Part of Hell

“I'm not concerned about all hell breaking loose, but that a PART of hell will break loose... it'll be much harder to detect.”

-George Carlin

George Carlin passed away at the age of 71 last year. Like most of us wanna be market prognosticators, he was an author, an actor, and a comedian. If you can’t wake up and find something funny about this business, you are probably not awake.

We have just witnessed the 2 largest percentage moves in modern US trading history – and as my former (Montreal born) hockey roommate, Frenchie Magnant, would say: “those are two fried egg, side by each, eh.”

1. SP500 October 10th, 2007 (1562) to March 9th, 2009 (676) = -57%
2. SP500 March 9th, 2009 (676) to August 25th, 2009 (1028) = +52%

No, these eggs can’t be scrambled. They are already cooked. No matter what your storytelling narrative said, and no matter where you go this morning, there they are – right on your plate.

Not that I am keeping track of the score or anything, but Bloomberg did that for me anyway this morning. On that fine aforementioned morning of March 9th, 2009, one Nouriel Roubini called for the SP500 to hit 600. This business is funny, indeed.

What’s not funny is losing money. Now that we know that markets can crash versus expectations, both ways, we need to learn from it. We as an industry need to continuously evolve. Every day we have to address this market much like a patient. Take its critical signals for what they are, and move forward.

As I look forward, I’m not so much looking for Roubini’s or Rosenberg’s one way advice – I’ll go with Carlin’s. As of this morning, “I’m not concerned about all hell breaking loose, but that part of hell will break loose.”

Trying to call intermediate term tops in markets is for storytellers. Trust me, I try to tell mine every day! What I have learned from the Top, to the Bottom, and Back Again (sounds like a good name for a book), is that tops and bottoms are processes, not points.

In the immediate term, I am very comfortable making what Wall Streeters of responsibility in recommendation years past call “making the call.” I’ve had enough pucks to the head to try to do this every day. I guess the numbness of it all provides me with outputs.

Today will change tomorrow. But today, I see the risk in the US stock market beginning to cleanly outstrip the reward. On the margin, I have been bullish. So this is a change for me, and here are the reasons why:

1. Daily risk/reward has shifted to the risk side for the 3rd day in a row – this is new
2. Immediate term risk/reward in the SP500 is -2% risk versus +1% reward (1007-1040 is my new range)
3. The range of probabilities (again, risk/reward) when I elongate my duration beyond 3-days is now 65 SPX points, that number was 40 points on Friday
4. Daily volume studies are starting to flash bearish (up days coming on sequentially declining volume – yesterdays new high came on -7% day/day volume)
5. The market’s breadth is no longer a layup (Advance Decline line was 59% to 38% yesterday – that’s barely bullish AT the YTD high)
6.  Howard Penney’s S&P Sector Views has flashed only 5 out of 9 Sectors closing up in the last 2-days (that number was 7 or 8 out of 9 last week)
7. US Healthcare and US Technology are almost flashing beyond 2 standard deviations overbought (my favorite sectors, but overbought is as overbought does)
8. The US Dollar has been holding the critical line of $78 support for the last 3 days; with the WSJ + Barons parroting my thesis, it’s starting to morph into consensus
9. If the US Dollar breaks out above $78.63 and the VIX breaks out above 25.04, everything REFLATION is going to go down

So, those are some of the quantitative reasons. However, any well rounded multi-factor model should incorporate Behavioral Psychology into its construction. On that front, I am seeing the most glaring level of groupthink I have seen on one specific factor since, well, the market was topping out in October of 2007.

That factor is the spread between Bulls and Bears in the weekly Institutional Investor Sentiment survey. This morning has finally registered more than 50% of the portfolio managers in the USA as being BULLISH. Yes, they will finally admit it! AFTER the move, of course, but no matter where they go this morning, there they are.

The Bulls have moved up from 48% last week to 52% this week (new highs). The Bears have been bludgeoned, dropping from 23% to 19.7%. The spread between the two is 32 points wide. This combined with 3-month US Treasury rates hitting a new low at 0.15% (yes, that’s ZERO lending rates), is a consensus cocktail for “part of hell to break loose.”

Sometime in the next 3 months, and I have not yet made my call from a timing perspective to the day yet (yes, I am numb enough to do that, and I will), “part of hell will break loose.” It won’t be in Brazil, or Hong Kong either. It will be right here, in the compromised US Financial System that we have barricaded ourselves with.

I have sold down my allocation to US Equities to 3%. That’s the lowest representation I have for any asset class currently. I’m going to go eat my eggs now.

Best of luck out there today,

KM

LONG ETFS

EWH – iShares Hong Kong — The current lower volatility in the Hang Seng (versus the Shanghai composite) creates a more tolerable trading range in the intermediate term and a greater degree of tactical confidence.  

EWZ – iShares Brazil — President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt –leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. Brazil is a major producer of commodities. We believe the country’s profile matches up well with our reflation call. 

QQQQ – PowerShares NASDAQ 100 — We bought Qs on 8/10 and 8/17 to be long the US market. The index includes companies with better balance sheets that don’t need as much financial leverage.  

CYB – WisdomTree Dreyfus Chinese Yuan — The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP– iShares TIPS — The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis. 

GLD – SPDR Gold - Buying back the GLD that we sold higher earlier in June on 6/30. In an equity market that is losing its bullish momentum, we expect the masses to rotate back to Gold.  We also think the glittery metal will benefit in the intermediate term as inflation concerns accelerate into Q4. 

SHORT ETFS

XLP – SPDR Consumer Staples – We shorted XLP on a bounce on 6/21. One way that investors chase a bearish USD is buying international FX leverage in global consumer staples. Shorting green.

DIA  – Diamonds Trust- We shorted the financial geared Dow on 7/10, 8/3, and 8/21. 

EWJ – iShares Japan –We’re short the Japanese equity market via EWJ on 5/20. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds – If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.