Punch Drunk Love

It was 5th grade at Paul Munroe Elementary. Three girls - you know who you are - used to chase me around the playground at recess. I could out run them for a while, but eventually they caught me, only to punch me repeatedly in the arm. 

After about 2 weeks of this, I finally told my old man what was happening. He said that the girls punched me because they liked me. I gave him a puzzled look and he simply said “you’ll understand when you get older.” 

My 9-year old self, couldn’t understand why you would punch someone you liked, it was counterintuitive. Now, a couple of decades later, I know 2 things for sure. Getting punched by a girl makes for a great Friday night and everything required to be a successful trader is counterintuitive. 

I spend a ton of time discussing the fundamental gravities of various markets within the pages of this commentary each week because the only true catalysts for the long-term direction of asset prices are: the trajectory of growth and inflation across global economies and how central banks respond to those trajectories with policy. 

However, my market tool is the 3G framework, not the 1G. That’s because quantitative and behavioral gravities also play an extremely important role in the direction of a market’s prices. In fact, over the short term, nothing has more impact on a market’s direction than the behavioral gravity.

The key to truly understanding the behavioral gravity and using it profitably, is to remember that girls ignore boys they don’t like, and they punch the ones they do. If everyone loves a market, ignore it. The markets you want to like and spend time with are the ones getting punched.


Fundamentally, gold remains very bullish because we live in a world full of negative interest rates and gold performs very well in declining or low interest rate environments. 

We now have over $13T in negative yielding government bonds and $500B in negative yielding corporate debt worldwide and those numbers grow with each passing week. 

Sweden is now paying negative interest rates on 50-year bonds. Think about that for a second. Wouldn’t you like to borrow money for 50 years and have the lender pay you interest?!  This is the kind of thing that is now part of the white noise each day and so it gets overlooked; but this is just absurd!

Germany just became the first Euro-country to auction brand new 10-year bonds with a negative coupon. Again, you’re probably yawning because negative yields are just part of the landscape now but don’t take this for granted. Next to US Treasuries, German Bunds are considered one of the “safer” asset classes on Earth. 

Clearly the word “safety” has a new definition these days. Safe used to be a car seat put in by the fire department. You can run that car through a nitroglycerin plant and the car seat wouldn’t move an inch. Now “safe” means climbing the 3,000 foot southeast route of El Capitan with nothing but an old mattress to catch you if you fall.

And from a quantitative perspective, gold is a California dime, it doesn’t get more bullish. 

It's up 25% this year, has broken through every significant line of resistance, and is on the verge of breaking out above its 5-year downtrend. Volume has been increasing throughout the 2016 rally and volatility has been high on up days and muted on down days. 

While both of these gravities are extremely bullish, what has me concerned short term is the behavioral gravity. Remember, think counterintuitively. 

When I switched to a LONG bias back on January 11, no one was talking about gold.

Until Brexit, the only people talking about gold, other than me, were the guys who think you should own gold all the time. You know who I’m talking about, right? The guys that run websites named “www.this is the end of the world as we know it.com” and “www.tinfoil is the new black.com.”

These types of sites will show you how to melt down all of your grandmother’s jewelry and then dip your dog in it so that you can carry as much gold as possible with you when all of the world’s currencies fail and gold is the only medium of exchange.

However, since Brexit, gold is the bell of the media ball. It's not just for the guns and canned food crowd anymore. I can’t turn on the TV without an amateur porn quality commercial from a local pawn shop owner telling me why I should sell him all of my gold and take the vacation of my dreams.

People aren't just talking a big game, investors of all sizes, from retail investors to professional money managers, are piling into gold at a record pace.

In fact, just a couple of weeks ago, gold ETFs had their largest 1-day inflow ever!

But the proverbial nail in the coffin is when Wall Street piles into a trade. These guys are always late to a trade, always! 

The day after Brexit, Goldman came out and initiated a “buy” rating for gold and raised their price target. Seriously? These were the same guys that advised a short trade on gold on February 15 with gold trading at $1205, only to close the trade in early May with gold trading at $1300. 

There are 2 counterintuitive facts about behavioral gravities that are important to remember. First, it is NOT bullish when everyone and their mother loves an asset class. Second, markets don’t go straight up or straight down.

I’m not looking for a significant correction but because of the uber-bullishness I’m seeing in the behavioral gravity that wasn’t present a month ago, I expect a 6%-8% pullback before the next leg up.

As long as global monetary policy continues to emphasize negative rates and investors maintain their 7-Deadly Sin-type appetite for that debt anyway, then the pullback in gold is an absolute buying opportunity. 

But until that pullback occurs, I would be very cautious about initiating new LONG positions or overstaying your welcome in current positions.

The Greenback

The most important market to watch for the last 6 months of 2016 is the US Dollar. No market is more interconnected to other markets around the world and no market is getting more shade right now than the Greenback.

Fundamentally, the case is very bullish. Put simply, every other central bank in the world is easing and burning their currencies like Salem witches, while the Fed is holding steady with one rate hike while contemplating a second. 

Quantitatively, the USD is showing signs of life after several months of dormancy. The post-Brexit reaction has pushed the Dollar back above the $96 area, which forced it out of its 2016 downtrend for the first time all year. 

Most recently, the USD managed to close above the $96.50 area for 6 consecutive days. This is a very significant and bullish quantitative development.

Behaviorally, I’m seeing exactly what I saw back in December when I was evaluating gold and US Treasuries.

Back then, no one was discussing gold and everyone hated Treasuries because the Fed had just raised rates. You can see the kind of run those two markets have had since then.

That’s what’s counterintuitive. You want to pay the most attention to the markets that are percolating but aren’t getting any fanfare.

Right now, the USD can’t even get just 5 minutes of fame and investor positioning is split right down the middle with no one willing to lean one way or the other. 

When the fundamental and quantitative gravities are flashing strong directional signs and investors haven’t figured it out yet, I get as giddy as the secretary pool when its someone’s birthday. It’s the ideal trade set-up and it's happening right now in the Dollar.

You can certainly get long the USD directly but I’m watching another trade that looks far more profitable, SHORT emerging markets. 

So far this year, emerging markets are up around 20%. This is ridiculously impressive if you consider that this performance has occurred against a backdrop of a slowdown in global growth and in the midst of a Fed tightening regime. 

This is unheard of!  So either, this time is different, or emerging markets are setting up for a shellacking. The investment portfolio graveyard is filled with investment accounts of people who thought “this time is different.”

EM equities are getting set up for a Jimmy Superfly Snuka-style takedown off the top turnbuckle. A strong USD and a Fed that is either holding steady with one rate hike or adds a second one will be the Superfly Splash that pins EM equities. And in case you were wondering, investors are piling into EM equity funds at fast clip because they don’t see that the bridge ahead is out.

So the next time you’re tempted to buy into a stock or a market that is all over the news and everyone is raving about, remember, successfully trading is counterintuitive.