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Trade Alert: Economic analysis, stock market set-up, shorting IBB

Cody Willard

Cody Willard

— 8 min read

In the Trading With Cody Chat Room this weekend, @jakef1111 wrote to me: “Your mindset doesn’t seem the same as when you were as bullish and shrugging off crisis after crisis like Greece, Cyprus, EU, Middle East tension, Russia/Ukraine etc… Do you see us having another leg down? Are you still positive on the year?”

He’s exactly right that I’m not as bullish as I used to be and willing to shrug off the current crises like I did for every single supposed “crisis” like Greece and Cyprus and the EU and the EU and so on from 2010-2014.

Remember when Greece’s many sovereign and bank debt crises kept tanking the stock market around here?

Remember when Italy’s elections were front page news on every financial paper and the market would freak out?

Remember when everybody was saying Apple, Amazon and Google were in a bubble…back when they were a fraction of today’s price?

Remember when everybody was saying that the subprime crisis would be contained back in 2006 and 2007?

See what’s different this time is that stock valuations are higher than they were at any point back when I was writing those wildly bullish posts into the teeth of short-term panicky sell-offs. That, and my analysis continues to highlight that oil’s crash is creating currency and economic turmoil in Russia, and OPEC countries and creating some pain in Australia and Canada. That, and the impact of an upcoming wave of a trillion dollars of energy and commodity sector bankruptcies in the next year have me a bit cautious and my portfolio higher in cash and with a few more shorts than I’ve had at any point in the last few years since I came back to trading from TV.Over the weekend in the Barron’s Round Table, Felix Zulauf brought up another potential Black Swan event, that China will eventually stop intervening in currency markets to support the value of the yuan in order to avoid losing all of its foreign exchange reserves.

With an annual capital account deficit estimated at $1 trillion, China could exhaust those reserves in little more than a year unless it allows a devaluation and a balance of payments crisis usually ends with a recession.

Zulauf explains that a Chinese recession could trigger a banking crisis in Singapore, which would eventually spread to Hong Kong.

I think the idea that China is also being crushed by the strength of the US dollar because defending it is very hard and because a stronger currency hurts their export-based economy, is another example of how the currency wars are having exactly the “Fog of War” kind of consequences I’ve discussed many times in the past.

Fog of War and tech earnings previews.

July 22, 2014 By Cody Willard

“From the markets reaction to the Ukraine/Malaysia/Gaza wars and escalating currency and economic wars between Putin’s Russia and the Republican/Democrat Regime’s US, you’d think they’re meaningless. Fog of war makes them important potential Black Swan events. The fog of war (German: Nebel des Krieges) is the uncertainty in situational awareness experienced by participants in military operations. The term seeks to capture the uncertainty regarding one’s own capability, adversary capability, and adversary intent during an engagement, operation, or campaign. Black swan is an unpredictable or unforeseen event, typically one with extreme consequences.”

That said, let’s be careful not to listen to those who might be caught in a permabearish kind of stance, as you can see Zulauf was bearish “for the next two years” in back 2010 and thoughout this bullish cycle.

I can’t say I was impressed with what I found on a quick Google search to answer a subscriber’s question about this on Trading With Cody’s Chat Room. Here are some of Zulauf’s commentary and predictions from the past six years to compare and contrast to that commentary and headlines from me above:

Zulauf in June 2009 (DJIA at 8600):
“The market is naïve in assuming the earnings models of the past 20 or 30 years can be extrapolated out to the next five years. The market will hit a lower low than it did in March 2009. What was missing last year was the complete desperation and turning away from equities as an asset class that marks the end of a secular bear market. That will come. European and U.S. policymakers believe China eventually will bail us out, but China is tightening. Its real-estate sector will get hit badly. All the leading indicators are topping around the world.”

Zulauf in August 2010 (DJIA at 10400):
“In March ’09, I turned bullish for a rally. I saw that in 2 to 4 months it went up 25 to 40 percent and I didn’t expect that rally at the beginning when it started to last that long and go that far. Once it never corrected, I had to go back to my drawing board and do the homework and I sought a bet that was very similar to two previous cases in the history. One was in the US — that was in 1938 — that rally had the same characteristics in terms of fundamentals and in terms of technicals. And the other case was in Japan in 1995, ’96. Both rallies lasted one full year. Both rallies were eventually fully retraced and that’s what I think will happen here too.”

Zulauf in January 2012 (DJIA at 12500)
“The biggest recorded credit and investment boom in history has gone bust. The Chinese stock market has given back almost 90% of its rally off the 2008 lows. We have to fall into a crisis that triggers a policy response. Equity markets around the world will top out during this quarter and then enter the next down leg in the cyclical bear market that started last spring, which could end in the second half of 2012 or in early 2013. The market could drop 20% from the first quarter’s high. Therefore we will need ammunition later this year or early next year to buy. My first recommendation is capital preservation, or cash. It doesn’t return anything but you’ll need it to buy when asset prices become cheap. Gold is in a secular bull market. The correction to the low-$1,500s is over. There is a lot of optimism in the market, and gold needs to come down a little. If Obama wins, the price could shoot up again. If Romney wins, the market could be weaker going into December, after which the price will rise. Next year, gold will go to new highs.”

Cody back here now. I’m not trying to pick on Zulauf, I just happened to want to know more about him after being asked about him by several people in the aforementioned Trading With Cody Chat Room. So, while I find his argument about China’s currency issues compelling, I think this is a good example of why I always preach being flexible and never locking yourself into either perma-bull or perma-bear status.

What’s interesting is that pretty much every bearish macroeconomy, geopolitical, currency, corporate earnings, energy and commodity bullet point we mention, basically, everything ailing the global economies and stock markets would be helped by a weaker dollar. Meaning that the Fed’s got a helluva lot of reasons to cut rates back to 0% and even kickstart another round of QE and try to come up with newer ways to print some money. You certainly can take any further rate hikes off the table.

A Fed back in easing mode and a weaker dollar would help increasing pressures of a China’s currency devaluation nearing a breaking point, it would help stop the endless decline in oil and commodity prices, it would help re-inflate export-centric economies and corporations and might even force savers and sidelined cash further into higher risk assets like the stock market.

Let me be clear that I’m not advocating for more of what Robert Marcin would call “whining free market hypocrisy begging the Fed for QE” but I’m simply trying to analyze the most likely scenario for the markets and the economy so we can be better positioned to profit and avoid losses in real dollars in our own portfolios.

Net/net, I do expect more near-term weakness and perhaps another test and even a breaking lower from last week’s Wednesday panicky lows. The Fed will start to rumble about cutting rates and at the next meeting they’ll go back to 0% and say that they’re worried about deflationary cycles (last quarter’s CPI rate was the lowest in many years as the St. Louis Fed noted Friday on Headlne). The stock markets and gold prices will rally 5-10% off that move and those comments and oil will pop 10-20%.

And then what, we’ll be off to the races again? Hmm, I’m not so sure. Then I’d be worried that the markets will fall as the Fed’s going into another easing cycle here, as I’ve pointed out before that the markets often do opposite of the old saw of “Never fight the Fed” and that we should “Always Fight the Fed.”

What to do? As I’ve been saying, we don’t have to commit fully either way. We don’t have to be aggressively long or aggressively short. We don’t have to try to catch every move in the markets or make sudden rash decisions to sell all our stocks and mutual funds when markets have tanked. We don’t have to try to catch the exact bottom in the markets and wait 100% in cash and shorts until then. This is why I repeatedly preached that we wanted to sell when we can, not when we have to throughout 2014 and 2015 before stocks tanked.

In the meantime, I’m going to go ahead and add another round of IBB Biotech ETF short as a hedge on the broader portfolio and as a way to profit if my above analysis for the market set-up is correct by getting more exposure to being short some biotech sector. I’m not buying put options this time (though I might at some point soon). I am going to sell short some biotech by shorting a 1/3-sized position of the IBB ETF.

A couple other notes:

$AAPL Earnings preview:  A slight miss and small guide down would likely result in a flattish reaction in the stock the next day. An inline result and just slightly lowering of guidance, given that the company is notorious for lowballing, is likely to result in a smallish, 2-3% pop.. A beat and decent guidance would pop the stock 10%. A big miss and ugly guide down — the stock would probably get hit 10% or more. I think the most likely scenario is this one: A slight miss and small guide down would likely result in a flattish reaction in the stock the next day. I’m holding my $AAPL call options, willing to take the risk.

I was talking to @KheangLy last night about our new site and apps, Headlne.com, which led us to talking about most popular headline there yesterday was about Dorsey letting four Twitter execs out the door. Twitter’s a company in turmoil but Kheang was thinking the same thing you are — maybe it can put in a bottom here finally. Still trading at 6x sales and 35x next year’s earnings estimates, it’s not that cheap yet, but I admit I’m a bit tempted to try do another bottom fishing on $TWTR around $17 a share if I’m looking out two years.

 

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