Bizarro World

There is an interesting seasonality to financial markets that shows up each January. Namely, trades that kicked butt during Q4 suddenly reverse pivot and start the year as the worst performing trades, and vice versa. Why would this be?

 

This seasonal U-turn can be explained by two logistical phenomena. Firstly, the world’s largest pensions and endowments tend to rebalance during Q4 and the beginning of the year. Secondly, active managers tend to actively manage their own career risk by window dressing their portfolios. To improve the optics of portfolio snapshots taken on December 31, they add stuff that has worked and sell stuff that has underperformed.

 

In 2017 this seasonal shift could be on steroids given the move in markets since the election.

 

There are any number of markets ripe for a pullback or a massive dead cat bounce, but the two I want to focus on are long-dated U.S. Treasuries and gold. Both markets have been absolutely hammered in the last two months, and deservedly so.

 

A year ago, the economic and policy environment could not have been more bullishly conducive for these two markets. Fast forward 12 months, and they are in Bizarro World. The deck is stacked against them and couldn’t be more bearish. I hate to go with the consensus, but these markets are ripe for more downside in 2017. Don’t be fooled by any strength they show early in the year: they will likely show signs of life, but rest assured that this is strictly an opportunity to position yourself for the next leg down.

 

 

Chicks Dig the Long Ball Bond

 

Since Trump’s victory I’ve felt like I’m stuck in The Wizard of Oz, with every money manager, pundit, and dentist-turned-financial blogger singing “Ding dong! The 30-year bond bull market is dead.” These were probably the same guys saying “this time is different” with the advent of the internet economy, and we all know how that ended.

 

I don’t know if the bull market is over or not, and nor do I care. I’m not in the business of playing Captain Prediction, trying to generate page views and clicks. I trade the markets that are in front of me, using my data-dependent investing framework to evaluate the three most critical forces, or gravities, that impact asset prices: fundamental, quantitative, and behavioral.

 

As we begin 2017, all three gravities are signaling that long-dated U.S. Treasuries will be one of the year’s best SHORT opportunities.

 

Fundamentally, U.S. Treasuries are facing a three-headed hydra, with U.S. growth accelerating alongside a stronger U.S. dollar and U.S. yields that are on the come. The last time this hydra showed itself was during 2013, when long-dated Treasuries lost approximately 14% in nine months.

 

Behaviorally, speculators are already leaning SHORT as they recognize the same trade set-up that I see, but that’s not concerning for two reasons. First, the number of SHORT positions could triple and still be lower than levels we saw just seven months ago. Second, LONG contracts are almost two standard deviations above their historic norms. Anytime positioning gets this out of whack there is bound to be a reversion. When those LONGs eventually capitulate, it will simply add more gravity to a market already in decline.

 

Quantitatively, 30-year U.S. Treasuries have been in decline since peaking in July, post-Brexit. This downward move accelerated in November, when U.S. yields dropped by three standard deviations in a month! This magnitude of movement occurs only about once every two years. [AG1] Treasuries have been consolidating since the beginning of December as they take a breather before deciding their next move.

 

The final weekly futures positioning data for 2016 shows that institutions ended the year by adding to their LONG 30-year Treasury future positions, bringing LONGs to the highest level since July 2015. Hedge funds did the exact opposite and upped the ante by adding the most SHORT contracts since February 2015.

 

This is the time of year when institutions, like pensions and endowments, rebalance their asset allocation percentages. U.S. stocks had a good year, so many institutions are rebalancing those profits away from the equity side of their asset allocation and toward the bond side. Until the process is complete, this rebalancing will provide some buoyancy for U.S. Treasuries early in the year.

 

On the upside, I think the January rebalancing and portfolio-polishing efforts could carry the 30-year Treasury futures contract as high as $160, possibly $165. This would equate to a rally in the iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT) up to $126, possibly $131. On the downside, if the 30-year Treasury futures contract closes below the $145 level, there is an air pocket down to $133. In TLT, a close below the $117 area would leave nothing but air until approximately $106.

 

 

Everything that Glitters

 

I don’t listen to “gurus” on CNBC, nor do I follow investment advice from websites with names like “www.gold is always the best investment of all time because the sky is falling and the end of the world is always just around the corner.com.”

 

When it comes to gold, I again evaluate the gravities in my framework, and all three are decidedly bearish for gold.

 

Fundamentally, there is no worse environment for gold than the current trajectory of both U.S. growth and the Fed’s monetary policy.

 

The Fed just hiked rates for the second time in 12 months and has officially begun the rate-normalizing process. On the growth front, after slowing for five consecutive quarters, the U.S. economy is starting to pick up steam. That is a bearish fundamental one-two punch for gold with the force of a Mike Tyson (pre-Buster Douglas) hit.

 

The last time we saw the U.S. economy slow and then begin to accelerate was between Q3 2013 and Q1 2015. Over that time frame, the gold price slipped 17% from $1423 to $1183.

 

Quantitatively, the U.S. dollar has cracked the critical $100 level, and U.S. yields have jackknifed straight up since Trump’s victory.

 

Gold simply can’t compete with the combo platter of a strong USD and higher U.S. yields. In fact, this type of entrée produces gold’s worst performing time periods: the last time the U.S. dollar and yields moved higher in tandem was September 2012 through March 2014, and gold lost almost 28%.

 

Behaviorally, speculators still maintain LONG exposure to gold that is well above historic norms, and the number of LONG futures contracts is still outpacing the number of SHORTs.

 

This positioning tells me that bullish gold investors have yet to figure out that the recent decline in gold isn’t a buying opportunity, but rather the beginning of a much larger move lower. Once those LONGs figure it out and capitulate, the floor is going to fall out.

 

On the upside, I think the annual January effect could carry gold futures as high as $1,200, possibly $1,230. This would equate to a rally in the SPDR Gold Trust ETF (NYSE:GLD) up to $114, possibly $119. On the downside, there is no significant floor until gold futures hit the $1,089 level, and below that $1,000 is the next significant support. Similarly in GLD, there is no support until $100, and beyond that $85 is the next likely floor where buyers will step in.

 

 

Stay Data Dependent

 

The greatest opportunities in trading come when the public’s perception of an event differs from the most likely outcome. There are any number of narratives that the media can spin when the markets I’ve discussed rally in January. The most likely is a questioning of the Trump trade or asking whether some of its fervor is being lost.

 

But remember, these markets aren’t bearish because of Trump and the expectations that he will Make America Great. Rather, they are bearish because U.S. growth is accelerating, inflation data is accelerating, and the Fed is committed to normalizing rates. This fundamental trifecta is pushing the greenback and U.S. yields higher, leaving gold and long-dated Treasuries in the dust. Don’t trade based on media narratives. Stay data-dependent, my friends.