Wayne Gretzky famously said, “I skate to where the puck is going to be, not where it has been.” Successful investing requires this same mentality.
Right now, investors are making a common mistake by extrapolating the current state of affairs into the future. Specifically, they are overly focused on the fact that global inflation has been raging to the upside. I can’t say it more plainly: economies and markets don’t go straight up or straight down. Rather, they are cyclical.
Just because inflation has awakened from its post-Crisis slumber doesn’t mean it’s going to continue to accelerate month after month.
In fact, inflation is getting ready to slow, and most investors are still woefully unaware of what is to come. Living in a world full of investors who like to extrapolate presents opportunities for those of us committed to being data dependent, process driven and risk conscious.
Global inflation has been ripping higher since last August, largely due to the spike in crude oil prices that began in early 2016. Black gold damn near doubled, moving in a straight line between January and June from $26 a barrel to $49 a barrel. Since then, crude has traded sideways, and this is an important factor as we move into Q2. Unless oil breaks above resistance around $55 a barrel, then inflation will continue to rise briefly from here, but begin falling once the translation effects of the price spike in crude and other commodities begin to subside.
German citizens are already seeing this, with the latest round of German inflation data showing that energy’s contribution declined from an annual clip of 7.2% in February to 5.1% in March. But this isn’t a Germany-specific issue. Core inflation in March for the entire Eurozone was the weakest since 2015, driven almost entirely by lower energy prices.
The U.S. hasn’t seen this rollover effect yet, but make no mistake, it’s on the way. Core inflation in the States is holding steady at the highest level in over five years, and the CPI has accelerated for seven consecutive months to 2.7% in February. There is a very good chance the CPI will touch 3% in the next month or two, but once it does, watch for the same mild deflation we are seeing in the Eurozone.
This is a great opportunity because despite down-trending inflation expectations across a plethora of economies like the U.S., Canada, France, Germany, Japan and Mexico, investors are still overwhelmingly positioned in the reflation trade.
The investor “reflationistas,” including our boy Gartman who has been loading his portfolio with “things that if dropped on your foot shall hurt,” have ignored the data. We know this for a fact because of two observations. First, companies like Caterpillar are still trading within spitting distance of their all-time highs. Second, hedge funds and other like-minded institutional investors have crowded into a highly-leveraged trade that can only work if inflation stays robust and the Fed hikes at least two more times this year.
More Shorts than Spring Break on Padre Island
Hedge funds have bet hugely on inflation by piling into short positions in the Eurodollar at an unprecedented pace. Short positioning has been at record highs for some time, but these guys continue to up the ante. As of last week, this positioning increased to a mind-blowing $3T. That’s “trillion” with a “T!”
To be clear, this magnitude of tilted short positioning speaks to the hedgies’ belief in continued inflationary pressures and more Fed hikes coming down the pipe.
But after last week, these guys are sweating bullets. First, Fed President Dudley struck a dovish tone in his latest Bloomberg interview. Second, several U.S. data points slowed a bit in March from their February levels. Both developments put into question the number of 2017 rate hikes, and that’s a big problem for anyone who is overly committed to the reflation trade.
Long John Silver
There are many markets and companies that will turn as ugly as a 60-year-old man in an Ed Hardy T-shirt once the reflation trade unwinds. But there is one market that is particularly poised to get rocked.
Despite getting no press, silver was the best-performing global market in the first quarter, gaining 15%.
Given the fundamental backdrop of accelerating growth and inflation, this gain isn’t surprising. However, silver’s 15% gain was nearly twice the average quarterly return experienced in that type of economic environment.
But the shine shouldn’t attract you. In fact, it’s an understatement to say that silver’s recent rally is long in the tooth. If the coming inflation slowdown is accompanied by slowing growth, then we will enter a fundamental environment that is silver’s kryptonite.
It’s not just the fundamentals blowing a headwind against further silver gains.
Quantitatively, silver failed just last week for the second time in a month to breakout above a critical price level of $18.46. Since trading below that price on October 3, it has managed to close back above it just three times in the last six months. That price is clearly silver’s glass ceiling, until further notice.
Not only do we have a solid line of resistance overhead, but silver has a negative correlation to the USD across multiple durations.
This is a big problem for silver bulls because despite the USD’s weakness to start 2017, it remains bullishly positioned. The revival of the “policy divergence” trade makes it very likely that the greenback will hold above both the quantitatively critical level of $97 and the psychologically critical level of $100.
While multiple aspects of silver’s Quantitative Gravity are stacking up on the bearish side of the ledger, the Behavioral Gravity is also tilted bearish, because investors remain blissfully unaware of inflation’s impending peak.
Speculative positioning in the futures market is leaning to the long side near a three-year high, while short positioning is at an 18-month low.
The options market is confirming this extremely bullish bias because the volatility people expect over the next month is less than what is currently being seen day-to-day.
This combo platter of data puts silver’s Behavioral Gravity at decidedly bearish levels; this tells me people are not only uber-long this market, but overly complacent as well.
Fundamentals are shifting, quantitatively the silver market is trading at a level with a favorable reward-to-risk set up, and investors are leaning long and expecting the low volatility rally of Q1 to continue for the foreseeable future. From a short-trading opportunity perspective, it doesn’t get much more appealing.
Remember, it’s not a matter of if, but rather when, global inflation starts to decelerate. Inflation is slowing in the Eurozone, and it’s only a matter of time before that spreads globally. If your portfolio is heavily invested in the reflation trade, it’s critical that you rethink those positions.
Clearly, most of the world isn’t prepared, but if you “skate to where the puck is going to be, not where it has been,” you will not only sidestep danger, but also position yourself for opportunities most investors never see coming. As always, stay data dependent, process driven and risk conscious, my friends.