Risk-off event this quarter?

This has certainly been the craziest year of my lifetime. The lockdowns, protests, endlessly spiking unemployment and huge numbers of small-buisiness bankruptcies coincide with US stock markets that march endlessly higher as any bearish momentum gets crushed.

Narratives have been shifting like crazy to fit the market, all trying to explain how the latest news story somehow justifies higher valuations. Last month, much of the optimism was attributed to the incredible vaccine rollout that would bring everything back to normal fairly quickly. Now that we have a botched and delayed vaccine rollout in the US, new variants of Covid that are much more infectious, lockdowns in the UK, Japan, parts of China, and truly aweful unemployment numbers, the optimism narrative has switched to the possibility of more stimulus.

The truth is simple – the stock prices drive the narratives, not the other way around. There are periods in the market where fundamentals simply don’t matter. As long as cash flow goes into the US stock market, it will continue higher. Modern passive vehicles (index funds) accelerate this path because they ignore fundamentals and assume the price is right. It’s like a classroom where everyone is cheating on an assignment by copying from the same key, and the few people who do the research fail the course because they come out with different results.

With financial markets, it is much more important to decipher why things are moving the way they are than what the underlying value should be. Fundamental analysis only works in distress situations – when you are either purchasing distressed debt, or purchasing stock in the midst of a market crash. Technical analysis tends to be a much more useful approach because it focuses on the patterns of these cash flows, looking for lines of support and resistance and at signals of growing or waning momentum, or even periodic patterns such as tax-loss selling or end-of-quarter rebalancing. That being said, it is rare to see valuations that are so obviously out of whack.

Above is a perfect example of the crazy markets we’re in. In the tweet above, Zach was doing an analysis on IWM (tracks the Russell 2000) showing a possible correction path from the latest resistance. I’ve been using IWM as a hedge for a while now, believing that a bigger index with more small caps would better reflect underlying economic damage, and I couldn’t help but notice that the big support line was at the pre-covid highs. We’re seeing a flood of small businesses permanently closing as unemployment soars while our political system is more dysfunctional than I’d ever seen in my lifetime, and the “small cap” index trades 24% above pre-pandemic highs.

A number of good traders have been posting signs of caution, such as excessively bullish sentiment shown in put/call ratios and other measures, price/volume divergence patterns consistent with early institutional selling, and unusually high insider selling. I’ve also heard the case for the knockown in gold and bond prices (higher yields) being a sign of tightening liquidity all while the US dollar is set for a counter-trend rally amid enormous speculative short-dollar positions. Rauol Pal also noted the institutional bias in the first quarter toward taking profits rather than chasing gains, as their annual score cards reset to zero and they want to make sure they don’t start the year trying to dig out of negative returns.

Whatever it is, I have been building my hedges significantly these past few weeks. I also sold off all of my cryptocurrency yesterday, deciding that these were my riskiest positions in the case of an overall market correction. If we do hit a major selloff than it will hit precious metals, commodities, and stocks as well – but I’ve decided not to touch my precious metals positions.

I will certainly play a market crash very differently this time than I did last March. Here are some changes I’m considering:

  • In March, I learned how responsive the markets are to Fed Policy, particularly in a world dominated by passive investing. I don’t expect fundamentals to come into play in forming a bottom, so the bottom will be higher and the bounce-back sharper than you think. In other words, wait for the decisive move by the fed and jump in.
  • Floods of money into passive vehicles like SPY will relentlessly put the most money into the biggest stocks and then reinforce that trend as they get more expensive. I will be looking at long-dated out-of-the-money call options on things like MSFT, AAPL & AMZN as a way to play this move.
  • Commodities may be crushed, but I really like the unique story behind Uranium, and I will get more long calls in CCJ.
  • Cryptocurrencies will get correct hard, but I expect them to re-visit their highs a lot quicker than you’d think – particularly the biggest 2 which is BTC & ETH. I will put in significant positions in both.

I could easily be wrong here, particularly on the timing. I just see the chances of a correction much higher now than I’m comfortable with. Almost all my call options have between 12 and 24 months duration on them – the only exception being TLT where I have batches of options expiring between 2 and 12 months (heavier on the long-duration end).

Last note – I have decided that it makes sense to look at my overall portfolio including crypto as well as stocks from here on out. I’ve also decided to organize them into categories better. Anyway, here’s where I’m at:

    • 26.8% Gold Miner Stocks, Large
    • 16.1% Gold Miner Calls, Large
    • 14.0% EQX (small gold miner stock)
    • 1.7% PVG Calls (small gold miner)
    • 2.3% SAND Calls (small gold streamer)
    • 8.9% SLV Calls (silver ETF)
    • 6.2% TLT Calls
    • 9.1% IWM Puts
    • 1.3% EEM Puts
    • 13.7% Unallocated cash

In a sense, my bet is pretty one-sided based on my intermediate-term macroeconomic view. Overall, the dollar will weaken as it becomes less important to worldwide trade, debt, and reserves as trade in foreign currencies continues to grow. Gold will grow in importance as a widely respected reserve asset, though it will remain a fairly minor one. Meanwhile, whatever fiscal stimulus we are likely to see will not be nearly enough to overcome the deflationary forces from defaults, large debts, and stagnant incomes. The federal reserve will try to counter this the only way it legally can – by purchasing government-backed securities and keeping interest rates low.

We are in a world where periodic floods of capital chase fewer and fewer investment opportunities bringing different assets to breathtaking highs as people struggle and political unrest grows. As the only game in town for capital returns, the US stock market continues to hold the highs until a sharp selloff occurs. This is a dangerous market to trade for bulls and bears alike, with opportunities for lottery-like winnings if you get lucky enough on the timing. Combine that with two working generations seeing few opportunities for creative growth in the workplace and dreaming of hitting it big to obtain financial freedom. It makes me think of the roaring 20’s, with the enormous wealth in “The Great Gatsby” contrasted by their brief visit to the shantytown for the poor & industrial workers. Crazy how history seems to repeat itself.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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