Mercenary Trader's  Instablog

Global Macro Notes Mon Aug 13th

NEWS FLOW

• Japanese GDP Slows to a Crawl. Japanese economic growth slowed to an annual rate of 1.4 percent in the second quarter, the government said Monday, as cooling global demand weighed on the nation's exports, while domestic demand, which had helped Japan outperform other Group of 7 industrialized countries this year, appeared to lose steam.

Japan stagnation shows further evidence of global growth slowdown. Twenty years on, still near stall speed. U.S. at increasing risk of becoming like Japan b/c policymakers fear the impossible outcome (Greece), thus improving odds for the more likely one (Japan).

• Hedgies capitulate on European shorts.

This sounds more bearish than bullish, re, contrarian positioning. Hope in stimulus is a time decay hope. The returns on such are rapidly diminishing. Hope for China stimulus over the weekend was not met.

• Preparing for a collapse of the euro. Banks, companies and investors are preparing themselves for a collapse of the euro. Cross-border bank lending is falling, asset managers are shunning Europe and money is flowing into German real estate and bonds. The euro remains stable against the dollar because America has debt problems too. But unlike the euro, the dollar's structure isn't in doubt.

• Belgian Gov: Buying Spanish, Italian debt 'makes no sense'.

Further evidence that Europe's problems are far from solved. There is no structural agreement that the periphery countries deserve to be saved, let alone how.

• China Is Running Out Of Money

• China Admits It Has A Food Inflation Problem

• China to release corn, rice from reserves

• Concerns About China Outlook Intensify

Deadly serious issues in China. Stimulus won't cut it this time, and may be off the table due to inflationary concerns. If China implodes, the Aussie implodes with it. More reinforcing evidence of global slowdown and meaningful cycle fears.

• Ryan Pick Jolts Race - WSJ

Romney pick of Ryan as VP candidate intensifies "America as Japan" risk. Fiscal conservatives wrongly believe America could become 'Greece.' This belief system could lead to a combination of economy-weakening austerity measures and non-job-producing, budget-draining tax cuts that increase the likelihood of becoming like Japan.

Democrats no answer either, though, as Dems more likely than Repubs to let America fall off the 'fiscal cliff.' No reason to expect logic or sound policy from either party.

FOOD FOR THOUGHT

• GMO: Death of Equities Exaggerated; Explaining Equity Returns

• Five years on, the Great Recession is turning into a life sentence

• Hussman: Begging for Trouble - August 13, 2012

• Morgan Stanley's 'Extreme Bear Case Scenario'

• The Disappearing Market. "There are times when the market gives the impression it is fading into nothingness. Volume becomes very low, trading ranges become very small, volatility becomes very low. Also, there is very little change in market levels and day-to-day fluctuations are minimal. Looking back at history, when that happens it is almost always a sign of a market high point."

CHARTS / TECHNICALS

• Doctor Copper not looking so hot.

Copper weakness = further confirmation of Asia / global slowdown thesis, serious threats of commodity led implosion. If we get a $USD ramp, all of this accelerates. To the degree that late stage China growth entered a ponzi stage (complete w/ Golden Elephant subprime), the ramifications are serious.

• Trend Tracker 0813 - dangerous bull drift .

Strong odds for more 'grind-up,' but non-trivial odds for swift sell-off. A very dangerous time to be complacent. Light volume and narrow ranges leave this 'grind-up' rally vulnerable to a sufficiently negative catalyst, or just a big enough sell order to crack things wide open.

• Nasty bearish engulfing in KOL (coal miners).
• Copper miners (COPX) rounding out?

Various and sundry base metal miners and other base metal plays have been beaten like a red-headed stepchild, but playing them for a rebound is a little too cute for our taste in respect to serious ongoing China concerns.

• Utilities (XLU) flagging out?

If the grind-up rally is going to stick, then bonds are going to head lower, which means rates are going to rise and safe haven capital flow is going to leave utilities and go back to more logical areas of the market.

Food for thought: Would a utilities short actually be something of a hedge / neutralizer for other shorts, as utes are likely to do worse (break down faster) if the risk on rally continues?

• GBPNZD: Beautiful clean downtrend pattern.

Don't know what the relationships here are (UK vs New Zealand), but odds are the UK is worse off than NZ and that pattern sure is pretty…

CLOSING THOUGHTS

General stance is to respect the price action without deferring to it. Price action here is increasingly bullish, but it also increasingly smells like bullshit. A low volume, low volatility environment, with junior traders manning the NYC desks and bears mostly neutered / scared off by threat of the big central banker mallet… with technicals to justify emotions, this is the type of environment where bulls could get ahead of themselves (or perhaps already have) enough to feed a severe downward dislocation.

Of course, the upward grind could also continue, against a backdrop of waving off macro data concerns, until the frying pan to the face comes at a later date. Right now, though, the general mood seems 'hopeful and unrealistic' in the manner that bulls love to embrace, where, when risk assets rally for bullshit reasons, the longs don't ever question it, they just smile and try to justify their hopefulness with fundamental backing after the fact.

Also classic from a poker / pot-odds type perspective in that the high probability play (going with grind-up) gives greater likelihood of a small, risk-inadequate payout; whereas the lower probability play (positioning for a less likely but meaningfully possible sell-off) has potentially excellent reward to risk. Being a contrarian and understanding expectation means understanding when the outlier bet is the better bet (as when your 30% draw has a 6 to 1 payoff and so on).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Many don't realize it, but Jesse Livermore was the original "global macro" guy.

He would trade anything back in the day - stocks, wheat, cotton, coffee, options contracts - and he surely would have traded currencies too, had the world not been on the gold standard.

Livermore, whose ideas and approaches were immortalized via Reminiscences of a Stock Operatorin 1923, is widely recognized as one of the greatest traders ever… his life and times contributing to the greatest trading book of all time.

Livermore has long been one of our "mentors from afar."

Our broad trading approach - long / short with a global macro overlay - is much modeled after his. (Along with later global macro greats who operate in the Livermore mold, such as Soros, Druckenmiller, Kovner, Bacon and Jones.)

Getting back to Livermore, it struck me how valuable the wisdom of Reminiscences has proven in this tape. Having gotten more involved on StockTwits and Twitter lately - and you should follow us if you aren't already - it has grown apparent the great degree to which others can benefit from Livermore's wisdom.

And by "others" I mean (ahem, cough cough) those who tried to be wiseguys this week, picking Thursday tops and bottoms in TLT and SPY, and thusly getting their heads handed to them.

Let's go through a few classic Reminiscences quotes and see how they've applied to this market:

But I can tell you after the market began to go my way I felt for the first time in my life that I had allies - the strongest and truest in the world: underlying conditions. They were helping me with all their might. Perhaps they were a trifle slow at times in bringing up the reserves, but they were dependable, provided I did not get too impatient.

Being a contributor to the StockTwits and Twitter Stream, one of the things that consistently amuses and confuses yours truly is the lack of regard for underlying conditions.

Underlying conditions - also referred to by Livermore as "general conditions" - represent the flow of what is going on in the world.

Here it is again, in plain English:

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.

Underlying / general conditions encompass not just technicals - Livermore didn't use charts, though he watched price action like a hawk - but fundamentals and sentiment too… a sense of which way the world is going and why.

Back to present day: For a macro oriented trader who pays attention to underlying conditions, it seems crystal clear which way the wind has been blowing.

In a recent piece on Gold vs Bonds, -- SPDR Gold Trust (GLD) vs DB US Dollar Bull (UUP) we laid out extensive drivers, along with story links, as to what was happening. Namely, the world is slowing down (as Europe slowly falls apart)…

In short, paying attention to underlying conditions can save you a lot of money - or MAKE you a lot of money - if you consistently make an effort to put the puzzle pieces together (technicals, fundamentals and sentiment) and then listen to the market's message.

I was not pitting my tape-reading knack or my hunches against chance. The inexorable logic of events was making money for me.

Sounds damn good doesn't it? Having "the inexorable logic of events" make money for you? As a trader, how do you do it? By studying and heeding the power of underlying conditions!!

Here's another bit of Livermore wisdom, re, overnight gaps in the tape:

…any important piece of news given out between the closing of one market and the opening of another is usually in harmony with the line of least resistance. The trend has been established before the news is published, and in bull markets bear items are ignored and bull news exaggerated, and vice versa.

It is hard to emphasize how true this is!

And we got one hell of an example today (June 1st), with bad news from Europe, China and the US whacking markets brutally all at once. Thursday seemed to tease, and give the top-and-bottom pickers a brief minute of smugness, but then Mr. Market said NOPE…

And we were "loaded for bear" into this tape, with no long positions to speak of. Why? Because of general conditions!

Really, seriously, this stuff works. Regardless of all the whining and bitching about how hard charting has become, it works as well today as it did 100 years ago - as long as you are comfortable on both sides of the market and not just one:

I cleared about three million dollars in 1916 by being bullish as long as the bull market lasted and then by being bearish when the bear market started. As I said before, a man does not have to marry one side of the market till death do them part.

Some traders only play the bullish side, and this is a respectable approach. But we also think it's like being a tennis player without a backhand… if you can only go long, you are going to miss half the opportunities in play, and be forced to twiddle your thumbs for interminable stretches (especially in markets like these).

Nor is this Livermore stuff just a bear market phenomenon… the "underlying conditions" logic applies in bull markets too.

Do you remember back in 2009, when markets just seemed to go higher and higher, no matter how much bears gnashed their teeth? When data point after data point from China was bullish, and everything just kept levitating?

Well, now we've got the opposite of that… but BOTH sets of conditions can be equally as good… as Jesse says:

They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side.

Amen. There is no such thing as a crystal ball, or a method of analysis that works flawlessly 100% of the time, but by golly you can get one hell of an edge by 1) getting a grasp on general conditions, and 2) applying said lessons correctly.

This stuff is SO INSANELY VALUABLE, it still blows me away that so many traders operate blindly, in shortened time frames, with no real sense of the "bigger picture" at all!

And that gets back to one of the biggest Reminiscences lessons of all:

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!

Now here is the key thing. When Jesse talks about "sitting tight" there, he does not mean sitting tight on the sidelines waiting for the next good trade. Patience is important, of course, but that isn't what he's talking about.

No, the "big money" he speaks of comes from SITTING WITH BIG POSITIONS.

Getting a low risk, high quality entry on a position of meaningful size… being aligned with general conditions… and then just SITTING with that sucker - maybe even pyramiding - as it develops into a huge trade!

Not to again call out my Stocktwits brethren, but really and truly, I am partly writing this as a friendly message of encouragement and exhortation to you guys, and to all the traders I see playing for small money in small time frames, when the tape offers much greater things if they would only step back and get some vision.

The big money is NOT in nipping around for teensy little gains! ("Don't be a dick for a tick," as my partner likes to sometimes say.) Short-term trading can certainly be profitable… but it isn't where the true killings, the FORTUNES, are made…

You want an inspirational example? Okay, here's an example (click charts to enlarge):

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non-currency traders could have used the CurrencyShares Australian $ (FXA) to gain exposure

This trade - which is time-stamped and still ongoing in the Mercenary Live Feed - was entered utilizing what you might call "the Livermore Method" (or what we less than modestly think of as the Mercenary method).

• First, the Aussie was sized up in respect to general conditions - the potential for the AUDUSD carry trade to collapse, due to Australia's resource-leveraged exposure to an overheating China. We have talked about this possiblity repeatedly in past Global Macro Notes, and publicly referred to the Aussie as a potential "trade of the year" on more than one occasion. Here's proof…

• Second, we made multiple attempts at low risk entry based on technical confirmation - the first few getting stopped out around breakeven or for small profits, as we waited for the real move to commence. We even tweeted out a chart following the entry that stuck…

• Third, we practiced the Livermore guideline of SITTING TIGHT on an excellent position, fully aware, via general conditions and clear sense of valuation / macro scenarios, that this could develop into a huge trade.

Ever wonder how traders make hundreds of thousands, or even millions of dollars, on a single monster trade, with an excellent entry and strategic pyramids along the way?

How guys get into those type of positions that, in hindsight, seem like a P&L dream?

THIS IS HOW… and it isn't "our" method, it's Livermore's. We just humbly apply it, on a day in and day out consistent basis, to all the markets we cover.

He laid out the blueprint, more than 90 years ago:

• Sizing up conditions
• Probing for strong reward/risk entries
• Being fully cognizant of scenarios
• Keeping a tight rein on risk
• Risking small, entering with size
• SITTING TIGHT when you land a big 'un

Of course, they can't all be "big game" trades. We're happy to be short-term guys too. There's nothing wrong with ringing the cash register in a tight time frame - like, say, 3 to 5 trading days.

But if you're stuck in tiny time frames as a rule, playing penny-ante poker and patty cake for pips, you've got to experience the thrill of the big kill… the hunt for big game… Jesse's way of making the BIG money on the BIG trades.

Wondering Where the Rum's Gone,

JS (jack@mercenarytrader.com)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Short AUDUSD

When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form… technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action.

- Paul Tudor Jones

There are powerful arguments for why gold should continue to go up. There are also powerful arguments for why bonds (specifically U.S. treasuries) should go down.

These arguments, in fact, are two sides of the same fundamental coin: An expectation of inflationary outbreak via mass money printing and central bank loss of control.

Consider, for example, the various scenarios in which U.S. treasuries could crash (causing interest rates to skyrocket) and gold could go vertical:

1) Stimulus-enhanced recovery unnaturally accelerates, morphing into katastrophenhausse, or "crack-up boom," as ZIRP-juiced credit activity amplifies leverage and the Federal Reserve refuses to withdraw accomodative monetary policy (for fear of the 1937 experience).

In this scenario, the markets recognize a new dominance of 'hot money' and accelerated speculative transactions, the "risk-on" gold rush comes to the fore, and bond prices collapse. Gold simultaneously rises along with food and energy inflation fears.

2) Global slowdown (first Europe, then Brazil, then China, then softening US gives way) leads to deflationary downward spiral - falling oil prices, falling equity markets, rising panic - which in turn leads to "nuclear" stimulus response efforts (QE III, LTRO II, Beijing Stimulus X, etc) that finally triggers a confidence-collapse tipping point in which traditional financial institutions are both symbolically and literally abandoned.

In this scenario gold comes into its own as "the ultimate credit default swap" - rising ever higher as a safe haven and currency debasement refuge - even as low-to-no-yield government securities are dumped as fiscal capital death traps.

Either of the two - red hot recovery or nuclear stimulus response - could fuel a fundamental backdrop in which gold skyrockets higher and bonds collapse.

There's just one problem: The above is not what's happening… neither price action nor real-time reaction to current events is confirming one of the two major "gold up, bonds down" scenarios.

If the macro picture were playing out towards the "gold up, bonds down" resolution in the major way so many fundamentally committed market participants are expecting, the charts would be hinting at such, or at least broadcasting a 'neutral' message.

Yet they aren't…

We opened this piece with some food for thought via macro trading legend Paul Tudor Jones, re, importance of reading the tape, i.e. paying attention to price.

Here's another PTJ gem, suitable for taping to the side of your monitor:

[No loyalty to positions] is important because it gives you a wide open intellectual horizon to figure out what is really happening. It allows you to come in with a completely clean slate in choosing the correct forecast for that particular market.

~ PTJ

When it comes to macro forecasting, price action (charts) are an integral aspect of "choosing wisely" (insert Indiana Jones reference here).

As Mercenaries we have been bearish on gold for some time now.

At one point we were bearish on bonds - even labeling short treasuries a potential "trade of the year" candidate - but stepped away from that view when the price action did not confirm (and when our low risk short bond position, pyramided off an initial profit base, closed out on sufficiently adverse price action to disconfirm the scenario in question).

This is "no loyalty to positions" at work. (Be loyal to your friends, not your trades!) In similar vein, we have no "loyalty" to our bearish gold stance at this juncture.

If gold starts "acting right" once again, we will consider a long side trade… but not before the market tells us to.

Why? Simple:

• When it comes to macro positioning, there are often multiple branches on the scenario tree (i.e. multiple ways things can play out).

• Furthermore, it is often the case these multiple branches have a bipolar aspect to them- meaning, scenario "A" is highly bearish for gold, yet scenario "B" is highly bullish and so on… or vice versa for bonds, equities etc… and we don't yet know which one will crystallize.

• This is why intellectual flexibility and "tape reading," i.e. paying attention to the charts, is so important. To trade macro successfully - or, heck, to invest at all successfully these days - you must
  • 1) be intellectually aware of multiple scenarios,
  • 2) be patient enough to wait for scenario confirmation,
  • 3) be nimble enough to profit accordingly (w/ price action as your guide)
  • all the while 4) practicing diligent risk control (fallibility awareness).

That last one, fallibility awareness, is huge. All you investors out there who stick like glue to your views, disregarding fallibility awareness completely… I gotta say I just don't get it. You are either way too smart for me, or else my instincts are right and you treat your precious investment capital with the same regard as a parent who lets their kids play on the freeway.

If the flexible / fallible mindset is new to you, by the way, here are some refreshers:

• On being right vs making money

• On Cockroaches, Extinction Events and Anti-Fragility

• On Earthquakes, Power Laws and Market Behavior

• On the importance of themes and getting around

• On Soros and false trends

Back to gold versus bonds and the price challenge to gold believers:

It is a tendency of macro-level fundamental players to dismiss near term price action as "noise," and to rely on longer-term trends as backing for their general views.

So with that in mind, let's look to the monthly charts for gold and the ten year, via mega-popular ETFs GLD and IEF (click to enlarge).

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Ayn Rand once said, "When you think you are facing a contradiction, check your premises." You don't have to be an Ayn Rand fan to recognize that as smart advice.

Right now the price action in respect to gold and bonds - on a monthly chart level, which is going to be least affected by short-term speculative activity - is saying in a thick Brooklyn accent, "YO, GOLD BULLS / BOND BEAHS: WE GODDA MAJA CONTRADIKSHUN HEAH." (Sorry for that awful phonetic rendering.)

Side note: In reference to a "food for thought" tweet that inspired this global macro notes installment, someone on Stocktwits essentially replied to me: "Look at the 100 year chart [for gold]."

My tongue in cheek response: "So if the 100 year chart breaks trend, will gold bulls say switch to the 1,000 year chart?"

Follow us on twitter if you want a daily serving of snarky bon mots such as this (and some thoughtful / useful stuff too).

It is further notable to yours truly that gold is acting so weak against a backdrop of renewed European turmoil.

Some Larry King style musings (though hopefully of more substance):

• As FT Alphaville has noted, capital is leaving Europe. So why isn't it flowing into gold?

• Gold saw acceleration and potential blowoff into mid-2011. What if that move representedthe anticipation and pricing in of all that is happening now?

• GDX bulls are pounding the table on how out-of-whack gold stock valuations have become, relative to the price of gold. But what if that valuation discrepancy corrects with a crash in the gold price, rather than a true GDX rebound?

• Deflationary bond bull Hugh Hendry has observed that bull markets tend to end with a bang, not a whimper. What if the spectacular bull market in US Treasury bonds - arguably two decades running now - still has an incredible "bang" left (driving yields down to Japan-like levels)?

Another extended Hendry / Shilling "what if deflation wins" riff:

• With Europe slowing down…

• China near a tipping point and running out of options…

• Japan getting downgraded… the UK in deep recession…

• Emerging market equities in the toilet…

• and the US jobless recovery on shaky ground…

• Is it possible, just possible, given the compiled evidence above, that the unprecedented tsunami of stimulus thrown at the slowdown problem was actually far too little to forestall the market's post-supercycle deflationary fate? Could it yet be that the global central banks' "massive" stimulus efforts of the past three years, in comparison to the scope of the deflationary wealth destruction at hand, pending a collapse in multiple DECADES of leverage and structured credit drivers, are the metaphorical equivalent oftossing a mattress into a volcano?

If the above is true - that the deep undercurrents, the post-supercycle wealth destruction and economic contraction trends after 25 years of binge (1982 on), are to heroic central stimulus efforts as godzilla is to an oversized iguana… if "throwing a mattress into a volcano" is a CREDIBLE view of what is happening now, vis a vis stimulus versus deflationary impact… then a scenario in which bonds yet advance to incredible, bull market supernova levels, with correspondingly jaw-dropping low yields, actually makes sense as stimulus efforts slow-motion fail… with further stimulus thwarted by austerians on both sides of the Atlantic… and in such a scenario the gold price could yet drop like a hot rock (or even crash).

As a bonus reason for gold bugs to be nervous, John "Riverboat Gambler" Paulson, aka "Sino-Forest for the Trees" Paulson, is up to his eyeballs in underwater gold positions - and clients are none too happy about it:

Investors with legendary hedge-fund manager John Paulson aren't taking a shine to his gold metal performance - in fact, some are heading for the exits.

Investors are upset over Paulson's huge gold positions - specifically, his outsize holding of AngloGold Ashanti, down 20 percent this year, The Post has learned.

That has dragged down two of Paulson's funds.

"I would be happier if he cut the gold position in half," says one investor who put in a notice to take his money out of the fund in June. "He would have been up 4 percent in the first quarter if it weren't for the goddamned gold."

~ Laying a Golden Egg, New York Post

You wanna hang around and wait for this guy to blow out the last chunk of his client base that hasn't yet capitulated (but which is getting more fed up by the day)?

Me neither… even if one is truly agnostic on gold, and merely value based, the threat of the Paulson overhang has to be at LEAST as big a counter-concern as bullish gold stock fundamentals are a positive driver…

So let's recap:

• To trade macro successfully, you have to pay attention to price. If you don't, you will eventually get your head handed to you (ahem, Paulson cough cough)… there are too many bipolar branches on the scenario development tree for such to be otherwise.

• Whether they claim to be macro or not, bets on gold stocks and / or the gold price are distinctly macro in nature.

• There are credible scenarios for the "gold up, bonds down" outcome - red hot recovery or nuclear deflationary response, respectively - but there is also a credible scenario for the reverse: Gold price crash, bonds massively further up, as "mattress in a volcano" stimulus efforts fail to dent the true level of global credit / wealth contraction, even as austerian political impulses in Western economies (Bundesbank, Tea Party et al) hold central bankers in relative check.

• Right now, price action is NOT favoring the "gold up, bonds down" scenarios that so many fundamental gold bugs favor… and as we have said, ignore price long enough in the macro game and you will eventually get carried out.

Final note, which, based on the nature of comment replies, needs to be added: We are NOT perma-bears on gold, and would be happy to switch our orientation back to "gold up, bonds down" if price action started once again CONFIRMING, rather than disconfirming, that particular branch of the scenario tree…

But right now that ain't happening. (And by the way, if you want to know what we're doing on a play-by-play basis, trade with us!)

Funny Old World Innit,

JS (jack@mercenarytrader.com)

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.