Traders Should be Shorting This Rally

by: Convex Strategies

I'm not one who believes timing the market, or even trading, can grow wealth over the course of a lifetime. That little factoid aside, I will at times initiate swing trades, typically using leveraged ETFs for no longer than a week. I keep this thinking entirely separate from my long-term investing philosophy, and I go so far as to perform the trades in an entirely separate, "speculative" account. My trades aren't particularly frequent; they are typically made with undeniable conviction that they'll be profitable. A couple of weeks ago, I initiated a trade in ERY (NYSEARCA:ERY), a triple leveraged bear fund that bets against the Russell 1000 energy index. I saw WTI crude approaching $100 per barrel, several energy stocks trading near their 52-week highs, and a general sense of excessive optimism in the overall market. These levels strongly conflicted with my intermediate-term view that:

  • The global economy has been artificially propped up by central banks for far too long
  • U.S. interest rates are laughingly low (they should be at least 100 basis points higher)
  • China's financial structure is going to lead to a terrific implosion (those who would like to know more about this opinion are more than welcome to ask)
  • Government debts are going to lead to either structured deleveraging or excessive printing (both of which will result in continued economic stress)
  • Italian yields over 7%, Spanish yields approaching 7%, Greece's eventual default, and other Eurozone issues are going to weigh on equity and commodity markets for years, let alone the next few weeks.

Logically, I concluded that oil was $10 to $20 overpriced, and energy stocks had a long way to fall. While my central thesis that oil was overpriced got blindsided by the issues in Iran, I closed out the position last Friday with a 26% gain. I lacked the conviction to stick with the trade, and was pleased with my profit. Currently, the Dow is up over 400 points, Copper is soaring, Oil is over $100 a barrel, because a bit of news is out:

Six central banks led by the Federal Reserve lowered the cost of emergency dollar funding for financial companies in a global effort to ease Europe’s sovereign-debt crisis. The new interest rate is the dollar overnight index swap rate plus 50 basis points, a half percentage-point cut, and the program was extended by six months to Feb. 1, 2013, the Fed said today in a statement in Washington. The Fed coordinated the move with the European Central Bank as well as the Bank of Canada, Bank of England, Bank of Japan, and Swiss National Bank (OTCPK:SNBN). Stocks rallied worldwide, commodities surged and yields on most European debt fell on the show of force from central banks aimed at easing strains in financial markets. The cost for European banks to fund in dollars dropped from the highest in three years, tempering concerns about euro’s worsening crisis after leaders said they’d failed to boost the region’s bailout fund as much as planned.

The news of this measure, along with positive payroll figures, sent the Dow positive for the year. Think about that for a second. What this measure actually does is provide a little more "liquidity" (what an over-used term at this point) to a global financial system already drowning in cash. Sure, Europe effectively needs several trillions to fund its debts, but that doesn't mean the system is lacking liquidity, it means European debtor nations are simply paying the price for years of spending way more than they take in. It really is as simple as that. Furthermore, let us not forget, how bad are things right now that the World's most powerful central banks had to do this? Rumors that a large European bank may have almost failed could very well be true. Worse still, this patch-up job only gives Europe a couple weeks at most to address the real problem; they are drowning in debt, and there is no one left to sell more of it to (with the exception of the Fed; the ECB cannot directly buy European bonds). This measure didn't solve a thing. It provides Europe with another few weeks to ignore its bigger issues. Italian 10-years? Still over 7%. Greece? Still hemorrhaging, and they just took another 8 billion euros to pay the next few bills. Spain, Portugal, Ireland? Still drowning in debts, and their banks are heavily exposed.

While this act may have delayed the inevitable contagion to Germany, France (sort of), Japan, and yes, the United States, it does not solve the problem. So, should the Dow really have just turned positive for the year? By all means, no. "But corporate profits are better than ever!" So? Profits are a lagging indicator, and while there is a ton of investment opportunity out there, including here in the U.S, a huge portion of revenues come from Europe. More importantly, a "fair" amount of revenues come from the rest of the Globe. And since the fallout in the European financial sector would quickly affect credit here and everywhere else, you can be sure the global economy has plenty of headwinds ahead.

On an even more sour note, the United States is going to be just as badly off as anyone else (if we aren't already) if we don't get our act together, but that's for another article. Given this information, traders should be shorting the heck out of this enthusiasm. Surely, a large portion of traders have been lightening their shorts since Monday of this week, and most people are now probably far more net-long than they are net-short. This is great time to be considering initiating shorts. My recommendation is to stay away from shorting energy, considering Iranian worries (whether they are unfounded or not). TZA (NYSEARCA:TZA) (3X bear on small-caps, which are overvalued at current levels and always get hit hard in down markets), FAZ (NYSEARCA:FAZ) (3X bear on financials, which probably have less downside at current prices than other groups), SPXU (NYSEARCA:SPXU) (Ultrashort on the S&P 500), and SQQQ (NASDAQ:SQQQ) (Ultrashort Nasdaq) will all work here. For day traders, TVIX (NASDAQ:TVIX) and VXX (NYSEARCA:VXX) work for a spike in volatility, but both funds experience enormous decay (even in the short-term) and don't always track the VIX particularly well. Those who are new to leveraged funds would be wise to understand the decay risks involved.

Disclosure: I am long TZA. I may initiate a position in TVIX at sometime in the coming days.