Short Squeezed

Aargh. Last week was awful. Terribly frustrating watching my performance go in the tank. Other than gold (which was up&down) all my positions moved against me. The worst move was the S&P/TSX, which is back where it was in the fall (and is a large position). HXD moved more than the index, indicating there may have been a short squeeze. The index itself has moved more than 12% in the past month, also suggesting a bear market short squeeze. Indices do not usually move like that, especially in bull markets, which tend to be slow upward grinds. I get the strong sense right now that people are jumping back into the market, worried that they may be missing the recovery. Perhaps I need to start introducing some stop losses, but I am not sure. I do not want to be stopped out and then miss the turnaround.

Economic news this weak continues to be weak. NY manufacturing survey showed no growth but the forward-looking parts of the survey were poor. Housing starts and Philly Fed were terrible, and initial unemployment claims ticked back up, with the 4 week moving average staying at 375k. The one bright spot was leading indicators, which actually moved slightly higher. I don't want to discount the leading indicators too much, but one up month does not make a trend. The other data still seem to be showing that we are in the early stages of a recession.

Financial data this week was confusing. The problems in the money markets continued, with LIBOR ticking higher and the TED spread and discount rate spread both remaining elevated. The bond market got whacked, with the 2 year Treasury trading well above 2% (up about 100bps from its low), and the 10 year Treasury up over 20 bps in the week, although it rallied strongly Friday afternoon. The bond market seems to have decided that, with inflation high and sticky to the downside, that the Fed may soon be done with its cuts. This could be bad for equities, if the Fed is prevented from cutting more even if the economy is weak. Currencies are showing that risk aversion has gone away for now, as the EUR/YEN is at almost 164, and CHF is also down. The most confusing trend though is the DJ Transports, which have rallied HUGE from their January lows and breached the October highs, even though oil is at $115, airlines are going under and UPS/Fedex are reporting problems. What gives? Is this a sign that oil prices are not sustainable, that the economy is actually doing OK, or is the market on smack? Definitely a trend to be closely watched.

MARKET POSITION: SHORT EQUITIES (10 units); LONG GOLD VS. SHORT HOMEBUILDERS (2 units)

Portfolio Performance

March was a difficult month (and so was the first part of April). There have been numerous reports of well-known hedge funds suffering big losses, but that is small solace. I made two fundamental mistakes last month: 1) not covering my short positions in the aftermath of the Bear debacle, and 2) entering into the long gold / short homebuilders trade. The first I should have known and discussed last week. The second was premature. I had been saying since Christmas that gold was overbought. I still need to work on being patient. There is no imperative to enter a trade. It is acceptable to hold cash.

So far my call earlier this week seems to be correct. But we will not know for some time whether I was truly right. This market is all over the place. It could rally sharply higher next week -- who knows? The price action the past couple of days was good (for me, being short). The market tried to move higher mid-day Thursday but failed, and then slowly ground lower all day yesterday, closing near its lows. But the volume was nothing spectacular, so its meaning is tempered. The news yesterday was bad though -- GE surprising on the downside, after assuring investors everything would be fine. They are very international, too. Consumer Sentiment reaching some of its lowest levels since the early 80s. That was a bad time, and this is a bad sign for the economy. So I watch and wait.

Going out on a limb here...

I am going to go out on a limb here and state that it looks like this rally may be over. But first, I want to quickly comment on the past few weeks. The most important lesson I learned was: trade the market you have, not the market you want. At the time of the Bear Stearns debacle, I stated that it looked like a near-term bottom was close in time (if not in price). But when the market did not collapse, I did not sell. I wanted lower prices, and I did not sell because I did not get them. NEVER be influenced by what you want. Trade the market you have. I learned the same lesson again 2 weeks ago with Agco, which briefly traded in the low 50s due to some margin calls (or so it appeared). Looked like a great opportunity to take a long position, but I wanted a slightly lower price and it got away from me. Now it is trading at $67.

Back to the present: The move over the past few weeks has been fast and furious. Some lingering negativity remains, but there is also a lot of optimism around. Many people are stating that the Bear Stearns debacle marked the bottom, as similar bankruptcies have marked major bottoms in the past. Seems unlikely. There was never a big washout. Sentiment never reached extreme negatives (although it was negative), VIX only briefly touched 36. The consensus now seems to be that there will be a recession but it will be short and shallow. Many people are using the rally to show that technicals are good.

Seems unlikely. Typically, you only get such large rallies in the middle of bear markets. And since when were bear market bottoms called by the consensus only a week after they occurred? True market bottoms are marked by pervasive negativity that lasts even as the market starts to grind upwards. No one believes it will last. Not like now.

On this basis I have increased my equity short once again, diversifying into the EAFE short fund EFU.

MARKET POSITION: SHORT EQUITIES (10 units); LONG GOLD VS. SHORT HOMEBUILDERS (2 units)

On patience, market timing, crowded trades, margin calls and deleveraging

Last week was interesting. One that I would like to repeat with a little better patience. I have been saying since the beginning of the year that gold looked like a crowded traded, and I was going to wait for it to correct before increasing my position. Instead I bought another unit almost at the (interim) top. HGU tumbled terribly last week. Even worse, the US homebuilders performed very well, so both sides of my new trade moved against me (rather rapidly), causing a serious dent in my performance.

In fairness, it looked like a lot of trades were blowing up last week as margin calls were made and funds deleveraged. Commodities took the brunt of it, with oil, metals and the ags getting smashed. The yield curve flattened, even as yields on very short T-bills went to almost zero and TIPs yields moved positive again. In the equity markets, the indices were all over the place. In the end, SPX was up about 5% from its lows, while S&P/TSX was down, finally closing much of its perfomance gap with SPX.

I am remaining bearish on equities and positive on gold. The market is certainly far from its full bottom, and there is also little evidence that a short-term trading bottom has been formed. We still have not had a downside blow-out. The VIX jumped to 35 on Monday but it was very brief and rallied strongly from that level. Sentiment is poor but has yet to be seriously tested. There seem to be many people that assume that the bear stearns debacle marked a bottom and the markets are headed higher. This may be somewhat true but the upside seems rather limited. We are not going to have a 20% bear market rally when the market is only down 20% from its peak. In addition, the market has already rallied over 5% from the bottom. Not enough upside for my purposes i.e. the risk/reward looks terrible.

Gold miners, on the other hand, start to look attractive after a 12% fall in value over a few days though I am reluctant to increase my exposure there after last week. The agricultural equipment makers also look interesting after sharp declines on Thursday -- seems they have been caught up in the commodity price crash. But as I have said before, it is not necessary for whet prices to remain at $10 for these companies to perform very well. I will likely take a wait-and-see attitude this week, keeping an eye open for opportunities that may open up in the turbulence.

TRADES: SHORT EQUITIES (8 units); LONG GOLD vs. SHORT HOMEBUILDERS (2 units)

Waiting for the next shoe to drop

When I wrote the post on Feb. 29 ("getting close to meltdown?") I was not expecting this. A major investment bank, one of the Fed's primary dealers, on life support. I was also rather surprised how the pessimism never lifted this week after the Fed's big announcement on Tuesday. Shows the financial system is in really poor shape. The central banks in the US and UK are completely out of their depth. They are used to having the financial markets at their beck-and-call. If there were any serious problems, they made a few soothing statements, lowered interest rates, and everything was fine. But such is not the case this time -- they are lost -- and I get the impression that things are going to deteriorate until governments get involved.

I will re-iterate what I said last Saunday, that in the past, such periods (where the situation has looked really bad) have been good times to invest. But even if we are close time-wise, we may not be so close price-wise. This week will be a major test.

On Friday (March 14) I closed out my position in HEU at a small loss. If markets are going in the tank, I don't think it's a good idea to be long energy shares. On the same day I took a short position in the US hombuilders (ticker SRS) to counter-balance the long gold position. I think this is a good trade and may increase it if it performs well. House prices in the US need to fall substantially more in real terms. Either nominal values will fall and inflation will stay low, or inflation will pick up and the adjustment will happen that way. If nominal house prices fall, the homebuilders will get seriously screwed. Probably a few of the really big names (e.g. Toll, Lennar, Horton) will go under. Alternatively, if inflation picks up even more, gold should continue to do well.

I still am waiting to enter the agricultural equipment makers at a good price. If there is a sharp drop in their share prices in the near future, I will probably take advantage and start to build a position.

TRADES: SHORT EQUITIES (8 units); LONG GOLD vs. SHORT HOMEBUILDERS (2 units)

More of the same

Global markets were very weak Monday as liquidity tightened and risk aversion increased. Tuesday was looking pretty ugly until the Fed showed up and offered to take $200B of crappy mortgages onto its balance sheet. The markets bounced initially (equities in particular were up very strongly) but now seem uncertain. Today's action was both positive and negative. USD continues to plum new depths against EUR and JPY indicating more risk aversion and less love for the USA. On the latter theme, the US Treasury 10yr auction today was very weak, and apparently foreign participation was almost non-existent. Perhaps we are finally nearing the lows in treasury yields. It IS pretty crazy that people are willing to accept 2.5% nominal yield when inflation is currently over 4%. You need to have an absolute collapse in nominal GDP growth to justify such yields, which seems inprobable. Ben has shown clearly that he will do whatever it takes to keep the economy out of a deflationary trap.

On that note, the Fed's actions seem likely to have the same effect as in the recent past -- propping up financial markets for 1-2 months before the problems return. Commodities continue to be well-bid, with oil at $110 and gold touching $1,000 today. I continue to believe that we will have some sort of correction at some point but timing is uncertain and prices will probably not fall as much as I thought earlier. So I finally dipped my toe a little deeper in the water and increased my gold holdings by one unit, plus one unit of energy companies. These should both perform well in the medium-term given current gold and oil prices. However, I also note that I added the position today at a time when I was very tired and stressed, and my judgement on the timing may not have been optimal. Time will tell.

On a portfolio admin item, I am re-basing my calculations of units to account for the fact that my holdings of SDS / HGU have perform much better than HXD.

MARKET POSITION: EQUITIES - SHORT (8 units); GOLD - LONG (2 units); ENERGY - LONG (1 unit)

Where to from here?

The fixed income markets are in a very tight spot. Swap spreads are the highest in at least 20 years. There is a lot of pricing dislocation as investors flee to quality. The corp. bond market has virtually dried up, and apparently off-the-run treasuries were trading sluggishly on Friday. Traders are very nervous. Pricing dislocations abound. There has even been some "end of the world" type talk.

Is this the end of the world? Maybe, but probably not. There are certainly some aspects of the current situation that very serious, and probably make it worse than previous episodes. In 1998 there was essentially one hedge fund in trouble, albeit one that was very large and had significant linkages throughout the major banks. But currently, it is the banks themselves that are in trouble, and it is not just one. Bank capital is low and declining, forcing banks to protect their balance sheets. An incipient recession and housing bust provide a negative backdrop, while large CDS exposures and mark-to-market accounting threaten to amplify price declines. The Fed has increased liquidity multiple times over the past 7 months, but it has failed to correct the problem or reduce the sense of crisis. Even worse, there is no leadership and no reasonable proposals on how to get out of the mess.

In the past, such overly negative situations have signalled major buying opportunities. Is now such a time?

I would argue that we are near time-wise, but still have some way to go price-wise. Prices tend to go down exponentially in a "blow-out" situation, and we have yet to see such movements. Fixed income is arguably much of the way there already. Equities have started, but as I mentioned before, the movement has been remarkably gentle given the situation in the fixed income markets. Equities almost certainly have much farther to go. Commodities may act as the signal of the final turn. There appears to be a lot of speculation and risk capital in the commodities. When that money is finally pulled and prices get hit, it will be a strong signal that the end of the slide is nigh.

MARKET POSITION: EQUITIES - SHORT (11 units); GOLD - LONG (1 unit)