A Corn Soybean Spread Trade

A Corn/Soybean Spread Trade

The following is straight from Operator Jose, a member of the Macro Ops Hub.

The Corn to Soybeans Ratio is very important to American farmers. In normal conditions, it’s a key factor that helps them decide how much Soybeans or Corn they’ll put into the ground. Both crops compete for the same acreage area. I like to think of it like this:

Farmers have a portfolio, but instead of money, they have acreages. There are two assets they can choose to invest in. Either Corn or Soybeans. This key decision is ASSET ALLOCATION. Whether they want more exposure to Corn prices, or prefer holding more Soybean bushels, depends on many factors, but price is a big one.  

Farmers can check, even months prior to the harvest, how much money they’ll receive for every bushel they pull from the ground. This is done by evaluating the relationship between the Corn and Soybean futures that’ll be trading by harvest time.

Here´s the long-term relationship for the front month futures:

Soybean Corn Ratio

The ratio is Soybeans over Corn. Whenever the ratio is over 3, farmers get 3 times more money for every Soybean bushel than Corn. Sometimes the ratio goes crazy due to weather risk and supply imbalances, but in normal conditions it shouldn’t be over 3.

Whenever the ratio is over 3, farmers plant a heck of alot more Soybeans than Corn. And by the laws of supply and demand, this will eventually cause the ratio to go down as Corn becomes scarcer relative to Soybeans.

The best way to play this relationship is through a spread trade. You can use one contract of Soybeans per two contracts of Corn. This means you’ll have 5,000 bushels of soybeans and 10,000 bushels of corn on a notional basis.

If we’re bearish on the Soybean/Corn spread, meaning we think corn prices will rise relative to soybean prices, we’ll need to short one contract of Soybeans, and go long two contracts of Corn. If bullish, meaning we think soybean prices will rise relative to corn prices, we do the opposite — buy one contract of Soybeans and short two contracts of Corn.

Soybean Corn Chart

You’ll notice that this chart is very similar to the previous spreads chart, but the Y-axis is now quoted in points instead of in a ratio. Every point on the Y-axis is worth $50 per the spread trade.

The reason we use a spread instead of playing the commodity straight up is to hedge weather risk. Weather is THE principal risk factor in grain commodities. Weather produces a largely asymmetric effect: while bad weather alone could completely destroy a crop yield, good weather by itself won’t produce a bumper harvest. Good weather is just one factor involved in a successful growing process. By taking the spread we’re strictly betting that Corn futures will do better than Soy futures no matter the other general conditions. Weather risk is partially hedged.

I´m bearish on the Spread. Here are the fundamentals that support my theory:

The chart below shows how the Soybean/Corn ratio went over 3 last year when farmers planted too much Corn relative to Soybeans (Soybeans became scarce and therefore fetched a higher price). Since December the ratio has been falling.

Soybean Corn December Ratio

The ratio didn’t do much in February and March other than consolidate. But at the end of March the USDA released the Prospective Plantings report. This report shows how many acreages farmers intend to commit between Corn and Soybeans. The keyword in this report is “Intention”. Following our portfolio analogy, the farmers are telling you the percentage of their portfolio they’re willing to invest in Corn or Soybeans.

But keep in mind that the grains aren’t in the ground yet. These farmers can change their planting intentions. There’s currently a small portion of Corn being planted right now, but there’s still time to switch acreages in later stages. Farmers aren’t forced to stick to what they reported in the prospective planting report.

On March 31st the report was released showing a decline in Corn acreages of 4% and an increase in Soybean acreages of 7%. Less Corn supply means each kernel is worth more. And more Soybeans means each is worth less. This confirmed my bearish bias on the spread. All that was left was price action to follow.

What do you think the big funds did on the day of the report? They shorted 11,000 contracts of Soybeans… and went long 20,000 contracts of Corn… a big 10,000 spread trade.

Amazing! It was almost like forecasting the future….

Here´s a chart with the Net Contracts position of Managed Money in the Soybean market. Notice the downtrend. They are finally net short!

Net Positions of Managed Money On Soybeans

The spread went from around 230 per bushel to 168 — a 27% move in 7 days. Report day was the biggest red candle of almost 30 points.

November Bean December Corn Spread

I believe there’s still downside potential to this trade. Price has retraced almost completely since the day of the report, and as I said, I don’t think the market has fully discounted a big soybean crop this year. And if you check the long-term historic spread, there’s still downside potential.

I am short the New Crop Spread ZSX17- 2*ZCZ17 (Short 1 November Soybean Future and Long 2 December Corn Futures.) These are the futures at harvest time when the market should be overflowing with Soybeans relative to Corn.

To learn more about how we trade at Macro Ops, click here.



Gaia: A Booming New-Age Streaming Service Run By A Zen-Monk CEO

When the median market PE multiple is at its highest level in history and heading higher, it’s nearly impossible to find investments that have long-term holding potential. Stock market tops are a trader’s purgatory — it’s far too early to start shorting, but going long is just as much of a crapshoot.

With that said, there are still some hidden value/growth opportunities that are improperly discounted by the market. To find them you just have to sift through the more overlooked areas of the market, which often means diving into the microcap space.

This involves digging through hundreds of junk stocks to only occasionally find a diamond in the rough, the one that has the real 10+ bagger potential.

After digging through hundreds micro cap stocks over the last month, I’ve come across one that has huge potential. The company is called Gaia and it’s run by an unusual CEO.  

I remember digging into this company a few years ago. At the time, I thought it was interesting but lacked direction, so I passed on it.

But over the years it’s stuck with me and I’ve continued to check up on it from time to time. The reason I do so is because of the founder and now CEO (he’s recently returned to lead the company after an 8 year hiatus).

That man is Jirka Rysavy, and he’s unlike any other successful CEO you’ll ever read about.

Rysavy originally hails from Czechoslovakia, where he was a national champion hurdler. He escaped Soviet rule during the 80’s and fled to America where he spent a good deal of time walking across the country and sleeping on park benches.

In 1984, with hardly any money or formal business training, he started an office supplies distributor.

He took a page from Sam Walton’s playbook and sought to revolutionize the highly fragmented office supplies space by selling cheaper and more efficiently than anyone else. In this vein, he was highly successful.

In under a decade his company “Corporate Express” became the largest office supplies distributor in the world, as well as a Fortune 500 company. In 98’ Rysavy sold Corporate Express to a Dutch firm for $2.3B.

During this time Rysavy also started a number of other companies that ranged from an organic market (which later became Wild Oats and was bought by Whole Foods) to a solar power company and nutritional supplements maker, all while still finding time to train for the Olympics with his native track team. Simply put, the man is a serial entrepreneur and an unusual one at that.

Even after accumulating a net worth that’s in the hundreds of millions, Rysavy chooses to live on a small secluded plot of land in the mountains of Colorado. It’s a tiny log cabin with no running water and little in the way of amenities — he sleeps on the ground in a sleeping bag. Once, when asked in one of his very few interviews, why he chooses to live so frugally, he responded “I have everything I always wanted. Just because I have money, why should I buy extra stuff?”

You can read up some more on one of America’s most interesting CEOs here.

I’m putting emphasis on Rysavy because the trade thesis behind Gaia is largely a case of betting on the jockey.

An exceptional jockey (management, leader) can make up for a lot of the present day shortcomings of a company. Just like great stocks, exceptional management is tough to come by. There’s only so many Steve Jobs, Mark Zuckerbergs, and Jirka Rysavys in the world.

When the opportunity arises where you have a rock star leader and a company with a long runway and low stock price… you get an amazing investment opportunity.

That’s what we have here with Gaia.

Gaia was started by Rysavy in 1998 immediately after he sold his office supplies company. It started off as a lifestyle brand that produced yoga clothing and nutritional supplements. At its peak 10 years ago it was doing roughly $300 million in revenue a year. But in 2008 Rysavy stepped down as CEO and the company lost direction. As a result, it saw sales and earnings decline.

This past year, Rysavy, apparently tired of meditating in the mountains and practicing his sun salutations, returned as CEO and has completely pivoted and refocused the company.

He’s sold off its large branded yoga apparel business for $167M and its travel business for $12M, leaving just a video streaming business and a large pile of cash. Gaia used some of that cash to buy back 40% of the company last July. Rysavy now owns 38% of the company.

The new Gaia is gunning to become the Netflix for the “New Age”, making it a play on the trend towards distributed and specialty programming in television. It’s creating a platform subscription business. I love these types of businesses.

Gaia’s content ranges from guided meditations and yoga, to holistic nutrition, parenting, spirituality, and some paranormal shows that are really out there (they make the History channel’s Ancient Aliens look like sober academia).

It’s safe to say that Gaia is going after a niche market. But because of its online streaming platform and global reach, this niche is potentially very large.

Gaia produces the vast majority of its content in-house. It has a number of Gaia stars or “gurus” that are paid on the number of subscribers they attract to the platform. This makes for low-cost customer acquisition and aligns incentives between the platform and its content creators.

Subscribers can watch Gaia’s content through its newly optimized VSOD site or through one of its many partners like: Apple TV, Roku, Amazon, Hulu, Comcast and Verizon. On average, users pay $10 a month for a subscription.

Like Netflix, the investment thesis is all about growth potential. So what does that look like so far?

As of last quarter, Gaia saw subscription growth of 52% over the year prior, bringing the total subscribers to 202,000 with members in 140 countries.

Given that Gaia started from scratch just three years ago and streaming video was just an afterthought of the business until last year, that’s impressive growth.

One of the many great things about the online platform business model is that the trend growth is not linear, it’s exponential. That’s how Netflix was able to more than 3x its subscriber base in under four years. Gaia can do the same.

According to Bespoke Research Group, there’ll be an estimated 300 million video streaming customers around the globe by 2020. Out of those 300 million, 55% are interested and willing to pay for at least one Gaia topic.

Gaia will only get to a fraction of the total addressable market, but that’s all they need for the stock to rise by a few multiples.

Right now, the company is projecting 80% subscriber growth for this year and the next. They expect to hit 1 million paying subscribers in 3 years time. With their expected margins, they should reach $60 million in pretax earnings within 5 years. With only 15.1 million shares outstanding, that would give the company an earnings  per share of $2.50.

And here’s the thing, we think these growth projections are on the conservative side. Rysavy has a long history of under promising and over delivering.

The company is currently losing money, but this is by design. Gaia has to expense all the costs of acquiring new customers as they’re incurred, but revenues from new customers are realized over their lifetimes, creating a mismatch between expenses and revenues. They could be profitable at current subscriber levels, but are foregoing current profitability to focus on growth, which is the right strategy.

Even though Gaia is unprofitable at the moment, they’re fully funded and shouldn’t have to access any additional financing as they grow. In fact, there’s a lot of safety in buying the stock at current levels.

Currently the company has $50M+ in cash that covers nearly 40% of its market cap. Gaia also owns a large campus that is less than 20% occupied by the company. The property and land values are estimated to be worth at least $20M. They also have 77,000 titles in their video library equating to around 7,400 hours of content, which is worth approximately $20M.

This means that at the current market cap of $132M, roughly 60% of the market cap is covered by cash and property alone. With no debt, our downside is protected.

Assuming Gaia is able to hit its conservative growth targets over the next four years, and given a very modest 10x multiple on those assumed earnings, we arrive at a market cap of approximately $350M… roughly 3 times what it is today — and that’s our conservative case.

Simply put, with Gaia you get a niche company with little to no current competition, that’s run by a serial entrepreneur who owns nearly 40% of the business (major skin in the game) and who has a long track record of being able to rapidly grow businesses. This trade is undiscovered for the time being, but once other investors see the potential here, the stock should take off. A three bagger is our base case.

Want to find another potential 10-bagger like GAIA? Then check out our Explosive Stocks Cheat Sheet here.



It’s Over

French elections are over.

The Populist hydra has been slain (for now) and the world has taken a step back from a repeat of pre-WW2 political turmoil. Center globalist Macron bulldozed the “French Trump”, winning 66.1% of the vote.

Macron did very well among the rich and educated white collar demographic. Le Pen on the other hand attracted the blue collar, less “sophisticated” rural working class.

In essence, the vote was a battle between the “haves” and “have nots”. If you’re doing well in life, you don’t want Le Pen rocking the boat. But if you’re out of work and struggling, then you want someone who can overturn the established regime.

This is the exact dynamic we saw with Trump. The “haves” wanted the stability of Hillary. The “have nots” wanted Trump to shake things up and make factory jobs great again. In America’s case, there were a lot more “have nots” than what people thought — hence the Trump upset.

So what happened in France? Why wasn’t Le Pen able to do the same?

It’s because she didn’t persuade the old folk.

Both the Brexit and Trump events were heavily supported by older demographics. The older you were, the more likely you were to vote for the populist option.

But this wasn’t the case in French elections.

Le Pen supporters actually topped out around 40 years of age and then rapidly tailed off. Only passionate young people, still jockeying for position in the work force, wanted to upset the apple cart. The old folks didn’t want to live out their golden years in the midst of an EU breakup, with a currency change to boot.

Despite the bad beat, Le Pen actually took it pretty well. She was caught dancing away at a nightclub on the night of her defeat in classic French “C’est la vie” fashion.

Anyone paying attention to the markets knew what was coming. On the Friday before elections, investors were so confident in Macron, that they pushed French equities to new highs for the year.

Our team still covered our downside risk with EURUSD option spreads just in case of a surprise. A fluke upset would have decimated the risk-on holdings we’ve been nurturing since earlier this year.

To make money on this theme you would’ve had to be long equities well before the 2nd round of elections. In early April the markets were still scared of a Le Pen win. You could see this through the expensive options and stagnant equities. The crowd wasn’t privy to the coming retrace in populist sentiment.

But the Macro Ops team was. We bet on a likely Le Pen loss well before the trade became consensus.

Since the beginning of April, we’ve been pounding the table about how the populism cycle had reached a short-term top.

Politics, like price action, doesn’t travel in a straight line. It moves in waves. Large impulse moves higher are followed by corrections to the long-term trend. Then, once doubters have been shaken out, the trend resumes again, with another impulse move higher.

Our favorite chart of 2017, the World Economic Policy Uncertainty Index, made our analysis easy. It became clear that anti-establishment sentiment was overstretched post-Trump. We were due for some mean reversion.

This was a major reason why we called for a Le Pen defeat. Beggar-thy-neighbor politics had moved too far too fast.  

And like clockwork, the index continued to revert back to its long-term trend line on the back of a Macron win.

Going forward we can finally take a breather from politics (thank god). German elections should be a non-event and Italy’s election isn’t until next year.

Now that political risk has subsided, there’s not much data pointing to a reversal in trend. It’s not just Europe that’s strong, econ data is picking up around the globe.  

Since mid-2016, global PMI numbers have rapidly improved and continue to hold at expansionary levels.

And Citibank’s macro risk index is back near lows.

Notice the last time the chart was down to these levels — the end of 2009, the end of 2012, and now. All these periods were followed by major market rallies

The classic “risk-off” trades are all in the dumpster too. Gold looks weak. It’s stuck trading below its down-sloping 200-day MA.

And the rebound in bonds has proven to be short-lived as well.

For now, we’ll keep to the long side of markets while enjoying a respite from politics.

“It’s a bull market, you know.”



Europes Big Test

Europe’s Big Test

A large impetus to the next thrust higher in European equities will be the final round of French elections this Sunday.

We’ve covered the rise of populism and how it affects markets for some time now…  

If Macron should win Sunday, as we expect, the populist threat will likely recede for the time being. The next contentious European election is Italy’s. But that’s not until the middle of next year. The Eurozone should be safe until then.

As we discussed in last month’s Macro Intelligence Report (MIR), the populist movement is cyclic with a tendency to swing back down towards its longer-term trend.

A Macron win will be a huge narrative boost that’ll clear a major roadblock keeping investors out of European equities. The elections are partly why US investors have been pulling money from European ETFs in 13 of the last 16 months.

Macron winning will also boost the euro against the dollar. This will raise total returns for those buying European stocks and create the possibility of a positive, although temporary, feedback loop.

As we’ve previously discussed, there’s still plenty of room for performance reversion to occur between the US and Europe. The chart below, via the CFA Institute, shows the rolling 10-year performance difference between the two. The blue line indicates when European stocks outperform US stocks over the previous decade. The red line shows when US stocks come out ahead. And the green line shows when US equities outpace European markets to an extreme — which is what we’re seeing today. As the writer of the article Michael Batnick notes, “In the 44 previous readings when the spreads reached 100%, European stocks went on to outperform for the subsequent 10 years.”

Data coming out of Europe is largely supportive of the recovery narrative as well. RBC’s economic coincident indicator is in a strong uptrend.

First quarter earnings for European stocks are coming in solid. In total, first quarter earnings on Europe’s STOXX 600 are expected to increase a solid 10.5% over the year prior. The companies that have reported so far have seen above average revenue and earnings growth.

And finally, we can’t forget to look under the hood of European liquidity conditions.

Just like in the U.S., credit spreads have continued to narrow in the Eurozone since the bottom in 2016. Liquidity conditions favor risk-on assets.

The other obvious thing to pay attention to alongside our liquidity indicator is ECB policy. As long as Super Mario keeps rates low, the system will remain liquid. As of right now the ECB has never been more dovish. All three rates are at all time lows…

If history rhymes (it usually does) there’s edge in betting on higher prices for Europeans equities in the months ahead. Favorable liquidity conditions place a bid under stocks as capital allocators take cheap money and pile it into higher returning assets.

One thing we like to do at Macro Ops is verify our macro assumptions with historical data. It keeps us honest and free of incorrect biases.

Recently Operator Junaid from London helped crunch the numbers (from 1992 to present) on forward equity returns given various changes in interest rates.

We used the DAX as a proxy for European equity performance and the 10yr rate on Bunds was used for rates. Rate changes are in percent terms, not absolute terms. For example, a rate increase from 1.00% to 1.50% is a 50% increase in interest rates.

In the chart below you will see different rate regimes on the x-axis. For example, the -59% to -50% regime includes all occurrences since 1992 when the 10Yr German interest rate fell anywhere between 59% and 50% over the course of two years.

The y-axis then plots the 2yr forward returns of the DAX given the interest rate regime.

Europes Big Test

It ain’t hard to see that falling rate regimes are good for equities while rising rate regimes are bad. You can see in the chart that as soon as the rate regime turns positive (the 11%-20% increase regime) stocks suck.

According to our study, if rates have been downtrending, the probability of DAX trading higher is 88.89%. That probability plummets to 36.51% if rates have been increasing over the last two years.

Right now we’re in the midst of an ultra dovish regime. This means we should play for higher equity prices over the next 2-years. As long as liquidity remains favorable, stay biased to the longside.

All in all, the broader environment is supportive of higher European equities. And though we don’t believe this is the start of a new cyclical bull in Europe, there should be enough tailwinds to advance the stock market well into the end of the year.

But of course, there’s always that chance that Le Pen surprises with a victory. And with the way politics have played out over the last year, it really wouldn’t be that crazy.

A Le Pen win would significantly distort the market outlook in Europe and especially its currency. It could also roil markets around the world.

We’ll be buying long dated bond futures going into the end of the week. The ETF alternative is the iShares 20+ year Treasury Bond (TLT). This will hedge out our long exposure over the weekend and protect our downside should there be a Le Pen upset and subsequent large selloff next week. If Macron wins and markets go on a relief rally, we’ll quickly close out the position Monday morning. We shouldn’t lose much on the trade.



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.


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.