The primary driver in today’s markets are the various Central Banks and their desperate attempts to stimulate inflation of any kind within their economies.  I believe we can view the markets through the lens of Central Bank policy and the associated market movements, and gain some insight into potential outcomes.  Hopefully this will provide some actionable trading and/or investing setups.

Issue #1: The elephant in the room in the Federal Reserve; they are in a tightening posture and I believe markets are underestimating the number (and possible dates) of future rate hikes.  On the other hand you have the rest of the world’s Central Banks, seemingly dead-set on doing whatever it takes to stimulate their economies.  This is despite the fact that each action becomes less and less effective.

Issue #2: We have the commodity markets, most of which are showing the characteristics of having potentially bottomed.  For example, crude oil is up something like 45% since it’s lows earlier this year.  It could simply be a short covering rally, but every bottom starts out that way.  I’ve said it before (here), in order for the commodity complex to demonstrate a sustained rally, one that perhaps leads to the next up-cycle, the U.S. Dollar needs to pull back against the rest of the worlds currencies.

Given that the above two issues are definitely related, what should we expect moving forward?   Let’s take a look at the currency trigger levels from my previous post:

 

Taken by itself, the USD/JPY cross trigger level of 115.50 was a good signal to buy commodities for a bounce; oil bottomed 2 days later.  However, I recommended waiting for the EUR/USD cross to confirm the move, and I suggested using a trigger level of 1.148.  See below:

 

To date, it’s not even close.  My recommendation is therefore NOT to play crude oil or any of the other growth (inflation) driven commodity on the long side, at least until both trigger levels are breached.

If the European Central Bank’s bazooka somehow disappoints, this situation could turn on a dime.  However, I think it’s more likely that Central Banks will continue with their current postures: the Fed tightening while everyone else eases.  Furthermore, I believe the U.S. economy is the proverbial last man standing, meaning we are stronger relative to the rest of world.

This is important, it implies that all of the Central Bank posturing is perhaps “correct” on a global scale (i.e. relative to everyone else).  For example, if the U.S. economy is stronger than the rest of the world, perhaps the Fed should be in a tightening posture.  Likewise, if the Japanese (or European) economy is struggling, they probably should be easing.

In summary, I expect the U.S. Dollar to outperform other currencies.  Why?  Because, if the Fed is raising rates and the U.S. economy is outperforming (on a relative basis), the U.S. Dollar will outperform.  Growth commodities should therefore either pull back from current levels or languish into a trading range.  Either way, they do not represent a good risk/reward long at this point in time.

So Here’s the Trade:

Short the banks – the risk is the Fed will guide to further tightening (or even raise rates in March).

Short the EUR/USD – divergent policies will continue and the performance of each economy will also continue to diverge (U.S. > Eurozone).

Short any of the insolvent Oil & Gas companies that are up over 30% in the past two weeks – research their bonds, find the ones that are due soon – these companies are at risk of default.

Follow me on Twitter @dyer440

 

 

 

 

 

 

 

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It’s finally here.  Perhaps the most important  financial week since probably 2011, when central banks around the world made coordinated efforts to “ease strains in financial markets“.  I remember that week clearly; unfortunately I was heavily short equities as markets looked like they were about to roll-over hard.  Instead, during a post Thanksgiving food coma, I had to rush to cover my put options and settled with heavy losses.

Lessons learned: don’t underestimate Central Bank power to save markets and don’t underestimate market participants reactions to Central Bank intervention.

From where I stand, it seems like the markets are currently trying to test the Fed’s resolve. Are they really “data dependent” or, are they S&P 500 dependent?  If the market sells off into Tuesday (Dec. 15 – the day FOMC members meet), will they decide to pull the trigger? If they do, what’s their narrative going forward?  And finally, how will markets react?

I’ll give you 3 scenarios, and then try to frame some trades around this big binary event.  Keep in mind, no one really knows how this will play out.

Scenario 1; No Hike (< 20% probability):

If the Fed fails to raise rates, equities will sell off in a tantrum!  US Dollar top will be in. Bonds will rally as yields go lower (perhaps negative if recession approaches).

Scenario 2; Dovish Hike (35% probability):

If the Fed raises rates then employs a dovish narrative for their guidance moving forward, equities should be appeased and I would expect a move higher to end the year.  The US Dollar top could be in, but it’ll depend more on economic data.  Rates will adjust slightly and their reaction will provide a key tell moving forward.

Scenario 3; Hawkish Hike (45% probability):

A Fed rate hike along with a narrative to get the Fed Funds Rate to a 2% target would be extremely hawkish.  Expect volatility; participants will be pleased that Fed communication finally matches their actions however, the expectation of multiple rate hikes in 2016 will not bode well.  I’d expect an initial positive reaction, followed by a sell off during Yellen’s speech – this is the most likely scenario.  The US Dollar will have further positive momentum going forward, i.e., “more of the same”.  Bonds will adjust, perhaps rapidly depending on how hawkish the narrative is.

Alright, so having some likely scenarios helps to provide a dose of clarity, but probable outcomes don’t typically equate to great trade setups.

Low probability events produce large returns on capital.

So Here’s the Trade:

Take 50% of a speculative amount of capital, enough to hedge the positions you’re carrying into Wednesday (Dec. 16.) and:

Go Long Gold (GLD) and

Go Long Bonds (TLT)

IF the US Dollar is down on Wednesday, post Yellen’s speech, deploy the remaining 50% by doubling down on GLD and TLT.

Let me explain.  If the US Dollar is down on the news it means either Scenario 1 or 2 is playing out… and the world’s reserve currency has likely topped (in my opinion).  This is a low probability call that the Fed is tired of being the only Central Bank not easing, and that they’re going to begin shifting the narrative from talking the dollar up, to talking it down.  It’ll be like slowly turning an aircraft carrier around (it may take time), but I can easily imagine a world where the Fed is trying it’s best to devalue the dollar and create some inflation at any cost – especially if we’re in for more growth deceleration in 2016.

This will likely mean negative US interest rates.  Janet Yellen has even discussed this possibility in November!

Alternatively, if the low probability trade doesn’t work out, and it’s “more of the same”, my trade from Yell Laughing at Commodities should work.

Regarding equities, I’ve provided a structured trade idea in the article The Perfect Pair.  This paired trade should provide the opportunity to pivot with the market once equities settle on a direction.

At the very least I’ve laid out some considerations which should help get the your own ideas flowing ahead of this event.

 

 

 

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American Express Co. (AXP) and Visa Inc. (V) are two companies that do very similar things, yet they are on two very different trajectories.  I’ll keep it simple here, and provide you with a potential setup for the intermediate term.

I write about it a lot – because it really is all that matters – after Fed Day (Dec. 16), equities are either going to break out, or break down.  There will be some whipsaws at first but by mid January I think the market will have settled on a direction.  We have been consolidating all year, and equities are either poised for a move higher, or building a top for a subsequent move lower.  No one knows which way it’s going to break, but we will soon find out.  Small investors like me (and I’m assuming you, the reader, as well) have three options on how to deal with this binary setup:

1. Keep your portfolio mostly intact, cross your fingers and see how your current positioning and bias plays out.
2. Go to mostly cash and jump in once the narrative becomes clear and prices confirm which way is correct.
3. Develop a structured setup for the event, one where you’ll be mostly hedged (albeit with potential alpha), but one in which you can quickly pivot in order to catch the direction.

Obviously, I’m going to describe a structured setup using American Express and Visa.

So Here’s the Trade:

Go Long Visa (V) and Short American Express (AXP)

Use the same amount of capital for each leg of this paired trade.  Both sides display plenty of upside (or downside re AXP).  Over the intermediate term, V should continue to outperform AXP regardless of what the Fed does and how the market reacts, so this paired trade would work without the big binary event on the horizon, see below:

While Visa continues the long term trend upwards toward $100, American Express has put in a solid looking head and shoulders topping pattern:

 

What makes this a fascinating setup for me is that if you incorporate stop loss levels into each leg of the trade, you will in effect automatically pivot with the market.  For example, on the long V leg, use a stop of $74.50; don’t stay in the trade below that level.  For the short AXP leg, use a stop of $73.50; don’t stay in the trade above that level.

If/when the overall market breaks out, you may be stopped out of the AXP short position but you can continue to ride the trend in Visa up with the market (most likely outperforming it).

Conversely, if/when the overall market breaks down, you may be stopped out of the V long position, but you will probably outperform the market on the downside in the AXP short.

Additionally, there is a small chance that both sides of this trade continue to work (avoiding stop levels), regardless of the overall market direction.

 

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As commodities continue to crash and pundits continue picking bottoms, you will do well by paying special attention to currencies.  If you haven’t noticed by now, everything is correlated to currencies at the moment.  Since we’re all currency traders now, it’s important to understand what is happening, and what the possibilities of it continuing to happen are.

First of all, if you haven’t read my article Fed Trade School, do it now.  I described what’s happening, and provided a strategy that continues to work (it’s not too late to put it on, or add to it, by the way).

Now, we are approaching a big binary event – an inflection point if you will: Fed Day, Dec. 16.  The market will read it one of two ways, in my view:

1. “One and Done”; the Fed raises rates and then attempts to reverse the narrative of additional rate increases.
2. “Fed 2% Target”; the Fed raises rates and then provides some narrative on how they will approach their 2% rate target.

After today’s speech, the odds favor the “Fed 2% Target” outcome, which will result in more of the same.  Meaning, the US Dollar will continue to outperform global currencies, and I will continue yell laughing at commodities as they crash, see below:

 

Most big research firms have suggested that equities are only in for modest single digit gains in 2016.  As you can see in the chart above, the S&P 500 is stuck in the middle of what’s happening to currencies and commodities worldwide.  Therefore, if you plan on outperforming in 2016 – I think you need more currency exposure.

So Here’s the Trade:

Part 1: If the Fed narrative is hawkish and they lay out their path to a 2% target, go long the following currency ETF’s:

1. ProShares UltraShort Yen (YCS)
2. ProShares UltraShort Euro (EUO)

Part 2: Go short your favorite commodity exposed countries via some of the following ETF’s:

1. Russia (RSX)
2. India (INDY)
3. Canada (EWC)
4. S. Africa (EZA)
5. Chile (ECH)
6. Brazil (EWZ)
7. China (FXI)

Part 1 or Part 2 will work on it’s own, but both parts paired together will work very well – especially if worldwide growth continues to slow down throughout 2016.

If you’d prefer more direct commodity exposure,  I have recommended shorting ConocoPhillips (COP), and Anadarko Petroleum (APC), here and here.  I still like those ideas and for full disclosure I am still in those positions.

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The picture above is the Pasha Bulker, which ran aground near Newcastle, Australia in 2007.  I’ve been to that beach and what an amazing sight that must have been!  Now that the Fed is going to hike rates in December, I figured it illustrated perfectly what could well be the (continued) fate of many commodities around the globe.  Not to get too “macro” here because academic economists are typically full of it- trying to explain things after the fact- but it should be apparent by now that the US Fed is running a monetary tightening policy whereas the rest of the world’s central banks are easing.

The effects of this are obvious:

1. The US Dollar is going to get stronger relative the rest of the worlds currencies
2. Things prices in US Dollars are therefore going to get weaker
3. Companies that produce and sale things prices in US Dollars will lose income/revenue
4. Countries exposed to exporting things priced in US Dollars are also going to feel the negative effects

See the chart below, Commodities ($GTX) vs the US Dollar (UUP), shown at the bottom:

 

 

Now that this is set to continue, at least until mid-December…

Here’s the Trade:

Countries: Short Brazil (EWZ), Short China (FXI), Short Mexico (EWW), Short Russia (RSX or ERUS), and Short Australia (EWA).  Use their respective recent highs as a stop loss, and use their recent lows as profit targets.

Companies: Short Freeport-McMoran (FCX), use Friday’s high as a stop loss; $11.25.

Currencies: Short the Aussie Dollar (FXA), and Short the Canadian Dollar (FXC), use Friday’s high as a stop loss.

Commodities: Short Crude Oil (USO), and Short Gold (GLD) – only on a break to new lows.

I’ll probably use options for that basket of positions since it’s a fairly short duration trade and I’ll be able to use a minimum amount of cash – allowing me to enter each one.  These trades are not that ingenious, they seem fairly obvious right?  There’s beauty in simplicity, and simple usually makes money.  Key Note: I think this strategy should be closed out by the day of the Fed decision, December 16 – It might self destruct Mission Impossible style, and here’s why I think so:

If they hike rates, the Fed will most likely hint at a “one and done” policy in order to talk the US Dollar back down.  More on this idea to come… but I think Dec. 16 could be the current commodity cycle’s low.  I think the Fed will begin to ‘turn their battleship around’ and start the slow process of changing the narrative back to easy money.  This is of course dependent on how weak the Q4 GDP estimates (and Q3 revisions) come in.   They could be hiking into weakness which is not good.  Furthermore, if you’re a little uneasy about staying long the market after one of the largest monthly rallies ever, the short ideas listed above are a good way to balance (hedge) your portfolio.

Last thing to keep in mind, it doesn’t matter if the Fed actually hike rates, what matters is that the jawboning and the perception of tightening is effectively tightening in and of itself.  That’s why these trades should work.

 

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