Distribution Fed Day

Equities have continued powering ahead, as the dollar-financed carry trade props up risk assets. The carry trade is fueled by liquidity, thanks to Bernanke's generous $300B in Tsy purchases and $1.25T in overall balance sheet expansion. But with only $10B left in the bond POMOs and purchases ending in October, the liquidity feeding the destruction in the USD, and consequently the rally in equities, is drying quickly.

Volume is indeed coming in on the sell-side, with September 1, 17, and 23 (today) showing some major distribution. Today saw big selling into the FOMC spike, and volume was heavy. Perhaps it's the corporate insiders, selling at unprecedented rates. Perhaps it's the carry trade being reversed, as the USD gains strength. Below is an exceptional video explaining the carry trade to readers who aren't familiar with it:

A look at the S&P 500 ETF (SPY) shows it is right near its 440-day moving average (important support/resistance line) as well as approaching the support trendline defining the primary bear move from March 2007 to September 2008. Retesting previous support often marks tops and begins reversals. Volume has been declining since March lows, with heavy volume days showing up this month, all on the sell-side. The market remains in its rising wedge and the apex draws nearer and nearer. The September 16 breakout surged the market through the wedge's resistance but after today's late-day selling, we are back inside of the wedge. This is called a throw-over and often marks tops, as well.

Here are closer looks at the market (with the same trendlines and moving averages):

The strength of this rally is to be respected, and I've been participating on the long side with some nice chart breakouts, like today's in Perfect World (PWRD), a momo Chinese video game developer I expect to tank this fall/winter. But today's nasty reversal bar could spell trouble for the market, especially with the volume involved. The fiscal quarter ends in a week and though we may see some end-of-quarter window dressing, that could be it for the stock market.

The US Dollar can't go much lower. It is nearing summer 2008 levels (remember energy crisis/inflation worries anyone?) and is currently sitting at 76.59. A break below 75-76 could send it back to its 2008 range and a break below 71-72 could send it spiraling/crashing down, with no support beneath to ease the fall. Going back into the 72-76 range it was in last summer represents a dollar depreciated to the point of hindering consumption/aggregate demand through inflation, even as recognized by MSM.

30yr Tsys are down almost 800bps from their June highs, as the bond market continues to forecast deflation. The yield curve is flattening, which should hinder bank profits on that end, which will show on 10-Qs. Speaking of which, after a "spring break" of sorts on the mortgage resets front, Option-ARM and Alt-A resets are coming in herds this fall/winter. And with resets come defaults, and with defaults come writedowns. Massive hidden writedowns from par to zero under mark-to-model accounting with no loan loss provisions to cover. This spells bad earnings for banks in Q4.

The market may continue its rally for now if the USD keeps getting hammered, but the reversal is imminent, if not here. Leading stocks (like PWRD mentioned above) are going parabolic, which often marks tops, and was an accurate forecaster of impending downside in March 2000 and October 2007.

The economy behind the market isn't improving, and in fact oil inventory data today showed a supply surge that send crude plunging. Aiful, the second-largest consumer lender in Japan, is cutting jobs and expecting an enormous FY loss, and is barely (if at all) solvent. And the $21.6B contraction in consumer credit reported in the Fed's most recent G.19 shows that American consumer (the basis to the entire global American ponzi scheme) has hit the debt wall. The current account deficit supporting our debt depends on foreign exports being consumed by Americans. Without the American consumer to raise more debt to keep the rest of the world buying our debt, the Fed is the only entity left to finance spending-- through debt monetization.

The market can continue unabated in its irrationally exuberant surge, however, until-- it doesn't. Sentiment indicators are pointing to very crowded bullish levels. This is scary, given the carry trade financing it and the lack of underlying economic activity to back it. The S&P's reported P/E is above 150. The bullish/bearish fund manager ratio is at record levels. Retail daytrading is at 2000 tech bubble levels. Speculative options activity has reached all time highs (courtesy of Sentiment Trader):

For now, the strategy of choice is momo-chasing, 50/20DMA retracement buying, IBD-style trading. As the unsustainable rally reverses, the profit-generating theses will change back to more fundamentally-driven concepts. For this fall/winter, my trade ideas are as follows:

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Short:

Equities

• insurers (large commercial real estate exposure, high leverage, large debt, high beta)
• banks (massive pending writedowns, large commercial real estate exposure, yield curve flattening, liquidity drying up)
• REITs (ridiculous leverage, entire exposure is to commercial real estate)
• energies (deflation/supply glut will hurt oil prices)
• casinos (real estate exposure, consumer demand gone)
• hotels (traveling plunging as discretionary income and business expenses tank, real estate exposure)
• high-beta equities (FCX, X, EJ, SPWRA, etc) against low-betas
• casino-style momentum plays (AIG, Citigroup, CIT Group, Fannie Mae, Freddie Mac)

Commodities

• oil (deflation/supply glut)
• copper (Chinese liquidity-fueled bubble implosion)
• steel (Obama infrastructure spending spike reversal)

China (massive property and stock bubble… again)

• EJ
• CFSG
• TSL
• CEO
• BIDU

Risk currencies (deflation/carry-trade unwinding)

• euro
• british pound
• australian dollar
• candian dollar

Long:

Volatility

• VIX call options
• option spreads on indices/equities
• option long straddles on indices/equities

 “Safe” havens

• US dollar (carry trade unwinding, deflation, deleveraging/debt liquidation)
• Japenese yen (carry trade unwinding, deflation, deleveraging/debt liquidation)
• short-term maturity govt treasuries/t-bills (short-term b/c risk moving up yield curve with deficit spending)
• precious metals (gold and palladium at all-time highs and my favorite long-term plays, might suffer pullbacks before next move up however)

Bear ETFs

• high convexity
• equity decline
• volatility expansion
• underlying leverage-delivering derivative vol premium expansion

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The point is-- there is a very nasty, volatile unwinding of this market rally/USD-funded carry trade in the cards. The only question is when. A break of the rising wedge should be the first short trigger, and then moving average and horizontal support trendline breaks should bring more selling. I leave you with my technical take on the S&P posted again:

Comments

[Leo Kolivakis]

I always said the market never goes according to logic. They sold the news into the close, it will dip today and they will buy the dip. I was reading Macro Man's comment, What Now?:

Could it be- and Macro Man is ashamed to admit that this never occurred to him- that equity guys actually thought that there was a chance that the Fed would announce more QE? The very suggestion seems ludicrous to a macro observer, which is why your author never contemplated it. But it would certainly serve as the simplest explanation for the generally disappointing performance of stocks in the wake of seemed to be a very benign, reflationary statement.

Regardless, the stars may be aligning towards a somewhat less favourable environment for risk assets. Oil was a notable laggard in the entire orgy of reflation that's dominated the past few months, and in the wake of a huge composite inventory build crashed below the support level highlighted in this space the other day.

I am not so sure that equity guys expected more QE, and as far as risk assets, the wave of liquidity will propell them higher. Be careful shorting here.

cheers,

Leo

[pm69]

Leo, you may want to clarify what do you mean by "wave of liquidity"... especially since it seems to be your main argument for the market continuing to go up.

[Anonymous]

yeah, he still can't figure out that it's about INSOLVENCY.
and, like any asset manager he's talking his book. that's cheap

[Anonymous]

Can someone explain carry trade to me? I feel like I'm missing the point of almost all of the past months articles without understanding USD carry trade and the EURJPY carry trade.

[Ned Zeppelin]

As I understand it, the carry trade takes advantage of differences in yield on various assets denominated in different currencies. You do this by borrowing a quantity of money in a particular currency, another currency which is, by comparison, cheap to borrow (think a very low Fed Funds rate, low U.S. prime rates), which is then converted to another currency to acquire the asset which has a certain yield in that currency.  Ideally, by the time you do all of the math, and hopefully lock it all in, you're showing a profit in the transaction. To me, it is one example of arbitrage, and exists because the convertibility ratios of currencies in real time do not perfectly correspond with things like interest rates/yields and such.  In a perfect world, there would be no carry trade, since every currency would have this already priced in.  Since currency pricing is a human function, it suffers from rampant imperfection, bad judgment and just plain stupidity, and thus opportunities to profit (and lose) are created.

 I'd give a example but my head would explode.

[cocoablini]

This is a fantastic rundown. Thanks for the article and recommendations. I think gold futures will get dumped hard-along with gold stocks. Keep the physical-its hard to get and it will bounce once the banks fall flat on their face again. Then, pile into gold miners at near bottom. Gold does much better(and golds) in a deflation because the production and labor costs crash and make gold margins go parabolic. Gold, in the end, is the money of last resort. In a delevering the dollar still has some fire power but in any recovery(let's say in 2020-bear markets are usually 1/3 bull markets) it won't exist much longer as a legitimate currency unless the Fed stops the BS.
Comex and London will probably go force majeur and default on the gold futures at around the same time. 80x paper versus real-and gold ain't easy to get.

[Anonymous]

Anyone have the chart comparing fed QE/monetization to S&P? IIRC it was somewhat in lockstep...

[Remus]

Execellent article !

[Anonymous]

Excellent post, and thanks to Leo for elevating the quality of the comments.

[Anonymous]

Excellent post, and thanks to Leo for elevating the quality of the comments.

[long-shorty]

Naufalsanaullah,

what software did you use to make such sweet charts?

I want that.

[naufalsanaullah]

thinkorswim