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Kevin Muir is the market strategist at East West Investment Management. He also writes The Macro Tourist blog – this is required (and entertaining!) reading for buyside and professional investors. We discussed with Kevin why hedge funds as a group need to be faded, how to tell the difference between investors simply puking up positions and legitimate buying/selling and why whenever you hear “new era” you should be worried.
Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ? How do you find long and short ideas and what do you look for in them? Can you give an example?
Kevin Muir: In my previous life, I worked on an institutional equity desk as a proprietary trader. My responsibilities were trading index arb and the option book. However, I would often come up with different ideas in other squares. My bosses were constantly reining me in - telling me to stick to my assigned products. When I left in 2000, I decided to try trading my own capital and for the next two decades, that’s all I did.
Often people would ask me what area of the market I specialized in. Or they may be more blunt and straight out say how do I make money. I would tell them that I often didn’t have a clue where I would make my money. All I could say is that I was constantly watching the markets for opportunities and I was hopeful to be clever enough to recognize them.
Sometimes I would focus on commodities, other times it would be convertible bond arbitrage, or some years a currency play would present itself as the best opportunity. Every year seemed to be different and flexibility seemed to be my greatest strength.
The one thing that often helped was an understanding of the bigger macro picture. For example, when oil collapsed from $100 to $20, I got bullish (a little too early, but it’s hard to catch the exact bottom). However, when I went to buy the oil futures, the commodity curve was so steep that I realized it would be difficult to make money owning futures outright. So, I had a look at energy equities. The problem was that they were trading like long term call options and were ridiculously expensive. But the energy bonds had been beaten up and no one wanted to own them. I ended up buying a different basket of energy company bonds at under 50 cents on the dollar. I figured if crude bounced, the bonds would be money good as the companies would issue equity and buy back cheap debt. If crude didn’t bounce, then I would own the next round of equity when the debt was converted in a restructuring. Either way, the energy company corporate bonds offered the best risk reward for playing a crude oil bounce. That year I traded more corporates than ever before.
My trading ideas are generally macro in scope but by being a jack-of-all-trades, I zero in on the area that I believe offers the best way to express that view.
SA: In a recent blog post, you said “the hard trades are most often the right trades” – how do you identify these hard trades in the idea gen process? What does the risk/reward profile look like for these trades? Can you give an example of a previous hard trade that worked out and a current hard trade?
KM: The “hard trades are most often the right trades” refers to the idea that often, the best trades are ones that few other market participants are recommending. These are the trades that when you make them, everyone tells you how wrong you are. These trades often make you feel sick when you execute them as you are so alone. It feels like you are the only one who doesn’t “get it.”
Writing a newsletter is an interesting exercise. By definition the more popular a post, the more likely it confirms traders’ existing positions. People want that confirmation bias. Therefore when I have a post where everyone agrees with my analysis, I generally know this idea has the potential to already be discounted by the market.
However, if I have a post that is universally decreed, then I know I might be onto something. The posts with the most pushback, the ones when market participants feel most confident to write me to tell me how wrong I am are the ones they should be most scared about.
This is what I mean when I say, “the hard trades are most often the right trades.” The more difficult it is to execute because everyone around you believes the opposite, the more likely it will work. If trading was easy and trades “felt good”, then everyone would do it and be rich. But trading is hard and the worse a trade feels, often the better it is.
SA: As Amaranth can surely attest to, the natural gas March/April spread earns its nickname as a widow maker (though John Arnold may call it whatever the opposite of a widow maker is) – are there any other widow maker trades that offer opportunity now (from either side)?
KM: I think shorting JGBs was the widow maker of the 2000s. Shorting bunds is turning into this decade’s version. And although I did foolishly try both trades (after all, you can’t call yourself a macro trader without losing a fortune shorting JGBs), I have recently come to the conclusion that a mix of extreme monetary stimulus (like the ECB is doing) with fiscal austerity (like EU is dictating) is a recipe for moribund economic growth. Therefore I have given up shorting bunds, but, and this is a big “but”, but if the EU ever takes its foot off the fiscal brakes, then I will short bunds with both hands and feet. However, until that happens, I am steering clear of this widow maker.
SA: Are there any opportunities in taking the opposite side of a trade when a famous fund manager talks their book or in taking the same position when they are essentially forced out of the trade?
KM: I think that hedge funds are increasingly becoming a group that needs to be faded. There is simply not enough alpha to go around and these funds are often the big elephants who make a mess and eventually leave the marketplace after trampling around.
When they all agree, you need to be extremely worried. And then when their consensus trade stops being profitable, the hedge funds’ ability to ride out bad periods is almost non-existent. Individual investors should be taking advantage of hedge funds' limited ability to withstand pain.
SA: Is it possible to determine in real-time the difference between investors simply puking up positions and legitimate buying/selling because of a change in fundamentals? If so, what are the signs of it and can you give an example?
KM: This is a great question. How can you tell the difference between a short-covering rally and a true bull run? It’s difficult for sure. Obviously you can watch the Commitment of Traders Report from the futures exchanges for clues. That can definitely help.
However, sometimes it is simply a matter of having enough experience to understand which fundamental changes truly matter. When there are dramatic market-altering events, it is often more important to have the courage of your convictions. For example, when Trump won the election, I was shocked at how strong bonds performed that initial evening. Although I understood why there was a flight to safety, I thought that Trump would mean inflation and lower bond prices. That evening I laid into the bond market (too early of course) but it ended up being a great trade. Yet it was emotionally taxing to say the least. For many hours, everyone was bidding bonds higher and seemed like a one-way street.
SA: How do you evaluate implied market expectations in a given market (such as Eurodollars) and determine if they are right or wrong, and if they’re wrong, how do take advantage of it?
KM: Eurodollars are fairly easy to mathematically determine implied market moves of the short term interest rate market. However, the one part that is often overlooked is the fact that Eurodollars still have a credit component to them. Look at some of the big market stress events. Sure, Eurodollars often eventually worked their way higher, but there were some scary dips. Be careful with the credit component!
As for how I take advantage of market expectations that have gotten ahead of themselves, I will sometimes use options, but most of the time I just take outright longs or shorts, with the occasional spread. Recently, I have been fading the Fed easing expectations that are being priced into the Eurodollar futures market by buying ED M9 and selling ED M0. I am betting there is not as much easing between the period of June 2019 and June 2020 versus what’s priced in.
Don’t forget it’s not the direction of the move that matters, but the amount versus expectations.
SA: In your profile you say “All I bring to the party is 25 years of mistakes” (more investors would be as candid about their mistakes except it would shatter the myth that they don’t make any) – what are some of your mistakes and what did you learn from them?
KM: My main mistake is not being able to ride a winning trade. I don’t mind being alone in a trade. In fact, I often feel better. But the point from a trade being lonely to the point where you should be exiting takes a long time. Too often, the moment investors start agreeing with my analysis, I worry that the trade is finished and pitch the position. This might not sound that bad, but you need to ride your winners to pay for your duds, so it’s definitely something I struggle with.
I also have made the same mistakes too many traders have made - trading too big, fighting with the market and the worst sin of them all - not staying humble. The moment you start to be overconfident, that’s when you are going to have an accident.
SA: Investors do and say strange things at tops and bottoms of a market and in your career you’ve probably seen or heard most of them – what are some notable ones, how actionable are they, and should investors look for “second-order” type trades here?
KM: I remember quite clearly how during the Dot Com bubble, tech companies that didn’t spend money quickly enough would see their stock price get hammered. Investors were so bullish on the internet that they punished companies that didn’t stake out their ground aggressively.
Housing in the 2000s was another one. There was lots of talk of this time was different. How housing never goes down on a nationwide basis. Whenever you hear of a “new era”, you should be worried.
It’s a little before even my time, but Irving Fisher’s prognostication of stocks being at a “permanently high plateau” in 1929 will go down as the all-time doozy.
SA: What’s one of your highest conviction ideas right now?
KM: Short US bonds. Full stop. Inflation is headed higher.
Minimum wages are going up during the next few years. Year over year energy price changes will also still register big gains for some months to come. Commodities appear to be bottoming and a few of the deflationary influences of prior years - like grain prices, appear to not be cooperating. Not only that, but the fiscal stimulus from the tax cut is still working its way through the economy.
And most importantly, the trend of globalization over the past couple of decades was deflationary. Trade wars are inflationary. And make no mistake, this is not a one-off trade spat. The world will become increasingly protectionist in the coming years.
The risk reward definitely favours a short bond position.
Thanks to Kevin for the interview. If you'd like to check out or follow his work, you can find the profile here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Kevin Muir is short U.S. bonds and long ED M9 and short ED M0.