Don't short the Sheriff

First things first: Happy new year, Fellow Traders!

In 2010, trade with the Lord… of Trading and don’t short the sheriff, I mean the Market sheriffs of course: the governments worldwide, the treasury departments, the FED, the BCE, the BOE and the other Central Banks. It’s not that I turned into a Bull, the thing is just that I’m a coward and scared of the Sheriffs. They showed us in 2009 how fast, big and powerful their guns are and how wide their arsenal is: interest rates slashes, Credit/Quantitative Easing and other money printing presses, banks bail-out, accounting changes, government fiscal stimuli and loads of programs: the TARP, the TARP strikes back, the return of the TARP, the TALF Episode I, the P-PIP, the HAMP and maybe the use of a few weapons that’s better not to mention, the kind of that can send a guy in jail for a few hundreds years, but no sheriff would send another sheriff who saved the world in jail. Here we go: the sheriffs saved the world. Remember one year ago as 2009 began, a few months after Lehman the markets were close to collapse and the end of the world seemed inevitable. Here came the sheriffs, they fired their weapons and shot in the Economy (well on the banks mainly) a few trillions (hey Sheriff would you shoot me a bit please?), supported the global rally from March as the injected money seemed to be used to a large extent to buy stocks and killed a lot of markets outlaws, namely shorters.

Dow Jones: 1/1/9 - 1/1/10

Firstly, this indicates that the lessons of the Financial History have been learned, particularly the chapter on the "Great Depression": the "laissez-faire" liberalism doesn't work and the markets are not able to recover on their own and need massive interventions and money injections. I read a book "The return of Depression Economics" written on this by Paul Krugman, winner of the Nobel Prize in Economics which I have found highly interesting and clear, for me not an economist (thanks to the Lord of Trading) and that I'd recommend in order to have an idea of the Economic school that has an important influence on the Sheriffs decisions.

Secondly, this suggests that the Sheriffs will keep on doing everything they can (and I do mean Everything) to support the recovery they initiated and avoid we fall back in a Recession. My opinion is while the stock market may take a breath after that rally, the sheriffs have still enough ammunition to avoid a deep correction and prevent us from the announced double dip recession, at least during this coming year. I also think they have enough ammo to exit their stimuli not before they are 100% sure the Economy can fly without them. Lehman was shot down for some obscure reasons probably by Sheriffs who underestimated the impact of its collapse, it was a mistake and I'm pretty sure we won’t see so soon this kind of mistake. The forecasts and talks about a double dip recession including by President Obama, appear to me like an extra safety net to ensure that it won't occur. The very same thing can be said for the anticipated crash in the Commercial Real Estate. This contrarian view here is based on a simple thing: when most of the participants are bearish, they just make the short positions expensive and the long ones cheap... That's what I tried to explain (in vain) to my former Master Bossy when I was happily running the "Orc race" (which is a TLofT variant of the "rat race"): as long as most of the market participants are bearish and expect the imminent end of the world, the rally will sustain... This said, I have the feeling this opinion faded lately (the "Double Dip recession" was the topic of many articles a few months ago, it is much less now) but there are still plenty of good reasons to feed the Bearish sentiment: I won't tell you anything you don't know if I say the recovery is fragile, that the past year the economic issues worsened, the unemployment soared to reach in some countries unbearable levels and doubled in the US, the US big banks recent profits seems to come only from cheap funding (1.4% last year according to The Economist) and their balance-sheet is still loaded with tox... legacy assets no one on earth seems to be able to properly price yet and which value is still highly dependent on the US government programs and their impact on the ultimate default rates and recovery values, it looks like the house prices according to Banks research have not bottomed yet and so on, and so on and so on. OK, you know these songs... In my humble opinion if there's a crash in 2010, it's unlikely to come from one of the listed above as the Sheriffs veil too closely on them. If I was required to give a guess, I’d say that the inflation will ultimately creep in and that’s the fight against it by the very same Sheriffs using the very same type of weapons that will bring us to the next crash but I think we still have some time before we see this. Another thing to make the game more difficult: a cataclysm often comes from where it is not expected, at least by the Crowd.

This said, after the systemic shock triggered by Lehman's collapse all the markets became highly correlated, as basically everything moved down then. During the most of 2009, all the markets seem to move up and down in tune with the 30 of the Dow Jones. We discussed in an earlier post the break of the correlation between the EURUSD and the SPX, but actually during the last months of 2009, the break in the correlation between the different markets could be observed more broadly (stock, bond, credit, interest rate, commodities markets). For instance the chart above shows the correlation between (the log returns of) the S&P500 and  the Nikkei 225 since Sept 08. It suggests that in 2010 the prices could reflect back the relative value between the different markets as they used to. In such a market environment, the strategy is simple: go long the best and/or short the worst. To be back to our metaphor: we could be in a situation where the Sheriffs after they saved the world together will more focus on their own ranch, even letting the outlaws steal the cows in their neighbourhood provided that those don't steal theirs. It might be the case if troubles get serious in the Euro-area (a Greek default? Ireland and Spain are not really healthy neither) or in the Middle East (bye bye Dubai?): things might go really bad there without any Sheriff intervention if the risk of global contagion of a slump looks limited and the initiated global recovery is not at stake.

Don’t short the Sheriffs until they run out of ammunition... and to me one sheriff that might run out of it shortly is the BoJ. I'm doing my homework on Japan as I've a beginning of bearish view for now motivated by pure gut feeling rather than anything else and I will post the fruits of my investigation (if any) later this year here. But at first sight and in a few words, the Japan has been using the Quantitative Easing weapon for a decade now and it didn't work. They may need to use it again and again as the current absence of interest rates differential led the currency to levels which are hardly sustainable for the Japan to stay competitive. If negative economic news in the US or in Europe hit the screens, the prospects will be that  the FED, the ECB or the BoE will keep longer their rates low and this will affect Japan as it would then expected that the absence of differential is to sustain longer. That were just a few thoughts at that stage, to be continued...

To end this post once again on my trading, last summer when I understood the commitment of the Sheriffs to do whatever the recovery requires, I "traded the FED" going long stocks and long EURUSD mainly and that paid off. For now, I will keep on trading this side, mainly adding on the long stock position with S&P500 names (let's trust Sheriff Ben to protect it) as the EURUSD direction in a few weeks is very uncertain to me. At the beginning of last year, I had the very opposite view, I was dead wrong, I reversed and managed to make money. In a very similar way, if it appears that I'm wrong this year, I will reverse. Then I definitely won't be the first to reverse to be on the right side but it's still OK as the trick with trading is not to be the last to do it...

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