The Trade that Defied Gravity


RECONCILIATION - We're just into Tuesday and I feel wiped out! I've been pretty much round the clock since Sunday, monitoring developments around the French election risk. Since the outcome, we've seen the Euro shoot up along with US equities, though US equities have performed stronger than the even the Euro. I had written that the reason stocks have responded more favorably to the French election outcome is because stocks were more sensitive to the systemic risk associated with an EU breakup in the event of a Le Pen victory in the second round. But Macron is heavily favored in the final round and unlike polling nightmares in 2016 with the EU Referendum and US Presidential race, this one has been on the money thus far and should deliver the market friendly result. The Euro on the other hand still has its own risk to worry about, including structural imbalances, ECB policy, Brexit and the health of the economy overall. So that's how I would best reconcile the price action. 

INTUITION - Of course, it's not that I believe stocks should be racing higher. I have my out of the money short equity exposure and believe US equities will see a major correction that will rattle the market big time in the months ahead (20-30%). When you look at the stock rally on the Monday open, at a very minimum, your intuition that the idea of a French election having so much of an impact on the US stock market is not off. Again, of course there was systemic risk associated with the French election that could have impacted the US economy. But to go as far as to say US equities have ripped to fresh record highs on the Monday open, all because of a first round election in France, that hasn't even determined the next President yet, is a little ridiculous. So yes. This is a pretty good sign the stock market is not exactly moving on the most legitimate of fundamentals. 

UP AND SIDEWAYS - But there's more to this. When you consider stocks have dropped quite slowly in recent weeks and haven't even threatened a legitimate reversal in that time, with the pullback associated with so much more than France, it is absurd that the elimination of the France risk alone has been the driver of the Monday rocket. On the way down in recent weeks (again more sideways than down), it has been the deluge of geopolitical tension, concern in the Fed Minutes of equity overvaluation, worry over the Trump administration, uncertainty in China, exhausted monetary policy around the globe, Brexit risk, and also the France risk that have weighed on stocks (kept them from pushing higher). A massive barrage of risk off and barely a drop. But stocks have been doing this for years now. With stocks, there are only two directions, up and sideways. The stock market will get hit with a wave of bad news and negative risk and it will mostly just trade sideways. And then, the moment that risk fades, it's off to the moon. 

PROPORTION - One of the interesting deficiencies adults with ADHD struggle with is disproportionality. That is to say, adults that suffer from ADHD are often overcome with intense emotional anguish disproportionate to the thing that has triggered the overwhelming feeling of anguish. So, an adult with ADHD may lose their keys and instead of being reasonably upset while looking around the house for the keys, they turn into lunatics, with end of world anxiety as though everything is falling apart. The person knows this is not the appropriate reaction but is unable to fight away the feelings. So why the heck am I talking about this? Well, I feel the stock market is doing something similar right now, albeit, with the opposite disproportionate reaction. Something bad happens to stocks and the market has no feeling of needing to react in a negative way. But when something positive happens, the reaction is far more exuberant than what would be within the spectrum of normal. 

SWEPT UNDER THE RUG - Now I used the word 'positive' in the sentence above because it isn't even as though good things have been happening. The recipe for this record run in stocks has been a pinch of ok, a splash of bad and then a reduction of the bad. Rinse and repeat and keep pushing no matter what. Down is never an option. So some sort of risk emerges, stocks kind of trade mostly sideways, the risk is narrowly averted and everything is awesome! This is not a healthy response from the market and all of this screams of other variables at play that are driving this thing towards what can only be a very large cliff. Just last week, there was a pretty big development in my opinion that was barely news. Last week, Goldman Sachs came out with a miss on earnings. To me, this was a big deal as it sent a message that one of the architects at the center of the financial markets crisis and beneficiaries of the recovery that ensued, had no handle on the pulse of the global economy. If Goldman couldn't produce a positive earnings result, all while stocks continue to climb to record highs, something must either not be right, or Goldman is stumbling because it is worried about what lies around the corner. 

PLUNGE PROTECTORS - So what has been holding it all up? Well, it's my belief that there are two players that have hijacked the stock market, demanding that it continues to go up, without allowing any time for reflection. The first is the quant-algo fund. These funds have been growing over the past several years and now make up a large part of the overall market. Systems buy and buy and buy. If there is a dip, the systems don't ask any questions because they can't. They don't worry about problems in the world, they just see the market trading at a discount and buy more. After all, it's been an effective strategy...until it isn't. Remember, the door is only so wide and when the selling starts, it won't have any room for everyone to get through at once. The other player is perhaps even more influential in a sense. This player is the ultimate plunge protector. They are the central banks. Central banks, the pillar of safety and security, have been buying equities at record amounts in an effort to seek out yield in a world where there is none. Central banks have lots of dough and if central banks are buying stocks, who can really fight against such force? 

There is only one fire exit door. G-d help us all when the fire starts. Via @joelkruger

MONSTER EXPOSURE - When you think of the two traditional currencies excluding the US Dollar that are considered to be safe haven currencies, what are they? That's right. The Swiss Franc and the Japanese Yen (I don't consider to Yen to be safe haven, rather a funding currency that behaves like a safe haven, but that is another report for another time). Now go and search SNB equity holdings and BOJ equity holdings and see what results you get. These two central banks have been monster forces in the equity market space. The amount of exposure they have to equities is eye popping and should be deeply concerning. But they have no choice. For all of this artificial stimulation to work, they have been forced to prop stocks. So does this mean all is well out there. Nope! Stock prices are not reflective of underlying fundamentals. They are reflective of artificial fundamentals, with tools that are also no longer there to continue to prop them up. Remember, monetary policy is exhausted. The option for additional SNB and BOJ negative interest rate policy is not a viable one and this leaves us in an interesting and scary time.

TIMING - It's true. I don't know when it will all come crashing down. I have also been selling rallies in stocks since 2013 and up until late 2016, had done quite well. So even though stocks kept pressing to record highs, I made money on the short side of that trade. But since the end of 2016, there has been no legitimate, healthy let up. A few weeks back, when the S&P500 hit 2400 (or in that area), I put out a piece highlighting risk for yet another push to 2485. In that piece (and also this one) I cited historical analysis that projected a potential move towards that level, which would be the ideal of ideals in terms of isolating an exact top. But it's never an exact science and all of the writing has been on the wall for months now. I believe we will know when it starts happening when rallies that should have supported the market disproportionately no longer do so. So if the market rallies up but fails to break to a record high after something like a reduction in systemic risk from a French election, and then that market breaks down to a new multi-day low, that would be a pretty good sign things are starting to reverse. 

WHERE BEGINS AND ENDS - One final note on all of this. In recent weeks, all of the developments relating to Brexit, Trump, France and geopolitical risk have distracted the market from Fed policy. We haven't been talking a lot about Fed policy during this time, which is somewhat refreshing. But in the end, this is where it all started and this is what could be the catalyst for the next big drop. The Fed has started to move rates up in recent months and will be looking to follow through with its rate hike guidance this year after falling on its face last year (and the years before = forward misguidance). And if we really are to say that we have just seen a major reduction in systemic risk from France. And if the snap election in the UK should produce a more stable path for the UK in its exit process, the Fed should also be thinking about green lighting its timeline for hikes, which could even be three more this year. So don't necessarily think that it all needs to be doom and gloom for stocks to come off. My hope is that it's all peachy and the Fed leads the way to a more pronounced exit from this unprecedented, out of control, monetary policy accommodation experiment. Higher rates makes stocks less attractive, especially at the levels we're at now. Higher rates also makes it less enticing for those central banks to continue to hold onto such a risky investment as stocks. As far as those algos go, it was a blast on the way up and will be a nightmare on the way down. But don't worry, there won't be any emotion associated with the selling which should make the drop....well....exceptionally brutal.  So that's where we're at. In the end, we may keep pushing. But you know what they say, the bigger they are.....


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