check because in this last bounce alone it has been oscillating between 10 and 14k. Makes it really hard to hang onto if you’re carrying any size.

Here’s the chart:

Daily chart of XBT

Good luck.

 

 

The Euro: Just because it’s obvious doesn’t mean you should fade it

[signinlocker id=675]The two themes that have been lurking in the shadows in support of the euro are now strutting their colors. The first, is that the US is closer to the end of its hiking cycle than the beginning, while the ECB is just starting its normalization. The second is that in this phase of the global risk cycle when US valuations look full to many, investors tend to migrate out the spectrum from core to peripheral investments. This too has tended to favor a weaker dollar.

Last week the euro had a big break out. So did the yield on the 10-year bund. It’s not a coincidence. And just because we all see it doesn’t mean the odds will be in your favor if you fade it. I could be wrong, but this has all the hallmarks of a move that is fresh and could have legs. Probably not wise to try and fade–no matter how heavy the positioning–until you see price and correlation signs that the above narrative is weakening. In fact, the break is fresh enough, and vol levels are low enough (despite last week’s pop), that outright calls or call spreads probably still make sense. (NB: the low tick in euro vol in 2014 was just before the big euro move lower.)

Here are the charts:

Euro over the past year
Euro over the past five years
Ten year bund yield over the past five years
Euro 3m implied ATM vol over the past five years

But, on the other hand….spec euro positioning in futures is the most long its been in the past 10 years

CFTC Net non-commercial futures positions in the euro

Manage your risk. Good luck.[/signinlocker]

Tricks for Hanging On in a Melt Up

Human nature anchors on the high tick of mark-to-market gains. It’s virtually impossible not to. And this makes it excruciatingly hard to stay fully positioned during a melt up. Every intra-day dip, every tape bomb, every ominous indicator du jour begs us to lock in paper gains before they slip away.

Even if you are fully cognizant of this problem you can’t make this feeling disappear. But there are some modest tricks that can help you, at the margin, manage it:[signinlocker id=675]

1. Remind yourself every day that markets tend to go up over time, and that the greater sin in money management is overthinking your way to the sidelines and not being able to get back in, not getting caught in a vicious draw down.

2. Throw a virgin into the volcano. Take a smaller, less strategic position (we all have them in bull markets) and sacrifice it. It won’t be material to your performance, and will go a disproportionately long way towards stretching that itch.

3. Sell half of a strategic position, but commit to stopping yourself back in if it doesn’t come in and starts to get away from you. (See the recent post about $GM and $F.)  If you are tactically selling part of a strategic position, having a plan for getting back in that doesn’t require you nailing the call is as important as having stops.

4. If one of your large, strategic positions has had a particularly feverish run, sell short-tenor upside OTM calls against half of your position. Either current month or next month–any further out than that and you’re giving away too much upside in a name you like strategically. I am not a huge fan of selling OTM calls, but it is a less damaging way of, again, scratching that itch.

5. Plan for the draw down. Make a list of areas that you think would sell off first and hardest and track them for signs that their price action is weakening and/or their prevailing correlation matrix is changing. This usually comprises the areas that hot money has most recently flowed into as a result of the narrative–in today’s case ‘global reflation’. This list should always evolve with the narrative. Being prepared for the inevitable drawn down doesn’t guarantee you will be able to sidestep it, but it increases your odds and makes staying fully invested easier.[/signinlocker]

For some people all of this is just too hard. It certainly is not easy for me, and I’ve been doing this for a long time. If you find yourself chronically under-invested because of a macro hair trigger, maybe passive investing or systems-based trend following is a better approach. Discretionary trading–especially in macro–is not for everyone. It’s better to go with what works best for your forma mentis. There is certainly no shame in that.

Behavioral Autos: $F $GM

[signinlocker id=675]For the past few weeks interest in the big auto companies ($F, $GM) has picked up. The narrative is simple and, I believe, will persist.

1.  Global growth is good.

2. We are past the ‘peak auto’ obsession.

3. Natural FOMO favorites at this juncture. At 6-7 PEs and high dividend yields, it is one of the only sectors to offer both beta and some sense of value protection. For skeptics who have been light beta or ppl who have to buy because of inflows, this the downside protection provides enormous psychological comfort.

4. Free option on getting lucky with innovation. GM and F have shown signs of life on the innovation front. We don’t know how successful they will be, but we do know they are not priced for it. And some 2nd mouse is likely to get TSLA’s cheese.

Here are the charts:

Ford over the past five years
GM over the past five years

Ford is breaking out from a low base and looks poised to run. GM has already had a primary breakout and appears to be consolidating in preparation for a leg higher.

This is how you can play them if you are not already involved:

Ford over the past year
GM over the past year

Because short term both names–especially F–are a bit stretched, ideally you’d want to see a low volume pullback into the areas indicated by the red circles. The way a pullback happens in terms of both volume and pattern matter. You want the pattern to look like it’s quietly wedging back. But given the longer term patterns, the odds of a pullback into the red circles being a good one are pretty high. If they drift back into the red circles, you could buy a full position with stops on a close somewhere below the bottom of the consolidation structure in GM, and somewhere not too far below the breakout in F.

(NB: The distance of the stops from the entry point is important in considering the absolute size of the position.)

If, however, GM doesn’t pullback and starts to break out, you can still buy it but no more than a half position, and the stop would have to be higher, somewhere not too far below the breakout point from the consolidation pattern (eg ~43.5).

For Ford it would be a little bit harder to buy a continuation with no pullback because the natural stop is further away than is the case with GM and it doesn’t have a secondary consolidation pattern to emerge from. But in theory it could still be bought if it continues, just in much smaller size.[/signinlocker]

Good luck and happy driving.

Of Bubbles and Polls

[signinlocker id=675]On Friday I put out two bare-bones polls asking, yes or no, if there is a bubble in stocks and bonds. The results were more balanced (I expected more Noes in both) and more similar to each other (almost identical) than I thought would be the case.

[/signinlocker]

What’s up with the dollar and yields?

[signinlocker id=675]Up until recently, when yields when higher the dollar got bid. But this has now demonstrably changed: the broad dollar has been getting weaker in the face of rising USD rates.

My take is that the market is now confidently saying the Fed is going to find itself behind the curve, either by design or by accident. This is why this rally has much more of a reflationary feel to it when you look across sectors.

If you want to track the reflation trade, I think you can boil it down to these two charts:

Nominal 5 yr UST yield over the last 6 months
5 yr TIP (real) yield over the last 6 months

For the past 2-3 weeks US 5 year nominal yields climbed higher, while 5 year real yields fell (BEs of course, rose). This is a potentially important change in correlation.

Three investment inferences

1.  The dollar is responding to the real rate and not the nominal rate until further notice.

2.   The spread in real-to-nominal and the general price action are saying reflation trade.

3.   At some point the reflation trade will overshoot, and the correlation of these two yields will likely be a good ‘tell’ when it does.[/signinlocker]