Time Arbitrage

There is a lot of noise in short term price moves.  Moves that are hard to predict because in the short term, a big institution or group of institutions suddenly deciding to increase or decrease their equity exposure will move the market for the next hour or two, or if they are looking to move very large size, for a day or two.  That could be in the direction of the intermediate term move, or against that direction.  The longer you go out in time, the less one or two big institutions can influence the direction of the market.  Its much easier to forecast what the overall crowd will do, rather than one or two of the big participants.  

Some may say that the longer out in time you go, the more exposure you get to news headlines and unpredictable events.  That's true, but most of the time, these news events don't affect the market for more than a few minutes or hours.  It is not common to get a market event that affects the market for more than a few days/weeks.  Covid type of market game changers are rare.  Even September 11 2001 doesn't come close.  In 2008, which could be considered a slow motion event, wasn't a black swan type of unpredictable market mover.  It was building steadily over the previous years.  The Russia/Ukraine war this year, which definitely caused the selloff to last longer than it would have otherwise in February/March, is already an afterthought compared to what is always on the minds of most investors: the Fed. 

Daytrading is profitable as long as retail investors are heavily involved in the market.  If retail is not active, daytrading gets a lot harder.  Daytrading against institutional order flow is possible, but much harder than against retail order flow.  Institutions are more disciplined, more knowledgeable, less predictable, and make fewer mistakes than retail traders.  The only place you will find retail traders making up a significant amount of the volume is in small cap stocks that are in play.  That is the only place where consistently large edges exist.  That is where beginner traders who are looking for an edge should specialize.  The big drawback from focusing on the small cap stocks is having to find shares to short, lack of deep liquidity (not being able to put on large size for more than the day that its active), and long periods of fallow periods with few opportunities when stocks are in a downtrend and/or retail speculation is subdued.  

But in order to play with the big boys and be able to scale up, one needs to trade markets where institutions dominate, and retail flows are mostly irrelevant.  These are usually macro markets that are covered by futures, such as stock indexes, fixed income, commodities, and currencies, and also large cap stocks.  That is where another type of edge appears which is not talked about much.  The edge from having longer time frames than institutions that trade frequently, in particular, hedge funds.  Hedge funds in particular are judged on a month to month basis, and extended drawdowns are avoided whenever possible.  Hedge funds always worry about drawdowns because it looks bad on their record and its frowned upon by their investors.  So they often get stopped out of long term positions that are in a long term downtrend.  These stop outs are not fundamentally driven decisions, based on investment merit, but based on risk management and fear of big drawdowns.  When you have investors that are making trading decisions based on risk management rather than fundamentals, there is an opportunity.

Let's call it time arbitrage.  This arbitrage comes from being able to enter positions that are currently out of favor and in extended downtrends, with some liquidations and stop losses exacerbating the trend.  These opportunities occur when something is fundamentally undervalued, but currently out of favor on Wall Street.  This arbitrage can also happen in the other direction, where a market is in a bubble and extremely popular, and fundamentally overvalued.  But usually its more difficult and more dangerous to try to short an overvalued market in a bubble than going long in a undervalued market that is in a bear market.  

In the current market, the only market which I see this time arbitrage opportunity is in bonds.  I see no long term time arbitrage opportunity in stock indexes or in commodities.  For currencies, there is definitely a long term opportunity in the yen, as its selloff is related to Fed policy, so highly correlated to bonds.  And buying Treasuries is a better expression of the Fed turning dovish on a weakening economy than going long yen.  

Yes, the best long term "time arbitrage" opportunity is in bonds, not because I think inflation will go down a lot more than market expectations.  Its because I believe the Fed won't be willing to hike as much as the market is pricing in, based on the global economy weakening, even though I expect inflation to remain sticky, due to continued commodities and housing inflation.  We saw in 2007 and 2008, in the face of rising inflation, mainly due to commodities, while the economy was noticeably weaker, the Fed was aggressively easing, and didn't care about inflation in that environment.  Now I don't expect a financial crisis or a great recession, but I do see a US/EU recession coming in 2023, like many are predicting.  That is another aspect of this opportunity which makes it interesting.  Its the fact that so many investors are now expecting much weaker growth or a recession by 2023, but most are not positioned for it, except for crowding into defensive sectors in equities.  But the best way to play economic weakness is not in defensive stocks, but in bonds.  They are for the most part eschewing fixed income, due to 1) continuous downtrend 2) Fed hawkish rhetoric 3) inflation fears.  

The investment flows out of fixed income and towards stocks have been sizeable since the beginning of 2021.  Investors were already historically overweight equities vs bonds going into 2021, with the flows since then, its become even a bigger overweight in equities.  This makes the weak equities scenario much more harmful for the overall economy, as the most dynamic part of the US economy is US equities.  Growth is low, without massive fiscal stimulus, so the wealth effect from equities is a much bigger factor than many are willing to admit.  So a few more hikes will cause stock market to go down even more, and thus, a weaker US economy via the reduced wealth effect channel.  That's not even factored into the leading indicators which are already rolling over hard. 

But the Fed is hawkish now, when the current Fed funds rate is 0.25-0.50%.  This isn't a tough time to be hawkish.  But the more important issue is this:  Will they remain hawkish after 3 rate hikes (50 in May, 50 in June, 25 in July), with the Fed funds rate at 1.5-1.75% and the stock market in a strong downtrend as the economy is clearly weakening (likely August/September scenario)?  That's not something many investors are considering at the moment, even though its probably the most likely scenario in 4-5 months time.  And no, I don't expect the bond market to be weak until August/September.  Unlike 2018, when the bond selloff was extended as the Fed slowly hiked 25 bps every other meeting, this time, they are looking to do 50 bps per meeting, so 4 times faster, plus a much faster QT than in 2018.  And leading indicators are more ominous now than in 2018, mainly because the economy didn't get so hot and inventory didn't get so bloated as they have now.  

I haven't entered any long term bond positions, but its the best market for those looking to play the long game, and can withstand short to intermediate term drawdowns (unlike hedge funds), with fundamentals that are unfavorable now, but will soon turn favorable. That's an opportunity for those willing to make a long term investment in an asset with a very bad looking chart that is in a slow motion liquidation cycle.  

Its brutal price action for the SPX.  It usually feels this way at the end of a downswing, unless of course you are in the middle of a protracted downtrend, which I don't believe is the case.  I could be wrong, but this looks like a deep dip in a 2-3 month countertrend up cycle that started in mid March.  I agree with the majority that the longer term picture looks weak, but disagree about the short term, mainly due to light fund positioning.  Still long, looking to hold for a couple of weeks.