Sunday, August 28, 2011

Week Recap And How To Trade In The Near-Term

This past week was another volatile one, but it seems the trading range is decreasing forming a pennant on the S&P 500 chart.

These formations are usually viewed as continuation patterns meaning that we will have further downside from here. This is definitely a possibility but after finishing the week up 4.7% and rallying on bad economic news, I'm bullish for the near-term. The week was capped off on Friday with revised Q2 GDP coming in at 1% on expectations of 1.1% and the much awaited Jackson Hole speech from Bernanke. The expectations were for him to just reiterate that the Fed is watching markets closely and will use any monetary tools they deem necessary. However, we got a little unexpected news when he said that the Fed's September meeting would be extended from one day to two days to have extensive talks on monetary policy. Initially, the market sold off as he did not confirm QE3 was coming, but then had a sharp rally. I think this rally occurred because people realized that an additional day of Fed meetings means it's more likely we are to get some kind of further easing (whether that easing is QE3 or Operation Twist, we will have to see). So, we got a sharp rally that held up the whole day even with Hurricane Irene approaching. Economic data continues to be weak and I expect that to continue, but markets aren't always rational and very well can rally for awhile.

The big headwind for the market continues to be Europe where things seem to be getting worse and worse. Christine Lagarde, the new head of the IMF from France, just endorsed using the European bailout fund (the EFSF) to assist banks with capitalization problems. This puts Germans in an awkward situation as they are the ones in the best financial situation and would be hurt the most by a further increase in the EFSF which would need to be substantial. $230 billion in government-guaranteed European bank debt matures in 2012 and needs to be paid for somehow because God forbid bank debt investors take a loss. Germans are growing weary of their sovereignty and financial stability slowly being drained and Europe is growing increasingly tense.

If Europe is quiet this week (or manages to stay out of the mainstream media), I think we rally up until Friday when we get nonfarm payrolls (NFP) and the unemployment rate. The unemployment rate is expected to come in unchanged and NFP is expected to decelerate to +75,000. I expect continued poor economic data and a miss in the NFP number, but it's always hard to predict these numbers since they are unreliable and manipulated.

Gold prices continue to be volatile and we got the margin hike this week that I was expecting. I sold my gold long on Tuesday morning when it looked like the parabolic rise was topping. Shanghai raised margins Tuesday and the CME raised them on Wednesday causing gold to sell off from about $1900/oz to $1750/oz. It only sold off for two days and is now rallying back hard. This volatility has me concerned that we will see another margin hike like we did with silver in May. To see what a series of margin hikes can do to prices, check out the chart of silver:

The first margin hike is indicated by the green arrow. We had a 2 day sell off and then continued higher. Then, another margin hike and some more and you see how margin hikes can manipulate prices catastrophically to the downside. Gold is acting the same way. View the gold chart below:

Green arrow indicates the margin hike
As you can see, gold is acting scarily similar and this is a cause for concern. If in gold, be ready to sell at any sign of a margin hike.

With so much volatility and downside risks, it still is a daytrader's market and that's how I'll be trading. On Friday, I rode the rally up via AMZN and sold at the end of the day not wanting to hold over the weekend. For risk-on days, I will be entering any high beta names that have bullish patterns. For risk-off days, I will simply trade via the 3x leveraged ETFs like TZA, EDZ, and FAZ. (If you want to know what I'm trading realtime, follow @Trader_Gator)

Volatility is the name of the game, so stay nimble and be cautious. Capital preservation is the most important right now, so don't get cute and don't be stubborn or ignorant.

Wednesday, August 24, 2011

What Keynesians Believe

Had to throw this into the blog. This is the economics that the government and idiots like Paul Krugman believe in.

This is why we are in so much debt. Public spending is not good. We are allocating resources (taxes) or printing money (inflation) to create jobs that the free market would not normally produce i.e. we are funding inefficient investments. This is how bubbles occur like the one we saw in housing in the last decade.

Congressional Budget Office Outlook Analyzed By Bruce Krasting

Today, the Congressional Budget Office, or CBO, released their ten-year outlook on how they think the budget will ebb and flow for the future. As usual, the government has extremely optimistic views on how the economy will fair for the next decade. For analysis, we turn to Bruce Krasting of You tell me if you think the government if being a bit optimistic.

Also, they basically admit that they're wrong anyway.

The Congressional Budget Office released their ten-year outlook for the US economy today. It is a very complex analysis. There are dozens of critical variables that go into this long-term report. A Base Line set of assumptions is put into a (very big) computer. The report makes projections on future debt levels.

This document is significant as virtually all other long-term federal budgets are built around the operating assumptions that CBO uses. Economists and politicians will use this report to push their own agendas. That is how things work.

My crystal ball is cloudy these days. I’m having trouble looking down the road past a week. I don’t have a clue what conditions will be like in five years. Neither does the CBO. But they have to produce this report and they have to make assumptions to do that. I think the variables were set at levels that are on the optimistic side. But I’m a pessimist so I’ll let you decide if these are reasonable assumption.

The most critical variable is GDP. The folks at the CBO see clear sailing and high growth for the whole ten years. Their average growth rate is ~15% higher than the previous decade. That is because of the big 08 recession. The CBO believes that won’t happen again. No "dip" in ten-years. There is no basis for that. The US has a recession every 5-6 years.

Another central assumption that drives the results is the rate of unemployment. According to the CBO happy days are right around the corner. Unemployment will fall to 5% in just a few years and stay at that level forever. We should be so lucky.

With the drop in unemployment would come an increase in hourly earnings. At least that is how the CBO sees it. Note that the hockey stick of improvement is supposed to happen, well, about a six months ago. Maybe I’m not looking in the right places.

Inflation drives many components of the federal budget. I’m not sure what number to use. The CBO thinks it will be tame. Maybe. But I doubt it. We are in a ‘short’ resource world and the monetary authorities are pumping high-octane fuel. It would be helpful if the CBO were to stress test this at 4 or 5%. The results would be quite different.

There are numbers for the revenue and expense side. Once again, the CBO plugs in some rosy assumption about the direction of income and spending. Just about every arrow is pointing in the right direction.


The bottom line from the CBO is that debt held by the public will rise from its current level of $10T to $14.5T over the decade. The good news is that the percentage of debt to GDP will fall from the current level of 67% to 61%. The conclusion is we’re headed in the right direction.

To do that the USA will have to hit the numbers that the CBO has set out. I see little chance of that happening. There’s too much ‘up-side’ built into the projections.

When S&P went to the White House and told them they were going to cut the USA’s AAA the Treasury Department went on the offensive. Tim Geithner led that charge and did his very best to convince the American people that S&P had it all wrong. That they were incompetent and did not understand the macro economic dynamics that drive our debt profile. Geithner used these CBO projections to make his case that the US was on a good track.

S&P said “No Sale” to that argument. Looking at the assumptions that Geithner relied on to make his case I don’t blame them.


Remember, on Friday we get the 2nd estimate of Q2 GDP. It's expected to be 1.1% revised down from 1.3%. I wouldn't be surprised to see a sub 1% print.

Source: Bruce Krasting: CBO Report: "The future is rosy"

Monday, August 22, 2011

The Fed's Secret Lending Programs

Bloomberg came out with a comprehensive report on secret lending programs the Fed used from 2007 to 2010 last night. The most shocking thing about the report is the amount of money lent out to banks not only in the US but around the world: $1.2 trillion. As the Bloomberg article states, "Denominated in $1 bills, the $1.2 trillion would fill 539 Olympic-size swimming pools." Further, the $1.2 trillion is an even larger amount than the amount the government lent out in its Troubled Asset Relief Program, or TARP, which totaled $700 billion. The banks who received the most money are not surprising: Morgan Stanley, Citi, BofA. What is surprising is that the Fed found it necessary to bail out not only US banks but also foreign banks. In fact, RBS and UBS are both in the top 6 in peak amount borrowed. Also, many of the banks that received these secret loans were touting just how strong their liquidity positions were while receiving them! JP Morgan mentioned its "fortress balance sheet" at least 16 times while receiving secret loans peaking at $68 billion.

The Fed's stated goals are price stability and sustainable economic growth. So how does lending at below market rates to failing banks lead to either one of these? It certainly doesn't lead to price stability. As the below charts shows, food (something we all consume) prices are anything but stable. They are not only volatile but have a long term trend of increasing.

Higher food prices are due to the Fed printing money, and printing and lending to banks is of course inflationary.

So, maybe these loans have created sustainable economic growth then. Check out this chart of the S&P 500 priced in gold.

Why is the S&P priced in gold the most appropriate graph? Because the S&P in dollar terms includes increases due to the dollar being worth less. Like my previous post on gold, gold cannot be created out of thin air like dollars, so it has a stable supply. Another chart showcasing this economic (non)growth is the unemployment rate.

 Even if you believe the government's made up numbers, the unemployment rate indicates anything but economic growth.

So, what did the lending program actually do? It gave banks who took excessive risks even more money to take excessive risks. In a capitalist society, rewards should come for performing and penalties for not performing. The Fed is distorting this and is rewarding those banks who took too many risks, who were not smart, and who directly hurt the economy more money to play around with. This is like the losing team in sports receiving a prize while the winning team receives nothing. These nonperforming banks are being encouraged to keep on doing what they've been doing and the Fed has etched in stone that we will continue having the same problems we have been of excess risk taking.

For the full Bloomberg article, click here

Saturday, August 20, 2011

Why A Portfolio Of Long Gold And Short Equities Has Been And Will Be A Very Successful One

If you follow me on Twitter (@Trader_Gator), you'll know that for awhile now I have been telling people about the merits of a simple portfolio containing just two positions: long gold and short equities. This has been a superb performer for the past few months, and I believe it will be for quite some time. There are a multitude of reasons I believe in this portfolio. But first, let's look at the charts of both positions using the gold ETF, GLD and the short S&P 500 ETF, SH.


Obviously, both have performed very well lately. This is a trade I've had on for awhile now (since June which is a long time for my trading style). I've had it in a bit more complicated and leveraged form but for the sake of simplicity, we'll analyze it in this form.

So, why has this been and will this be a successful pair trade? Let's look at each position individually.

Gold is a real asset meaning you can hold it in your hand. It cannot be created or grown, so its supply is relatively fixed. Historically, gold has been used as currency for just this reason. So while gold has a relatively fixed supply, dollars do not. Central banks and specifically the Fed have money printing power; they can increase the supply of dollars anytime they want and lately have been doing it via quantitative easing or QE. When dollars increase, there are more of them for every ounce of gold, so gold's dollar value increases and the dollar's value is decreased. Our current Fed chairman, Ben Bernanke, has an affinity for printing money as he believes that artificially reducing interest rates by buying treasuries will help the economy (whether it does is up for discussion but I think it clearly hasn't). So, gold's value has been increasing in dollar terms pretty much since former President Nixon took us off any form of gold standard for good. In fact, it has risen from $250 per oz to now $1850 per oz since 2001 (a 640% return). So, inflation is one reason gold has risen so much.

The other reason gold has performed well, especially as of late, is the mounting fears of a US currency crisis. The US dollar is by far the most used currency in the world and has what is called "reserve" status. The debt ceiling drama has alerted the public to the massive fiscal problems the US has and has many worried that we will default on our debt i.e. not be able to pay our creditors. If the US defaults, the dollar will lose its reserve status and will suffer a cataclysmic drop in demand, lowering its value. However, since we are able to simply print money that can pay off debt, it is unlikely it will occur and we will indeed print dollars. This has caused a scare among some investors who seek safety with their assets. The US has been viewed for about a century as the safest place to put your money, so it is pretty standard to have a portfolio with a significant amount of money invested in dollar denominated treasuries. This is slowly changing with the increased fear of US fiscal issues and has caused some investors seeking safety to invest in gold rather than treasuries as gold is a real asset that cannot be created with some paper and ink. Currently, an average portfolio contains between 1% and 5% of assets allocated to gold. Clearly, there is a lot of potential demand out there to further increase the price of gold.

In sum, gold will continue its increase in value because the Fed has to continue to print money to pay off debt and they believe it's good for the economy.

Onto equities: US equities have suffered quite a bit lately beginning with the debt ceiling debacle and then were exacerbated by the S&P credit downgrade. Also, economic indicators have taken a downward turn since the spring and have caused many economists to lower their GDP forecasts and corporate profit estimates. It seems anytime you hear about the economy on TV now, you hear people discussing whether or not we will have a double dip and go back into a recession. Arguably, we haven't dug ourselves out of it and the only reason people think we have is because they believe in the government's unreliable and inaccurate numbers. However, from September 2010 to May 2011 we had a 30% increase in the S&P 500. This rally was sparked by the Fed announcing QE2 at Jackson Hole last August. Some people thought QE2 created real growth in the economy and perhaps it did, but it is now looking like it was temporary, or as the Fed likes to say, transitory growth and we are now back where we were prior to QE2. Another reason QE2 may have created a stock market rally is simply inflation. Dollars were printed to the benefit of banks and banks invested those dollars into stocks and commodities. To see the dollar's devaluation from QE2, view the below chart of the ETF 'UUP' which represents the dollar.

Clear dollar devaluation

To see how commodities were the biggest beneficiary, view the below chart of oil after QE2 was announced and after it was affirmed to be ending:

A clear boost to oil prices
Higher food and energy prices are not beneficial to consumers; they decrease discretionary spending. The reason I bring up the effects of QE2 are because central bankers are again gathering at Jackson Hole this coming week to discuss central banking and it is widely thought that the Fed will again give some kind of announcement in regards to QE and perhaps will announce the 3rd QE program. This announcement will have a huge effect on markets and if QE3 is their decision, commodities including gold will certainly soar. The question, though, is will the stock market have a big rally again? With so much research into the effects of QE2, it seems economists and the public are waking up to the fact that QE has no real long term benefits to the economy and simply props it up temporarily and boosts commodity prices. At the same time, QE3 would would help the banks out and would give them money to put into their chosen investments, but I believe much less will be allocated to stocks this time because more people realize QE does not help the economy and there are substantial headwinds to the US economy.

So, for the scenario where we get QE3, gold will most certainly increase and I believe equities will ignore the monetary boost and continue their downward trend but to be conservative, we'll say they are flat.

GLD up, SH flat. Portfolio up.

The no QE3 scenario is harder to predict in my opinion. Gold will probably sell off for a few days as people seem to expect some kind of easing. I believe gold will resume its uptrend, though, as no QE hurts banks and will lead to fears of another Lehman Brothers incident thus inducing a run to safety in gold. Equities on the other hand are a tough call as some investors may be happy that we won't have QE and inflation while others believe QE is necessary for this economy that needs its life support and saw what QE2 did to equities. Again, we'll say conservatively that equities will be flat from this outcome but I believe they would sell off.

GLD up, SH flat. Portfolio up.

The reason I really like this portfolio is because it seems that there are very little downside risks. It is hard to think of a situation where gold would fall while equities would rise. I think the only thing that could hinder gold's momentum is market manipulation via margin hikes like we saw in silver earlier in the year, but that is only a short term problem as silver is back at $40/oz already. With so many economic indicators pointing towards another recession, it is hard to believe that the market has priced it in with only a 17% drop in equities especially since fears of default have also factored into the sell off. For these reasons, long gold and short equities will continue to generate absolute returns for the foreseeable future.

Since this is my first blog post, I want to let people know that I'd love to hear their thoughts in the comment section. I like to think I have no ego, so feel free to hate, love, or anything in between regarding the blog and this post. Obviously, there are numerous other factors that make me feel confident in this portfolio but for simplicity's sake and for the sake of not writing a novel, I think this post adequately states my thoughts and views.

Also, I like music. So, I'll put an appropriate YouTube clip of a song that relates somehow to each post.