We have been discussing in recent weeks and months different market thematics, trends and flows that have been underway in an attempt to better understand and predict where financial markets are headed. One of our key points had been that in a late stage bull market we always see dispersion. That is, a breakdown in the bullish correlations that most sectors and asset classes have.
The Federal Reserve QE program ended in October 2014 and following that there was a mini-correction of 9.9% in the S&P 500 before quickly returning to new highs. However, not all sectors, stocks and asset classes did so. Commodity prices quickly fell (most notably oil and precious metals), emerging markets crumbled, specific sectors within equity markets (tech hardware, resources, non-profitable social media stocks, etc) and also high-yield corporate debt (as reflected in the High Yield Debt ETF – discussed in my 5 June article) started to decline.
These low quality assets which were lifted by free cheap money from the Fed, had their support mechanisms erased and those unwise to what QE had done were left holding these sinking ships.
On the contrary side sectors which we discussed were signs of euphoria continued to boom – Facebook, Google, Netflix, Amazon and virtually the entire biotech sector surged through to record highs. In fact gains of over 100% were seen in some of these since the Fed announced the end of QE less than nine months ago. Why? Simple. These are market leading stocks with disruptive technology and solid profitable businesses that are gaining market share globally. They don’t need QE to appreciate in value.
This dispersion and apparent bipolar opposite trends is repeated in the final months and times even years of a bull market. Just a few weeks ago I showed some of these that occurred in GFC where US housing stocks peaked years before the S&P 500 did and in fact by the time the GFC hit (caused by the US housing market), US home building stocks were already down 90%. US investment banks peaked a year earlier.
So as we headed down to the lift off US rates I highlighted markets were at risk of heightened volatility in much the same way markets corrected post QE ending in October 2014. A tantrum would occur from those low quality assets and sectors that would cause some volatility – warning signs were given by the HYG ETF and emerging markets. In turn this volatility would provide buying opportunities in the market leading stocks that will continue to surge as they benefit from their own fundamentals as well as the benefit of funds being rotated from these poor performing assets into those that are performing. Similar again to 1999 as people rushed into tech and into resources in mid-2008. The latest reporting season gave further evidence of this with the results from our aforementioned market leaders.
Three weeks ago I pointed to emerging markets as where I believe the next GFC style collapse would occur and even emerging market bonds would also free-fall. So the recent equity market rout where the Dow Jones Industrial Average fell by its maximum points ever (1089 points) in my opinion is not the “big collapse” I am looking for. To put this into context I think we are in the mid-to –late 2007. Big indices like the S&P 500 don’t ever just rally- peak and collapse. There is always a backing and filling and topping out process that occurs first. While some sectors, regions and asset classes are done for the whole process of boom to bust takes far longer than everyone expects. It’s a very drawn out process and in reality this recent short sharp drop is only a small fraction of what is to come.
As a trader it is important not to be clouded by a one-sided view and a one dimensional trade. The most important thing for trader is not to have the right view but to make money. I often define a great trader as one who had the wrong market view but still is able to make money. Wrong but still made money. Think about it. Understand that one very point and you will unlock the secret to trading success. This therefore means that although the emerging markets are clearly unravelling and that a collapse will occur it’s not my sole focus and certainly doesn’t hinder me from being long market leading stocks. In fact as bubbles deflate there are significant short covering rallies. Being caught on the wrong side of one of these and profits that took a year to produce can be unraveled in just weeks. The process will be long and arduous. Although I can see every sign on the wall of a collapse coming it won’t happen overnight and to be positioned as though it will is just suicidal.
So what I want to do is have several uncorrelated trades that still capture all of what I believe and have predicted will occur over the next few months. Using market volatility I buy the dips on the US tech leaders, the Italian market (discussed a few weeks ago) and use the same dips to take profits on my short positions within emerging markets and high yield corporate debt (via ETFs) – available on most CFD platforms. When the rebound occurs I begin to take profits on my longs and slowly re-build my short positions in the areas I am bearish.
This way if I am wrong and there is no emerging market collapse – I still make money on my market leading longs and my exposure on my shorts are not excessive as they would be if I were to let my emerging market view govern my entire trading strategy. Trading each market within the context of a broader market view is one thing but also trading it within the context of its own trend is also key. Until the market leaders actually have a change in trend or some other news that we haven’t discussed yet here begins to alter what I see forthcoming over the next 3-12 months then the strategy remains.
This isn’t the big collapse yet. Maybe it won’t ever happen. Maybe it might be somewhere I never thought to look. But the crucial thing is to cover all possible permutations and combinations and if you can cover as many circumstances of where not only you are right but also where you are wrong AND still make money – then you are starting to learn the art of a great trader.
