Sage Weekly Letter – 6/3/2012

In the span of just ten weeks US equities have gone from Goldman Sachs’ “Long Good Buy” and nearly unanimous bullish sentiment to pervasive despair and a panicked flight to safety. Equity market participants aren’t unfamiliar with the market changing character on a dime given last year’s sudden u-turns to the south after sharp rallies in July/August and then again during October/November. While last year’s twists and turns were enough to give anyone whiplash the 180 degree turn in market character, macroeconomic backdrop, and market sentiment since early April will go down in the history books.

To say that financial markets look bleak right now would be an understatement. After combing through dozens of charts I can count the number of reasonably attractive equity long candidates on one hand. Meanwhile, most sector and individual names look to be in free-fall after breaking major support levels and key moving averages on Friday.

Before I delve into the current market structure and offer a few thoughts as to where things might be headed over the next few weeks I want to lay out some tips that have helped me survive, and at times thrive, in volatile fast moving market environments (h/t ChicagoSean who reminded me of some of these yesterday):

  • Less is more: You will see traders who try to catch every market move, let them try it but don’t get caught up in playing that game. Overtrading can be deadly and 99% of hyperactive traders don’t last in the market while the other 1% still don’t do as well as the traders who make fewer trades but manage to catch much larger moves.
  • Volatile markets offer opportunities to catch BIG moves: 40 S&P points in less than 24 hours or $80 in gold ($GC_F $GLD) in less than five hours like we saw on Friday – put yourself in a position to ride a big wave, once you’re on the wave manage risk and hang on as best you can.
  • Cut out the noise and intently focus on your edge: Is your edge in watching CNBC? Do you have an edge trading the fourteen different daily rumors and denials of rumors coming from Europe? I didn’t think so, focus on what you’re good at and don’t fill your brain with unnecessary clutter.
  • Reduce your position size: Volatility means large moves within short periods of time; therefore, it is important to adjust your position size accordingly.
  • Don’t average into losing positions: Just don’t do it! 4 out of 5 times you will get away with it but the one time that it doesn’t work will likely lead to a blowup or, at a minimum, severely reduced account equity. The first loss is the best loss, particularly in a market environment as unforgiving as the current one.

 Market Structure

The market has been damaged for several weeks, however, last week was the first time that I sensed real panic in the air. The rush into the US dollar, US Treasury bonds, German bunds, and other perceived “safe” assets reached an entirely new level as Friday’s poor US payrolls report added to an already fragile market backdrop.

Click to enlarge (notes on charts)

$TLT Daily

US Dollar Index Daily ($DX_F $UUP)

Last week’s flight to safety was accompanied by a mad rush out of equities – out of the major equity indices only the Nasdaq-100 ($QQQ) still remains above its 200-day moving average:

$SPX Daily

Russell 2000 Daily ($IWM)

Nasdaq-100 Daily ($QQQ)

The index charts look bad enough but without boring my dear readers with any more charts than necessary I will simply say that the damage beneath the surface is extensive and widespread ($BKX $KOL $XLE etc.) – while the few remaining bulls may point to the QQQ chart as their last remaining source of hope, the $IYR chart looks to already be at a crucial “make or break” level:

A clear head & shoulders top has formed with a neckline at the major area of support ~$59.50 – this will be an important chart to keep on your radar this week.

During my weekend reading & analysis two main themes kept coming into my mind:

  • Every bullish/non-apocalyptic scenario I read included a heavy dose of ECB/Fed intervention at some point in the next month
  • Markets are currently heavily positioned one way: Long US dollar, short euro, long treasuries, low equity allocations with nearly everyone recommending holding unusually large cash allocations

While I agree with some of this conventional wisdom (some central bank action will have to take place soon and cash isn’t a bad place to be) I’m fairly certain that some of the above conventional wisdom & market positioning will look rather silly two months from now.

While i’m not ready to call a top in the dollar or treasuries we know that parabolic/vertical rallies driven by panicked market psychology almost always end in spectacular crashes (think silver April/May 2011). The record speculative short interest in the euro combined with record commercial short interest in the dollar and another new CTA long interest record in the dollar (along with a new record amount of open interest in the dollar) sets the stage for an epic correction in these overstretched trades.

Macro Picture

If you haven’t had your fill of Europe already, you are likely to be thoroughly sick of the continent by the end of June. Aside from the Euro 2012 soccer tournament there are multiple important events to mark on your calendar:

June 4th – IMF review of Spain begins

June 6th – ECB meeting

June 14th – Eurogroup meeting

June 17th – Greek elections

July 1st – ESM (European Stability Mechanism) begins to operate with EFSF

The situation in the eurozone is dire: Banks aren’t lending to one another, the inter-bank market is seizing up, economic activity is slowing at an accelerating pace, Greece is a mess as always and continues to be a major wild card, and Spain is in a very serious situation with a banking system that cannot function properly because it is up to its eyeballs in bad property loans. However, I see a sufficient number of potential catalysts over the next month to deem a major crash/meltdown to be unlikely. Moreover, market participants are currently positioned so heavily to one side of the boat that if a truly bullish catalyst were to emerge it could trigger a substantial risk rally.

While my crystal ball is a bit cloudy this weekend I can state with a high degree of certainty that I believe volatility is here to stay for a while longer and may in fact accelerate further over the coming days/weeks:

Friday’s action across markets was particularly noteworthy as we saw a huge rally in gold along with a counter-trend snapback rally in $EURUSD. Both of these market moves appear to have been driven by a sense among market participants that the Fed was now much more likely to embark upon additional monetary policy easing, perhaps as early as its June 20th meeting:

Friday’s bounce in EUR/USD may be market participants rushing in ahead of this week’s ECB meeting in the hope that the ECB will announce some new policy easing actions in order to calm panicked markets and to provide some support to deteriorating economic conditions throughout the eurozone. Decisive actions by the ECB on Wednesday such as a 50 bps rate cut along with a new liquidity program and/or easing of collateral requirements could lead to a substantial market rally, whereas, a 25 bps rate cut or no rate cut along with no new policy programs would almost certainly lead to markets cratering even further. Get your popcorn ready for Wednesday morning…..

Here are last week’s best ideas:

  • Euro futures ($6E_F) speculative short interest is at a new all-time high, this combined with extremely one-sided bearish sentiment and oversold technicals make June/July bull put spreads ($FXE) an attractive proposition
  • Long gold – gold ($GC_F $GLD) has many ways in which it can work well from current levels and pretty much only one way in which it loses (global deflationary recession with little or no central bank stimulus)
  • Long $USDCAD on a pullback to the 1.0150-75 area – this is a good risk hedge
  • Short $CRM either outright or via puts/put spreads
  • Sell volatility ($VIX) into volatility spikes – $SPY iron condors are a good method of doing this
I must say that I am really warming up to the euro and while the current market situation is quite fluid I will say that I have a long euro bias currently. Long gold and long USD/CAD were my best trades last week, while I trimmed both of them on Friday morning I continue to ride these winners. $CRM fell apart along with the overall equity market last week and I am now neutral on the stock. While volatility appears to be breaking out to the upside I still like the idea of $SPY iron condors, this will be one of my main trade priorities early in the week should volatility accelerate further.

Best Idea

  • $TLT July bear call spreads using the premium intake to finance put purchases – this is an excellent method to define risk while expressing a view (calling a top :) ) that the treasury rally has gotten overheated and could correct sharply lower over the next 6-7 weeks.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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