Le Pen Is The Last Thing Standing Between Equity Bulls And The Promised Land

Le Pen Is The Last Thing Standing Between Equity Bulls And The Promised Land

The Trump-flation narrative has driven U.S. stocks to valuations last seen in the tech bubble. On a relative value basis, Europe is a bit more appealing.

As a result, hedge funds have been increasing their equity exposure to Europe since early 2017.

The Fed is also in the middle of a rate hiking cycle while the ECB remains 40 basis points south of zero. The easy money is overseas.

Plus there’s a record gap between U.S. and European EPS. U.S. earnings have always been larger than their European counterparts, but never by 53%…  

Given those facts, it’s easy to see why money managers are tilting their portfolios away from U.S. equities and towards European ones.

But this thesis has one huge hangup. Something so big and nasty that it could completely override typical macro fundamental and quantitative analysis.

That something is French elections. And more specifically, that someone is Marine Le Pen.

Marine Le Pen is the next populist threat to the Eurozone. Some of her policies include:

  • Taxing employers who hire foreigners.
  • Hiring 15,000 more police and building jails to make room for another 40,000 inmates.
  • Leaving the Eurozone.
  • Ditching the Euro.
  • Immediate expulsion of illegal immigrants and cutting legal immigration to 10,000 people per year.

Populism and all of its beggar-thy-neighbor policies are one of the biggest threats to global markets at the moment. That’s why we’ve been tracking the populism trend so closely. Ray Dalio has gone so far as to say that this trend will be even more important than both monetary and fiscal policy in the years ahead.

If Europe can get through the French elections Le Pen-free, then the global reflation narrative will pass a significant test, thus strengthening its adoption.

The Story So Far…

Markets were incredibly nervous going into the first round of elections. Traders bid up volatility across the board to protect against a possible “Frexit”. And rightfully so. A Le Pen win would mean absolute destruction to the common currency followed by gut wrenching equity volatility.

But these fears ended up being unfounded — at least after the first round. (France has a two round election system.) The base case played out exactly as the polls predicted. Center globalist Emmanuel Macron took down 24% of the vote. And far right Le Pen came in second place earning 21.3% of the vote.

Macron and Le Pen face off in round 2 on May 7th to determine the final winner.

Even though the numbers above look close, Macron is a huge favorite to win the second round. All the support behind Fillon and Melenchon is expected to either move to Macron or abstain altogether from voting in round 2. Le Pen will get no love.

Markets have already jumped the gun on this conclusion and have priced in a Macron victory.

DAX has hit new all-time highs.

And VSTOXX (European VIX) has plummeted back to the basement.

The Euro also rallied against USD and broke out of its short-term range.

The initial reaction and results are in line with what we first expressed in early April. Our thesis is that we’ve reached a cyclic top in the trend towards populism. At its core, populism is driven by economic uncertainty. And economic uncertainty has a tendency towards mean-reversion, leading it to cycle around its longer-term trendline.

Following the two major upsets in 2016, the secular trend got ahead of itself. We’re due for a reversion back to the long-term trend line. The recent Dutch election results, in favor of the non-populist candidate, strengthened our conviction.

We plan to ride the euphoria higher and press our risk-on bets if Macron is confirmed after round 2. Marcon’s win will eliminate investor fear and cause capital to flood into Europe. The recovery narrative will gain steam.

Macron is an independent centrist running on a “do what’s best” platform instead of a “my way or the highway” approach like most politicians. He started his own political party, En Marche! (Forward! In English), just for this election. Macron holds no allegiance to mainstream parties. His background is in investment banking, not politics.

Macron wants to implement pro-business reforms and jumpstart the economy with a €50 billion package spent over five years. He’s also looking to slash corporate taxes from 33.3% to 25%, the EU average. These are all policy moves that will boister the European reflation narrative, driving their stock market higher.

But even though the market is currently acting like Macron will be the next president of France, the Le Pen risk is still not 100% out of the picture. Betting markets give Macron an 85% chance of winning, eaming Le Pen a legitamate 15% chance of upsetting markets big time.

In the U.S. elections, according to betting markets, Trump only had a 30% chance of winning going into November. But that 30% was all he needed…

We’re sticking with our original call — that populism will subside for the rest of 2017 and Le Pen will lose. But at the end of the day we’re speculators, not pundits. That means we’re constantly updating our views while continuing to manage risk.

Le Pen hedges look cheap after this week’s market moves. Now that volatility has collapsed, EURUSD puts are back on our radar. In next week’s Macro Intelligence Report (MIR), we’ll dive into the weeds to see if we can find anything attractive to hedge our risk-on stance over the second round binary event. We’ll also be sharing a few new European companies we’ve been researching over the past month that will benefit from the rally. If you’re interested in learning more about the MIR, click here.



Profiting From French Election Volatility

Profiting From French Election Volatility

Attempting to predict the outcome of an election is a fool’s errand — we don’t bother with it.

But that doesn’t mean we can’t make money off the vote…

Over the last few weeks we’ve discussed the reasons for the rise of populism and how it’s impacted the false trend in European equities. We explained how these Soros-style false moves are dependent on narrative “tests” that either strengthen the trend or reverse it. In Europe’s case, its narrative test is arriving in the form of French elections.

This year’s elections are pivotal because the French are dangerously close to electing a populist, anti-euro candidate named Marine Le Pen. If she clenches a victory, there’s a good chance France will leave the EU, hammering the final nail into the coffin of the European experiment. The aftermath will quickly negate the short-term positives driving European equities.

The general consensus is that Le Pen will lose. But this is only one possibility. There’s also a good chance Le Pen actually wins. Like we said, no point in trying to predict the outcome directly. We’d rather put our money in something clear cut when it comes to these narrative “tests”. And that something is volatility.

The way we play volatility heading into macro events is based off how vol behaves around equity earnings. Take a look at Amazon’s option volatility below:

The red dotted lines denote earnings announcements, and the blue line is the implied volatility of the weekly options. (To learn more about implied volatility and options click here.)

The pattern is clear. As earnings approach, traders bid up implied volatility. This reflects the increased uncertainty that comes with a data release. The results serve as a narrative “test” for the stock. After earnings are announced, implied volatility plummets as pent up uncertainty is resolved. You can see this in the chart. The blue line crashes to normal levels after each earnings date.

Extrapolating this pattern into macro land means going long vol into uncertain events. And then being short vol over the event to benefit from the vol crush after the uncertainty is resolved.

We executed this exact strategy during the U.S. elections. It played out perfectly. VIX ran up before the event and sold off hard afterwards.

The VIX puts we traded post U.S. elections were one of our more profitable trades in 2016.

For the French elections we wanted to pull from the same playbook.  

The European stock market has its own volatility index called VSTOXX. It’s their version of the VIX. They also have futures on VSTOXX making it possible to bet directly on vol.

But in this case, VSTOXX futures weren’t the best option to play the French elections. They had already priced in the coming volatility.

VIX futures on the other hand were sitting in a quiet range near lows.

And on top of the election catalyst, U.S. markets had gone a while without the VIX term structure inverting (represented by a value over 1.00 in the chart). At the time it had been 147 straight days of peace and quiet since Trump’s win. And as we know, long periods of low volatility tend to precede a large spike.

There was clearly a trade here.

We ended up pulling the trigger and going long vol using UVXY on April 6th (our Hub members were alerted to the trade immediately).

Over the next week UVXY ripped as traders rushed for cheaper hedges into the French elections. Our UVXY position appreciated 20% in six days before we exited.

The original plan was to hold into the Friday before French elections. But Monday’s price action warranted an exit. The vol term structure (VIX/VXV) closed below 1.00. Historically speaking, this was a reliable signal that VIX would continue to mean revert lower.

Vol could still spike more before elections, but the risk/reward isn’t good enough to continue holding. At current levels the trade is more of a 50/50 proposition than 80/20 like when we first entered. We aren’t in the business of betting on fair coins. We need edge. It was time to take profits and move on.

But lucky for us the fun isn’t over. Things are getting more interesting as the election approaches. According to prediction markets Le Pen is expected to win the most votes of any candidate in the first round of elections on April 23rd. She’s represented by the light blue line below.

French elections are conducted over two rounds. The first includes all 5 presidential candidates. To secure the seat in the first round, a candidate needs over 50% of the votes. Otherwise the elections go to a second round between the top two candidates. So although Le Pen is expected to win the most votes on the 23rd, it likely won’t be enough to end the election. The race will go on to a second round on May 7th. Emmanuel Macron (the safe bet) is the favorite to win the second round because both Fillon and Melenchon voters are expected to support him over Le Pen. (Macron is pictured in light blue below.)  

We made good money betting on vol into the first round of elections. The plan now is to sit back and see how things shake out on the 23rd. From there we’ll look and see if any volatility trades look attractive for the second round. Our upcoming May edition of the Macro Intelligence Report (MIR) will have all the details. To learn more about the MIR and how you can profit alongside us, click here.  



Trading A Le Pen Win In The French Elections

Trading A Le Pen Win In The French Elections

Success in the markets requires thinking in possibilities. A great trader understands the permanent information deficit he’s faced with and why it makes market prediction impossible. All he can do is plan for a range of reasonable outcomes and adjust his strategy as new information presents itself.  

In the latest issue of our Macro Intelligence Report (MIR), we discussed the reasons for the rise of populism across the Western world and how it’s currently impacting the Soros-style false trend in European equities.

To review, a Soros-style false trend develops when a narrative is founded on untrue assumptions, and yet is so compelling, that price moves in its favor anyway. The positive price action further enhances belief in the narrative and creates a positive feedback loop between market, fundamentals, and narrative strength. This loop continues driving price further away from the truth, creating more instability. Eventually this loop breaks when belief in the narrative falters and price corrects.

Just as general market prediction is a fool’s errand, so is attempting to predict the end of a false trend. But what we can do is track key events that may poke a hole in the recurring feedback loop. These events are narrative “tests” where should the market pass, the trend will grow stronger, should it fail, the trend may reverse.

The upcoming test for the European equity rally is the French elections. The outcome of these elections will either strengthen the current European recovery narrative and send prices higher, or dash investors’ beliefs and cause prices to correct.

The reason French elections are key to the current narrative is because of the possibility of populist leaders gaining power — in particular Marine Le Pen. Le Pen is the leader of the right wing National Front, an anti-euro, anti-immigration party. One of the main pillars she’s running on is exiting the EU. If France (Europe’s 3rd largest economy) manages to leave, the rest of the union will fall apart. This will quickly negate the short-term reprieve in economic numbers Europe is currently experiencing. The equity rally will quickly reverse as investors abandon the European recovery narrative.

That being said, we believe Le Pen will likely lose.

Populist movements tend to oscillate around secular trend lines. And while the long-term populist trend is up (blue line on the chart below), we’re likely near the peak of the current short-term uncertainty cycle (yellow line). We expect political events to swing back towards benign outcomes for a while (Le Pen losing).

A Le Pen loss should bolster the recovery narrative and push European equities higher.

But in reality, trying to predict elections with high confidence is just like trying to predict markets — impossible.

This is why we understand that a Le Pen loss is only one possibility. And ensuring we have a solid trading strategy requires that we need to look at the other side of the equation — a Le Pen win.

French elections are conducted over two rounds. The first round is set to take place on April 23rd and includes all 5 Presidential candidates facing off. Now if one candidate wins over 50% of votes in the first round, he or she will secure the office immediately. But this is rare. A second round is usually held where the top two candidates with the most votes face off. This will be on May 7th.

The favorite to win the presidency is Emmanuel Macron. Macron was the minister of economy for two years under the previous president François Hollande. He later split off to form his own progressive, pro-EU centrist party. He’s considered the safe bet who won’t shake things up which is good for the economy and the stock market.

The general consensus is that Le Pen and Macron will make it into the second round where Macron will defeat the populist candidate. Current polls say as much:

1st Round

2nd Round

And the prediction markets also have Macron winning:

But one thing you’ll immediately notice is that the polling numbers aren’t too far apart. Especially in the first round, Macron and Le Pen are neck in neck. And in the second round Macron is by no means dominating Le Pen. The gap between the two is larger in the prediction markets, but these have the tendency to be much more volatile.

So while the media likes to tout a Macron win as a lock, it really isn’t. There’s a legitimate chance of Le Pen winning.

Eurasia Group puts Le Pen’s chances at 40%. Eurasia Group’s founder Ian Bremmer cited voter turnout as a particularly important factor:

Turnout is key. Mr. Macron, who is neither left nor right, and is generally inoffensive to the entire population, is not super attractive to anyone. And so as a consequence, if you get low turnout…  Le Pen can win. It’s an actual possibility.

If you remember, part of the reason Trump won the electoral vote in the US is because of lackluster voter turnout. He won after garnering just 26% of votes from eligible voters, less than all 3 previous republican candidates. Low democratic turnout in key states propelled him into office.

The same thing may happen in French elections. Turnout is expected to hit record lows this year. Over 30% of French voters said they’ll abstain from voting in the first round.

This bodes well for Le Pen. Her support base may be smaller, but they’re by far the most angry with the status quo, and therefore more devoted to the cause. They’ll absolutely show up to the polls. As Bremmer said, someone less divisive like Macron doesn’t spark the same kind of devotion. Goldman Sachs strategist Bobby Vedral explained in a note to his clients that if Le Pen can get just 85% of her supporters to show up at the polls (average turnout is 80%), and if Macron only gets 75% of his base out to vote, Le Pen will win the election.

Le Pen voters are also the most sure about casting a vote for their candidate. Many of the other candidates’ supporters lean more undecided, meaning there’s a higher chance they vote for a different candidate when it comes down to ballot day.

In general there’s an unprecedented amount of indecision in this year’s elections. 43% of voters said they don’t know who they’ll vote for in the second round if their first round candidate loses. If those votes swing to Le Pen, she’ll likely win.

And if you move away from the “official” polling, Le Pen’s chances look even better:  

Clearly there’s a decent chance here for Le Pen to take it. This is the reason we focus on possibilities. While we have a gameplan in place for a consensus Macron win, we also wanted to red team that thesis with a potential Le Pen win.

We currently have a basket of European equities we’re tracking that should benefit from Macron winning. But at the same time we’ve put on a number of option/volatility plays that will profit regardless of who wins. This is important because even though we’re focused on just Macron and Le Pen here, there’s still the chance of a 3rd candidate coming through and sweeping. The polls continue to get tighter and the latest results show the communist candidate Jean-Luc Melenchon surging (because, why not?). And of course Putin has his hands in this election as well. He met with Le Pen in Moscow last month after previously giving her party $10 million. Anything can happen. And that’s why we stay fallible and make sure to prepare for every scenario.


If you’re interested in seeing how trading legends like George Soros played political events like this, click here

Current Target: Populism & Europe’s False Trend

One of my favorite sci-fi series is The Foundation Trilogy by Isaac Asimov. The book was first published in 1951 and is a grand “space opera” that takes place in the distant future. At the heart of the series (and what makes it so interesting) is the fictional philosophy of “psychohistory”.

Psychohistory is a blend between mass-crowd psychology and probability theory. It’s founded on the principle that while it’s impossible to predict actions at the singular individual level, you can still successfully apply statistical probability theory at the group level to predict the general flow of future events.

Asimov discusses how he came up with the idea of psychohistory in the following interview:

At the time I started these stories, I was taking physical chemistry at school, and I knew that because the individual molecules of a gas move quite erratically and randomly, nobody can predict the direction of motion of a single molecule at any particular time. The randomness of their motion works out to the point where you can predict the total behavior of the gas very accurately, using the gas laws. I knew that if you decrease the volume, the pressure goes up; if you raise the temperature, the pressure goes up, and the volume expands. We know these things even though we don’t know how individual molecules behave.

It seemed to me that if we did have a galactic empire, there would be so many human beings—quintillions of them—that perhaps you might be able to predict very accurately how societies would behave, even though you couldn’t predict how individuals composing those societies would behave.

So, against the background of the Roman Empire written large, I invented the science of psychohistory. Throughout the entire trilogy, then, there are the opposing forces of individual desire and that dead hand of social inevitability.

Like Asimov, we view people at the individual level similar to gas molecules; unpredictable and seemingly random.

But if we pull back and view large groups of people such as societies and nations, we find that their collective decisions under certain conditions are not only explainable, but completely foreseeable.

In a sense, the broad strokes of history are predictable while the details are not.

And just as we need to understand the “gas laws” to predict the behavior of gas on a macro level, so too do we need to understand the “laws of social history” if we want to anticipate the grand tide of human affairs.

There are three socio-economic truths that we know of:

  1. Nations (large tribes of people) are relatively open and peaceful when their standard of living is perceived as improving.
  2. Nations become closed and retaliatory when their standard of living is perceived as getting worse.
  3. We measure our standard of living on a relative scale. It’s better for a society to benefit less, if all together, than for parts of the society to materially benefit more than others, even if the standard of living is higher for all. When there’s a large gap between those who benefit and those who don’t, the society becomes increasingly susceptible to its “baser” tendencies.

Take these laws and combine them with our knowledge of debt cycles and you get a powerful framework to help understand history and present day geopolitics.

The long-term debt cycle (75-100 years) is where debt accumulation over a generation drives consumption and quickly raises living standards. At its zenith, a large chasm forms between debtors (those saddled with a mountain of debt) and their prosperous creditors (those with all the capital).

This long-term debt cycle inevitably leads to a society of Haves and Have-nots. As stated in our laws of social history, this relative prosperity gap leads to a closed and vengeful society.

Through this lens it’s clear that the rise of populist leaders across the Western world in the 1930’s was not some historical anomaly, but something completely expected, as was the world war that followed. When people feel their standard of living getting worse, they become angry. They elect someone to “fix” it regardless of the means. This is par for the course during the turning of the secular debt cycle (which last occurred in the 30’s).

Now, nearly 90 years later, we once again find ourselves in another secular deleveraging. And we’re currently in the early stages of attempting to rectify the gap between the Haves and Have-nots.

This relationship between the long-term debt cycle and populist policies can be seen in the two charts below.

The first is from Bridgewater — the most successful hedge fund of all time. It shows their index that tracks populist votes throughout the developed world.

The chart has gone vertical since the Great Financial Crisis. The last time we saw these levels was during the Great Depression and the destructive two decades that followed.

Now compare that chart to the following from GMO. It shows that private debt levels peaked at the height of the Great Depression alongside the percentage of unionised workers in the workforce.

There’s a virtuous cycle at work here.

The start of the long-term debt cycle sees rising living standards that create acceptance and complacency across a society. This complacency allows power to concentrate among those who have capital, while shifting it away from those who don’t (ie, labor).

This goes on until a saturation point is reached. Eventually, increased debt can no longer add to productive means. At this point laborers’ living standards start to stagnate or fall, creating an increasing level of wealth disparity. This is when the debt cycle kicks into reverse.

Labor unifies and the Have-nots battle the Haves for more power. At the same time, a debt deleveraging occurs and then the whole cycle starts anew.

With our “psychohistorical” framework, it’s safe to assume that populism, as a political movement, is in its early stages of a secular uptrend. Over the next decade or two there will be less global cooperation, more protectionism, and greater proclivity for global conflict. And it’s through this framework that we can get a clear view of what’s currently going on in Europe…

Charts of a number of European ETFs and indices look constructive.

The bullish narrative here is simple.

Relative to the US, European stocks are cheap. The US stock market is trading at a CAPE of 29x (the second highest reading in history) while Europe is trading at 18x. This isn’t cheap, but it’s a bargain compared to the US.

There’s also the case of diverging monetary policy.

The Fed is tightening rates with two more hikes planned this year. There’s serious talk of reducing the balance sheet following the third hike as well.

This is in stark contrast with Europe, where the deposit rate is -0.4% and the ECB is still conducting large scale quantitative easing. They’re buying €60B worth of bonds every month…

There’s also the assumption that the large EPS gap between US and European stocks will mean revert, with Europe doing most of the work to move its EPS higher.

These factors form the basis of the European bull case. Relative valuations, diverging monetary policy, and mean reversion in EPS set the stage for a run in European stocks.  

This is why fund managers have been jumping into the trade since the end of last year.

A catalyst that would ignite this positive trend further would be the defeat (or the perception of the inevitable defeat) of presidential candidate Marine Le Pen in the upcoming French elections.

Le Pen is the populist leader of the right wing National Front. The National Front is an anti-euro, anti-immigration party. A Le Pen win would send shockwaves across Europe… signaling the demise of the EU as we know it.

She’s currently not projected to win. But we all know how well the polls have performed in the last two major political events…

Though just like short-term debt cycles oscillate around long-term debt cycles, populist movements oscillate around secular trend lines as well. While the long-term populism trend is up (blue line on the chart below), we’re of the mind that we’re near the peak of the current short-term uncertainty cycle (yellow line). We expect political events to swing back towards more predictable outcomes for a while. Le Pen will likely lose.

This thought is bolstered by the outcome in the Dutch elections where firebrand Geert Wilders was handily defeated.

Le Pen losing would be a positive (however short-lived) for Europe because after France comes Germany with a big election in September.

It could be a boon to markets if Europe can blanket the flames of populism for the rest of the year. This is also why the ECB is so keen to play it loose. They are an offspring of the EU experiment after all.  

Based on all this data, it looks like the coast is clear for Europe and we should pile in on the trend right?

Well… not exactly.

The bullish case for Europe is a classic George Soros-style false trend. The current rally is founded on untrue assumptions and will eventually reverse… hard.

None of the original reasons to be bearish on Europe have been settled. None of them.  

The reality is that Europe is just behind Japan on their transition along the long-term debt cycle. They have structural problems that include inflexible and uncompetitive labor markets, dwindling demographics, a misguided currency union, and an increasingly troubling immigration problem that’s pulling at the seams of their already fragile political union.

Europe’s recent “recovery” isn’t so much a recovery as it is another dead cat bounce on its long road of decline.

But Soros-style false trends can be powerful moves. And if the French election plays out how we think it will, with Le Pen losing, the false trend will likely continue. We’re willing to surf long with the true-believers, but we’ll be quick to  jump ship when things turn.

We discuss populism and Europe’s false trend in depth in our latest issue of our monthly Macro Intelligence Report (MIR). We also dive into 3 equity plays we think will benefit the most from the rally, along with 2 option/volatility plays that should profit regardless of the French election results.

If you’re interested in joining our team as we track and profit from these events across Europe, including this month’s French elections, then check out the MIR. It comes with a 60-day money-back guarantee. You have the opportunity to see our trades, take them, profit, and then refund your payment if you’d like. You’ve got two whole months to test it out. To learn more about the MIR, enter your email below:

And if you’d like to explore our European playbook further, check out the following articles:

Lastly, to dive deeper into any of the concepts discussed above, follow the links below:


Is The Dollar About To Break

Is The Dollar About To Break?

A couple of my favorite quotes from legendary trader Bruce Kovner are:

What I am really looking for is a consensus the market is not confirming. I like to know that there are a lot of people who are going to be wrong.

As an alternative approach, one of the traders I know does very well in the stock index markets by trying to figure out how the stock market can hurt the most traders. It seems to work for him.

If you can figure out how the majority of the market is positioned and where the most consensus trades are, you can do very well by opportunistically fading the herd. This is playing the player and trading at the second level… a skill that’s vital to long term market survival.

Fading crowded trades is a great strategy, especially recently.

For example, our oil short went against near record long speculative positioning as noted in the COT report. Our long bonds trade went against speculative positioning as well and has been very profitable.

Since markets have lacked volatility and benchmark indices have gone vertical over the last few months, money managers have been desperately chasing and recklessly crowding into trades. This has resulted in a lot of one sided positioning that traders like us can continue to take advantage of.

Looking around global markets there’s one obvious trade that would make a lot of people wrong and hurt the most traders. That trade is the ole’ greenback.

Let’s look at the evidence.

The chart below shows speculators are max long the dollar against broker dealers. This is an extreme reading. When you see COT positioning at this level of divergence, it’s almost always the dealers who win out. The market doesn’t pay a bunch of speculators so easily.

BofA’s monthly Global Fund Manager Survey was released this week. The chart below shows that a large net % of respondents are saying the dollar is overvalued. This survey has a pretty good track record of noting short-term reversal points in the dollar.

It’s been a long time since there was a large and violent forced selloff in the dollar. That means dollar longs have grown complacent and many of them are probably leveraged. When there’s been mostly one way moves in an asset for a few years, it creates a situation where positioning, leverage, and complacent beliefs are like piles of dried, kerosene-soaked kindling. They’re just waiting for a spark.

Take away talk of the border adjusted tax and combine it with other global central banks like the BOE and ECB looking to end their easing cycles, and you have the potential for a ripe and violent reversal… or a dollar bonfire if you will.

Is The Dollar About To Break

USD price action is setting up in what looks like a textbook head and shoulders pattern. We could see a break below the neckline this week.

Now we don’t think this is a major reversal in the dollar here, it’s only short-term. But it’s still very playable.

There are a number of ways to get short the dollar since it directly and indirectly affects the pricing of many other assets (ie, emerging markets, oil, gold etc).

But in order to find the optimal dollar short trade, let’s again look at market positioning — using COT data and the BofA Fund Manager Survey —  to see how other players are long dollars directly or synthetically.

The chart below via www.freecotdata.com shows the 5-year percentiles for Net Speculator positioning. The instruments in red on the right are those that speculators are net short and vice versa for those in green on the left.

ZB, the bond futures contract we’re currently long, is essentially a synthetic dollar short position.

The 10-year yield and USD have moved in lockstep fashion over the last two years. This means that the potential for a dollar selloff looks good for our long bond positioning.  

The next instrument — 6B —  is the British Pound futures contract. Looking at the graph below from the Fund Manager Survey, you can see that respondents are historically net short the euro, pound, and bonds.

Like the dollar, both the euro and the pound have been forming inverse head and shoulders and are close to closing above their necklines.

We took a crack at going long the pound (FXB is the ETF alternative for the pound and FXE is the euro ETF alternative) a few months ago but closed our position for scratch as it failed to carry through. I’m willing to take another stab at it and perhaps the euro as well should we see price break those necklines.

If you’re interested in seeing exactly how we play these coming currency moves, take a trial of the Macro Ops Hub. Hub members get alerts to our exact entries, exits, and position sizes of both our model portfolios. Membership comes with a 60-day money-back guarantee. Check it out for 2 months, and if you don’t get your money’s worth, we’ll return it right away. Click here to learn more.



Optimism and Complacency

A Dovish Hike and a Third Step Before a Stumble?

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

The Fed hiked on Wednesday as expected, bringing the Fed Funds rate to a whopping 1%. The market, with its rose colored glasses in full effect, interpreted the hike as dovish.

In reality the meeting was neither overly dovish or hawkish. The Fed stuck to its playbook of hiking rates and muting expectations going forward. Their infamous dots still project two more planned hikes this year and three more the year following.

Nautilus Research published the following chart noting market action following the third rate hike in a tightening cycle.

The “3 steps and a stumble” theory was put forth by late trader and market guru Marty Zweig (he wrote a book worth reading titled Winning on Wall Street). Zweig noticed that the market has a tendency to considerably underperform following the third rate hike in a hiking cycle. Here’s the following from Nautilus.

The SP500 has endured significantly below average results from 1 to 12 months after  3rd rate hikes in 11 events back to 1955.  Note that 6 (more than half) of those hikes occurred within a year of a major cyclical top for stocks (1955, 1965, 1968, 1973, 1980, 1999).  However, the market defied that relationship on the last occurrence in 2004 by rallying for 3 more years… When looking at all hikes – note that hikes are generally bad for stocks, somewhat bad for the US Dollar, and bullish for 10yr yields and commodities.

Yale economics professor Robert Shiller, of CAPE ratio and “Irrational Exuberance” fame, noted the similarities in sentiment between the current market and that of the late tech bubble (an analog we’ve discussed quite a bit).

In a recent Bloomberg article Shiller said, “They’re both revolutionary eras, in the tech boom it was a new era of prosperity brought on by the internet now it’s a ‘Great Leader’ has appeared. The idea is, everything is different.” But no matter how you cut it, Shiller says “The market is way over-priced… It’s not as intellectual as people would think, or as economists would have you believe.”

Going off of the chart below, it’s safe to say we’re transitioning from the greed to euphoria stage. Take a look at magazine covers and article headlines and it’s easy to see that the market is entering a new level of optimism and complacency.

Optimism and Complacency

As we progress further into the latter innings of this cycle, and as expectations become more and more dependent on a narrowly defined and exceedingly optimistic future, it pays to remember the following from the book Ubiquity: Why Catastrophes Happen (bolding is mine):

In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

(Note: There will be eleven(!!) Fed members speaking this week. Who knows what kind of tone they’ll take, but it should make for an interesting week).

The above is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.



SPDR Bloomberg Barclays High Yield Bond ETF

Hawkier Fed, Drowning Oil, and Insiders Jumping Ship

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

The Fed is going to hike this Wednesday. They’ve made that clear. But why the complete reversal in tone since their last meeting?

The answer is obviously because of the Fed’s unspoken third mandate — putting caps on bubbles. This is something it’s historically been poor at. But Yellen and team have commented in recent weeks on the market’s seemingly lack of concern over economic and political “uncertainty”.

Charts like the one below are evidence of this:

So the Fed’s gonna hike. But the real question is, do they talk dovish following this week’s hike as has been their modus operandi? Or do they increase their hawkish rhetoric out of fear that the market and expectations are running away from them?

I don’t know, but we’ll find out shortly.

We nailed the breakdown in oil. Our option play in Vol Ops should pay out nicely.

Now we just need to see if oil experiences another v-bottom reversal at its 200-day like it did the last two times, or if the third time’s the charm and she trips off the cliff here.

What happens to oil will have big implications because it’s wagging the tail of credit (see nearly identical chart below). If oil turns lower, then credit will continue lower and we’ll see spreads begin to widen and defaults increase.

SPDR Bloomberg Barclays High Yield Bond ETF

Not to mention what a lower oil price will do to S&P earnings over the coming year. The rebound in oil prices have been a big boon to earnings and revenue growth over the last year. The chart below shows expected forward earnings for the SPX, Energy and SPX ex-energy.

If oil prices roll over from here then expect that blue line to come crashing back down. And the green line showing S&P companies ex-energy doesn’t look a whole lot exciting either.

Indicators are pointing South for the credit cycle. The chart below is a prime example of an end of cycle liquidity suck. Falling liquidity = falling demand = falling growth = asset prices adjusting lower.

The 12-month, 3-month and 1- month change in bank lending (an aggregate of business, consumer, and real estate loans) growth is rolling over and looks like might actually start contracting later in the year.

This liquidity tightening is happening all while sentiment and retail participation is markedly picking up. The chart below shows soft data (dark blue) which is various business and consumer sentiment survey data compared to the hard numbers (light blue) which report actual data on the economic state of our country.

Large divergences between exuberantly optimistic soft data and the actual hard numbers as shown in the chart above don’t have a history of working out well for those giddy individuals.

My call last week for a coming market retrace still stands. The divergence between breadth and credit is still there (has actually widened more). I suspect the market levitates for the next few days and starts selling off into the end of the week.

I’m not calling a top here, just a retrace. The highs haven’t been made on this market yet. It has some more room to run. But expect things to start getting a lot more bumpy…

The above is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.



Uncertainty Is Good For The Stock Market

Uncertainty Is Good For The Stock Market

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

Here’s an interesting question: Is the Trump administration’s erratic policy and governing style bullish or bearish for stocks?

Lately, I’ve read a number of analyst notes talking about how the current political uncertainty spells trouble for the stock market. They all include the line “…if there’s one thing markets don’t like, it’s uncertainty about the future.” I think that’s lame thinking.

I would argue that this “uncertainty” is bullish for equities, at least over the short-term.

I say this because this “uncertainty” is feeding into the Fed’s rake hiking decisions. Remember the hawkish tone coming from Fed members back in December? That seems to have been reversed since Trump took office and started significantly shaking things up. Fed members have cited the uncertainty over future fiscal policy as a key reason to err on the side of caution in raising rates.

FOMC member, Neel Kashkari, wrote a post this week explaining his reasoning for voting to keep rates steady at last month’s meeting. The whole post is worth reading (link here). but here’s Kashkari’s concluding remarks:

We are still coming up somewhat short on our inflation mandate, and we may not have yet reached maximum employment. Inflation expectations remain well-anchored. Monetary policy is currently somewhat accommodative. There don’t appear to be urgent financial stability risks at the moment. There is great uncertainty about the fiscal outlook. The global environment seems to have a fairly typical level of risk (though that can change quickly). From a risk management perspective, we have stronger tools to deal with high inflation than low inflation. Looking at all this together led me to vote to keep rates steady.

Fed President James Bullard, also cited fiscal uncertainty in a speech he gave this week saying “It is unlikely that fiscal uncertainty will be meaningfully resolved by the March meeting… We don’t have to move. We have a lot of fiscal uncertainty. Why not wait until that is more clearly resolved?”

So Trump’s unconventional governing style is creating uncertainty over the future which is making the Fed step back from its rate hiking path. This is supportive of equity prices over the short-term. The breakouts this past week in many of the indexes seem to confirm this.

This creates the unusual situation where a more steady governance and a clearer picture of future fiscal policy would likely lead to faster rate hikes and thus be a net-negative for markets.  

The Fed conducts a Senior Loan Officer (SLO) Report every quarter. In this report they survey roughly 60 large commercial banks and up to 24 large foreign banks with branches in the US. The survey is intended to provide a quarterly update on credit availability and demand as well as developments in lending standards. It’s a good barometer of the overall credit market and provides us useful insight into how the credit cycle is developing. Read more

SKEW Index Has Trended Straight Upward

Low Volatility Begets Low Volatility. Here’s Why…

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

The trading community has been yapping away about the VIX trading sub-11 and the extreme number of speculative shorts involved. They’re saying it’s gotta burst higher.

Their proclamations are presented with a chart like the one below which measures net nominal non-commercial positioning.

VIX Future Positioning

But these positioning charts are misleading. They fail to account for the growth in open interest. The VIX futures in particular become heavily distorted because open interest and volumes have increased 10x since they first started trading in 2004.

VIX Future Open Interest

Net nominal numbers therefore mean nothing. Yes, the total amount of net shorts is higher than it’s ever been, but that’s because more people are trading VIX futures than ever before.

It’s easier to see why this is true with a simplified example.

Say they’re 100 open contracts and specs are short 99 contracts. Well obviously that’s a crowded trade. If the specs race to cover, price will squeeze hard. Specs are short 99% of the open interest.

Now let’s say activity grows and there’s 1,000 open contracts. Of these, specs are short 600, or 60% of the open interest. Compared to the prior reading, net short 600 looks a lot bigger than net short 99. But in reality the first situation has a more concentrated spec position. Participants previously were short 99% of open interest instead of 60% of open interest now.

That’s why you need to make sure you’re accounting for open interest.

We know a number of you visit freeCOTdata.com to look at positioning. We emailed the site owner Adam to ask if he was accounting for changes in open interest or not. As of now he is not accounting for them. But he’s rolling out an update soon to reflect the changes. After that update, the charts should give us a better idea of whether or not we’re at a true speculative extreme.

It’s worth noting that even without the update the 5-year percentile in VIX futures is not at an extreme. All the fuss on twitter was for nothing…

Futures Is Not At An Extreme

Given that positioning isn’t at an extreme (money managers are way too afraid to short vol in the Trump era), we’re in agreement with Goldman on what these low VIX readings mean. The data shows that low vol begets low vol, not high vol. Goldman conducted a study going back to 1990 to find out what happens to VIX and the market after VIX crosses below 11. The specifics of the study are shown below: Read more

Why Equities Are NOT Overvalued

Why Equities Are NOT Overvalued: The Relative Risk-Premium Spread

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one–common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.

How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms. In my view, it is only a matter of time before today’s yield pigs are led to the slaughter house. The shares of good companies and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today’s investment-grade issues will be downgraded to junk status if the economy doesn’t begin to recover soon.

What if you depend on a higher return on your money and can’t live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss. Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable.

I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the gettin is good. Caution has not been a profitable investment tactic for a long time now. I strongly believe it is about to make a comeback.  

The above is from a Forbes article written by legendary value investor and hedge fund manager Seth Klarman.

In the article, Klarman excoriates common investors for being “yield pigs” blindly piling into common stock. Low yields having driven them into a frenzy for return… as they hoof their way to the slaughterhouse to be ground into some expensive breakfast sausage. Read more