Trade Like a Lion

There are many great quotes out there about the dangers of groupthink and herd mentality as it pertains to trading the financial markets. No quote is more fitting than “It’s better to be a lion for a day than a sheep all your life.” 

As we enter trading in 2015 there is a theme that we have been discussing for months that the sheep are just getting hip to and believes will continue to play out in 2015. So, if all the sheep agree, what could possibly go wrong?

The overarching theme, which is now mainstream, as we enter 2015, is the “US Divergence trade.” The US Divergence trade, which I’ve been discussing here for the last 6 months, is based on the belief that the US will be a beacon of light in an otherwise sea of slowing growth, specifically in the Eurozone and Japan.

While we have been discussing it here for the last six months, talk of this theme has only been in the mainstream for the last 2 months, or so. At this point, it is a widely accepted theme that many people have extrapolated well into 2015.

Once a theme is widely accepted, its time to pause and reflect. There are three ways in which the US Divergence theme could disappoint and in so doing cause a massive realignment of positions in several key markets.

Problem #1

The first way the US theme can misfire in the months ahead is if the Eurozone’s economic growth surprises to the upside. While the December data we received last week didn’t show signs of upside surprise, don’t underestimate how quickly economic data can start to turn at the margin. I’ve harped on the idea of what matters most in economics and financial markets occurs at the margin.

Rather than headline numbers, we are generally aware of a shift in the underlying dynamics of markets months ahead of the trading herd. I will be paying very close attention to the margin of Eurozone data and will discuss any significant developments in TWR.

Problem #2

The second way the US theme could fall apart is if the herd is too pessimistic on Abenomics and Japan’s potential for upside growth surprise. The playbook is the same here as with the Eurozone.

Pay attention to Japanese economic data and be prepared to take advantage of non-consensus trade ideas if we start to see an upward shift in the data.

Problem #3

The final, and most obvious way that the US theme could surprise investors during 2015, is if US economic growth disappoints.

Measuring how much of a slowdown in the US it will take to cause the unraveling of the US Divergence theme and associated trades is a bit more tricky than with our prior two examples. The reason being is that most of the world’s money is “long-only” and seeks to be as close to fully invested at all times as possible.

This in contrast to the way we manage trade ideas in TWR, which includes being both LONG and SHORT as well as opportunistically initiating trade ideas rather than simply always being 100% invested.

But in order to consistently outperform the sheep, its important to understand and keep at the forefront of your own process, how the herd makes its decisions and how the herd is influenced.

As it pertains to the US slowing during 2015, because capital is always flowing to the highest possible returns, the US could slow but by slowing less than other regions, namely the Eurozone and Japan, could still see a continued inflow of capital seeking above average returns.

This capital flow, could in turn, keep US equity and fixed income markets buoyed and also provide a continued tailwind for the US Dollar. Keeping in mind the 3 possible catalysts for the unwinding of US Divergence trades by the herd, lets discuss the herd’s positioning in various markets as we begin 2015.

The Sheepeople's View

The US Divergence theme has been the primary catalyst, which has sent the US Dollar to its highest level since 2003! The US Dollar has been ripping since early May 2014 with very little resistance.

A primary underlying factor of this theme is that the Fed stopped easing just as Japan and the Eurozone have started new rounds of easing. These new rounds of easing and frankly, just the discussion of further easing has pushed the Euro to 6 year lows and the has equally depressed the Japanese Yen.

Obviously, the Fed stopping easing in the US is a US Dollar positive in its own right, and then the tailwind for the US Dollar gets stronger as the Eurozone and Japan burn their currencies further to try and spur economic growth and fight deflation.

This is all well understood by market participants, which is why we enter 2015 with extremely lopsided positioning in the USD on both an absolute and relative basis. The large speculators, or “smart money” is currently sitting at an all-time high in both gross long positions in US Dollar futures contracts as well as their net positioning relative to long contracts versus short contracts.

In addition, the small speculators, or the “dumb money,” is also sitting at an all-time high in both gross long positions and their net positioning. It should also be noted that both groups of speculators just pushed their LONG positioning to new all time highs in the last month.

This means that everyone jumped on the band wagon in a big way AFTER a 6 month, 17% move in the US Dollar, which pushed it to its highest level in 12 years. People just don’t learn.

Investors will always chase performance. So, in short, everyone agrees that the way to trade the US Dollar is from the long side. Don’t be a sheep. This is not to discount the USD’s quantitative strength. Week after week, the USD continues to trade very strongly and without any faltering.

I am maintaining by LONG bias in UUP for the time being because the fundamental and quantitative factors indicate that is the appropriate bias to have currently. That said, I become VERY wary when positioning gets historically lopsided and both the smart and dumb money both push all their chips to the middle of the table, so to speak.

Are there any buyers left to push the price higher? As we’ve seen in the past, sentiment can stay out of whack for long periods of time and cause a lot of pain for traders on the other side of the consensus trade.

It’s important to remember that there is never any such thing as a “sure thing.” And everyone right now seems to believe the USD trading higher is a sure thing.

The US Divergence theme has also led to a massive flow of capital into US Treasuries as a safe haven. This in turn has pushed yields from a New Year’s Eve 2013 high of 3%, all the way back down to a 1 handle as of the close of business this past Friday.

The 2014 downtrend in US Yields caused a lot of pain for the smart money who entered the year positioned extremely SHORT of US Treasuries, believing that further upside in yields was inevitable. The smart money believed that the long overdue global recovery would finally take place, and in turn both yields and inflation would be pushed higher.

Obviously this didn’t happen, and with the exception of the US, the rest of the world experienced a significant slowdown during 2014. Apparently last year didn’t hurt enough because the smart money is positioned even more SHORT entering 2015, than they were in 2014.

The net positioning of smart money is at its shortest level ever! The gross short positions are at the highest level in 10 years and within spitting distance of marking a new all time high.

What happens to this extremely bearish positioning if the US starts to slow and US yields are pressured lower? Or if the rest of the world slows more than the US and capital continues to flow into US Treasuries as a safe haven?

The short answer, no pun intended, is that the SHORTS will get squeezed and squeezed, pushing Treasuries higher and yields lower, thus perpetuating the squeeze higher until the excess positions have been worked off and a balance is found once again.

Don’t be a sheep. Don’t chase performance and allocate money to investments that have already made their move. Don’t chase markets that have already run really high or really low because you’re scared of missing out on the next move.

Trade like a lion. Opportunistically look for non-consensus ideas and wait for them to become mainstream. Be the lion who is selling to, or buying from, the sheep, well after the truly smart money has been made and the move is almost over.