Market Risks, Problems and Positions – Part II

Victor Sperandeo with The Curmudgeon



This is part II of our analysis of major market risks that have not received proper attention by the mainstream media (that’s the primary reason the Curmudgeon started posting 14 years ago and was joined by Victor – “the man for all markets” in early 2013).

This piece includes: dangers from derivatives, a reiteration of the U.S. debt problem, market positions (but not trade or investment recommendations), a closing comment and end quote.

A Potential Nuclear Time Bomb:

It is useful to remember how large the derivatives market is.  In December 2015 the total value of leveraged assets through derivatives was estimated to be between $600 trillion and $4 quadrillion (that’s a 4 with 15 zeros after it).  Last year the value of all leveraged positions in interest rate derivatives alone was estimated to be $542 trillion.  Compare that to the GDP of the entire world, which is somewhere around $75 trillion.  At some point, if history is any guide, the derivatives bubble will burst, and the effects worldwide will be beyond catastrophic.

Curmudgeon Note:

The reason the derivatives market is so large (estimated to be more than $1.2 quadrillion) is because there are numerous derivatives available on virtually every possible type of investment asset, including equities, commodities, bonds and foreign currency exchange.

“Derivatives Time Bomb” is a potential situation where the financial markets plunge into chaos if the massive derivatives positions owned by hedge funds and large banks were to move against those parties.  Institutional investors have increasingly used derivatives to either hedge their existing positions, or to speculate on given markets or commodities.  So have ETFs and ETNs which are bought by many unsophisticated traders and investors.

Last week, several Inverse (Short) Volatility funds blew up.  Consider this chart:

Shorting volatility was a high-risk, high-return and crowded trade: it tripled during the past 18 or so months so was deemed a “free lunch.” But high expected returns (all things being equal) always come with greater risk. Whether it is higher yields (e.g. junk or emerging market bonds, lower rated mortgages) or expected higher returns for equities (e.g. nifty fifty, dotcoms, FANGS) this is a cardinal rule of investing.  Expecting otherwise ultimately leads to disaster, even when pundits claim “it’s a new era and the old rules no longer apply.”


Victor - The Essence of the Market’s Problem:

It is my belief that the debt has finally overwhelmed the U.S. economy as we noted in part I of this two-part article.  What tipped the scales is that interest rates are finally rising, and the Federal Reserve is now reducing its balance sheet.  See Curmudgeon Note below. 

Higher interest rates and unlimited debt levels have become a problem for the markets, instead of just a political football.  Therefore, I believe the high for equities has now been established. If the Fed announces it will not reduce its debt portfolio (i.e. if it starts to panic) it will cause a huge rally, but more pain will come first.

Curmudgeon Note:

The Fed has begun to slowly reduce its bloated balance sheet (=total net assets) by allowing $6 billion in Treasury securities and $4 billion in mortgage-backed securities to mature every month.  The proceeds will be sent to the U.S. Treasury Dept. rather than be reinvested in debt securities. Eventually, $30 billion in Treasury securities and $20 billion in mortgage securities per month will be remitted to the Treasury rather than reinvested.

You can see from this table that the Fed’s balance sheet was reduced by a very small amount (-$34,481) in the latest reporting week and stands at $4,467,962 as of February 8, 2018.  That’s only slightly down from the all-time high of $4,509, 462 reached on December 22, 2014.  You can view a graph of the Fed’s balance sheet from 2008 here. 


Victor’s Market Positions:*

* These are NOT recommendations, but only my personal opinion for intermediate trading.

Using the above analysis, I would be short the U.S. Dollar index, and thereby be long commodities (which are priced in dollars and therefore trade counter to the greenback). The grains are the most undervalued in the commodity complex, in my opinion.

I would also be long Gold, Silver, and Platinum.  I would position myself short U.S. Government Bonds but go long 2-year Treasury Notes as a hedge.  After flattening for well over one year, the yield curve is finally starting to steepen. 

As a shorter-term trading strategy, I would short stock indexes on any rally of +2.5%, and then buy when markets drop -3%. The equity market will be volatile so for the moment “nimble trading” is the best low risk strategy. 

However, keep in mind one overriding rule: do not go short during the last hour of trading. The Federal Reserve (via its proxies) and/or the Plunge Protection Team (PPT) will step in to stop a crash in equities, but they will likely allow the market to decline in a stable way.

Victor’s Closing Comments:

I’m on record as saying “the market would end - not top!”  So, I assume January 26th was the true high, for as far as the eye can see.

The world is changing from repression to inflation and growth. It is time to recognize this reality and forget the insane “zero interest rate - free money” mindset used to save the financial system.  It also may be prudent to realize that the Federal Reserve – like nearly everyone else in the U.S. Federal Government – likely wants to see President Trump fail.  That might even include the current Federal Reserve Chairman Jerome Powell, who was recently appointed by President Trump over preceding Fed Chairwoman Janet Yellen.

End Quote:

Perhaps this quote may explain why Congress and Trump signed the $300 billion deficit bill:              

“And many writers have imagined for themselves republics and principalities that have never been seen or known to exist in reality; for there is such a gap between how one lives and how one ought to live that anyone who abandons what is done for what ought to be done learns his ruin rather than his preservation: for a man who wishes to profess goodness at all times will come to ruin among so many who are not good.” — Niccolo Machiavelli.

Good luck and till next time...

The Curmudgeon

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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