by Jack Sparrow
A wave of QE2 euphoria has washed over markets like a syringe full of heroin hitting a grateful junkie’s bloodstream.
Some assert that the wave could well continue, as we enter the seasonally strong Nov – Dec period for markets and marginalized bond investors look on the equity bonanza with longing.
A further rush of upside would do us just fine, as we ride the wave with precious metals names and an assortment of other carefully selected longs.
At the same time, though, we inch ever closer to the door by systematically building out short positions, particularly in names that have been ‘acting right’…
Though there is good money to be made on the long side, one cannot know how long that will remain the case. (Weeks? Months? Days? Already over by the time you read this?)
One CAN see with a fair degree of clarity, however, that the Federal Reserve is merely driving markets toward a brick wall… with the inevitable collision set to be horrendous.
The numerous “bricks” in this looming wall include:
- failure to stimulate the real U.S. economy
- the death of credibility for the Federal Reserve
- rising anger (bordering on rage) at pro-inflationary policies
- foreclosure-enhanced odds of a housing double dip
- a breathtakingly oversold $USD threatening to surge
- looming “currency war” (full-on trade war?) with China
- austerity-induced self-asphyxiation in Europe
The motto of the bulls thus well might be: “Eat, drink and be merry, for tomorrow we die (or at least face reality)”…
~~~
“If you don’t eat your meat, you can’t have any pudding. How can you have any pudding if you don’t eat your meat?” ~ Pink Floyd
When the party gets hot, the bears are accused of being joyless sticks-in-the-mud. Our medium-term outlook is, sad to say, ferociously bearish at this point. And yet, we are not bears in spirit, but Mercenaries — so it seems necessary to point out that, no matter how dark the bigger picture, in the short term there have been excellent long opportunities to seize…
The largest position in the Mercenary portfolios has long been the GDX Gold Miner’s ETF — a vehicle that needs no introduction — coupled with an assortment of gold and silver names.
Our long side exposure is not limited to precious metals, however, having expanded to names like Assured Guaranty (AGO) that have performed rather well (click on chart to enlarge).
Rip-roaring performance notwithstanding, we trust this rally about as far as we can throw it, given the overcrowded nature of the QE2 trade and the laughably cynical foundations of the bullish case — faith not in the prospect of economic healing, but rather in the expectations of a non-stop money printing orgy even as the real economy continues to wither.
Rather than ditch our strong-performing longs, our concern leads us to hedge with a growing roster of attractive looking shorts.
Many previous high flyers, like PF Chang’s (PFCB) and Netflix (NFLX), to give two examples, have looked noticeably tired and laggard in the midst of the QE2 wind storm, suggesting good reward to risk for a sharp downside break in the event that a trap door opens up.
Another area we are opportunistically short is crude oil, for multiple reasons.
For one, crude oil’s relative performance has been terrible given the dollar’s sharp decline. For two, a crude oil short serves as a rough hedge against our long-side precious metals exposure. If oil goes nuts, gold and silver will go even more nuts.
And finally, there is simply a lot of crude oil in the world. Crude oil inventories just keep hitting record levels. New production keeps coming online in all sorts of places. The peak oil thesis, if not flat-out defeated, seems at least very much on hold from a medium-term supply and demand perspective. Here are a few quick snapshots:
- U.S. demand for petroleum products lowest in nearly a year (WSJ).
- Iraq Oil is ‘Game Changer’ (WSJ).
- Top oil trader sees price band of $70 – $85 per barrel (FT).
- The $USD is sharply oversold (TPC).
Dollar weakness is relevant because a sharp $USD rally could hit oil hard.
Another area of keen short interest — balancing out that long exposure! — is the iShares Dow Jones Home Construction Index (ITB).
It is hard to see how home builders will avoid the fallout from foreclosure-gate and the looming threat of a housing double dip. At the same time, we now find that one of the biggest hidden threats to home builders might well be… other home builders. Or, to be more specific, builders that have emerged from bankruptcy in fighting shape.
As the WSJ reports in “A Home Builder’s New Lease” (emphasis mine),
While most builders done in by the housing market’s collapse are gone for good, a few are emerging from bankruptcy revitalized—with less debt, choice land and sharper business plans. Like WCI, whose public shareholders were wiped out under its reorganization plan, they are more likely to be owned by their creditors.
Relieved of day-to-day shareholder pressure to keep up their stock price and pay all their bills, these companies can take steep write-downs on the value of their land, which was often purchased during the industry’s boom years. That allows them to price homes low enough to capture consumers’ attention and still post a profit.
Indeed good news — for builders who have already been through the bankruptcy wringer. For the still-public builders that have to compete against their newly lean and mean peers? Not so much.
Last but not least, we have the stuck-in-a-rut financials, for whom the news just keeps getting better and better. And by that we mean worse and worse:
- Mortgage Mess Could Cost Big Banks Billions (Dealbook)
- JPM CEO: Foreclosures Could Hurt Housing (Reuters)
- AGs in ALL 50 STATES now investigating (Reuters)
At the very minimum, the big banks are back in a sort of “black box” situation where no one can be truly sure just how deep the rabbit hole goes. This time, though, there may not be a contingent of suicidally brave value investors and SWFs (sovereign wealth funds) to buy into the teeth of balance sheet risks no one can quantify.
And by the way… QE2 will fail miserably
Against this crazy backdrop, one further must ask two questions:
- Is there anyone who actually believes QE2 will work?
- Is there anyone who hasn’t yet heard the QE2 story?
The situation is deliciously bizarre because so many traditional game theory dynamics seem to have been thrown out the window. We simply KNOW that QE2 will not work, as do the more honest participants inside the Fed itself:
Thomas Hoenig, the president of the Federal Reserve Bank of Kansas, on Tuesday launched his most strident attack yet against QE, arguing it would not help drive an economic recovery.
“There is simply no evidence the additional liquidity would be particularly effective in spurring new investment, accelerating consumption, or cushioning or accelerating the deleveraging that is hopefully winding down,” Mr. Hoenig told an audience in Denver.
However, the separate release of the minutes of the Fed’s Open Market Committee (FOMC) meeting on September 21 underlined that Mr Hoenig is in a minority of one in his dissent.
And in the true nightmare scenario, fund manager Van Hoisington wonders if the Fed’s very independence could be at stake:
More important, however, is that by implementing QE2 the Fed could eventually lose its historical independence. The Fed is facing some economic headwinds over which they have no control, and thrusting itself into situations with enormous potential for unintended consequences. If the Fed takes additional actions that are as ineffectual as they have been previously, this could lead Congress to assume that the Fed should be given more direct instructions regarding the purchase of financial assets. Congress might assume that QE1 and QE2 were unsuccessful because they were too small, not that they are fundamentally flawed concepts. On such a path, monetary policy could then become a mere branch of fiscal policy–a road to economic perdition.
Ironic, that. As the Fed actively destroys the market mechanism, it runs the risk of destroying itself. It’s a nutty world out there, and one quickly growing as cartoonishly nightmarish as Pink Floyd’s The Wall.
Our essential positioning is to ride the QE2 wave as long as it lasts, via selective long positions, while simultaneously building a foundation of attractive shorts – to both preserve capital in the event of sudden collapse and prepare for the inevitable bloodletting when this Alice in Wonderland euphoria cycle turns.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.
