The Rule of Three
Before digging in, I just wanted to remind people that I am a strong believer in the “rule of 3” or alternatively “by the time my mother knows it” rule. It is simple, sometimes it doesn’t even seem serious, yet I think it is in play here.
The pattern I see over and over is that the “first time” an event happens it is only noticed or captured by a few investors. This could be as simple as stocks ramping into the close starting after 3pm or more complex such as Washington negotiations where it looks like they are at loggerheads until some last minute kick the can deal is reached.
Now some investors are looking for the “event” to occur and start playing it. Many investors refuse to play the game as it seems illogical, but they notice it works. The next time the “event” is in play, more investors play the game. More people get comfortable that this is the way to trade the “event”. When it works again, every investor decides they know how to trade the event. Everyone now “knows” to buy the market at 3:30 or to buy puts coming into negotiations and buy the market after the deal is reached, or some such variation. Suddenly your “mother” or whoever you deem as least likely to care about the market now “knows” how the market works. That is when to worry.
In yesterday’s piece we took a look at why economic data or earnings, or something other than the “debt ceiling” might be the problem for the market. On Monday we examined the potential pitfalls of fixed income hedge funds trying to generate 10% in a 4% yield environment, so I guess the theme is to be looking for the unexpected.
I think everyone is playing the debt ceiling a very similar way – long with some puts and looking to get longer on any noise surrounding it. I think people are generally long in some belief that the fiscal cliff will release pent up demand and business growth (I think a mistaken belief) and that QE forces stocks higher and treasuries lower (the market so so excited about this prospect that it has front-run the trade, backed up over the body and run it over again).
Expecting the Unexpected
I am fairly confident that the market is set up largely the way I described. I also believe that credit is over owned and complacent while equities are right up there and treasuries are despised in spite of the reports we have been putting out this year on why they are interesting.
I remain bearish US stocks with a target of 1,400 to 1,425 but let’s see how some scenarios play out.
The first and scariest problem facing a bear is that investors have puts anticipating the “debt ceiling” sell-off. So the first wave of selling is not a problem for the market. It actually plays out nicely for the market. The “obvious” pain trade is the market just goes higher and the puts turn out to have been a waste of money and investors feel cheated about being “not long enough.” This scenario is possible and would capture much of the pain out there. Why don’t I think this is what will play out?
- In part it already has played out, investors hedged too early (I got bearish US stocks at 1,451) so some of the weakness followed by “buy the dip” has already played out, admittedly this is a relatively feeble argument, but I think has played out
- Apple is confusing many people, in particular the ability of the market to move in the opposite direction of Apple is causing either problems or great joy for traders, but is in any case muddying the waters as it is hard to see that continuing too long (I think Apple stabilizes and even bounces a bit into earnings)
- Credit markets are not happy. I can ignore the strength in treasuries because I don’t believe in the “rotation” trade and think much of the strength can be attributed to a limited float, fed buying, and yes, some realization that the economy is not about to go gangbusters anytime soon. The weakness in credit is more concerning. IG19 and HY19 were briefly at their widest levels of the year this morning. While both significantly better than the December 31st close, HY19 is now below where we recommended closing the long position on January 2nd and IG19 is wider than where we recommended shorting after the FOMC minutes. A far simpler warning sign is the LQD has seen shares outstanding decline on an almost daily basis. HYG has been more stable, and the outflows of LQD have been small, but we are looking for warning signs here and those seem to fall into that category
- What if the decline isn’t shallow and the bounce doesn’t occur?
That is the really interesting part of this scenario and concerns me. If everyone “gains” from a market sell-off and buys the dip, the only other real pain trade is that the dip is only a brief stopping point. If some investors have already closed out hedges or given up on waiting for the dip to buy, then this can happen sooner, but the worst case for the market seems we get this “expected” sell-off, hedges get taken off and positions added and then we continue to decline.
If everyone is “limit long” or “all-in” at 1,460, what happens if we don’t get an immediate bounce? Since everyone is playing the same strategy, who is going to buy on “debt ceiling relief”? That is the big question, who is really that scared of the debt ceiling? While some believe in the platinum coin, even those who dismiss that idea don’t expect any serious problems to come out of the debt ceiling debate. It is just too serious for Washington to screw up. Find me one person who really thinks we will have a debt ceiling calamity and I would be surprised. I’m not saying show me the person who bought 1,300 strike puts on the S&P 500 “just in case” but anyone who really thinks we see long lived debt ceiling problems? I don’t think they are out there, so who will buy? The scenario everyone is playing relies on some mythical investor waiting to pile into the market after the debt ceiling.
So if no new buyers and valuations that are stretched, with things like LIBOR lawsuits, conflict in the Middle East, disappointment that no one changed their business plans post Fiscal Cliff, all set in, the market could be set up for further selling. Earnings have seemed lackluster. Again, nothing currently horrible, but stocks at 1,470 seem to require conditions better than just “not horrible”.
Weakness in credit would add to the problem. High yield is high yield for a reason. I have liked it, and will again (probably sooner than later) but just because CLO’s are attracting money at a fast pace doesn’t mean every single company with an unsound business will get financing. The Best Buy saga is interesting as on the one side you seem to have hubris coupled with deep felt emotion from its founder versus, umm, reality. I haven’t followed closely but don’t see this ending well, though maybe we can get an LBO and default in the same year.
In any case, I think we are far closer to the longs being tested. To see how much capital they are willing to risk. How much of a loss they can take. How hedged they are. The problem I have with my scenario is I think a target of 1,400 is too high if this plays out. We would have crowded longs everywhere looking to get out.
So for now I remain bearish, and if anything, my bearishness is increasing across the board. I am nervous that the pain trade is stocks going to 1,500 but don’t see that happening and deep down am not sure it really is a pain trade at all since investors are pretty long if not limit long already.
As a good old fashioned contrarian, the rule of 3 does mean the rule of 9 also works – i.e., every third time the rule of 3 should work, it doesn’t, because the rule of 3 also applies to the rule of 3, but that is too confusing this early in the morning and the slopes await.
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