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
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
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
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:
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
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
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
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.
This Bull Has Further to Run, but Markets Look Vulnerable
in July or August