Rogue Wave

Crowded Low Vol Trade Unwinds

You will forgive me if I feel a bit seasick this morning. As I write this from our seaside Florida rental, looking out over the ocean, all is calm. But as old navigators know, the threat of a rogue wave is ever-present. It comes from out of nowhere. That wave has just hit big time.

I last week's missive, I was bullish. Obviously I failed to correctly 'anticipate the anticipations of others'. I didn't see the violent reaction to the bond yield back-up. My comfort came from the an over-reliance on strong earnings and robust equity inflows. Underpinning that, I postulated that interest rates would only present a problem if they had broached 3%.

When Friday's jobs report data showed accelerating wage growth, the market, previously complacent to such threats, seized on this and "priced in" a 3% handle, creating a liquidation of leveraged positions. The threat of the Fed going to four rate hikes this year was put on the table.

I'm actually kicking myself a bit. In my Jan 9 piece, I actually laid it all out by arguing :

"... the market could enter a melt-up phase that would signal a risk appetite peak.... For equities, this could set up a 1987 style correction based on the relative value trade between bonds and stocks."

This sell-off has the hallmark of a mini-1987. But unlike 1987, the long term bond yield is no threat to current valuations. At that time, they were yielding almost three times what stocks were. Remember, a bond is like a stock that has a 100% payout ratio of 'earnings'. At 3% that equates to a 'PE' of 33X, not much a threat to the S&P 500 with a 17.5X forward PE.

Add to that unlike stocks, a U.S. Treasury bond can't be taken over at a huge premium, doesn't allow you to vote, isn't ownership of real assets and only represents a 'promise of repayment'. Although to be fair, I've never liked bonds. Who knew Deck?

This rout has been prompted by the concerns that inflation is accelerating and rate hikes would accelerate. It fuelled mechanistic unwinding of leveraged positions in crowded trades like short volatility. Margin debt has been elevated for too long.

But the complacency shown in the crowded low volatility had to be dealt with sometime. The trigger was the sharpness in the reversal bond market. Goodbye single digit volatility!

Bull corrections are like a rogue wave, sudden, sharp and short lived. This one is pretty standard. The good news is how well the markets have functioned during this liquidity panic. I remember 1987 not being so orderly.

This could also mark the beginning of a rotation into Value from Growth. I am watching for this trade to develop, as many rotations occur shortly after corrections. Watch copper versus gold for a guide.

The Credit market is acting well and the Yield Curve has actually steepened - a bullish sign. The stabilization this morning is encouraging but will need to be tested to be believed.

To my faithful Tues@11 readers I'd like to argue that last week's entry was not mine but the consequence of a successful hack by a rival blogger who commandeered my WIX account to plant the story. Alas, it was me all along.

I like Cramer's comment that even Belichick didn't see the pass to Foles coming either.

Risk Model: 3/5 - Risk On

The XIU rule of below 95% of the 200 dma is intact. The Copper/Gold ratio is still good and the AAII Bull/Bear from last week is good but will undoubtedly move lower this week. The AAII survey is taken from Monday to Wednesday and published Thursday. We will see if the 'home gamers' want to buy the dip or not.

VIX was the canary in the coal mine last week and given the climactic blow off yesterday, will take time to kick back to positive.