This is going to be a long report, as we have a lot of ground to cover. I will break this weekend’s report down into the following sections: (1) Model Portfolio update & summary of positions; (2) thought experiments / investing hypotheses; (3) the dollar / currencies; (4) the market and (5) precious metals & miners.
MODEL PORTFOLIO & SUMMARY OF POSITIONS. From here on out, when the Model Portfolio needs updating on a particular position before all open positions have been closed out, I will start attaching the Model Portfolio to the Reports. Today’s closing trade is one such example – we still have three open positions and one that we closed today. The Model Portfolio link on the right will be updated less regularly, though I will track the % return with every closed trade. The updated Model Portfolio is attached below.
Our current open positions are in SQNM (5000 shares @ $4.50), the December 21 SPY put (1 @ $7.80) and the December 21 DUST put (1 @ $42). While SQNM had a nice pop towards the close of the day, the SPY and DUST puts are currently both suffering losses, albeit relatively small ones.
I closed the SLV put position today because I did not want to be in possession of 1000 shares of SLV come Monday. While there is potential the dollar may turn down again, boosting precious metals (PMs) prices, there is also a decent risk that PMs could continue to move down on Monday. I did not want to take the risk of a $18500 position losing 3-5% through a gap-down opening on Monday – similar to what happened this morning. I’d rather take a ~$200 loss than risk owning a potentially much bigger (by $ value) losing position.
THOUGHT EXPERIMENTS. I wanted to step back and think about the news and bigger trends on which to base potential new positions or think through existing ones. What follows is my attempt to understand how the forces of money printing and bonds interplay and affect various other asset classes.
(1) For the first experiment, let’s start with the assumption that the Fed will actually start curtailing its bond purchases and eventually cease altogether. If the Fed stops buying bonds – I include in this category treasury notes of various duration and mortgage backed securities – then there will be a greater supply of these in the open market that will need to bought by investors. A supply increase implies a price decrease, which implies a coupon rate increase. The US government will need to keep issuing treasury notes to finance its deficit, unless it miraculously figures out a way to cut it, which is about as likely as me growing another two feet. The Fed has controlled the rates on treasuries by creating money out of thin air (electronically) and buying treasuries, setting up the signal that there was an overabundance of demand, which drove up bond prices and lowered their rates. If the Fed stopped buying bonds, I would expect all of this to reverse, resulting in less demand for the notes/bonds, lower prices, higher rates. Higher rates, in turn, will put the brakes on home price increases, decrease number of mortgage applications and slow demand and returns in the housing market. Over the last two months, we have seen treasury rates rise in response to the bond buying tapering discussions issued by the Fed. So far most, including Goldman Sachs, believe that the Fed will start cutting back its bond purchases in September, which perhaps explains why rates are rising in anticipation of the beginning of the Fed’s wind-down. Take a look at the 10-year treasury note’s chart below:
What are the follow-on effects of higher rates? Generally, rates creep up when inflation is on the rise and the rise in rates counteracts or tempers inflation. Stock markets rise with outright inflation. Inflation and precious metals prices also tend to correlate positively, but since PM prices have been declining hard, the message being broadcast by the market is that inflation is not really present (leaving aside the calls for extended manipulation in the PM space). Deflation tends to be the nemesis of higher PM prices. Rates, then, may be going higher not as a result of inflation, but because of the de-repression that the Fed has induced through the tapering discussions; rates may be starting to represent the risks contained in the notes themselves, on the basis of the steep increase in government debt (and the debt to GDP ratio), reflecting the risk of default in treasury notes (we are nowhere near defaulting on an interest payment on outstanding treasury notes, but that number is also no longer 0).
What should we invest in if the Fed is preparing to exit the bond purchase program of the last four years? PMs are not the place to be long if the market’s projection of deflation is true. Bonds are also not the place to be long as rising yields will kill prices. A deflationary environment (which is what the Fed has been trying to fight – see Japan the last 30 years) with rising treasury rates means that defensive stocks will do well – an example sector would be healthcare (people get sick no matter what the economy is like). Each of these sectors have their own risks, but the risks are quite company specific instead of cyclical for healthcare stocks. Aggregate consumer spending is expected to decrease in such an environment and the stock market, overall, would be expected to decline, making stock picking (in the healthcare sector, for example) a delicate and difficult task. The best investing strategy in such an economy would either be to stand aside or to be short the aggregate market, with carefully chosen long positions in certain companies in specific, counter-cyclical sectors.
(2) For the second thought experiment, let’s assume that the taper talk by the Fed is BS and that when the economy is assessed accurately as barely limping along, the Fed will do the opposite of tapering and crank the QE printing press higher than it currently is. What would induce the Fed to do so? Spiking treasury interest rates, at a level high enough to make interest payments painful, possibly threatening default; plunging market; economy grinding down almost to a stand-still; dollar screaming higher against all other major floating currencies; and probably a number of other things I am not thinking of. Those would be the broad indicators to watch.
What do we invest in if we see turmoil ahead and then another QE printing spree? In the near-term, a number of specific short positions seem worthwhile to establish. When the Double Down QE (DoubleD QE) is announced, going long all the usual suspects might work initially, until the market realizes that DoubleD QE is actually a bad sign. Before DoubleD QE, bonds will have gotten crushed, along with the market and the economy. Currency directions will flip the day of a DoubleD QE announcement, the market will likely scream higher and rates will collapse, as the Fed hurries to sop up all the paper that it can get its hands on. Things will seemingly be returning to “normal,” but the places that were hot before the plunge and DoubleD QE will lose their bubbliness as investors go in search of the next bubble to blow. My guess is that it will be in the precious metals sector, healthcare and food.
(3) CONCLUSIONS. At the moment we have a market that is surging higher, bond rates going higher and precious metals continuing their collapse. Here’s what I think these components may be telling us: market surging higher – more QE anticipated; bonds plunging – QE done; PMs going down – QE done (although this did not hold true for QE4). The last shoe to drop for a QE done consensus appears to be the market taking a plunge (which will probably be the cue for DoubleD QE). Once we have everything making a strong move down, the conditions will be set up for a no-QE to DoubleD QE transition. From a trading perspective, so long as stringent risk management is applied, going short and then flipping long is possible, but needs to be timed correctly. Alternatively, you can choose one or both sides, QE ending vs DoubleD QE, position accordingly over a longer horizon and let winning positions prosper.
THE DOLLAR. The usual correlations between the dollar, market and PMs seems to have been broken. It used to be the case that a higher dollar pushed the market and PMs lower; whereas the converse resulted in a lift in both. The three currently seem to be moving nearly independently of each other, but there is still some influence of the dollar on PMs, albeit a small influence. The next two charts illustrate the lack of correlations:
The above chart shows the dollar in candles and a black line behind it for the S&P. In 2010 and through most of 2011, when the dollar moved up, the market responded by moving down. This correlation flipped in November 2011, when global currency devaluation wars got underway or intensified. We now have surging markets alongside a surging dollar.
For gold, the correlation with the dollar seems to have decoupled after the start of QE4 in October 2012. Since then, the PMs have cratered regardless of the dollar. Take a look at the chart below to confirm the decoupling observation:
Thus, it seems the dollar is playing little role in affecting the PMs (quite unusual), while it is showing positive correlation to the market. Strange times.
For us, a rising dollar will do well for (or at least keep steady) our SQNM position. Our PM positions (HL and DUST) will continue to be unaffected, but will likely experience further deterioration, at least until gold bottoms. Lucky for us, HL has held steady in the face of declining silver value. DUST, as expected, is screaming up with every step lower of the gold miners, which are magnifying the gold move. The DUST position is one which I may take a loss on and re-enter at a better price. At the moment, I will watch it closely.
THE MARKET. Let’s review the market analogy we have been tracking recently. Here is its chart, marked up with green arrows for where I think the market turned and labeled with how much longer we have until the serious plunge happens. Provided the analogy continues to hold, that is.
We are one week past the green arrow, which means we have another up week ahead of us, then two down weeks, before we push higher for the following couple of weeks, then hit a peak and start grinding down from there, never to hit those peaks again before the Big Plunge. If this analogy is correct, I have bought the SPY put too soon and it will be a losing position for the next couple of weeks. I bought it, of course, in case the analogy fails and we get our big plunge before making new highs in the market. After all, we can buy another put to dollar-cost-average the position. For now, it’s an inexpensive enough hedge to the analogy and with enough time past the time of the plunge for the position to pay off handsomely, even if it stays in the red for a little while.
PRECIOUS METALS SECTOR. With the discussion in the Thought Experiments section in mind, let’s see if we can make sense of the PMs. If some form of deflation is ahead with QE ending, then PMs will continue to decline in value; if we get DoubleD QE, then (forced liquidation notwithstanding), we should see PM prices rebound and possibly launch much higher. Where do our HL and DUST positions sit relative to the no QE / DoubleD QE alternatives? Simply put, I have positioned for a DoubleD QE / increased inflation scenario, despite the market arguing otherwise. This is a problem. It is a painful proposition to trade against the market. I may jettison our higher risk DUST position if it continues to move aggressively against me and buy back in at another date. It’s unfortunate, but it is better to take a small loss earlier than a much bigger loss later. The DUST position is one I will be watching closely over the next week or two.
Despite this being a very late Weekend Report, I think it’s worthwhile to be thinking through the market forces discussed and continue to refine our positions based on the messages the market is projecting. We have markers to assess the thought experiments by; we should be able to adjust positions quickly by the guidance provided by the indicators.
That’s all I have for now. Happy Monday!