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Not the Big One
Yes! There is risk in the market! That was the hard lesson learned by latecomers to Ben Bernanke’s quantitative easing party who, having watched the prices of all assets climb relentlessly for the last 2 ½ months, jumped in at the end and got burned. Perhaps they didn’t want to be the last one in the locker room at the country club to profess their admiration for everything hard this year.
Let’s start with a forensic examination of the wreckage. There were gut wrenching plunges in everything that had raced up the most, including precious metals, copper, sugar, coal, the commodity currencies, and technology stocks. The markets with weaker fundamentals that hadn’t moved much, like the broader US stock indexes, managed only a whimper instead of a bang.
There were more possible triggers than found in an Agatha Christie murder mystery. My favorite is the weakness of the Euro, which I have been predicting is the new canary in the coal mine for global risk taking (click here for the piece at http://www.madhedgefundtrader.com/october-22-2010-4.html ). Another smoking gun is the hike in Chinese interest rates, which calls into question their economic miracle that is enriching everyone. Also suspicious is a computer glitch at the Federal Reserve that scared traders into thinking that the central bank’s first bond purchases for QE2 had been a complete failure.
Suffice it to say that the trading short term books had piled risk higher than Mount Everest, and also had a hair trigger to bail at the first sign of trouble. Could it be as simple as buy the rumor and sell the news?
You can use days like Friday as a great crystal ball for the future. This is what the shadowy spirits are communing to us. That it is a binary ‘RISK ON’, ‘RISK OFF WORLD”. When things go bad, there is no place to hide but cash. The CFTC raised silver margin requirements, and corn and sugar get trashed? Even flight to safety Treasury bonds were unloaded in size. Everything went up the most went down the most, regardless of fundamentals. And that we are dealing with a substantially higher level of risk than only a couple of months ago.
Living in California, one gets used to monthly earthquakes that rattle the dishes, rock the water in the swimming pool, and scare small children, but little more, so we ignore them. However, we all know that “The Big One” that will flatten the city is coming someday.
I think the current pull back is only a minor tremor. Trading conditions have been far too easy recently, and we were overdue for a healthy dose of mean reversion. There are not doubt a lot of year end effects going on here, with traders looking to book profits so they can get paid bonuses in January. In a zero return world, the 50% gains many stocks, commodities, and precious metals have recently posted are not to be left on the table.
I don’t think you can get a true crash as long as interest rates are at zero, and the Fed’s quantitative easing either ends, or is proven to be an abject favor. But the “Big One” for the markets is coming, and could unfold as early as the next quarter. Please tighten up you stops and your risk control accordingly.
To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at www.madhedgefundtrader.com . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.
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"and the Fed’s quantitative easing either ends, or is proven to be an abject favor."
Go long with the Fed whatever the flavor.
"Tighten your stops." This mantra is repeated endlessly. In case you haven't been paying attention the last 3 years, volatility is higher. Which means tight stops will increase the probability of being stopped out to a much greater degree than in quiet markets. Which means your returns suffer. In fact, the misuse of stops can take an otherwise profitable trading strategy and render it ineffectual.
In the event of a true panic, your stop-loss order is a market order, which translates to "I give the market makers permission to rape me as they see fit." Remember how well those stops worked one day in May for some marks? Options exist for a reason -- they are insurance with a known cost. Please, stop babbling about tight stops and just buy some puts to fix your downside risk and calls for your shorts. If you are going to manage risk effectively, you must be a student of volatility, which means planning ahead and buying long-dated options while the sun is shining, when they are cheap.
This is a good point. There are way too many traders with the same strategy: buy strength, sell weakness, be liquidity takers (stops/market orders) instead of liquidity providers (limit orders).
Shanghai dropped 10%? in a matter of days. Under estimate what investors know and are saying at your own peril.
China has problems that has to be dealt with now....watch this space.
BTW I hope a lot of newcomers DID jump in the QE insanity late and get heavily burned!
In modern times have you ever seen so much uncertainty, soveriegn default possibilities, unemployment, call for spending cuts, asset deleveraging, fraud accusations, balloning deficits and above all DENIAL ? EVERYBODY !
What does it matter what the concensus is, when everyone is delusional and in mass denial?
NOBODY thinks the markets are going significantly down from here.
NOBODY.
Not even the bears.
I sure think they could. You are putting too much faith in inflation. The US states' might not get bailed out.....in fact, many believe this already. The Bush tax cuts might not be extended. Unemployment bennies might not be extended once again. A nasty little bit of austerity could cave the market. Bernanke can keep infusing money into every corner of the market stimulating as much as possible, but he could still fail. I agree with MadHedge, keep your stops tight.
Bernanke has stated quite clearly he will not stop inflating the economy until hell freezes over. However, his track record is not that good. We could definitely fall into a deflationary spiral. At this point, every outcome is possible. My portfolio is structured for all outcomes. I am more interested in just keeping what I have right now, but ever alert for herd moves that provide short term opportunity.
Asset class correlations seem as fickle as a virgin on prom night. There is much indecision in the markets right now. Ever seen a herd of animals panic? I don't think Bernanke, even with his unlimited (in theory) printing press could stop a stampede. And if he were to try and fail to stop a crash, he might cause a hyperinflation event in the process. There is real risk for some very negative outcomes here.
Just depends on how long the FED keeps buying stocks...other than that, DOW=3,000.
Even if the FED stops supporting stocks and QE is shut down, and the Eurozone is forced to restructure, and BAC, C, and WF go down and are taken into receivership, even if all those things happen next year, we still won't go to Dow 3K. The only thing that could take us that low is ww, which I pray does not come to pass. There is fundamental demand and growth in the global economy. Yes, there are sustainability issues, but the main reason stocks will not drop that low is that the USD will ultimately get weaker after the next round of debt deflation. If gold goes to 2K, the Dow will hit 15K+.
USD weakness is the key reason stocks will go up. Those who are looking for the Dow and gold to converge 1:1 are barking up the wrong tree. This is not an argument in favor of real returns, just nominally higher prices driven by a weaker USD in the next five years once the US gov debt rollover issue becomes acute.
Yeah they will just re-jig the Dow Components. Bye Bye JPM, Hello Smith and Wesson
or another flash crash to skew the charts. manipulation? naw.