Tuesday, August 9, 2011

Will The Fed's Green Light Be Enough?


What an amazing trading day. If you played it right, you could have made a killing during Tuesday's session. This is my new motto: you will never beat the sharks on Wall Street engaging in high-frequency trading with their multi-million dollar computers based on insanely complex algorithms, so you are much better off joining them.

Actually, I lied, you can beat these 'hedge fund' punks but you got to stomach insane volatility in the process and trade without fear. You have to be crazy and ready for cliff diving. Not exactly recommended for the average investor looking to buy and hold and collect 6% a year with little risk. And while it sounds easy, be prepared to lose a ton of money before you start making it back. I have the advantage of knowing where hedge funds hide, what they liquidate and buy when they are in 'RISK OFF' and 'RISK ON' mode, and when to buy or sell given the macro background. Remember this: traders love selling the news and buying the rumor.

Anyways, today was a perfect day for a short-covering rally. The Fed released a statement pledging for the first time to keep its benchmark rate at a record low through mid-2013, confirming a growing consensus in the markets: Economic growth in the near future is likely to be less robust than previously thought.

There was a lot of volatility today around the time of the Fed's announcement as traders sold the news, but in the end stocks and risk assets in particular came roaring back. The Dow rose 430 points and the Nasdaq and S&P added 5.3% and 4.8%, respectively, after initially selling off as the Fed's statement was released. Below, a sample of stocks I was looking at today. Just look at what a difference a day makes (click on image to enlarge):

Why was this such a violent reaction on the upside? Several reasons. First and foremost, there is an old Wall Street adage, Don't Fight the Fed. You can criticize Fed Chairman Bernanke all you want, you might think quantitative easing (QE) is a terrible thing, but at the end of the day, the Fed is doing exactly what the banks want by keeping an upward sloping yield curve so they can trade risk assets all around the world for free. That is why the Direxion Financial Bull 3X Shares (FAS) rallied so sharply today (never buy and hold these leverage ETFs but trade them like crazy!).

Remember, banks borrow on the short end of the curve and lend out on the long end. By pledging to keep rates low until 2013, the Fed is basically giving Wall Street the green light to trade risk assets, making a killing in trading profits, buying the big banks time to shore up their balance sheets. Fed policy matters on the short end; inflation expectations matter for the long end of bond yields.

Right after the Fed's announcement, the 10-year note ticked down to 2.19%, down from the previous session's close of 2.33%. The 2-year dropped to 0.18%, and the 5-year fell to 0.95%. The 30-year yield declined to 3.58%. The 2-year note yield is now at record low levels, but don't be in any rush to short bonds, they will continue rallying along with risk assets.

What are some of the big portfolio moves I see going forward? You'll notice market fear came down significantly today as the VIX, a gauge of market fear, contracted 27% after surging 46% on Monday. I see this continuing in the short-run and remain short volatility, long the XIV, believing that markets will regain their senses for the remainder of August. Importantly, keep buying the dips here.

What else would I be doing here? I am long risk assets, long solars, and would take any profits I made out of gold and book them. Gold extended its gains today but I think it's due for a major correction as market fear dissipates and hedge funds lever up on risk assets again. Tread carefully, these aren't easy markets to navigate through, but I think the Fed's latest move will prove to be enough to ease uncertainty and if it's not, get ready for QE3.

Below, Marc Faber, publisher of the Gloom, Boom & Doom report, discusses today's Federal Reserve policy decision and the prospects for another asset-purchase program by the Fed. Faber, talking with Carol Massar and Matt Miller on Bloomberg Television's "Street Smart," also talks about the Treasury market and investing in gold. I do not agree with Mr. Faber that it's a Treasury bubble so investors should flock to gold but he may be right that stocks will go lower before ultimately rebounding. If that happens, and the economy contracts sharply, QE3 is a done deal.

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