Thursday, July 20, 2017

Playing the Downside

The market has "plunged" 10 SPX points from pre market Draghi highs, and is clawing back as I write.  Yes, he was dovish.  But the market knows that unless the ECB changes the capital key rules or goes into buying stocks, they will run out of Bunds to buy in 2018.  So they have to reduce QE or change the rules.  Of course Draghi will never admit that, but that's the main reason they want to taper, not because of a stronger European economy.  Europe is Japan 2.0.  It is unrecoverable.  The European economy will be right back to  near zero growth as the benefits of a lower euro dissipate, now that the euro is heading back up.  Based on the inflows into Europe and emerging markets this year, it seems like retail has fully embraced the "value" in European and emerging market stocks.  In 2015, that signaled a topping phase after a long uptrend.  I see a similar situation here, but with more dire consequences on the other side of the mountain.  Just because this time, the mountain and the air underneath is so much bigger.

There are a few options for playing the downside after the market makes a top.  And I really believe the top is coming soon.  These tops tend to come slightly below big round numbers for the S&P 500.  The 2007 top occurred right under 1600, at 1576.  The 2011 top happened at 1370.  The 2012 mini QE 3 top happened at 1475.  You get the idea.  It would not surprise me to see this market make a top right below the big 2500 psychological number.

You are getting a steady stream of low put/call ratios ever since the French elections removed a pall of uncertainty from the market.  While the super low VIX is not something I like to see when trying to pick a top, I believe that stems from investors selling volatility for income, artifically lowering volatility.  The tech stocks are acting bubbly, much like they did in 2015.  And we have gotten the good news from a dovish Yellen and today, from a dovish Draghi, which provide the final wave of FOMO buying which often forms a top.

I see three good ways to play the downside.  1.  Shorting equity indexes.  US, Europe, emerging markets, they will all work.  2.  Buying longer dated SPX puts, with SPX volatility so low, actually a good risk/reward.  3.  Buying 5-10 year Treasuries, with an equity market correction reducing the odds of future Fed rate hikes.

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