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War Games


The trick to trading is two-fold...

War's going on across the sea,
Street soldiers killing the elderly,
What ever happened to unity?
It's like that, and that's the way it is.


While 2007 is a fresh slate from a P&L standpoint, many of the themes we saw last year have carried over into January. Bad news has been absorbed, good news is being embraced and the world, uncertain as it is, is operating in a realm distinct from the market machination.

With a fresh set of earnings on tap and January expiration in sight, the great debate continues to rage. Are stocks in a sweet spot, enjoying a historically low interest rate backdrop and the benefit of a coordinated central bank agenda? Or are the bears quietly biding time, swapping equity gains for greenback malaise as structural imbalances percolate under a seemingly calm surface?

The answer, in a word, is yes. The simple truth is that these two dynamics aren't mutually exclusive. In fact, one could argue that they're collectively cumulative.

The trick to trading is two-fold. Identify the disconnects between perception and reality and ascertain opportunities that offer the most advantageous risk/reward. It's easier said than done, particularly with 9000 hedge funds standing in a circle shooting at each other.

Sometimes, however, those two dynamics commingle to offer the best of both worlds.

The sloppy action in crude implies one of two scenarios. Either the global economy is drastically and suddenly slowing or we've seen forced liquidation by heretofore hedge fund holders. If the former is the culprit, the broader market landscape (particularly the financials) would be equally morose, which has yet to unfold. If the latter matter is at hand, the tape could be offering us an excellent entry in secular winner.

I opined last week that hedge fund liquidation of crude has created an opportunity. That, given the carnage in the space, there is no longer any geopolitical risk priced into Texas Tea. That seems odd, particularly given the obvious tensions in the region (Iraq, Israel) and the emerging angst in Iran (where escalation may be closer than many people think).

And my mark words, when conflict escalates in the region, energy and metals will be the only two sectors that will be green the following morning.

To be sure, there are intuitive reasons for commodities to trade lower. The chart, for one, is the nastiest technical patterns I've seen in a long time. There is also the risk of structural deflation or recession, as suggested by the inverted yield curve and supported by our negative savings rate. And of course, there's the heavy hands we already spoke of, "forced selling," or liquidation in Wall Street parlance. There's nothing worse than an invisible catalyst, particularly when there's trillions of dollars of derivatives involved.

But here's my take, for what it's worth. If the world slows and both China and India falter, the decline in crude will pale in comparison to the slippage in the financials (the financing arm of this expansion) or high multiple tech. If the expansion continues, which is to say if the elasticity of debt continues to expand, the need for "stuff" (commodities) will enjoy a healthy second wind.

With volatilities as low as they are, my chosen strategy is to play primarily through options. Upside calls in the energy and metals, downside puts in the financials. To be fair, and to be honest, I've favored this strategy for some time. Timing is everything, however, and the recent liquidation in crude is offering a favorable entry point for those with a similar perspective.

Good luck today.

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Position in energy, metals, financials.
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