2018. You ready?

I hope this is the shortest 2018 post you will read. In my battle against overthinking, I’ve tried to boil this down to bare bones. Feel free to follow up with questions. Try out montrealmovers.com when you like to travel and move.

Here are the three thoughts to which I attach the most importance for 2018. Things never turn out ex post as neatly as you lay them out ex ante, but this is my base case/point of departure for the year:

We are probably underestimating the positive effect of tax cuts on earnings. I think we have two biases holding us back. One, many of us dislike the policy and reflexively want to short anything Trump does. Two, after the fantastic run the market has been on, it is hard at some deep intuitive level to believe it can continue apace. And if we really are underestimating the effect on earnings, multiples are very likely to continue expanding as well. The US has a disproportionately large effect on global market psychology, so this would also be very positive for risk assets around the world.

Easy to imagine a shortage of assets narrative emerging this year. Moreover, it might even be true. We know it’s probably true in bonds. Might be true in equities as well. True or not, though, it would provide good cover for multiples to expand further, and could open the door to some really ludicrous valuations down the road as well.

Solid global cycle + markets tend to go up over time = It’s still too risky to position bearishly.

Yes, I know markets always top on good news, and I know it’s going to end badly sooner or later. But we also have to remind ourselves that, over time, getting caught out long in a bear is a less costly than getting left behind in a bull. If you got out 3 or 4 years ago and let valuations and macro ‘possibilities’ keep you out, you’ve been in pain. I’m not trying to mock anyone with this, just pointing out that for institutional asset managers right now not enough beta is real talk.

So, bottom line is this is the backdrop I have to run with—or at least should try to run with—until abundantly indicated otherwise. In other words: be generous with the benefit of the doubt. Especially given that this is the phase when things could easily accelerate to the upside, as if often happens later in cycles. I know it’s natural for it to feel wrong to be bullish after such a run, but you’ve got to focus on playing the odds.

And frankly I like the embedded odds that the Fed won’t make a disruptive policy error. They could, but the market in the aggregate has convinced me that it’s still clinging to too much expectation/hope of one. Also, for the first time in a long time, you can’t dismiss out of hand the risk of inflation upside, making bonds a much more balanced bet. Lastly, if/as we move out the risk cycle from here, I would expect it to continue to impart a bearish bias to the dollar.

Basically, if these points are even close to being right, that’s AYNTK.

So you want to short bitcoin? Here’s your road map.

Do you think bitcoin is a bubble? Do you think the speculative crypto fever has broken? After last week’s price action, a lot of people—myself included—think the answer to these questions is Yes.

None of us really knows if this will prove to be the case. After all, bitcoin—the de facto benchmark in the space—has declined by 30% or more probably a dozen times since its inception, coming back stronger each time.

But this time feels different. It feels like a bubble. The fever in the post-Thanksgiving moonshot ran hotter than we’d seen before. We also began to see a robust supply response.  Bitcoin futures were also introduced, allowing investors to short or hedge their holdings for the first time. Maybe it’s a coincidence the ATH price in bitcoin came just before brokers allowed customers to short the futures last Monday morning, but I wouldn’t bet on it.

Bubbles are complex dynamics. What they all have in common, however, is they require emotion to truly go parabolic. Moreover, the less we understand the object of the bubble, the greater the scope for greed and FOMO to fill in the blanks. It’s much easier to make a bubble out of TSLA than it is out of GM.

Accordingly, we’ve seen a lot of creative crypto narratives recently. But scrutiny brings knowledge, and knowledge kills bubbles. And over the past few weeks we have started to figure a few things out.

1.  You can be simultaneously bullish on blockchain and bearish on bitcoin.

2.  The supply of crypto tokens is not de facto fixed. If prices hold up, a rush of upside-capping supply is almost a certainty.

3.  Even if crypto currencies settle down and eventually become an adoptable medium of exchange, it’ll likely be emerging tokens, not bitcoin that will win that race by being quicker, more efficient, and more practical

So, if you believe that we’ve likely seen the highs in bitcoin and you want to go short, how do you go about it in a responsible way?

First, bitcoin is volatile. It’s annualized volatility is over 100%, implying daily moves up or down of over 6%. Second, bitcoin exchanges are open 24/7, but bitcoin futures follow regular Globex hours. Third, the exchanges have integrity risk (e.g. Mt Gox) and the futures have 20% collars. These last two factors increase gap/discontinuous pricing risk for those who trade the futures, even though I suspect these factors represent more risk for long positions in bitcoin futures than for short ones.

In sum, you have to be extra careful with bitcoin in your sizing and risk management.

I see two ways to play a bitcoin short. First, the longer-term play. In my experience the smart way to play bubbles is to short when the momentum fades on the first bounce after the fever breaks.

Here are two recent bubble charts, the NASDAQ 1998-2002 and Silver 2009-2013.

NASDAQ 100 (Dotcom bubble) 1999-2002
Silver (precious metal bubble) 2009-2013

You will see that the charts of the NASDAQ and silver (precious metals) share a  basic pattern: parabolic, fevered top, followed by a sharp drop and then a weak, protracted bounce channel as investors attempt to “recreate the magic”.

So the long-term play is to wait until the momentum in the bounce attempt has faded and it breaks down out of the bounce channel. This could come a lot faster in bitcoin because arguably the understanding of the underlying asset is more nebulous and the illusion factor was higher. But you never know. You have to size it small and hope you make the right call on the entry point.

Nearer term, the opportunities to short seem cleaner. Here are charts of XBT intraday over the past 31 sessions, and daily, over the past year.

Bitcoin, intra-day, last 31 sessions
Bitcoin, daily, over the past year

You can see on both charts there is heavy overhead in the 15,000-16,000 area. Going up into that area and then breaking down from it would be a logical trigger for a short. You could then set your stop and position size based on some rule that defines a violation of that pattern (e.g. two closes back up into the bounce channel).

The other near-term scenario is where bitcoin tries to get away from you on the downside. Given the faith-based nature of the asset, it is entirely possible that we get very little bounce here, and bitcoin continues to tumble. The dramatic fall late last week took less time than it does to say “cold storage”, leaving a lot of trapped sellers. Moreover, we knew NASDAQ and silver weren’t going to zero, but we can’t say the same about bitcoin–at least not with anywhere near the same degree of confidence. The odds of a continuation selloff are high.

So this is what you can do. Bitcoin closed at 14,240 on Friday, after an intra-day low down near 11, 000. If we close below 14,240, you can short it, betting that the unwind is not over. Again, you have to set a stop that makes sense at that point in time, and size your position accordingly. And you need to be mindful that it is quite possible bitcoin will trade weaker when the futures maket is open than when it is not. But you should not be afraid to chase. If it is truly a bubble, and the fever has now broken, there is still a lot of potential downside–however viable you might believe the underlying technology to be.

Of Patterns and Psychology: Shorting TSLA by the Numbers

I love tracking the assets that develop cult-like status. The kind where the narratives are powerful and the emotions run high, where our behavioral biases become most transparent. It’s why it impossible to take your eyes off of bitcoin these days.

But it’s also true for TSLA. Over the past two months, TSLA for me went from financial entertainment to an investment idea, and I wanted to walk followers through how that happened and how I’d manage it.

Back in October I noticed that TSLA was forming a bearish pattern. It made sense to short it based on the pattern alone.

One year chart of TSLA. The break is clear.

Since it’s not core to what I do, I did it in small size, mostly for sport. But as I tracked it it became clear to me that TSLA’s financial runway was getting shorter every time there was an announcement of a large car company making up ground in the EV space. And these announcements were becoming more frequent. It was equally clear that Elon Musk is the kind of guy who has a dream and would go for broke trying to achieve it. I wrote a quick post about it here.

So, with TSLA forming a large topping formation and with falling odds of achieving the ‘good’ binary outcome, it has become an attractive risk/reward short from both a fundamental and technical standpoint. I suspect that below 300 is where the TSLA fan boys would start to abandon ship.

Three year chart of TSLA, highlighting the forming top

The problem though, is that TSLA, if things do work out, could go Amazon on you, which for a short position would be deadly. So, you have to set parameters to manage the risk.

Here’s how I’d do it.

If you have no position, decide how much of your NAV you’re willing to lose if wrong. That’s the first thing you need to do. Then look at where a natural stop would be if you were to short some here. My read of the chart is you want to be totally out if 350—the top (roughly) of the current range. If I saw TSLA hit 350, I would be convinced that my topping scenario is not playing out. It might play out later, but it is not playing out now.

I would then size my initial position. TSLA is currently trading at ~330, so a break of 350 would generate a loss of 6%. As an example—because this is a very portfolio-specific choice—if I were willing to lose 50bps of NAV, this would allow me a position size of 8.3%.

If we hit 350, then you’re out and you’ve lost 50bps of performance. However, if you’re right and 300 breaks and the major top is completed, that means the odds of the Zero scenario have increased and you can add to the position.

This is how I would do add to it. If TSLA closes below 300 for two consecutive days, you can add to the short. I would—again this is a very portfolio-specific decision—double the position. I would then put a stop on the new portion of the position at a close back above 305. And I would lower my stop on the first portion of my position from 350 down to a close above 315. This would give you an all-in breakeven on the trade if the breakdown turned out to be false (which happens a fair amount), and a first target of 200 if the break plays out. Once you get to 200, you could then take profits on one half of the position, and let the rest run—after lowering the stop on it to 250.

I am not a TSLA expert. I have no emotion or pride invested in TSLA failing. In fact, I very much admire all of the amazing innovation Elon Musk has catalyzed. But patterns and the psychology drive most of my trading decisions, these factors are telling me TSLA is a good risk/reward short here.

The Vibe in Rates Has Changed. Know Yourself.

For the past few sessions we are seeing a new vibe creep into markets, driven by bonds.

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 US nominal yields have shot higher. Real yields have shot higher. Breakevens have shot higher. European bonds have shot higher. Yield curves have steepened. Unusually, the dollar has not rallied with US yields and precious metals have bounced from the pressure they were feeling last week. (Spreads between US and German yields have remained roughly unchanged).

Here is the yield on the German bund over the past one and 5 years. There’s a lot of scope for upside.

All of this is a very new, more inflationary vibe. Up until now, not only has the correlation between real yields and breakevens been negative (statistically very significant), but European bonds have tended to ignore increases in US yields. And any time US yields rose, the dollar reliably rallied.

The 5 year real yield and the 5 year breakeven are in the last two columns and rows, respectively.

It is tempting to say that this was catalyzed by the realization that the US tax package was going to pass, and do so against backdrop of synchronized global expansion with an infrastructure bill likely to be attempted in the New Year. And I think this is the right narrative—at least for now.

The question is how long will it last. Is it just another example of the markets belated overreaction to news that an efficient market would have discounted earlier, or is this something more real and the Phillip’s curve is finally being awakened from its slumber? After all, the US is moving along nicely in its economic cycle, president Trump seems determined to throw as much fuel on the US economy as possible, and Europe and Japan are likely to begin the normalization process 2018. And we know what an outsized role foreign flows have played in treasury yields.

I add to this that 2017 has been the first year since the GFC that taking the under on the Fed’s projected rate path was not the winning bet. This is important. The behavioral temptation for investors (and I very much include myself in this) who have been on the right side of that bet up until this year will be to dismiss it as an aberration, and assume ‘their world’ will reassert itself in 2018. As a general rule, the longer you hold on to your thesis, the harder it is to let go of it. And this is doubly true when your thesis has been working.

Personally, despite all this, I would still rather take the under with respect to the four projected US rate hikes in 2018, but my commitment to this thesis will now be heavily tempered by the recognition that this is the point in the cycle where I will be most vulnerable to confirmation bias.

Quantitative Tightening and Mortgages

The Federal Reserve currently holds about $2.5 trillion in Treasury securities and about $1.8 trillion in mortgage-backed securities. These securities were purchased in the aftermath of the GFC to help the Fed achieve its policy objectives once the Federal Funds rate ran into the ZLB.

In October, the unwind began.

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The Fed went from reinvesting all of the proceeds from maturing securities to reinvesting all but $10 billion every month for the first three months, with further reductions of monthly reinvestment by another $10 billion every three months after that. So, by Q4 2018 the amount non-reinvested will have climbed to $50 billion a month. The treasury/mortgage split within those amounts will be 60/40. All told, if things go to plan the Fed’s balance sheet will have been shrunk by about a half a trillion dollars by this time next year.

There was a lot of fear that the market would start discounting what people were calling Quantitative Tightening and that yields would start rising–perhaps disruptively–putting pressure on risky assets and economic activity.

It is against this backdrop that mortgage spreads jumped out at me. Granted, reducing your holdings by $4 billion a month should not have a huge mechanistic effect. But, allegedly, markets are forward looking and the Fed has a lot of mortgages hanging over the market.

Here is the mortgage spread on one and five year horizons:

Here I’ve taken the 30 year FNMA current coupon and subtracted the yield on the five-year treasury. I use the five year because the five to seven year area of the Treasury and swaps curves is the part of the curve that institutional investors use to hedge the duration of their mortgage books.

The collapse in mortgage spread since September speaks for itself. What we’ve seen is five-year yields increase by about 50bps while mortgage yields have stayed flat.

Some might be tempted to argue that the 50bps rise in the 5yr yield is the sign that QT is having an effect. But if the unwind of the Fed’s balance sheet were having the supply effect so many feared, you’d expect to see the yields on both rise with only a modest change in spread. Could it be that effects from the Fed’s balance sheet at this point–to the extent there are any at all–are mostly about signalling and psychology?

The Easy Macro Policy Hack

We live in an increasingly complex world moving at an increasingly fast pace. The way it comes at us, it feels like we’re at the receiving end of a firehose. It demands quick reactions and baits us into quick conclusions. Compound this by our ever-shorter attention span, and the age-old challenge of battling conformation bias is today a lot tougher.

Typically, when we confronted with an issue where we have little knowledge, we’ve looked to public figures whose views we’ve come to trust. But in today’s world, the pressures of social media/cable TV forces these people to have impossibly immediate, confident answers, so they—just like us–tend to shoot from the hip and fill their own information gaps with some combination of ideology and tribalism. As a result, bad (often partisan) ideas proliferate wider and faster than ever before. It’s not a coincidence that measures of political polarization started going haywire after the advent cable TV and have accelerated in the age of social media.

So how do you deal with the partisan cacophony? Here’s my policy hack: Look abroad. One of the best ways to cut through the bullshit is to look around at other countries’ experiences. My general rule is if you see the same problem in a raft of other countries, it’s almost certainly a global phenomenon and not about policy.

This doesn’t mean policy doesn’t matter or can’t attenuate the problem. Certainly, it does and it can. But when the phenomenon is global, policy is unlikely the primary cause and policy remedies might not be able to do all that much to fix it.

Not all policy issues lend themselves to international comparison, but many do. Let me give you two prominent examples.

Income inequality

The popular divide is conservatives want to blame low interest rates over the last 15 years and progressives want to put it all on tax cuts that didn’t trickle down. There is a mountain of evidence in the US that pushes back against these views, but in the clamor of partisan politics and tribal allegiances it is all too easy to find a way to dismiss them.

But not when you look abroad. When you look around world what you see very clearly is income inequality is increasing within most countries, even as it decreases across countries. And that it started in the late 70s-early 80s—well before we in the US had ever heard of the Greenspan put or The Bernank.

Here’s a handy chart of the timeline of income inequality in the US from a Bloomberg post last week:

Income inequality started a long time ago. https://www.bloomberg.com/news/articles/2017-12-15/how-america-s-inequality-machine-is-firing-the-dow-into-orbit

Again, I’m not saying that tax cuts and Fed policy didn’t play any role. Tax cuts that didn’t trickle down certainly did and Fed policy could have. But when you look around the world across countries that have an array of different monetary and fiscal policies and see the same basic pattern, it puts our parochial talking points into better perspective.

The Global Financial Crisis

There was a very strong ideological narrative that persists in certain quarters that the Global Financial Crisis was caused by Congress forcing Fannie Mae and Freddie Mac to crank out sub-prime mortgages and the Federal Reverse keeping interest rates too low for too long.

Again, there is plenty is data here at home to beat this thesis down. We know that Fannie and Freddie’s CRA lending was very small in the grand scheme of things and their market share shrank sharply in the bubble years, and that the collapse in credit standards was a market-driven shadow banking affair. We also know that the years of most aggressive mortgage lending were 2005-2007, when the Fed fund rate was around 5%, making it hard to pin the market frenzy on low rates.

But the easier path is to look around the world, to countries that didn’t have a Fannie or Freddie, whose central banks had different policies from the Fed. And when you see countries like Ireland, Spain, Iceland, who had real estate bubbles magnitudes larger than ours, it becomes much easier to recognize it was at its core a global, private-sector phenomenon.

Using international comparisons in policy analysis is not a panacea, but in macro it should be the first tool you reach for to beat back confirmation bias.

The Dollar, the Euro and Rates

One of the strongest beliefs in currency markets is if a central bank is hiking policy rates its currency will strengthen. Nowhere is this a more powerful thought than in the US, whose reserve currency is dominant and whose policy rates set the tone for global cycles.

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But it’s not always true. Yes, the dollar tends to go up when the Federal Reserve is raising rates, but the correlation is much lower than you’d think. The dollar fell pretty hard across the board throughout the 2004-2007 hiking cycle, and if you look at 2017—a year we came into with an overwhelming consensus of rate hikes and dollar strength—we got rate hikes, but the dollar fell. Policy rates do matter and can be a powerful component of a narrative, but you don’t want to let the often mindless mantra of higher policy rates, stronger dollar blind you to other factors.

What are the other factors? My view of the dollar is that we are in the part of the global risk cycle where US-based capital looks at relatively full valuations at home and starts moving from core to periphery. In fact, this stop-and-go process started in early 2016. This is typically dollar bearish. Shorter-term, the central bank narrative is that of the Fed passing the hiking baton to the ECB, also dollar bearish.

The only problem is reality disagrees. At least for now it does. Yes, if you look at the chart of the EURUSD today you could, with enough mental gymnastics, imagine a scenario where the euro goes higher. And if the euro goes higher, it means the broad dollar is going lower. But, right now, I have three issues that are getting in the way of dollar bearishness.

One, the positioning is not favorable. By all accounts, investors are long euros. We can argue about how much and the extent to which euro positioning is a proxy for other currencies, but investors are short dollars. Because it’s easy to access, here’s the CFTC futures data for net spec positioning over the past 10 years as an example:

Two, the spread between the US 2-year yield and the German 2-year yield has not started to move. For evidence the baton-to-ECB narrative is taking hold, this needs to at least look like it might be forming a top. So far, its ascent is relentless.

Three, same thing for the spread between the US 10 year note and the German bund. Just doesn’t seem ripe for the full-blown narrative.

And, for the record, here is the 5 year chart of the euro:

Timing currency moves is a notoriously tricky business. It was just a few weeks ago that I thought the narrative of baton passing to the ECB was about to take hold. But today, despite the long-term view and scope for a bullish narrative in the coming months, it doesn’t look as though the stars are aligned. The good news: at least the euro looks like it will be strong in gold terms….

Good luck.

How much economic info is there in the yield curve?

I know none of this is terribly new or groundbreaking, and I’ve oversimplified for the sake of parsimony, but here’s the null hypothesis:

The US yield curve reflects a global equilibrium rate for ‘risk free’ financial assets much more than it does any kind of capital formation equilibrium rate. In other words, it equilibrates financial activity, and economic activity is somewhat of a price taker.

Not only is the yield curve much more driven by financial balances these days, but, within financial balances, the share of price-insensitive demand for risk-free assets has grown sharply. And at the same time the supply for these assets has contracted.

Here are a few reasons why:

  • Rating agencies were chastened by the GFC and aren’t slap happy with AAAs anymore
  • Derivative structurers are, let’s say, more modest in their issuance ambitions
  • Insurance companies and pension funds have endless structural demand
  • Banks have higher liquidity requirements to meet
  • Central bank QEs

This isn’t to say yields don’t react to economic info or don’t say anything about the state of the economy. Of course they do. But the dominance of financial drivers after 30 years of global financial deepening has made attempts to extract economic information from the level and shape of the US yield curve unhelpful–or worse, vulnerable to false positives.

TSLA – Closing Below 300 is a Big Deal

Single name stocks are not my bailiwick, so get your salt grains ready. But we’ve all seen this movie before: A cult-like stock with crazy, revolutionary technology that loses to the 2nd, better funded, mouse that executes better.

And in the case of TSLA, it’s binary. Elon Musk wants the dream and will risk everything to get there. If the switch is flipped, TSLA could easily become a zero.

This is not something I wish, though I do think it is increasingly likely. Musk’s funding is not infinite, production and labor issues are mounting, and the competitors have finally woken up and are gunning for him.

Technically, we appear close to that breaking point. Investors look to the stock price as a sign of a company’s health–even when they shouldn’t. And when a company has chronic financing needs, a bad signal from the stock price–justified or not–can be fatal. The world of finance and economics can be brutally path dependent.

Here are two charts of TSLA that illustrate why the 300 level is meaningful. You can tell me until you’re blue in the face that round numbers don’t matter, but I know from experience we are not that rational. They matter. That’s why I have so may silly Dow hats (okay, not the only reason). And in this instance the round 300 level lines up with important support ranges on two important time horizons.

First, here is the one year chart:

TSLA one year chart

Now, the 30 day intra-day price chart:

TSLA 30-day intra-day price chart

Even a TA tourist like me can see that the round 300 level we keep bouncing off is important support in TSLA’s price pattern.

If we close below 300 for a couple days in a row, odds are we are seeing the beginning of the end of the cult.

Oil Stocks – This Time of Year Investors Love to Play the Laggard

Everyone is starting to take a look at oil names, and with good reason this time.

Back at the end of July I posted a quick thought on oil, arguing that we were starting to price in the oil industry’s secular headwinds. We had seen a sharp rise in the price of crude starting in mid-July, yet neither big oil or oil servicer names were following. At the same time, market analysis/chatter was that EVs were inevitable and would be on the market sooner than we thought.

Since then the performance gap between crude oil and oil stocks have continued their divergence.

The blue line is WTI, the burnt orange line is XLE, and the white line is OIH.

The upshot is that we have priced in a lot of secular headwind in a short period of time, investors, desperate not to lag the indices in a super bullish year marked by aggressive sector rotation, are likely to turn to the oil sector, as a laggard, to make up ground into year end.

And the charts are constructive.

Here is OIH, from one and 5 year perspectives:

OIH one year chart
OIH 5 year chart

Now, here is XLE, from the same perspectives:

XLE one year chart
XLE 5 year chart

It probably doesn’t matter for now that valuations are not attractive (i.e. oil names are pricing in a big earnings rebound) and that the secular headwinds haven’t gone away. And it probably doesn’t matter that late last week people already started recommending the sector.

What will likely matter most—unless crude oil ‘closes the divergence’ by itself taking a dive—is that people need performance, oil names have lagged crude sharply, and their chart patterns just turned up nicely.

So much for fundamentals and the efficient market hypothesis.