3 Pain Trades That Could Derail The Stock Market (Part 2)

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Includes: GLD, TLT, USO
by: Harry Long

Summary

Where are we in the pain trades?

Oil has jumped sharply.

Gold is only slightly higher.

Long duration government bonds have not yet crashed.

As I wrote in March, let's think like a risk manager and not like a prophet. Let's imagine scenarios that are not probable, but painful. In other words, let's examine low-probability/high-impact scenarios that could destroy the average investor's portfolio - scenarios that will screw the greatest number of people and cause maximal pain. Here were the pain trades we listed in March, along with updates.

Pain Trade #1: Oil (NYSEARCA:USO) could rise 50% or more

This pain trade is counterintuitive, because everyone believes that higher oil is correlated with higher stock prices. However, investors should be careful what they wish for.

One of the major factors allowing the Federal Reserve to delay raising rates has been low energy prices. Large investors recognize that it's hard for the Fed to make the case that inflation is rearing its head when oil, a major component of prices in the real economy, has dropped over the past year. If oil rises from $40 to $60 per barrel, that Fed has less room to stay pat on rates.

The correlation of higher oil with higher stock prices could be broken as market participants realize that higher oil prices could lead to higher inflation, to disastrous effect. Even worse, if oil pops 50% based upon monetary inflation, as opposed to robust real demand for oil, we might start to see the nightmare scenario of inflation without strong economic growth.

Update: Since March, WTI has risen from $38 to just below $50 per barrel. This part of the pain trade is starting to happen. In order for the rest of the scenario to unfold, oil must continue to rise or stay flat, and gold must continue to skyrocket.

Pain Trade #2: Gold (NYSEARCA:GLD) could skyrocket

If market participants believe that a rise in oil is due to monetary inflation as opposed to robust real demand for oil, the rally in oil could eventually stall, but gold could skyrocket. The reason why gold could skyrocket is because it would be rising based upon the quantity of money, aka monetary inflation, as opposed to economic activity.

One could easily imagine a configuration of the world in which gold rose due to monetary inflation in the face of weak real demand for industrial commodities.

Update: Monetary inflation without real demand for industrial commodities would be a nightmare stagflation scenario for markets, because it would take away the ability for central bankers to engage in monetary easing which has been the life support of the global speculative class. If gold continues to skyrocket, watch out for a reversal in long duration government bonds...

Pain Trade #3: Long-duration government bonds (NYSEARCA:TLT) could get hit

Gold (as far as we know) is freely traded. It represents an opinion about the value of fiat currencies and the rate of inflation or deflation. If the gold market started to signal rapid monetary inflation, long-duration government bonds could sell off sharply.

We often forget that the Federal Reserve directly controls short-term interest rates, but not long-term interest rates. A crash in long-duration government bonds could jack up longer-term interest rates. A rise in 10- and 30-year interest rates raises the discount rates for the market. Imagine if interest rates on the 10-year went to 7%. That scenario is not probable, but it's maximally painful. Why would one invest in a dividend-paying stock with a yield of 5% if 10-year government bonds paid 7%? The answer is that equities would drop precipitously in such a scenario. This is absent any Fed action.

The next domino to fall in a pain scenario is not exactly a trade. The Fed could be forced to raise rates at the short end of the curve in order to get the long end of the curve under control. Literally, the Fed would be raising rates into a weakening economy in order to get monetary inflation under control.

To conclude, this scenario would be maximally painful and screw the greatest number of investors. And this scenario has started to occur. I will continue to monitor developments in these three markets closely.

Markets hit pain points, not because of a magical reason, but because the popular trades are overcrowded. Almost no one is left to take the other side.

The market has expected the Fed to act as a put option of sorts ever since 2008. The discussion of negative interest rates is really the frenzied conclusion of this fantasy that the Fed serves as a combination of put option, adrenaline injection, and wealth guarantor to the rich - a wet dream of sorts to those who wish to socialize risk.

I would suggest that the Fed cares a lot less about the stock market than is popularly believed. When push comes to shove, it will be forced by its mandate to act on rising monetary inflation. In such a shoving match between calls to pump up the market further and to rein in inflation, reining in inflation will win that shoving match.

But first, inflation must rear its head, which is why the recent pop in oil is troubling medium term, not healing.

Update: Long term duration government bonds have behaved absolutely the opposite of what I predicted. Either the bond market is calling for a deflation, directly opposite to the view of the gold market is taking, or the bond market is manipulated. I believe that the bond market is massively manipulated. In that case, the bond investors may be getting set up for one of the most nasty reversals of all time.

Remember if oil sets off a chain reaction, most of us are screwed. After all, the stock market is like a con man - it exists to screw the greatest number of investors possible. And we would be wise to remember that when contemplating pain trades that could massively destabilize the global economy.

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