MorningWord 4/19/16: Rails on a Krazy Train

by Dan April 19, 2016 9:51 am • Commentary

Let’s power through this together.  For the last couple months I have been of the belief that no matter how far we bounced off of the February lows, the eventual failure will likely be below the November high of 2116 in the S&P 500 (SPX) and below the May 2015 high of 2134, successfully completing my view of a rounding top consisting of a series of lower highs in the worlds largest equity index. A top seemed confirmed by something that hadn’t happened in the SPX since its lows at 666 in March 2009, the index made a new lower low on Feb 11th, meaning closed at a level below the prior low of the uptrend and looked set-up for a meaningful correction:

SPX 7 year chart from Bloomberg
SPX 7 year chart from Bloomberg

Could this still play out? Sure. But this bounce is a lot sharper than most expected. And a new all time high is a possibility. A failure after the SPX makes a new all time high (already has if you include dividends), changes the narrative to a long consolidation that broke out and failed. And of course there’s the chance of a bubble-like breakout to the upside, which would be unhealthy in my opinion, but possible.

So here is the thing, I have no clue what’s going to happen here in the broad market in the near term. The only thing we can do as investors is formulate a top down thesis for the economy, financial markets and work from the bottoms up with specific investment instruments and hope to meet in the middle with a sound thesis. I (like most) own stocks passively in retirement accounts for the long term, but unlike (most) I trade stocks and options with an intermediate term time horizon with the goal of catching inflection points in single stocks, etfs and indices and adding beta, especially in periods of downward volatility.  

In late 2015 I took down my equity exposure in longer term accounts, set up longs in trading oriented accounts that would benefit from a move by investors into more defensive equities and treasuries (utilities, U.S. telcos, TLT) and placed long premium defined risk short positions with options. This was a great strategy for a few months, until mid February. Since early March I have been wrong on short delta trades in single stocks, sector etfs, commodities, currencies and equity indices.

So while my long term equity accounts suffered far less than most in Jan/Feb because of tactical hedges and directional short bets, they have not benefited from the recent run because of new shorts placed way too early in the run (even though I did my best to be patient. My losses in trading shorts since March have now eclipsed my gains from shorts in Jan and Feb.  So what’s a girl to do?? Not panic.  I didn’t panic in Aug 2015, or Jan/Feb when the markets were collapsing, and I don’t plan to do so if the SPX makes a new high.

With the SPX less than a couple percent from all time highs, I have that feeling of wanting to throw in the towel on my big call (that looked genius in early February). We all know that feeling. But it’s important to stay disciplined in times when things aren’t going your way.

Regular readers know that I fear that current monetary policy the world over has painted central banks into a corner and set us on an eventual road to ruin in financial markets. The timing of that is unknown, and completely avoiding investing in risk assets waiting for that ruin to occur could be costly.  I have always said that directional punting in financial products like options should occur in 10% or less of one’s investible capital, and should never interfere with your long term investment goals. So I stick with that if you are a DIY’er and you enjoy trading and think you have an edge. The goal of RiskReversal is to help educate readers on how they can trade and invest with an eye towards risk management. My view over the past several months has been steady: As long as that rounding top and the asymmetrical macro risk exists, it’s best not to commit new money to equities and to look for portfolio hedges and tactical shorts at possible inflection points. We are not your financial adviser or broker, and certainly not your hedge fund manager. One of the most important features of this service in our minds are the discussion on portfolio hedgers and single position hedges or stock alternatives. We believe when utilized properly, these overlays can be additive to long term returns, or at least help keep your heart rate at reasonable levels and sleep at night.

But I’ll just say this, over my nearly 20 year career in the business, I have never seen a period like the one we are in now. I don’t mean in the financial markets, because we have lived through long periods where markets climb walls of worry, what I mean is the framework adopted by the powers that be for dealing with an ailing global economy.  Crisis monetary policy instituted in 2008 to avoid a global financial meltdown, and likely a depression has become monetary policy, as many central banks push further into the unknown and unconventional, negative rates.

So in sum, I’m clueless, about what happens next as markets are reacting almost entirely to central bank moves. And to be honest, the combination of low rates in the U.S., despite the data dependent Fed having hit prior targets, coupled with recently weakening dollar, could set up for an epic breakout. I’ll tell you this, I won’t chase that with my long term investments and you shouldn’t either, because at that point we will be in Krazy Town.

So when and how will I get back in on the long side? The next meaningful correction I’ll start dollar cost averaging into what a buddy of mine likes to say is the only trade in this new world order, Spoos and Twos.  Meaning S&P 500 and Two Year U.S. Treasury bonds. Of course I’ll keep trading in options on single digits of investible assets, even if we enter Krazy Town.