May 29/15 – Day 172 of Knife Catchers Anonymous™

2015-05-29 9am EDT  | 

Sometimes it is difficult to judge when a trade is crowded. There is no Yogi Berra giving you the heads up. Often the moment a trade gets popular, I decide it can’t work because too many traders are in it. This is usually when it really takes off, leaving me behind counting my pennies as the late hooligans make dollars. I have accepted my inability to ride a trend into the late innings much like I have accepted I will never play in the NHL or marry Carla Gugino (I was going to go with Kate Upton but on the oft chance my wife ever reads this, I decided to go with an age appropriate unattainable Hollywood star. Plus when I googled Carla I found an actress that finally does the ice bucket challenge right.) As I get older and wiser, I am content to simply not be on the other side of the final stages of crowded moves.

But if you were going to try to take the other side of crowded trades (and I am not suggesting doing this as I am now 172 days without a relapse – another eight days until I get my six month coin from Knife Catchers Anonymous) the key would be to identify crowded trades and not fading them until the trading action is showing signs of being tired.

So in a purely hypothetical exercise, let’s talk about one of the more crowded trades out there right now. The other day one of the better macro research firms sent me a complimentary report trying to get me to subscribe to their service. It was a good report, and I am not trying to pick on them, but merely use them as example of how this particular trade is crowded. Their number one strategic recommendation was short US equities versus long a basket of Euro area, Japanese and Chinese equities. To be fair to the research firm, they initiated the trade in February and it has been stellar. Hats off. They also had a long Euro area bank stocks tactical trade from January. Again, a great call.

It’s not as if I don’t understand why this trade would work. The ECB is in the midst of expanding their balance sheet while the Fed is about to raise rates (maybe). It is one of those “no brainer” put it on and forget about it, trades. Which is what everyone has been doing. Have a look at the weekly equity flows of US versus Europe:

And sentiment surveys are confirming this extreme positioning:

I have noticed this US stock market pessimism in my trader twitter feed. Considering American stock indexes are hovering near all time highs, sentiment is relatively bearish. Now, don’t misunderstand me and confuse this observation as a reason to be bullish. I can’t bring myself be outright long US stocks at these obscene valuations either. But I just wonder if the top could look so benign. Could we simply just roll over with so many traders looking for a top? Isn’t it more likely we top in an emotionally filled “just get me in” exciting affair? The market often goes where it will hurt the most traders, and I don’t think the pain trade for the US stock market is lower.

The European stock market on the other hand is stuffed to the gills with fast money longs. Every hedge fund and want-to-be CNBC pundit knows that QE is stock market friendly, and has been busy buying European stocks for the past few months.

For the past couple of quarters this trade worked well. The ECB’s Quantitative Easing was achieving its objective of filling the European system with liquidity, sending the short end of the curve lower in yields, and also causing the Euro currency to fall.

This ECB balance sheet expansion was a much needed policy adjustment.

But don’t forget, this monetary expansion is not guaranteed to work. In this day and age of Central Bankers Gone Wild, the relative rate of expansion is sometimes more important than the direction. If the ECB is not expanding as fast the Bank of Japan, then they will lose the battle, and the Euro will rise. Or it could be that even though the ECB is expanding their balance sheet, private sector credit is being destroyed even more quickly. Either way, as we experienced with the multiple Federal Reserve QE programs, sometimes the forecasted balance sheet expansion is not enough.

Which might be the case right now in Europe. The Euro currency has stopped declining. The ECB’s QE might not be enough anymore.

And if that is the case, then the dramatic European stock overweighting by all the fast money guys will bite them in the ass. Have a look at the chart of the EuroStoxx 50 versus the Euro currency:

For the past couple of quarters European stocks have been joined at the hip with the Euro currency. The failure of the Euro to continue its decline is an ominous sign.

Over the past few days, some of the fast money guys have started to get nervous and are unwinding their European stock market overweighting. For the first time in a long while, the European stock market has been a drag on global equities.

Yesterday the Eurostoxx was down almost 1.5% while the S&P was barely lower. Once Europe closed, the S&P rallied to close on the highs. And this morning, the same thing has happened. European stocks are down big again, dragging the S&P lower, but not by nearly as much. Have a look at the trading over the past couple of days:

This trade of long Europe / short US stocks is being unwound. There is no doubt in my mind it has finally become too crowded, and it has stopped working. The failure of a crowded trade to stop working is the first step, the next one is when some of the smarter traders head for the exit. This is where we are now. The shrewder traders are taking the position off. Pretty soon the mopey slow traders are going to stampede for the exit.

Fading a crowded trade just for the sake of being on the other side of the masses is never a good idea. But when that trade is showing extremes in sentiment, and the technical action is finally starting to show signs of being tired, well that’s when being on the other side of the trade makes sense. Quick – some one get me the number of my Knife Catchers Anonymous sponsor, I feel the urge to short Eurostoxx and buy S&Ps.

Thanks for reading and have a great wk-end,

Kevin Muir

the MacroTourist