Monday, October 30, 2017

Fed Chair

The market has been waiting for Trump's Fed chairman nomination and the suspense was building up until Friday, when a trial balloon seems to have made it almost a lock that Jerome Powell becomes the next Fed chair.  Trump got what he wanted with the Powell trial balloon.  The stock market rallied strongly as did the bond market.  I am sure Mnuchin will be in Trump's ear telling him Taylor as Fed chairman will tank the stock market. 

Powell is a low interest rate guy, someone who follows orders, and I am sure Trump has asked him for a pledge to keep interest rates low if he were to be Fed chairman.  Unlike Taylor, Powell seems more interested than Taylor in playing politics and strategically being dovish to increase his chances of getting future government and corporate gigs.  That's why he was basically a yes man to Bernanke and Yellen.  That is why Neel Kashkari has taken the strategy of being the dovish outlier, the crazy dove who thinks rates should be lower in the face of near consensus rate hikes, complaining about the lack of inflation.  That is how he is able to get himself into the conversation for Fed chair nominee even though he's only joined the Fed board recently. 

By the way, on inflation, and the Fed still looking for that 2% inflation rate.  Well, good luck with that, because it is clear as day that the CPI and PCE inflation numbers have been so manipulated to the point that it can really only spit out low inflation readings unless there is hyperinflation.  Hedonic pricing, substitution, and "new" valued added features compensating for higher prices of goods, etc.  It was comical in the middle of  2008 to see the government pump out low single digit % CPI numbers as the dollar weakened against everything, corn went from $3.50 to $7.50/bushel, and oil went from $50/barrel to $147/barrel from 2007 to mid 2008. 

Anyway, the Fed chairman job, if Trump is looking for someone who will obey his commands and keep interest rates low, Powell is his guy. 

On Friday, we took a page out of 1999 and got a huge surge in the high flying big cap Nasdaq names, while the rest of the market was doing nothing.  It is a bubble, but there are so few of those high growth stocks remaining in this market that the supply just can't meet the demand unless prices go higher.  Even at these levels. 

Hoping (however, not expecting it) we could maybe get a sustained VIX rise for once, but it petered out again after the Powell rumors and Nasdaq surge on Friday.  Back to the same old low VIX grind. Again.

Thursday, October 26, 2017

Worried About Rates

Now we see Fast Money bring up the bond market excuse for stock market weakness.  This often happens late in a down move for bonds, as those who usually don't care about that market suddenly get interested, almost like passers by who stare  at two people yelling and pushing each other, and about ready to start a fist fight.

You've got to have a long term fundamental basis for your trades if you really want to be able to hold on through the volatility and drawdowns.  The current levels for bonds are quite compelling from a long term view.  I don't believe the global economy can take much higher rates, which means that rates can't go up much before the stock market has a tantrum, and in a circular loop, that will keep rates low.

But we live in a short term driven hedge fund world, so the short term price action can run counter to your long term view, even though the view is still valid.  While you are seeing stronger economic data recently, a lot of it is based on rebound effects from the 2016 slowdown, and the extra confidence boost provided by a rising stock market.

You cannot rule out the bubble expanding, especially since volatility is still low and it doesn't appear like we have topped out.  But longer term, beyond the next few months, into the next few years, you are looking at future stock market weakness, that could persist for quite some time.  The valuation levels just are too high for this type of earnings growth.  You are looking at a demographic headwind of Japan, Europe, and U.S. getting older, with many retiring and reducing consumption.  That is a powerful headwind that could only be held back by massive amounts of global QE, and that was just to keep the developed economies growing at low single digits.

At an S&P of 2560+, you are pricing a continuation of the past 5 years of steady growth because of low interest rates.  Yes, the monetary policy will be easy in the future and interest rates will probably stay low, but the market has gotten used to low rates, and priced it in, so that's not a positive catalyst anymore going forward.  Monetary stimulus works because you are changing conditions by making them easier, not by keeping them easy.  So just keeping rates low will not stimulate anything.  You will have to have growth, for stocks to keep going higher from these levels, and that will be harder to come by in the future.

Short term, this a hard market to trade, although buying intraday dips like yesterday usually works, at least until the dips become more frequent, in which case, the dips become more dangerous to buy.  We are not at that point yet, but a few more intraday down days like yesterday in the near future, and you will likely see that weakness go all the way to the market close.

Thursday, October 19, 2017

Waves from China

The trigger for the gap down today is the late day selloff in Hong Kong.  It is no coincidence that the last time we had meaningful sustained selling was on worries about China.  Hong Kong is basically a proxy market for foreigners to trade China.  We are just back to levels of last week, so this is nothing meaningful, but it does show you that the weak point for global equities markets remains in China, so that is where you have to look for signs of weakness. 

The top is a while away, and you will have these "scary" gap down days, this just happens to be on the 30th anniversary of the Oct 19 1987 crash.  So it puts a look of extra psychological pressure on stock holders today.  If we bounce right back within a couple of days, which I expect, then this down day only confirms future strength.  However, if we can sustain selling for more than a couple of days, then this market is giving us something to think about, which could be significant or not. 

The positive seasonality is hard to fight with the lack of volatility and persistent strength.  November is historically a strong month, and it is also the heaviest time for corporate stock buybacks, so definitely a tailwind for this market after earnings season is over. 

Not only is the stock volatility really low, so is bond volatility.  The MOVE index is hugging the lows for the year, even though rates have been trending higher over the past several weeks.  Usually, bond volatility tends to rise with rates.  It seems the bond market isn't too scared of a Fed determined to hike in December or a more hawkish Fed chairman.  That is basically the story of the year.  No fear and no action.

Monday, October 16, 2017

Grind Can Last a While

It is not at all unusual for the market to grind higher like this for several weeks in row, or even several months in a row.  It happened for nearly 12 months straight, with one brief interruption (in late Feb 2007), from August 2006 to July 2007.  It was a regular feature of the powerful bull market in the mid 1990s.  It just hasn't really happened since 2008, even with an 8 year old bull market.  You had regular meaningful dips from 2009 to 2016, which would scare out those who had 2008 flashbacks, only to V bottom higher.  This year, you had a few shallow dips, almost as if the dip buyers were so thick that they stopped the dips from getting deep.

It is the triumph of the dip buyers.  They have won. They have been so successful that the dips are now so shallow and brief, that even a 3% correction looks like a monster buying opportunity. 

When does it end?  You want to see a VIX that is rising when the S&P is rising.  That is the first and biggest clue.  You want to see less inflows into bond funds and more inflows into stock funds.  And you want to see China's markets do worse, because they often foretell broader global stock market weakness. 

It is a grind these days, and there is not much new to add.  I don't want to repeat myself, but the top is months away, so either be long (if you can ride bubbles) or in cash.  Just don't be short. 

By the way, I will be writing fewer posts with the lack of action.  If things pick up, I will write more.

Wednesday, October 11, 2017

On their A-Game

They are on their A-game.  I am talking about fund managers.  It is easy to not make big mistakes when you are making money.  An equity market at all time highs and a bond market that is stable is about as ideal an investing environment for institutions.  They will not do anything rash under these conditions. 

While you can question their long term positioning, in the short term, they are not making the mistake of puking out positions on a short term dip, because they have learned their lesson.  They realize it is a loser's game to set tight stops and regularly get stopped out, only to see the market reverse right away and go higher. 

It is a lot like poker players, when they are making money, they play more optimally and make better bet, call, and fold decisions.  There is no feeling of desperation to make their money back, so they can play more calmly and without need.  Usually those that are losing money start to play more hands, try to win more pots, and go on tilt.

Right now, the players in the game are making money, and not making any short term mistakes.  To try to make short term money in this market is like trying to squeeze blood out of a rock.  I would rather just play high stakes poker.  At least that game is more interesting than trading this market.

Here is the thing about playing the money game.  You have to want it, but not need it.  Those that can trade without a need to make money can play the long game, looking out months and years ahead.  Getting caught up in the day to day market action can often prevent one from catching the longer term opportunities.  That is where the real money is. 

Friday, October 6, 2017

Finding Distractions

Dabbling a bit in stocks, anything to keep me occupied and away from making any big trades.  There isn't much of an edge trying to make a stand here against this type of momentum, with the VIX so low.  This type of calm upward, relentless momentum reminds me of late 2006, early 2007.  If you remember, the market didn't top till summer of 2007, so if this market follows that analog, then we've got about another 6 months of uptrend remaining. 

We are seeing a lot of speculation in small cap stocks, which is also similar to what you saw in 2006/2007, as well 2014/2015.  They proceeded tops by about 6 to 12 months. 

So there are couple of very early warning signs that the clock is ticking.  But lots of time left before we hit the apex.  If you can't ride the bubble higher, just stay away.

Wednesday, October 4, 2017

Hedge Funds and Risk Tolerance

With the low volatility, the day to day trading edges are very slim.  Sure, these days there are a few small cap speculative stocks where you have insane and irrational moves, but there are lots of trading frictions in those markets, the difficulty in finding borrows, exorbitant borrow fees, extreme tail risk, and lower liquidity.  The liquidity is the big thing.  You can't move large size easily in small cap stocks, which limits the scalability of a strategy.  So that pretty much leaves either large cap stocks or futures/options.  Since the large cap stocks provide little leverage, futures/options are a much more attractive area for speculative trading. 

I recently heard that hedge funds are making a comeback, with inflows over $80B this year.  I also noticed that their YTD returns are 5.1%.  The SPX is up 12% this year.  Bonds are also up.  Once again, a simple 60/40 stock/bond risk parity strategy which can be put on for near zero fees is beating the hedge funds again.  I recently saw that a hedge fund of funds manager, Mark Yusko, made a bet with Warren Buffett that he could beat a SPX index fund in 10 years, net of fees.  I think Yusko will lose that bet.  Just because of the fees.  Even with the SPX highly overvalued, hedge funds are basically a more costly, lower beta play on the stock market. Hedge funds don't really provide alpha anymore, just damped down beta covered in a thin veil of secrecy to protect their 2 and 20 business model. 

The reason I bring up hedge funds is because they are the main reason there are short term market dislocations.  If you take away hedge funds, that removes a lot of the speculation in the futures and options space.  Most of the money going into mutual funds and ETFs don't make big bets on FX, interest rates, and commodity prices.  The hedge funds are there to provide more fuel to the fire, making trends last longer, going to prices they probably shouldn't go to. 

Most hedge funds in the futures space are trend followers, so in general, they will blindly buy strength and sell weakness.  In the past, when trends lasted a long time, it was a good strategy.  Nowadays with so many following the same strategy, as well as low inflation and money printing central banks, you don't have as many long term trends in FX, interest rates, or commodities.  So they have been getting churned and burned since 2008. The returns of the Barclays Hedge CTA index (survivorship bias inflates these returns) is basically flat since 2008, while the S&P has gone up over 200% in the same time period. 

These CTAs built up a lot of their record when the futures markets tended to have long trends, and before their strategy got overpopulated, splitting what little edge they got from following the trend with other hedge funds.

Whether it is hedge funds liquidating positions that have gone bad all at the same time, or piling into a position with a herd mentality, there are opportunities created in their trading.  But the only real way to capture those opportunities is to extend your time frame beyond the hedge funds' time frame.  The hedge funds' time frame is constrained by their inability to accept big losses, since institutions don't want a lot of volatility in a fund's performance. 

This is their big handicap. Risk tolerance.  Hedge funds cannot withstand big drawdowns, which means they have to cut their losses before they get too big.  This creates opportunities during their liquidations, because often, they are liquidating not because they suddenly discovered a fundamental change in the market, but because they hit their loss limit on the position and they had to get rid of it.  That is where the opportunity lies.

On the other hand, the individual trader can trade more aggressively and trade more optimal size because they can weather big drawdowns and don't have to worry about redemptions.  They don't have to puke out their positions as much.  Yes, sometimes the individual gets a trade wrong and has to get rid of it, but it should be based on criteria of market behavior and price action, not a loss limit.  Remember, the fastest way to grow your account size is to follow the Kelly criterion.  This exposes your account to big drawdowns, because you are betting your edge, basically. A 10% edge on a 1 to 1 bet calls for a 10% bet. A 99% edge on a 1 to 1 bet calls for a 99% bet! 

Most hedge funds can't bet that way.  They are reluctant to lose more than 2% on any one trade.  That is a big disadvantage.  They follow a much, much less risky money management strategy, which while safer, offers much lower potential returns.  This is why I believe profitable traders are much better off accumulating their own capital and trading it aggressively, rather than try to gather assets and trade more capital, but in the process be pigeon-holed by their investors' lack of risk tolerance.  Plus, its a headache dealing with all the paperwork and regulations of managing a fund.

I expect the hedge funds to be the ones to push this equity market towards its ultimate top, taking prices too high.  I also expect them to be the ones who liquidate their positions en masse as the trend changes.  That is what you saw in 2015/2016, and I think you see that again in 2018. 

Monday, October 2, 2017

Long Way to Go

The S&P just won't quit.  It is going to surprise the mean reversion traders here, as this thing will grind them to dust, as they look for that 5% correction.  The problem is, the 5% correction will probably finally happen about 10% higher than here.  There is nothing worse than being an early short in a bull market.  And pretty much anything except for shorting within 2-3% of the top is too early.  Which leaves a LOT of time for being early as a short seller. 

I don't know why this thing is going up. I just know that with high probability, we are nowhere close to the top, in both time and price.  The driving force higher could be a few things:  animal spirits, bubble psychology, and momentum building on itself.  It certaintly isn't improving fundamentals, not with the Fed looking to continue to raise rates.  Those tax cuts aren't going to move the needle unless they get everything that they want, which is unlikely.  And even if they did pass those huge tax cuts, the pain in the bond market from higher deficits and more Treasury supply would temper any stock market gains off the euphoria. 

These are the type of markets that favor those who are expert bubble riders, riding it to the top, and getting out when they sense the volatility rising and signs of a top building.  It is not easy, and its something I definitely will not do, just from the inherent vulnerability of a market that is trading so high with no fundamental backing.  I don't think we crack, but it does feel like being long is the equivalent of selling cheap put options.  And I don't use a put selling strategy. 

The only real comfort I can take from this type of market is that it is building up potential energy for the market to get exciting again when the SPX does finally top out.  I think that happens in spring/summer of 2018.  In the meantime, I will focus more of my energy on other markets which have better opportunities, such as bonds, commodities, or individual stocks.