Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

What Happened In The Stock Market Yesterday, And How Can We Trade It?

|About: SPDR S&P 500 Trust ETF (SPY), Includes: HYG, IEF, JNK, XLF
Summary

Market reaction seems irrational: it's not.

Market taken by surprise.

Market getting ready for higher interest rates.

Dislocation, dislocation, dislocation!

So there seems to be a little confusion about exactly what went on yesterday. After all, the news was fundamentally good, right? The Fed sees the economy strengthening, so stocks should go up, no?

The answer is no. For the next 6-12 months, forget everything you thought you knew about trading. Good will be bad, up will be down. The market is so distorted and warped from the QE programs that no true price discovery has taken place for years. The reason why markets have been rallying on seemingly bad news and falling on good is because the only thing traders have been weighing lately is WWFD....." What Would the Fed Do?"

Bad news has been taken as hope that the Fed will reduce the taper, or even increase buying. Good news has been taken as a sign that the Fed was right about the recovery and will indeed taper as indicated.

We believe that March 19 will go down as: A Day That Will Live On In Infamy! Ok, maybe we're being a little dramatic. But we do think it will be a significant part of the QE story when all is said and done. We think that yesterday was day the punch bowl was taken away. Or rather, we feel it's the day the market finally BELIEVED that the punch bowl will be taken away.

To understand the markets mentality right now, think back to when you were young on a driving for hours with your family on a long roadtrip. If you're anything like me, the only thing you had to entertain yourself back before there were iPods and portable DVD players was tormenting your little siblings. Remember when our father would have enough of the crying and fighting and say something along the lines of "If you two don't stop right now so help me God I'll turn this thing around and go home!!" And we would all kind of snicker because we were 1000 miles from home and we'd be at Grandmas in about 20 minutes. We knew no matter what wrath would befall us, one thing that we were pretty sure was NOT going to happen was Dad actually turning the car around.

In short, we didn't believe him, and our behavior reflected that.

The markets are like that guy right now. Only yesterday, Mama Yellen actually turned the car around and is headed home. We think that despite The Taper officially starting months ago, the market didn't REALLY think the taps were going to be turned off. Surely somehow they'd find a way to keep the party going. Yesterday is the day the market turned: The inflection point happened. The markets collectively realized that, like it or not, this is going to happen. Which means that all the old trades probably won't work and it's time to start from scratch.

First, we'll look at:

What DIDN'T happen: Despite the CNBC narrative, the markets did NOT react mostly to a slip of the tongue by Yellen. "6 Months Gate" is not what caused the important trading action. While that quote definitely moved markets for day traders, that has nothing to do with the fundamental shift that occurred yesterday at 2 PM. It seems the narrative is that the "slip of the tongue" is what tanked the markets ("because after all, the news was good right?") and once someone from the Fed clarifies it today or tomorrow, stocks will recover. In other words, BTD!!! (buy the dip) We feel this is a huge red herring. The big market tells were all happening long before Yellen got to the infamous "6 month" slip.

Why do we think so? To explain, let's take a look at:

What DID happen:

  1. Interest rate sensitive plays were killed immediately

Bonds were hammered down immediately, while it took equities about 30-60 seconds to fall significantly (a lifetime in todays algo heavy equities market). To us though, there were some significant difference in the types of action. Here's what stocks did, via SPY

To our traders eye, this chart looks like pretty basic "sell the news" action, nothing significant either way. As we see, the big move came on the "6 months" comment, which we feel was simply a pretty bauble for the day traders to play with, followed by a substantial recovery off the lows.

Meanwhile, over at the bond market (via 7-10 year Treasuries ETF IEF)

We can see a much larger selloff immediately that is sustained and on heavy volume. There was no recovery, and the "6 months" comment seemed to not affect the action much either way. Not much bounce and closed near the lows. Compare that with the utilities sector as represented by XLU

Utilities are important as they are very interest rate sensitive. Lots of expensive infrastructure financed with lots of rate sensitive debt. This chart looks more like the bond chart then the equities chart, with sustained selling off long before the "6 months" comment and closing closer to the lows then SPY does.

There are other examples of interest rate sensitive trades getting hurt far more then the overall market (junk bonds, for example JNK) but the charts look more or less the same. Needless to say, we found the action in these instruments yesterday telling and supportive of our opinion that an underlying shift in the way the market prices risk has now begun.

  • Financials jumped

On the flip side of the coin, we want to look at what sector does WELL in a rising interest rate environment. Banks do, as the margins on loan repayment increase earnings. How did banks react?

Despite a fall in sympathy with the overall market at The Comment, what's most interesting to us is that banks (via sector ETF XLF) jumped at the FOMC statement despite an overall market drop.

  • Unwind of EUR/JPY carry trade, double down of USD/JPY

This one requires a bit of context. When we speak of "the carry trade" what we are referring to is a bit of interest rate arbitrage, borrowing in a currency with very low interest rates (almost always the Yen) , selling that currency and buying one with a higher interest rate. Traders borrow Yen and pay 0.10% interest and buy say, AUD with the Yen, putting the money into Australian bonds paying 2.5% and earn the difference in spread. Leverage it with enough size and one can make significant profits without much risk (of course there is always currency risk). Of course, AUD is somewhat of a minor currency and the trade is hard to do in the size needed to make it worthwhile.

the traditional carry trade has always been short JPY, long USD and put the proceeds in Treasuries. However QE has put the kibosh on that trade as bond yields are too low to make it worthwhile. So the NEW carry trade is buy USD, sell JPY and put the money in US equities. Your profits are made via capital gains rather then the typical way of earning interest rate spread. This is why the USD/JPY has been highly correlated with S&P over the last few years: The thinking goes, the more the S&P goes down, the more those involved in the carry trade lose, and so the more likely they are to cash out their winnings. At least, that's what the algos have programmed into their parameters.

This correlation is strongest intraday, as the following chart shows an example:

Note: the correlation is not exact; there's no way it can be given the different asset classes. For example, the S&P was up 30%+ last year. There's just no way that the USD/JPY could be up the same 30%+ one year. So we're not looking for exact correlation, just be aware that USD/JPY typically trade in tandem with S&P. Or, that's been the case in recent years.

So when we saw this price action yesterday, it strikes us as very significant:

Interestingly,what we see in the forex market was the USD/JPY move higher:

This is to be expected however. After all, if the markets are switching to a rising interest rate trading environment (which we believe is what everything points to) then of course the USD would attract more money then the perennially low yielding Yen. So in this sense, we do not think the carry trade will end. Indeed, we feel it will probably increase. However, we feel that what will happen is a REALLOCATION of carry trade funds from Carry Trade 2.0 (buying USD/JPY and using the money to invest in stocks) back to the more traditional use of carry trade money by simply investing in bonds. Remember, the carry trade only switched to equities in recent years because bond yields were too low. As the expectations of rising interest rates (and thus, higher bond yields) increase, we expect the money to flow from stocks to bonds.

Putting it all together:

Watching the price action yesterday, we were a bit surprised. The story was one of dislocation everywhere: correlations that have been consistent broke down. We feel yesterday was an inflection point, a transition from an environment of stable interest rate expectations to one of rising interest rate expectations. The market was taken by surprise and now must reprice risk in the system. Markets are notoriously good at sniffing out rate rises long before it actually happens, so it would be a mistake to assume that since rates themselves won't change for over a year that market will not react to until then

We DO NOT expect a crash or black swan event. Instead, what we see is an orderly change from a stable interest rate environment to a rising interest rate environment.

So what are the new trades?

For the short term trader trying to hit the home run, we like buying volatility right now while it's relatively cheap. Even though we expect an orderly retreat for stocks over the next 6-12 months, volatility should do well. We see the VIX hitting $25-$30 before stocks rebound in the coming months.

For the longer term, we really like buying USD/EUR in the forex market. One thing we noticed yesterday is that while USD/JPY shot up the EUR/JPY sold into a small bump and is now down significantly. We think we are witnessing the UNwinding of the EUR/JPY carry trade with those funds REallocated into the USD/JPY carry trade. The carry trade was roughly split between the two countries as they have similar interest rates, and thus it was merely a way to spread out risk to investors as the returns would have been more or less be equal. But in a rising interest rate environment, USD should substantially outperform the Euro (not to mention there are rumors that the EU could host it's own QE, hurting the Euro even more), benefiting from a double whammy: The Euro will be hit as the EUR/JPY carry trade is unwound, and the USD/JPY should benefit from all that liquidity being reallocated to the dollar. Subsequently, we expect the USD/EUR to do very well over the next year or two

Our favorite trade right now is shorting junk bonds (JNK, HYG). One of the unintended consequences of QE was to stimulate poor quality debt as yield starved investors bought up junk in huge numbers.

There is no denying junk bonds have been big winners of QE. However with QE coming to an end, (and even if it wasn't) junk bonds have literally no where to go. Bonds are valued primarily on their yields, and with the spread between Junk bonds and Treasuries being at historic lows, junk yields basically cannot go lower unless Treasury yields themselves go lower, and we don't view that as likely.

The following chart shows the yield premium investors demand to hold poor quality debt over high quality debt. In other words, the lower the price, the less premium is paid to hold junk over quality debt.

We think the market - in it's quest for yield - is overlooking the risk of principal depreciation, and we think buying long dated, in the money puts provides excellent upside with very little downside

Disclosure: I am short JNK. 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.