Most of the way there.

The bounce has been faster and more comprehensive than I expected. I was thinking that we would top around these levels, but by summer or fall, not early May. I have continued to scale into distant-expiry SPY and QQQQ puts, favoring ITM and ATM, and have now deployed about 1/3 of the money I am willing to allocate to shorts. I also have a smidgen of shorter-term positions in certain ridiculously high-flying restaurant and other consumer stocks.

The bond sell-off and commodities rally indicate that inflation fears now have the upper hand, as most people still believe deflation will be a short-lived phenomenon. The aforementioned movements are setting up nicely for long and short replays, respectively.

Notwithstanding a long-overdue correction, I suspect that stocks have further to run, and am no longer such a skeptic of certain Elliott wavers’ target of S&P 1050. Bullishness is now at 80%, up from 2% in March, but judging from attitudes on TV, there is still a great deal of skepticism to be overcome before we can call a top. That said, the speed and evenness of the advance leads me to expect much more choppiness for the remainder.

Shorting precious metals has been frustrating, and I suspect that we are repeating the pattern of last spring, when we had to work our way through several months of chop after receding from manic levels (1030 gold that time, vs 1007 in February).

It is important to keep in mind the real situation, not just the current market mood (though you can’t trade on fundamentals alone). We can’t work off the greatest credit bubble in history in 18 months and just a 57% loss in the stock market. The real (private, productive) economy is not going to stop shedding jobs, let alone add them, for years, and people are so indebted that they cannot be enticed to reflate the asset bubble or return to previous levels of wasteful spending. It will take a generation to work through our debt and lifestyle delusions.

It bears repeating that today’s official headline unemployment number (8.9%) cannot be compared to numbers from before the 1990s, when the Clinton administration changed the reporting methodology to exclude large segments of unemployed. A more useful measure for historical comparisons is U-6 unemployment, which now stands at 15.8% for April. Today on Bloomberg I heard Christina Romer say that things were nothing like the Great Depression, as she compared apples to oranges. In reality, we are at solidly depressionary levels already.

Also bear in mind that stock valuations remain at bubble levels. This is easy to see when you remember that stocks have no intrinsic value other than marked to market book value and heavily discounted future earnings. The major indexes’ trailing PE’s on net earnings will be under 10 by the time this is over. We still need to work off the bubble that was blown in the 1990s, which didn’t finish deflating in 2003 because of the easing of credit. Every kind of credit is tightening now, unless of course you are a bank holding company.

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5 thoughts on “Most of the way there.

  1. Equities:
    The market is frangible, it could sell-off at any day now. Going long means you have a very steep discount curve since the upside is limited (and would be short term paper gains that could not be sustained), while the downside is a potential retest of the March lows.

    I am not a good value player since I do not have the skills to analyze stocks, but who cares? I suppose “short beta” will be simple and effective equities strategy. Do you have any equity shorts that would outperform that has more complexity than simply “short beta”. (Of course XLF, IWM, an XLY would outperform because they have a higher beta than other stocks.)

    Do you think other markets have decoupled yet. Does it make any difference to short the DAX, FTSE, or Nikkei anymore, or the correlations in for most developed market equity indices is one. But I think Japan, Australia, and Canada are starting to decouple, along with other emerging markets.

    Regarding your views on currencies… what do you think about the dollar?

    I think there will be a new paradigm where the dollar (and pound) will replace yen as funding currencies for carry trades (to fund bets on CAD and AUD as I think CAD might increase interest rates eventually). Bernanke isn’t going to raise interest rates for a long time (maybe when actual inflation kicks in and the money actually tickles down). Bernanke’s printing press would increase the upside for that type of trade.

    I am bearish on the pound as a deflationary trade. I suppose GB would not receive any capital inflows, and they would have enormous trade deficits since their manufacturing base has been ruined. Also, it is in a “balance sheet recession” where companies seek to minimize debt, not maximize profit. So, capital would not be attracted to English equity since the returns on capital will be low when everyone is deleveraging, and people are not eagar to spend. Also, unlike the dollar and yen, not a lot of loans are taken out in the pound.

    And let’s not forget, that the North Sea Oil has peaked too.

    Thoughts on BRL, CAD, AUD? I think they might suffer short term negative volatility, but they are nice long term bets.


    I do not think going long on bonds is a good trade from a risk/reward perspective (but you didn’t recommend that). Do you think people will seek the safety of nominal protection and a low interest pay (especially on high duration products which are more sensitive to interest rate changes)? Or that discount rates on paper currency would go up as people become less certain that the value of the currency (not its scarcity as the money could be in a black hole) would fall due to hyperinflation or default (even during a period of deflation)? The current steep yield curve supports the hypothesis of increasing discount rates on long term assets.

    I said this before on another blog:

    The bond market (and Bernanke’s manipulation) still seems to be betting against a recovery or inflation (despite what the inflationists on Seeking Alpha are saying). Do you think a 210 bp for 5 years is pricing in a recovery or inflation. 2.10% yield is not enough to protect against inflation? 210 bp for 5 years is a very high opportunity cost if one expects the returns on capital to be higher.

    It would be more tempting to put on a long position when perceptions significanly diverge from reality. (Which doesn’t seem to be the case.) Initiating equity shorts now seems to be a better risk/reward than going long (with leverage) on Treasuries now.

    Do you have any commentary on what the Treasury market is pricing in?

    4/06/09 US Treasury yields

    3 mon: 18 bp
    2: 96
    5: 205
    10: 316
    30: 410

    I like 10 year German Bonds as my favorite sovereign bond long.

    Precious metals:

    I am not a gold bug, but in order to understand why gold is a “good” investment, we need to understand why gold wasn’t a good investment. Long story short, Volcker when he restricted money supply and let the market set short term rates, defeated inflation. Also, wage inflation did not happen during the Greenspan era, and that made the elites happy to hold stocks (since profits were going up, and costs remained stable) instead of gold. Central bankers were perceived as competent then. And then you have a credit bubble caused by excess risk taking and the Fed more or less denied it. I suppose gold will keep its “Fed incompetence premium” for a long time during a deflation. It has nothing to do with the argument that gold is an inflation hedge (but it is a hyperinflation hedge, and just about everything is too such as copper.)

    I think silver, over the long run (maybe not really long run as we might reach the technological singularity and that might solve all our problems), would outperform gold. I think silver has more upside, with the downside being a littler greater than gold.

  2. The CRE levitation in particular has been amazing to watch. I’ve added some downside exposure in those names as I’m not entirely sure they will fully participate in the final push to the wave 2 top.

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