This week, as I watched the nature of the price action in stocks, I couldn’t help but be reminded of how the market was behaving in 2011. No, not the QE II rally in stocks during the first half of the year but rather during the August meltdown that blew up that very crowded and leveraged long risk position.
When Ben Bernanke kicked off the notion of QE II at Jackson Hole, I began monitoring what I deemed the reflation correlation trade whereby all dollar-denominated reflated risk assets rallied inverse to the price of the dollar. Below is a timeline of various comments I made to colleagues documenting this market dynamic and the systemic risk that it presented.
S&P 500 (INDEXSP:.INX) 2011
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10/24/10: This possible correlation breakdown will likely confuse the market and drive a spike in volatility which should push credit spreads wider and stock prices lower.
3/27/11: I’m not trying to predict moves three to six months in the future but realize there will likely be a market response to the Fed’s exit strategy and therefore need to be prepared before it occurs. In expecting events by anticipating the market response we can be better prepared to interpret the price action.
4/10/11: Unlike 2008, there is a lot of speculative and leveraged money already long this trade that I call the reflation correlation, and I doubt they can all successfully navigate the turbulence of a reversal.
5/8/11: Each asset class is exhibiting characteristics that I have past highlighted as being signs of a reflation correlation change in trend. Since 3/09, markets have been dominated by this discount, whether actually in the market or not. Unwinding this trade will be tricky…. When all major asset classes violently react to a move in the silver market, it proves the correlation trade is on, and everyone long trying to exit at the same time can cause a massive systemic disruption.
When the Fed took a pass at the June 22 FOMC meeting it was apparent they were prepared to let QE II expire at the end of the month. Initially the markets shrugged it off but you still had a very crowded trade predicated on the Fed continuing to weaken the dollar.
Nearly a month after QE II expired, seemingly out of nowhere stocks started to fall in late July, and when S&P downgraded the US credit rating, the catalyst was in place to ignite the unwind I had been looking for. Between July 25 and Aug 8 the S&P 500 fell 225 points for what was a mini crash of 16% in 11 trading sessions. The nature of the selling was so tenacious with no countertrend bounces for which to sell, participants were literally freaking out, invoking the nightmare of 2008. But I knew better.
8/8/11: This week, while many were scrambling to find a reason for the relentless sell-off citing a pending recession, the EMU debt crisis, rumors of a US sovereign downgrade or any other market horror stories that were all well-known and thus already discounted, I felt comfortable that the market was simply fulfilling the objective I outlined in March.
Market participants could not figure out what was going on because they had not recognized that market prices were a function of correlation positioning that was now subject to a chaotic liquidation. Analysts were suddenly downgrading economic and earnings projections based on what they perceived to be as a market discounting deteriorating fundamentals. The speculative community that was in the same crowded trade and with 2008 fresh on their minds, quickly turned from long risk assets to short, and by the end of September were massively net short 300,000 S&P e-mini contracts. I, however, I knew that the flushing of this leveraged crowded position presented an opportunity to buy.
10/2/11: In navigating the market’s price, time, and emotion, I am looking for the discount to own and the one to fade. The discount that everyone wants to buy is one of negative yields supported by post-traumatic stress syndrome and central bank manipulation of a fear bubble. That discount I want to fade. The discount that everyone wants to sell is one of cheap risk premium supported by strong cash flow and pristine balance sheets. That discount I want to own.
10/9/11: So was that it? Was that the low? I don’t know, but that’s how they happen and this is unfolding according to plan. The reflation correlation “mother of all carry trades” (as Roubini calls it) is unwinding much like we have expected according to our evolving playbook, and as we finally flush the asset inflation excess, it may be signaling a change in trend.
Fast-forward to June 12, 2012 with the S&P 500 experiencing the first major correction after rallying 350 handles (30%) off the 2011 crash lows when I laid the groundwork for my working market thesis in Trading the Wrong Playbook Bubble
. The basic idea was that market price was not a function of the fundamentals or discount that so many hedge funds were employing, but rather simply predicated on the positions and sentiment that was now the inverse of just a year earlier. In the wake of August 2011 there was an explosion of speculative shorts, and I believed this time the market was on a mission to flush these positions by squeezing them into new highs.
S&P 500 E-Mini Large Specs Net Position
On July 30 in Bernanke’s Astonishingly Good Idea
I wrote the following:
This week’s CFTC
commitment of traders report showed large speculators (aka hedge funds) remain net short for the 50th consecutive week…. I remarked to a friend that I didn’t think the market would stop rallying until “they” get flat to long.
Last year the speculative community was still long the QE II reflation correlation trade thinking they were going to get an extension and when they didn’t it was Katy bar the door. This year they are short. If we don’t crash soon, when the boys come back from the beach they may be piling in to get long before year end. It could be melt-up city.
On August 13 in The VIX According to Seinfeld
I stated the following:
But after two weeks into August, risk assets haven’t crashed and now the market is at the post-crisis highs, looking like it wants to break out despite decelerating economic and earnings growth. Investors are hearing it from both Costanza and Kramer and the uncertainty with whether they will get suckered yet again gets more intense the longer the market rally lasts. It is a dangerous time for all investors, retail and professional alike, but if this market remains bid into the Labor Day weekend, there will be tremendous pressure to get exposed to risk into year end.
On November 12 in the midst of the last corrective countertrend low I wrote the following in Rally Off 2009 Lows Flushes Hedge Fund Shorts
My thesis ignored these issues and was predicated on what I believed to be the primary driver behind the price action: the positioning of hedge funds.
To understand the significance of their positioning you have to understand there has been a seminal change in the investment community over the past decade. Hedge funds used to generate alpha by betting against the crowd, but today they are the crowd, and they are betting against themselves. As an investor class, hedge funds had been short the entire rally since last year and were being forced to cover and eventually get long.
On Jan 28 in The Great Rotation
referring to the citing of 1265 support back in June. This area was the critical 1265 pivot on the S&P 500 that goes back to 2008, and as you know, the market proceeded to rally 200 handles into the September highs squeezing every last bear in the process. Now, as the S&P sits at new post-crisis highs, those same smart money investors are bullish for the same reasons they were bearish at 1265 despite very little change in the economic and earnings landscape. You now hear them extol the virtues of equity valuation relative to bonds, predicting a massive asset allocation shift in what is deemed The Great Rotation.
As an analyst and participant I begin with a thesis, monitor how the thesis evolves in a market trend, and then look for conditions to emerge that could derail the trend. The parabolic price action of the past few weeks is very reminiscent of the 2011 crash. Back then the market was in full-blown meltdown mode with no one able to quite explain what was behind the selling. Today the market is in full blown melt-up mode with no one able to quite explain what is behind the buying. This is the same trade perpetrated by the same traders. Now I’m not going to pretend that I have called this market with absolute precision, but I was also providing early warnings in 2011 that went unheeded. It’s not as much timing the turn that’s as important as realizing what driving underlying market dynamic is not sustainable and therefore a suggesting a reversal is in the offing. This way you can be better prepared to take advantage of dislocation ex ante without succumbing to all the reactionary melodrama. I am happy to miss out on the short term wiggles in order to catch the long term trend.
I do believe I have the nature of trade correct, whether short outright or in terms of net market exposure. And just like 2011, once this position gets fully flushed, there will be a violent reversal. However from a technical perspective, unlike 2011 where the market was recognizing long term pivots now that we are at new highs, there is no such reference. This makes identifying a spot for a final flush and subsequent turn much trickier. For my money the best technical tools at your disposal are regression and momentum, and by these measures the market has extended into a zone where at a minimum a reversion to the mean should be expected.
S&P Daily RSI Regression
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S&P Weekly RSI
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S&P Monthly RSI
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Typically when I try to identify a swing, I line up the RSI (relative strength index) on different time frames. For example, when the daily and 60-minute reach overbought levels, I look for the market to work off these overbought conditions in order to generate the energy for further gains. Last week the S&P accomplished what I have been waiting on for months. The weekly and monthly RSI both exceeded the overbought level at the same time. This is a rare occurrence in history. Obviously markets can stay overbought for a long time, and this is by no means a recommendation to blindly short the market, but putting new cash to work with these two long term timeframes in overbought territory is not prudent money management, regardless of whether you are bullish or bearish.
S&P Vs. PCE YoY Growth Rate
Don’t make this too complicated. There is a lot of pressure to jump aboard this squeeze from financial advisors, strategists and yahoos in the media. Be mindful these same participants were the same ones freaking out in 2011. What could possibly be responsible for this newfound bullishness? It’s certainly not fundamental improvement. Every tier-one data point that I follow -- employment, ISM, nominal GDP, and personal consumption -- are all materially weaker than this time in 2011. The only thing responsible for this excessive bullishness is price and confirmation bias. There is no doubt about it.
This is not one of your perma bears talking. I call it like I see it, and I don’t think participants appreciate how much this short squeeze dynamic is at play or how much downside it presents. I may be wrong, but I want to see the market prove it to me. A parabolic rally that no one can explain reeks of desperation and lends more credence to my thesis, which continues to play out. In fact this may go down in history as the mother of all short squeezes.
See also: This Bull Has Further to Run, but Markets Look Vulnerable in July or August