May 15/15 – The pain trade

2015-05-15 9am EDT  |  #Fed #stocks

Last night the S&P 500 finished at a new all time closing high. It did this with little fanfare.

We have not yet broken out cleanly, but this is the fourth time pushing up against this resistance level. Just as triples bottoms are as rare as sober Lindsay Lohan sightings, quadruple tops are equally uncommon. The more a security pushes up against a level, the more likely it will eventually break through. The S&P 500 is bumping along the 2120 level, valiantly trying to break clear, and in the mean time, making a series of higher lows. The chances of 2120 holding and making a quadruple top is extremely low. I might not like it, but the stock market wants to go higher.

Lately I have noticed a lot of hedge fund managers turn pessimistic about the stock market’s prospects. Einhorn, Tepper, Gundlach; they have all been issuing warnings about equities. This pessimism has raised my antennae, and I have been worried there might be too many hedgies leaning the wrong way.

The reason there is so little excitement about the market is there are precious few bulls.

We have a stock market that is pushing up to new all time highs, all the while we have terrible sentiment readings. I wince as I write this, but the pain trade is higher.

Markets often head to where they will hurt the most amount of investors. I think the fast money is all leaning towards being underinvested in stocks, and they will be forced to cover higher.

I don’t think we will top with so much negativity. We will top with the hedgies falling all over themselves buying stock because they are convinced it has to go higher. Remember the euphoria at the height of the German Bund bubble? That was the sort of lopsided bullish sentiment that makes a top. The chances of the stock market topping with AAII US Sentiment Bullish Readings trolling along at 26% are slim.

I am not advocating getting long. I am scared about all the same things worrying those hedge fund managers. But I am suggesting that if you want to write some pink tickets, waiting for the breakout to the upside, and after a couple of days of the weak shorts chasing the market higher, might prove a better entry.

Few believe in 2015 hikes

It is actually quite ironic that the hedge funds are so negative towards the stock market because I think the majority of them are convinced the Fed will not hike rates any time soon.

According to one of the sharper traders out there – “Two and Twenty”:

Fully half the people at the Milken Conference did not expect the Fed to hike this year..

I don’t know if they took a poll at the conference, or if this was an anecdotal comment, but I believe it. When I read through my research and other market commentary, I am struck by the amount of calls that the Fed “will not hike in 2015.” I know the inflation numbers have continued to come in under target, but at the same time, the employment figures are pushing well past the point where 0% Fed Funds are justified. Yesterday’s continuing claims hit a new low we haven’t seen since the 1970s.

It is amazing that we have claims ticking at 264k and yet, Fed Funds are still zero! I know, I know, the employment picture is much more complicated than just claims. But this is just bat shit crazy!

I have long believed the Fed will leave rates lower for longer than anyone anticipated, but I am beginning to wonder about that call.

There has never been a Fed that has started a rate tightening campaign with inflation below target, but we have also never been at zero. There has to reach a point where the emergency rate of zero is removed.

Last year the market was busy pricing in a Fed that was going to steadily march short rates higher. The specs put on a record short 3 month Eurodollar position to position themselves for higher short term interest rates.

Yet over the past quarter, they have not only covered their entire short position, but they have gone net long. This is corroborating the skepticism about rate hikes in 2015.

Putting it all together

What if risk assets break out to the upside in the coming weeks? There is the real possibility of a monster chase higher. And what if that “risk on” squeeze scares the Fed? Don’t forget it was only a week ago that Yellen was warning about the stretched equity valuations.

Or what if we get even a modest uptick in the economic numbers? The market is not prepared for a rate hike. It has been so long, with so many broken promises, the market has forgotten Fed Funds move in both directions. There is a whole generation of young traders who have never seen the Fed actually hike rates.

I don’t think the market will believe the Fed will raise rates until they follow through on their word. Given the market’s skepticism, the hike will be far from priced in. In fact, it will hurt way more than it should.

Putting it all together, I think the pain trade is for risk assets to take off in the coming weeks, with the Fed then panicking and surprising the market with a hike sooner rather than later. That scenario would hurt the most participants, so I feel the Market Gods will find a way to make it happen.

Thanks for reading and have a great week-end,

Kevin Muir

the MacroTourist