Reflation fade vindicated

Today’s action (equity and commodity sell-offs through key levels, major bond and dollar rallies) confirms once again that the dollar is still king and that deflation is the name of the game.

The action since March can be summed up as (1) a dead-cat bounce from oversold conditions in equities, (2) a replay of early 2008′s speculative rally in commodities, and (3) premature fears of the dollar’s demise.

The charts below show how things have played out since I noted the following on June 5:

Well, the reflation trade has managed to hold on for a few more days and even reached new heights, but the case for a pullback is looking that much better. Precious metals, non-dollar and non-yen currencies, oil and treasury yields have all benefited from what looks like a fairly extreme fear of inflation. …

From this juncture, I am still more enthusiastic about the prospects for the dollar, bonds and related commodity shorts than I am about stock market shorts, since the sentiment in the later has not reached the same levels of broad consensus. That said, it would be surprising if we don’t at least stop making new highs for a few weeks, if not fall well under 900 in the S&P.

This trade has gone well so far, but a bit over a week ago I had very large shorts (with futures) on the euro, pound, franc and oil, in addition to my large equity, copper and gold shorts, but the former made a little pop to new highs that stopped me out. I put on some more pound and franc shorts, and retained some puts on oil, but I’m kicking myself for being such a wimp with tight stop prices. My excuse for not re-shorting in bulk is that I was about to move for the summer and wouldn’t have much screen time again for a while.

I am also guilty of getting cute and taking profits on my silver futures short (from 15.75) at 13.92 and not re-shorting at 14.40 when I had the chance, though I have thought all along we are going well under $10. Nonetheless, today was a good day, and squiggles notwithstanding, I think we have turned the corner here.

Here are a few three-month charts from Yahoo! to show how things have gone so far (the little dots are placed on June 5 (actually I first said to fade the reflation trade on May 28):

S&P500:

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The dollar vs. the euro (not much action so far, but certainly no dollar flameout):

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USO (United States Oil Fund):

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Precious metals complex (GLD, SLV and GDX):

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30-year Treasury bond yield:

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Even grains have sold off hard (DBA agriculture fund):

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Now, we’ll see if this is just a setback from premature extremes or if we’re headed for new deflationary lows in a hurry. I think the reflation trade has topped, but that doesn’t mean equities can’t make a last ditch effort to stop out the shorts with new highs. That said, I’m sitting on a big load of index puts.

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30 thoughts on “Reflation fade vindicated

  1. Nice analysis even though I’m long silver and gold :-)
    I am massively short equities as well (short ETF) and expecting a major decline…

  2. Thanks. Careful with the short ETF, though. In case you aren’t familiar with their particular risks, this is a primer I put together last year:

    http://sovereignspeculator.com/2008/08/08/inverse-etfs-vs-leaps-puts/

    Basically, you can be right about the market going down, even right about the timing, but lose money in your short ETF if the market moves in a choppy manner (which it always does over a time frame of a few months or more). Witness where SRS is today vs. early 2007 and where REITs are (both are massively down, though many expected SRS to go up twice the percentage that REITs went down).

  3. That said, I still occasionally use inverse ETFs, but for trades of a day to a few weeks at most. For longer term shorts, I use long-dated puts.

  4. Thanks for the info. I don’t like leveraged or inversed ETF because they do not correctly replicate the market if the moves are massive (leverage is ajusted daily). Imagine a 3x bullish etf pricing 100 today. The index drops 30% (imagine the financials index meltdown), you finish at 10. The following day, the market goes up 50% (bernanke+paulson call in action) you end up at 25 while the market is back at around 100.

    Appart from that, i was looking to get a delta-1 and options were too expensive in terms of volatility. so the short ETF seemed like the best move, but it might prove costly, yes, specially since I got into the trade a bit early in May. I am currently +3 to +4% on those trades. We’ll see if they hold…

  5. Mike, when markets are confused, your spot-on analysis always amazes me. How about a subscription service for the less financially agile?

  6. Thanks, Leonard. This market has been fairly straightforward for the last 12 months. I’m afraid that things will be harder to play after the next big plunge, when prices are lower across the board and closer to fundamental values. Things will also get trickier 2-5 years out as the scales tip further towards inflation as the private debt load shrinks, government deficits mount, base money builds up, some measures of lending expand again, or if there is a big war.

    I haven’t ever considered a subscription service, since I like to keep my writing efforts casual (as you can see, I have not even run google ads here, and have turned down an offer from one targeted advertiser, since I like the freedom from regulatory and legal concerns that would be lost from simply running ads — such is the nature of business in the US today).

    I intend to use my trading skills to manage third party capital at some point in the future. Unfortunately, depending on the structure of that business, when it happens I may not be able to post here anymore. Blame the lawyers.

  7. Aki, I just approved a comment of yours on a post from about 4 weeks ago. I’m sorry — I hadn’t noticed it until now. I don’t know why your comments get picked up by my spam software, but I wouldn’t be surprised if it were because you often include a bunch of links.

  8. Congrats Mike. Same here about ads and also managing private money :-)
    I have been thinink a lot and have now started to post links to amazon for book recommendations.
    Keep up the good work !
    Pej

  9. Hi Mike,
    Sorry I just noticed I misread your reply to my comment and that you misunderstood/I wasn’t clear enough: I am short ETFs meaning I am actually short the long ETFs, and not long the short ETFs. Not sure I am clearer at all, but worth the try. Re short ETFs (prices going up when underlying going down) I agree 100% with you.

  10. Oh, of course shorting the long ETFs is a straightforward way to play. I do much of my trading with options on the big long ETFs like SPY and IYR.

  11. This week has certainly been an unpleasant surprise. The unwinding of the reflation trade has stalled, though not reversed much, but the extent to which animal spirits are still strong in equities has been a bit shocking.

    This has been a short-squeeze, maybe part of the dreaded chop that we’ll have to endure before things roll over again.

    I’ll try to post some more thoughts before Monday.

  12. There is always chop in the markets — what I mean above is a trading scenario similar to the period after the post-911 short squeeze, when the markets went nowhere in an interesting way for several months before rolling over to plumb new depths in the second half of 2002.

    When playing a big bear market, you have to be aware that these bounces can keep prices above previous lows (like March) for 8, 12 or even 24 months. In this case, I would be surprised if things held up for longer than a year, since the economy is deteriorating so unrelentingly and the yield on the S&P500 is now less than 1%.

    The name of the game here is patience, and making sure that you are not using instruments that will lose you a lot of money even if you are right in the long run (such as inverse ETFs, bear mutual funds, or short-dated puts). Once again, this is why I favor very long dated puts for shorting. My favorites now are Dec 2011s on SPY, and if we are still elevated this fall when the 2012s are listed, I’ll roll over into those.

  13. Sorry, I didn’t see that you asked about the past 5 days of earnings reports. No, I have seen nothing there to surprise me in the least. US companies are earning much less than a year ago but have only begun to cut dividends. I expect this bear to end years from now with the market yielding 5% or more on much lower dividends.

    The S&P paid out $11.40 in the first half of 2009, though they only earned about $15. That is unsustainable — earnings must either double or dividends must fall by half.

    The price investors pay for those earnings and dividends changes with the mood of the times, and the stronger tide here is clearly toward caution and frugality. It is a very carefree act to pay $41 for each dollar of yield, as people are doing this Friday afternoon in July.

  14. I do not how much higher this market can go. This rally has low volume.

    In the end, I suppose bears who didn’t do anything stupid such as establishing positions when the market was moderately oversold (such as when the S&P 500 was at 880) would do well and they would survive the attrition. My own technical analysis picked up a moderately oversold signal, but not a panic bottom; there was no change in volume (such as a volume spike) during the moderate sell off, the VIX “only” peaked at 31.5 , the MACD and the difference between the MACD and signal were low, the RSI didn’t break 37, and it was below the 20, 50, and 200 day EMA but not significantly. The technicals at least indicated the potential for further falling. Again, good speculators have the discipline not to establish short positions when the market is oversold.

    I deny that there is much predictive power from technical analysis; to me, it serves a descriptive function that tells whether markets are “overbought” and “oversold”.

    How people actually believe the rally is for real now? “Bear market rally” seems to have disappear from the lexicon, and this offers some nice fuel for a potential sell-off to the March lows again. I suppose (I am suggesting this tentatively) a nice indicator for that is the website hits for bearish finance sites such as Zero Hedge; if there popularity drop, I suppose it would be resumption of the bear market.

    Deflationary environments are hard to trade: some of the best deflation trades are the enantiomer of common sense; one has to be willing to long stocks even when they are overvalued on a historical basis; short oil even when oil has probably peaked; long the dollar despite the long erosion of “dollar hegemony;” long US Treasuries despite record deficits and historically high valuations. In order to do well in this environment you have to be willing contradict yourself; it is like taking Holy Communion in a Catholic Church when you are an atheist. You have to think one way, yet act another way.

  15. Ten year Treasury is at 365 basis points now. Yields went up along with the stock market. It seems that the smarter bond traders think the recovery is real, that there is increased inflation risk, or priced in a credit event.

  16. Mike,

    I am new to trading but I like your idea concerning SPY puts vs ETFs. Can you elaborate on the differences between the various 2011 SPY puts? Also, is it possible to lose more than your initial investment when buying PUTs?

    Thanks

  17. Do you think the markets could rally at this point?

    I suppose the actually bear market rally is about to end; it will end when:

    1. Traders with short term time horizons are actually going long for short term gains.

    2. People (“smart” money who supposedly have long-term time horizons) actually believe in an economic recovery AND believe that asset prices (or cash flow from these assets) will benefit from the “recovery.”

    3. Idiots who buy stocks expecting a position long-term return and have no understanding of the long-term fundamentals or short-term technicals. [There is evidence for this in mutual fund inflows.]

    During March and April people were defensive and calling it a short-covering rally, a dead cat bounce, and bear market rally. These terms seemed to have disappeared from the lexicon. Now if those three groups are bullish, one could exploit the short term time horizon of the traders, the irrational exuberance of the long term investors, and the stupidity and ignorance of the latter group for a nice short position with an excellent risk/reward profile. Many bears might join the one of the three groups, and those bears with perseverence are the ones that will prosper.

    Regarding your position on gold, I could imagine it going to 600-700 per ounce in a deflationary environment. I do not see how this would have a nice risk/reward relative to other long term trades such as short equities (of course, one can short gold if it is short-term overbought for a short-term trade can be nice). If gold does go that low in a deflationary environment, it seems reasonable that stocks would also do that same too because their yields are too low for holding solely for yield and would be liquidated. I could not see gold falling more than equities and I do believe that equities will fall more than gold since those holding gold have a longer time horizon, and equities are more like trading instruments. Gold can have a larger fall if many holders of gold are levered, but this does not seem the case.

    You can’t lose more than your initial investment on puts or calls unless you used borrowed money to pay the option premium. If you are selling calls or puts, you can loss more unless the exchange liquidates your positions to avoid a margin call.

  18. GDM: If you don’t know what a PUT is, it’s unwise to start trading it. Stick to what you know. If you don’t know something, studying it extensively before trading it would be the wisest thing to do in order to avoid major losses due to lack of understanding and overpaying.

  19. Mike: what kind of strikes are you buying on your puts? And what time of expectations do you have in terms of holding period? Are you aiming to sell them close to maturity? or as soon as a major correction happens? I’m trying to figure out what kind of theta/delta exposure you have. And obviously, with implied vol decline in the past few months, it might start to get interesting to buy options. I think a major signal for buying puts would probably be if/when the VIX goes below 20.

    Aki_Izayoi: I agree on your opinion about gold. I actually am long precious metals and some oil as well. Interestingly, the idiots on the markets believe in a “jobless recovery” where commodity demand will remain weak. Also, looks like the US Gov has decided to deplete the country of its little saving, buy selling trillions of dollars worth of negative yielding treasuries…

  20. GDM: If you have to ask the kinds of above questions on options, that is fine, but PEJ is right: don’t trade them until you have researched and followed a market extensively.

    PEJ, I buy a mix of strikes — deeper OTM when the VIX is low, NTM or ITM when I think the risk of market advances is higher. With a sub-20 VIX, I’ll be buying OTM. At times with a very low VIX and a strenuously overbought market with weak internals, I will even look at expirations of 12 months or less.

    I try to sell into the final declines of intermediate degree downdrafts. I sold most of my 2010 puts last October, November and February. If, for instance, we were to fall to SPX 400 by next summer, and the market was starting to look oversold, I would be getting out of 2011 and 2012 puts, even though my final bear market target is much lower.

    PEJ, my own opinion on oil and PM is pretty clear: when this corrective bounce ends, they should resume their major decline and make new post-peak lows. I still think gold could fall to 700 and oil to under 20. Aki, I agree, the gold short is in general not so great a trade relative to equities, but the shorter-term set-ups can be attractive coming off these hyperinflation panics.

  21. Mike, agreed on oil, it could collapse if all the money that poured in the commodity indices and oil related trackers was to be withdrawn. But on the longer run, it’s better to hold oil and PM than dollars or pounds or even CHFs.

    Markets are mad, I’m a bit annoyed: a new-new ear. What do you think?

  22. Aki asked if I think the markets could rally more. Of course they could, after a bit of a pull-back. SPX 1000+ is still very much a possibility, though the air would be thin up there. That would be a gift for bears with dry powder. In that scenario, the reflation trade would probably revive for a while.

    We could of course already be rolling over, in which case the past week was just a short squeeze to clear the way for a sustained decline. Or we could bounce in the 850 – 970 range for a while and make no headway up or down for several more months. Who knows?

    The market has such a range of possibilities now. The bubble mentality is still alive, as evidenced by the PE (well over 100, going on infinite, since trailing 12 month earnings will be negative after this quarter) and dividend yield (currently 2.6% on dividends that must be slashed by >50% in the next couple of years). So long as investors care nothing for fundamentals, there is not much holding the market down, but because fundamental value is to be found only so much lower than today, the declines from here could still be mind-blowing.

    I think value won’t be approached until we have at least a 5% yield on (and I’m being optimistic here) $15 of dividends for the S&P500. That is the 300 level, though pessimism and government actions that worsen the depression could drive prices much lower still. We are still in the middle stages of this bear market and early stages of the depression.

  23. I also believe we are in the early stages of the depression, but I’m not as sure as you are that it will be a deflationary one. I am afraid inflation will blow the paper currencies away in several western countries…

    PS: my previous comment still is marked as “Your comment is awaiting moderation.”

  24. At some point deflation will turn to inflation and possibly destroy some major currencies. I just think we have more severe deflation ahead of us first, during which I intend to buy hard assets like gold. Of course I already own a core physical gold position and have no intention to sell.

    I see no comments awaiting moderation. When is this one dated?

  25. yes, i have also physical holdings of gold and silver in a safe abroad… but why wouldn’t gold and precious metals rise in a deflationary environment? Gold is money after all? I think gold behaves well when high inflation and high deflation and performs poorly when inflation is low (or when central banks are dumping all the reserves to hide inflation, like after the 80s top).

    The comment I mentioned is from this mornings: July 21st, 2009 at 6:57 am

  26. Ok, I refreshed things and found and approved the comment. I think wordpress flags comments with links.

    Yeah, oil should do well long-term because production has peaked, but in a crisis like this you want the best liquidity, and that means gold. You can use your gold to buy oil and other assets when things get really depressed.

    Gold does act like money, so yes, it should go up against other assets in deflation. When I talk about being bearish on it, that is only short-term and from a trading perspective. It could even rise more against the dollar in deflation, if more and more people perceive and panic about the risk in holding fiat currencies or get more afraid in general. There isn’t that much of it to go around, so sure, a major shortage could develop. I just think that these concerns have been very strong for well over a year now and that gold needs to take a breather.

  27. Admittedly, Silver and platinum far more attractive at current prices than gold. But It’s difficult to get physical possessions of any of these two :-(

    Also, yes, my comment contained links. But it’s not showing up :-)

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