In the summer of 2008, I told my hedge fund clients to sell everything ahead of the greatest economic crisis since the Great Depression.
And on March 27, 2009, I predicted in a front-page article the “oncoming and unexpected bull stampede” before one of the longest bull markets in history.
And in December 2015, in front of a national TV audience, I told viewers to “sell everything in January” before the markets lost an estimated $8 trillion in the worst start to a new year ever.
Now, I’m going to tell you something else, so listen up.
I’m watching three crucial “barometers” right now, and they’re giving me a clear picture of the economy’s immediate future. And it’s not good.
A global recession is coming – and the signs couldn’t be any clearer.
We’re already seeing it in countries like Greece, Belgium, Italy, Portugal, Netherlands, Czech Republic, Venezuela, Brazil, Russia, Taiwan, and as of Monday, Ireland.
And we’re next.
The U.S. saw a paltry 0.7% (annualized) GDP growth rate in the fourth quarter of 2015. But for all of 2015 notched an estimated 2.4% growth rate, so it doesn’t appear close to turning a corner into recession.
However, based on a host of recession barometers, including industrial production, consumer spending, and stock prices as a reflection of sales and earnings, as far as the U.S. and the global economy go, dangerous “objects in the mirror may be closer than they appear.”
Recession Barometer No. 1: U.S. Manufacturing
Industrial production in the U.S. showed negative readings in ten out of the last twelve months. Over the past six months, industrial production is down 3%.
The Institute for Supply Management’s Purchasing Managers Index (a survey of private sector manufacturing companies in five different fields) just came in at 48.2. That’s four months in a row the index has been below 50. A reading below 50 points to contraction in U.S. manufacturing.
The January ISM report additionally says customers’ inventories are “Too High,” the backlog of orders is “Contracting,” exports are “Contracting,” and prices are “Decreasing.”
But don’t take my word for it.
The chief executive officer of Fastenal Co. (NASDAQ:FAST), North America’s largest fastener manufacturer and a major supplier to other businesses, this month repeated that “the industrial segment of the U.S. economy is in the midst of a recession.”
And the CEO of CSX Corp. (NYSE:CSX), operator of the largest railway network east of the Mississippi, said demand will drop amid a “freight recession.”
The question right now isn’t that U.S. manufacturing will enter a recession – it’s already there – but whether or not that slowdown will creep into other parts of the economy, namely our next barometer…
Recession Barometer No. 2: Consumer Spending
In spite of the apparent jobs growth that’s pushed unemployment down to 5%, U.S. consumers, responsible for a full three quarters of GDP growth, aren’t stepping up.
According to the Commerce Department, personal spending in December was flat from a month earlier. Spending on durable goods, meant to last at least three years, fell .9% in December. And spending on nondurable goods also fell .9%.
That translates to the end of the most important quarter for retailers – and the true picture of the consumers’ propensity to spend – as being a disaster for the economy.
For all of 2015, retail sales, including autos, were the worst since 2008-2009.
One reason consumers aren’t spending is wages have only increased 2.2% in the past five years. With rising healthcare costs courtesy of Obamacare and an uptick in the savings rate to 5.5%, it’s unlikely still deleveraging consumers will be much of a positive for GDP growth in 2016.
Recession Barometer No. 3: Global Stock Markets
And then there’s the stock market, make that global stock markets.
Not all steep market selloffs signal a coming recession. But, frighteningly this time around, that’s exactly what they’re doing.
The January 2016 selloff in U.S. stocks followed global equity markets getting hit last summer through yearend 2015. Now we’re all headed lower.
Selling isn’t the result of a valuation correction, what’s happening is investors are selling over fear of falling earnings, or an outright collapse.
The root cause of global market volatility, and why equity markets selling off portends a coming global recession, is all about currencies.
The currency market is the largest market in the world. Trillions of dollars of currencies trade every single day, dwarfing the volume of all the world’s equity markets, combined. That’s because currencies are used to buy goods and services the world over and as global trade has grown, more and more trading is necessary to make payments in different currencies.
Currencies don’t just move up and down based on short-term buying and selling based on daily trade transactions. They mostly move up and down relative to each other based on interest rate differentials between countries.
And interest rate differentials are now the “last stand” for central bankers whose no-interest, zero interest and negative interest rate policies have done nothing to keep staggering economies from slip-sliding back towards recession.
By managing their currencies down, exporters cheapen the cost of the goods and services they sell globally. With the sole exception of the United States, which has the largest domestic consumer economy in the world, and is still an export juggernaut, almost every country in the world relies on exports to propel growth.
But, when lowed interest rates, which cheapen a country’s currency relative to its trading partners, are met with counter-party interest rate cuts, trading partners and exporting competitors have nowhere to go but try and keep lowering interest rates.
When countries compete to lower rates to spur exports they’re are said to be engaging in a “race to the bottom” strategy to maintain export revenues.
Not only has that been happening, it’s going to get a lot worse as exports everywhere are falling.
The IMF recently noted that the 2015 year-over-year change in global exports was the second-lowest its seen since 1958. The smallest change was in 2008-2009.
As “currency wars” heat up in Asia, South America, and elsewhere, the U.S. dollar remains strong and on a relative currency basis is getting more expensive.
That means trillions of dollars of Chinese, emerging markets and other global debtors, all of them exporters, who grew their economies and export businesses by funding growth with dollar-denominated loans are going to see the cost of their debt skyrocket.
The only way they can pay it off is to export more to generate revenue.
It’s that “negative feedback loop” that’s going to cause major devaluations in currencies, debt defaults and bankruptcies worldwide. At the same time, U.S. multinationals who get increasingly larger revenue streams from overseas will see those revenues decimated when they have to translate earnings in foreign currencies back into U.S. dollars.
Stock markets see this. Earnings are going to get hit, and even collapse for some companies.
Between faltering industrial production in the U.S. and across the globe, retrenching consumers here and elsewhere when layoffs will be announced in the first quarter and throughout the year, and stock market investors selling on account of rapidly diminishing earnings in the face of escalating currency wars, the warning lights couldn’t be any brighter.
I predicted what was going to happen last August, and what was going to happen through the fall of 2015 and in January 2016.
Now, I’m going to show you what I saw that brought me to those predictions, and how you can see the market’s future, too.
It’s not hard to see where the stock market’s going. In fact, it’s incredibly easy… especially when it’s about to go down.
You just have to read between the lines – and by that I mean “channels” and “support” and “resistance” lines.
This is technical analysis 101. It’s easy, fun, and can make you a fortune.
I’ve got four charts to share with you today to help you understand exactly how I knew the markets were due for a big, fat correction – just like we’re seeing right now – and how you can do this yourself.
Let’s take a look at the first chart…
As you can see in Chart 1, this one-year chart of the Dow Jones Industrial Average is broken down into three timeframes: T1, T2, and T3
For now, I want you to focus just on T1. Imagine there is nothing to the right of that timeframe, no T2 or T3.
If you were looking at a chart of the Dow over that period (T1), even if your chart went further back, you would have seen that the market was going sideways.
I looked at that and thought, “We’ve made nice new highs in this long bull market and now we seem to be going sideways. We could break out, make new highs and start another leg higher. Or the market could be getting tired and investors might be thinking about taking profits here.”
So I drew a couple of channel lines.
Channels are parallel lines that go sideways, go up, or go down and look like a channel.
I look for channels, but they’re not always obvious and they can be drawn differently by different people depending on how they interpret a given chart.
But for the most part our channels and support and resistance lines will all be pretty close; close enough to not matter how exact they are – they don’t have to be exact. Drawing channels and support and resistance lines is more art than exact science. As long as you have a ruler and can draw a straight line, you’re going to be as good at this as I am.
Looking at T1 you can see there’s a pretty clearly defined sideways channel there. So I drew Line 1 to delineate the top of the channel, and I extended it all the way to the right of my graph. I also drew Line 2 to delineate the lower channel line.
If you were just looking at a graph of T1, your line would end where T2 starts. The thing about drawing channel lines and support and resistance lines is that you always extend them out. Draw them going forward so you can see in the future when you have more graphed data where the old lines are. I keep my old charts and use them to recreate my existing lines when I print out updated charts. I draw the old lines onto the new charts.
The top line of the channel actually becomes an upper channel resistance line and the bottom channel line becomes a lower channel support line. So, now you have a channel and support and resistance lines. Sideways channels, especially the longer a sideways channel extends, are very important patterns to watch.
What’s happening in the real world, not on the chart, but in terms of prices being paid to buy and sell stocks (which is what the chart shows you graphically), is that stocks are trading in a range. Investors aren’t pushing stocks higher or lower, they’re just changing hands within that channel of prices.
Investors making decisions within this sideways channel know what’s happening. Buyers are hoping stocks will break out and sellers are afraid they won’t.
Buying investors, and especially buying traders, see the resistance line of the channel as a price level, above which, people will say, look the market’s going higher, we don’t want to get left behind. And if the market breaks down through the support line, people will say, the market couldn’t go higher after trying, it’s tired, it’s time to take profits.
Technical analysis, exactly like this channel we’re looking at, and the support and resistance lines they formed, are important because so many traders (most, and every big institutional trader and hedge fund manager everywhere) are looking at what you and I are looking at, too.
Very often, because there are so many traders looking at the same “lines” breaking out or breaking down when they get breached can become self-fulfilling. If for no other reason, that’s why you have to know where channels and support and resistance lines are at all times.
So we’re going sideways and everyone sees it. The market’s been on a long bull run and a lot of things have changed. For one, the Fed is going to raise rates at some point.
The thinking – the psychology of investors and traders – becomes clearer in terms of our sideways channel. If we break down through support, investor sentiment might turn negative. It’s even more important at this juncture because we’ve made all-time highs and the market’s stalled out waiting for more good news to take it higher.
If we don’t get any and keep going sideways, investors will get nervous.
As we’re moving to the right within the channel, we can see at Point A that after the peak high just to its left, we went down and tried to get back up to the highs again, but couldn’t. The Dow got up to Point A and fell right back to the support line, which saved it from going lower.
But that was a warning.
Then stocks tried to rise again. The next time they only get to Point B, which is a lower high than Point A. So the market was trying to go higher, but the last couple of times it made lower highs and fell back to the support level.
That was another warning.
If the Dow broke support here, investors who placed bets in that sideways channel would think about getting out because the breakout they wanted didn’t happen. Traders will look at a break below support as a bearish sign and not only sell what they are holding to book whatever profits they have, but will short-sell stocks there to try and push the market down. They know investors are nervous there and if they can get them to sell they will push the market down, making their new shorts profitable.
Believe me, that’s what big traders do. I used to do that all the time when I was running trading desks and my hedge funds. If you’ve got a lot of capital and think you can move markets to your benefit, you try. And because you’re not the only one trying, it happens.
Market action, as reflected in charts, is all about psychology. What are investors seeing? What are they thinking about where prices are? What action are they likely to take based on their fear and greed?
You see, technical analysis isn’t about lines or patterns, it’s about psychology. How investors and traders think and how they’re going to react to price movements.
Just like me, you would have seen that we broke support right at the end of T1 and you would have thought, oh boy, this looks dangerous if we fall from these heights.
I saw the exact same thing you could have seen. And I knew, because things were changing globally and domestically, if we broke that support, investor psychology would change quickly and there’d be a lot of profit-taking, selling, and short-selling.
I was right.
We did fall and my newsletter subscribers made a lot of money catching the tumble.
But then the market made a remarkable recovery. We had covered our short plays and were watching it go higher. When we got above the old support line that was the lower sideways channel line, everyone thought the steep selloff was an anomaly and we were recovering and could make new highs again.
Sure, that was possible. But we’d have to get to new highs to really change investor psychology from the fear they just experienced. So at the end of T2 I was thinking, “We’ll have to wait and see now that we’re back above the old support line.”
When a support line gets broken enough – and that wicked August selloff was certainly more than enough – the old support line becomes a resistance line. Investors and traders are nervous there at that new resistance level that investors who didn’t get out before and see the market rise there again, might take the opportunity to sell now that prices have recovered, in case the market headed down again.
But once the new resistance (the old lower channel support line) is broken to the upside, the thinking becomes more positive and investors and traders will start to nibble and buy stocks.
That’s what happened as we went into T3.
Once we got to Point C in T3, which was just shy of 18,000 (big whole numbers are very often important psychological levels, especially 18,000 on the Dow because it was close to the all-time highs), I figured that might be a line in the sand. We tried to get to 18,000 but couldn’t. I figured I’d draw a horizontal resistance line there (Line 3) to delineate the psychological resistance that getting above 18,000 convincingly would require.
From Point C we saw the market fall below the old support line (that’s not good), back to point A. Then the market tried again to rally, but couldn’t even get back to Point C. Then it fell below the old support line again, but worse, it made another lower low to Point B. Then it tried to rally again and only got to Point D (a lower high), before falling right back through the old support again.
At that point the market looked exhausted and unable to get to 18,000.
Just before that time, I said on Fox Business’ Varney & Co. to sell everything, that the market was going down in January. I knew that because I knew if we broke down below the old support line again, investors would throw in the towel and big traders would try and easily be able to push the markets down.
And that’s exactly what happened.
When we made still another lower low at Point C, it was clear psychology had turned completely negative.
It was game over for the bulls.
When Markets Break Down, Old Support Becomes New Resistance
Now look at Chart 2. I drew a top channel line connecting all the high points on the graph – Line 1. Now, because I’m looking to draw a channel, I had to look to see where there could be a lower channel marker that would be parallel to my new upper (downward trending) channel line.
It was easy to draw Line 3 because it created a parallel channel and started back where the old sideways channel began.
Take a look at Line 3. See how the market broke down from there in August, and when the market gets above that lower channel line (which looks positive for a while), it still can’t get above the upper down-trending channel line (Line 1), which had become the new down-trending resistance line of the channel.
And notice how after trying to get above the upper resistance line throughout the fall, stocks came back down to the lower channel support line.
The same thing was going to be true if we broke that lower trending support line – we were going to go even lower, probably a lot lower because, again, fear would be the predominant psychology.
And that’s just what happened.
Line 2 in that chart is just the old lower sideways channel marker. It’s there to show you that even that old support line is still in the mix within the down-trending channel.
Can Stocks Rally From Here?
Chart 3 is a six-month chart of the Dow.
Line 1 connects the lows from last August to the latest lows. It is now a critical support level. I then looked for a short-term channel and found a steep one (not unexpected) and drew it using Lines 2 and 3. The point of that steep channel is that it demarcated the big selloff. Line 3 is upper resistance. If stocks get above that (and they have) they can rally.
But how far up might they go?
The dotted Line 4 is a soft resistance line. I drew it there because looking to the left, in the past, stocks had some difficulty getting above that level before, and they might have some difficulty there again. It is a soft resistance line until we try and get above it in the future; if we try a few times and can’t get above that line, and start to slip again, it will become a more important resistance level.
But we’ll have to wait and see.
It’s All About Fear and Greed
Lastly, we’ve got a five-year chart with a major up-trending channel (Lines 1 and 2). You can see we broke down through the lower support channel line (that’s bearish) and tried to get above it (it is now a resistance line) and couldn’t.
I drew a new bear channel (Lines 3 and 4) to mark the down-trending channel that has taken over sentiment and the general trend. The X Line is where there’s support, but it’s a long way down to get there.
Right now, I’m watching to see where we can go on the upside and what new channels and support and resistance lines I can find.
We’ll just need a few more days and I’ll have the next installment of charts for you and show you where we’re likely going next.
But I hope you can see that technical analysis isn’t “reading tealeaves,” it’s about the psychology of traders.
It’s about fear and greed.
And if you can read investors and traders minds, you can correctly predict which way the market’s going to go.
P.S. – If you’ve been following along with for the last few months, you know I’ve been consistently predicting that China would crumble, setting off a chain reaction that would bring global markets to their knees.
It’s happening right now.
And I’ve got a trade that could bring investors as much as 1,000% gains as the Chinese economy continues to falter.
All you have to do is set aside everything you think you know about trading and use this simple technique to rake in huge gains. Click here for more…
Shah was featured on Varney & Co. yesterday to talk about his August prediction that the markets would fall 20%.
While they’re only halfway to his 20% target, people are starting to notice that Shah has been right about these markets all along. Stocks, which were dragged higher into the end of the year by a few large-cap leaders, are crashing. So is the price of oil and other commodities Shah’s been watching – and warning investors about – for months.
Will the markets fall another 10% to the downside? What’s driving the correction – is it China’s debt bubble? Where do we go from here?
Starting today, America’s big banks turn in their fourth-quarter 2015 report cards.
A handful of analysts, citing the pounding big banks’ stocks have taken, driving them deeply into “oversold” territory (with a few trading near their 52-week lows), expect positive earnings news to push share prices sharply higher.
I say, good luck with that.
That’s because there probably won’t be any positive surprises – and any unexpected good news will likely get discounted quickly as investors look past short-term revenue bumps or cost-cutting measures and see a tough year ahead.
The KBW Nasdaq bank index shows bank shares down 17% from their July 2015 highs, down 15% since December, and down almost 10% so far in 2016. That much negative momentum is going to be hard to overcome.
And if the big banks don’t turn in good report cards – it could spell trouble for markets that have plenty of bad news to deal with already.
Here’s what to expect…
Even though big bank stocks have been widely shorted (another reason analysts are calling for a pop in bank stocks), it will take extraordinary, sustainable earnings gains and positive forward guidance from management to keep share prices from falling, or reacting positively on announcements then falling from lack of follow-through buying.
One of the bright spots big investment banks are expected to point to are advisory fees.
Mergers and Acquisitions in the fourth quarter reached near record levels, capping a record year. Globally, M&A activity topped $4.9 trillion in 2015, outpacing the previous record of $4.6 trillion set back in 2007.
But amidst all that activity, Dealogic recently estimated investment banking (IB) revenues in the fourth quarter will be $9.5 billion,12% lower year over year and the lowest level of fees collected in the last three months of any year since 2011.
Deutsche Bank expects advisory and underwriting IB fees will be down 15%.
Meanwhile, the consensus of surveyed Street analysts are calling for M&A quarterly revenue to be up 20%, but for debt, equity, and capital markets revenue to be down 10%-25%.
There’s no question debt and credit trading was difficult in Q4. High-yield debt in general hit the skids hard, and nowhere was that more prevalent than in the Energy sector.
Even the Federal Reserve is worried about the impact of energy losses and bankruptcies from energy companies.
Their most recent Shared National Credits exam, a review the Fed’s been putting out since 1977 on large syndicated “classified” loans (loans divided up between banks with unpaid interest and principal and in danger of default) noted that 74% of the increase in classified loans were oil and gas loans, “where near default loans increased four times.”
No matter what revenues banks might squeeze out of credit and debt trading in Q4, the expected turn in the credit cycle, now being forecast widely, will dampen future revenue prospects in this traditionally robust revenue-generating arena for banks.
The feared turn in the credit cycle is already causing banks to increase their loan loss provision expenses.
Deutsche Bank analyst Matt O’Conner expects big banks to increase their loan loss provisions about 10 basis points starting in the fourth quarter. Every 10 basis points of expense increases will knock 4% off banks’ earnings, according to O’Conner.
“Principal” Trading Could Take a Huge Hit
Besides debt and credit trading, equity trading’s been a rough ride for most banks. Not only has the IPO market dried up, and underwriting slowed considerably, wide swings, especially to the downside, impact banks’ “principal” trading.
Banks take down blocks of stock clients want to sell and end up selling them at much lower prices when markets plunge. Generally, large block principal trades are money-makers for the banks, but with so many steep down days, it’s unlikely trading desks have been able to make money off a lot of those big blocks.
To the contrary, they may have taken some big hits. We’ll see.
Then there are those notorious “one-off” provisions and charges. It’s going to be interesting this earnings period to see what “one time” write-offs banks take. For example, some might take one-time losses on energy loans that they say are one-off, but which investors might consider to be the tip of an iceberg, depending on how banks classify certain loans.
The bottom-line: fourth-quarter earnings might have a couple of positive surprises that might create short-term pops in some banks stocks. But with more potential negatives lurking in their reports, it’s possible they show their worst hand, hoping to get the bad news out and create better sequential comps for the first quarter’s earnings.
Again, I say, good luck with that.
At my Short-Side Fortunes service, we’ve already placed our bets that the banks will continue their downward trajectory in 2016. And we may add to the list of banks we’re betting against if the markets don’t settle down soon and banks don’t turn in some spectacular earnings surprises along with better forward guidance.
Most investors – I’m talking about institutional mutual fund managers, buy-and-hold investors, diversified investors, everyday investors – are deathly afraid of crazy volatility.
But not me. And not the biggest baddest, richest hedge fund managers in the world, not investment bank trading desks at Goldman Sachs or Morgan Stanley or Deutsche Bank.
We’re not deathly afraid. We’re thrilled to death because we make money from volatility.
The thing is, we know how to make crazy money from crazy volatility. We live for it.
Now you’re going to learn to love volatility because I’m going to tell you exactly how to make boatloads of money off all the volatility we’re going to experience this year.
First, let me tell you what’s causing the volatility.
Then, I’ll show you how it can make you rich…
This Volatility Began With The Fed
First of all, volatility – the crazy kind of volatility we’re seeing already in the first trading days of 2016 – isn’t going to subside.
It will ebb and flow all year. There’ll be weeks at a time when things will calm down, then seemingly out of nowhere they’ll get crazy again. It’s going to be that kind of year.
The root cause of volatility we’re facing is the Federal Reserve’s zero interest rate policy (or ZIRP, for short).
ZIRP was, is, and will be madness.
I say “was” because it’s already been tried. I say “is” because we’re dealing with its implications now. And I say “will be” because the Fed’s wrong about the recovery they think they see.
ZIRP was the Fed’s desperate play to lower interest rates to zero so big banks could borrow for nothing and use the proceeds to buy low interest rate-paying U.S. Treasuries.
In the process the U.S. Treasury got to issue tons of debt at low rates to keep funding the country’s growing deficits. Big banks got to make huge profits via the risk-free return they made borrowing at zero and collecting interest on Treasuries they bought, which the Fed bought from them to multiply their profits exponentially.
The whole insane idea was that low rates would trickle down to consumers who would borrow and spend to get the economy going again.
That didn’t quite happen.
What happened is most of the excess money and credit created by the Fed’s policies was taken advantage of by big-scale borrowers who actually could borrow cheaply. They were banks who also trade and corporations who could borrow to buy back their shares, lift their stock prices, and make their earnings look good (buybacks reduces shares outstanding, which makes earnings per share metrics a lot better). That brought in sidelined investors who thought we were out of the woods and markets were safe.
After all, if you can’t make anything on your savings account, if bonds don’t pay squat, you have to risk going into stocks to get some return if you want to retire.
Not surprisingly, manipulation distorted markets as capital flowed – not into productive capital expenditures (capex) or infrastructure building, mind you – but into stock buying sprees.
Central banks everywhere followed the Fed down the rabbit hole.
Of course stocks soared. Bond prices soared, so much so that some countries sovereign bonds have negative yields! And commodity prices soared… for a while.
The Cracks Are Starting to Show
Commodities were the first asset class to tumble. Cheap money flooded into oil and energy capex and into mining capex, until overproduction led to oversupply, stockpiling, and imploding oil and ore and metals prices.
Stocks are now facing that paradigm shift. And bonds will be right behind them.
Now, when nervous investors look at commodities markets, stock markets and bond markets, they’re seeing how gross distortions led to bubbles everywhere.
That’s the basis of volatility. But it’s only the tip of an upside-down iceberg.
Markets are facing geopolitical headwinds, which is a polite way of saying craziness.
Russia is fighting in Ukraine and in Syria where they may face off against U.S. and European interests. Russia’s also facing down Turkey and stirring up trouble elsewhere in the Middle East by backing both Sunnis and Shiites fighting each other. Saudi Arabia is facing off against Iran. Sectarian fighting is engulfing the whole Middle East and threatening regimes across the region. No one knows how heated it will get.
That’s adding exponentially to volatility.
China’s economy is on the brink of imploding. The little engine that could – and did – carry the world on the heels of the 2008 credit crisis is faltering. If China can’t prevent its economy from slipping, if the Chinese yuan crashes in currency markets, all hell will break loose across global markets.
That’s adding exponentially to volatility.
Then there are the other volatility-creating beasts roaming the investing landscape.
Cybersecurity threats, diverging central bank policy prescriptions, sovereign wealth funds liquidating assets to meet budget shortfalls, huge carry trades being unwound globally, deflationary trends picking up steam, unsustainable public debts, ISIS incursions, global terrorism threats, negative bond yields, backsliding economies in Europe, questions about European unity, Brazil in a free fall, looming currency wars, and black swans circling that no one can see but investors fear are out there somewhere.
All that’s adding exponentially to volatility.
And I’m not even getting into the brass tacks of the markets. Like how only a handful of momentum stocks took the markets up since last August’s swoon, which by the way was caused by China devaluing the yuan less than 2%. Or how 40% of stocks are trading below their 200-day moving averages. Or how high-frequency trading has reduced liquidity and made markets prone to 1000-point drops. Or how more regulations on banks is sidelining them and further reducing liquidity. Or how corporate profits have peaked and are heading south. Or how more than $3 trillion in buybacks is about to go up in smoke. Or… shall I go on? Because I can.
But you get it. Everything the markets are facing creates volatility, and there’s so much they’re facing that volatility is becoming “layered” on top of itself.
The last time global markets faced this much volatility was in 2008. But his time around, the volatility factors are much more diversified and fundamental on top of technical issues facing stocks, bonds, and every asset class.
Preparing Yourself for Volatile Markets
Volatility in 2016 is going to be insane.
So much money can be made off volatility it staggers the mind.
Crazy volatility means huge price swings, both down and up. Over and over.
To make money you first have to protect what you have invested, so you don’t lose it. The best way to do that is with stop-loss orders.
We just put down stop-losses on all our long positions in my Capital Wave Forecast service.
We’re doing the same at my Short-Side Fortunes service, but we’re mostly short the market already. And about to get a lot shorter.
After you’re protected on the downside on your existing positions, it’s time to put on a bunch of defensive plays that will make a ton of money when markets fall out of bed.
I’m talking about buying put options or outright shorting. I recommend shorting stocks near their all-time highs. If the market turns back around, which it could do because it’s getting “oversold,” cover those shorts if they make new highs. If the market keeps going down, add to your short positions.
When markets fall and you’re making money on your shorts or on the puts you’re buying, I strongly recommend taking big profits when you get them, like we do.
We’ll be booking profits and ringing the register when we have big gains from falling stocks because we’ll then be buying big selloffs to ride the inevitable bounces higher when markets become grossly oversold.
As a trader I never worry about leaving profits on the table. If I’m making a ton of money getting the big up and down moves right, I don’t care about squeezing out all the profits.
That’s a loser’s game. The way to make money when there’s crazy volatility is to ride the big moves and take your profits fairly quickly when you’re sitting pretty so you can calmly (and with a pocketful of cash) get back in going the opposite direction.
The luxury of trading extreme volatility is you can enter positions close to the bottom of a move, or close to the top of a move, and not have to catch the exact top or bottom. In other words, trading tops and bottoms of big moves actually becomes less risky, not more risky.
Whenever I’m positioning for a turn in the market near a top or bottom, I give my new positions about 5% to 10% swing room to go against me. If I get a 10% loss, unless I’m more convinced and am willing to add to my position because I “know” the turn is coming (and sometimes I know), I’ll get out with a small loss so I can calmly assess the market before making another move.
Make Money on Volatility with These Instruments
Another way to make money when volatility is extreme is by actually trading volatility.
I like buying the iPath S&P 500 Volatility Short Term Futures ETN (NYSEArca:VXX) and buying calls on the VIX (which are actually calls on the VIX short-term futures) when I’m expecting a spike in volatility.
These are short-term holds. If you’re right, you should ride a directional move up in volatility as long as it’s obvious. As soon as you’re not sure, or better yet, if you’ve got a quick, fat profit, take you gains quickly. You can make windfall profits if you get in and out and capture the majority of a move that lasts just a few days.
And because volatility goes both ways, once it’s spiked it usually falls, sometimes very quickly as investors exhale and go to the sidelines to figure out their next moves, I like shorting volatility (betting volatility will subside) after a big volatility spike.
You can do that by buying puts on the VIX, or by buying inverse volatility ETFs and ETNs like VelocityShares Daily Inverse VIX MT ETN (NYSEArca:ZIV), VelocityShares Daily Inverse VIX ST ETN (NYSEArca:XIV), and ProShares Short VIX Short-Term Futures (NYSEArca:SVXY).
Buying and selling volatility as a combined strategy – meaning buying volatility when you expect it to rise and selling it when you expect it to subside – is called a “reversion to the mean” trade.
The VIX generally trades in a fairly narrow range, so buying it when you expect it to go up and then betting it will revert to its “mean” or average trading range makes sense, and lots of hedge funds and big traders trade the VIX that way.
Last, but certainly not least, all the volatility we’re going to see in 2016 isn’t just going to impact stocks. Every asset class will experience extreme volatility in 2016.
We’re going to trade every asset class all year in my newsletter services because volatility is going to mean making money in 2016. And it will be the easiest it’s been in a long time.
Shah checked in with Varney & Co. this morning to offer some more context on his tweet yesterday that we could see a 1,000-point drop in the Dow if the index couldn’t sustain the bounce off 17,000 following Monday’s losses.
The drop could happen any day – and very quickly if market nervousness turns into market panic.
He also talks about why gold isn’t acting right, whether or gold is the safety net it used to be, whether or not he’d take a flier on gold or gold mining stocks, and where he’d rather put his money if the markets continue to decline.
If you want to thank someone for the year-end stock market rally, thank the junk bond market.
Just don’t fall in love with stocks as they’re rallying… because the help they’re getting from the junk bond market won’t last.
In fact, stocks will likely be headed back down in first quarter of 2016 when the junk bond market resumes its ugly selloff.
Here’s what’s going on with junk bonds, why stocks are rallying, and why momentary calm in the junk bond market will give way to a storm that’s going to take stocks back to their August 2015 lows… and possibly a lot lower.
And when that happens, we’ll be ready. Because I’ve got the perfect way to play it.
Let’s get started…
The Fall in Junk Bonds Sent Billions into Stocks
A brief rally took junk bond prices higher in early November, but when the brief rally in oil reversed, junk bonds fell too, hitting new lows in early December.
On December 9, 2015, the Third Avenue Focused Credit Fund, a mutual fund loaded with junk bonds, announced it was suspending investor redemptions and would be selling its portfolio and closing the fund.
That got the world’s attention focused on what was happening in the junk bond market.
The Third Avenue fund had invested in illiquid high-yielding bonds, and as the market for junk bonds hit the skids starting in June, the fund didn’t have enough liquid positions it could sell in the open market to meet investor redemption requests.
Third Avenue, a distressed bond-focused fund company that opened its doors in 1974 and was considered one of the best high-yield mutual bond fund managers in the business, ended up with a portfolio of bonds they couldn’t easily sell.
According to Moody’s, high-yield bond issuances total more than $1.8 trillion today, about double the $994 billion outstanding at the end of 2008. And Third Avenue couldn’t exit their positions in an orderly fashion in such a huge market.
Investors have been fleeing junk bonds in droves. The first week of December saw $3.8 billion exiting high-yield bond funds. According to Bank of America Merrill Lynch, that’s the biggest outflow in a week in the last 15 weeks. On top of that, more than $500 million exited leveraged bank-loan funds in the same week.
Most of the money exiting junk bonds has been flooding into money market funds. Bank of America Merrill Lynch recently reported $212 billion flowed into money market funds in the second half of 2015, with $48 billion coming in during the last four months and $27 billion of that coming out of bonds.
So, you can thank the selloff in bonds for the more than $31 billion that subsequently moved into stocks over that same period, which looks like it will continue through the last days of 2015.
That’s where the money’s coming from that’s fueling this late year-end stock market rally.
But then what?
A Junk-Bond Collapse Could Set Off a Financial Panic
In its December 15, 2015, report, the Treasury Department’s Office of Financial Research Director Richard Berner said, “We see elevated and rising credit risks in U.S. non-financial business and in emerging-market economies, the continued reach for yield in a climate of persistently low interest rates, and the uneven resilience of the financial system.”
The report points to “high levels of leverage” and while noting that credit remained resilient, except for issuers of junk bonds and the energy and commodities industries, “resilience could be short-lived as creditors reconsider their exposure to those markets.”
What’s most disconcerting in the report is its assertion that:
The combination of higher corporate leverage, slower global growth and inflation, a stronger dollar, and the plunge in commodity prices is pressuring corporate earnings and weakening the debt-service capacity of many U.S. and emerging market borrowers. A shock that significantly further impairs U.S. corporate or emerging market credit quality could potentially threaten U.S. financial stability.
In other words, a shock – like, say, a further plunge in high-yield bonds – could set off a financial panic.
Junk bonds are facing their first down year since 2008. Year to date, the highest-rated junk bonds are down more than 5%, while CCC-rated bonds are down 13% on the year.
With energy related junk bonds comprising more than 20% of U.S. domestic high-yield issuance, any further drop in oil prices will hit a large part of the total market hard.
As 2016 unfolds, most of the hedges put in place by oil and gas issuers will expire, exposing them to falling oil prices and further weakening their cash flow positions and ability to service their high interest debts. A precipitous drop in oil prices would likely trigger a rush out of energy-related junk bonds before most hedges expire by mid-summer.
A panic in the energy-related junk sector will force high-yield bond holders, especially mutual funds and ETF sponsors, to sell their more liquid positions, depressing them, as they attempt to cash up to meet expected redemption requests.
What happened to Third Avenue, in other words, could be a coming attraction for a horror movie we’re not prepared for.
How to Play the Coming Junk Bond Collapse
If high-yield bonds break in 2016, which is likely, the best way to make money is to short high-yield ETFs like the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca:HYG).
While it’s currently enjoying a quick bounce after reaching 52-week lows of $78.21, HYG could easily drop another 25% to test the lows it saw back in 2009, just above $60.
To be safe, an investor could short HYG anywhere around its present level and use a 10% stop-loss to cover their short if oil rises and junk bonds rally in relief.
More aggressive investors who want to bet that junk bonds will continue to get hit in 2016 might want to buy longer-term puts on HYG that expire after mid-summer, when most of the oil hedges energy-related companies have on expire, exposing them to big losses if oil prices stay below $35.
When junk bonds start slipping again, stock investors will panic over the fact that the year-end rally won’t have taken markets above any of the resistance levels they’ve struggled to break through in the second half of 2015.
And if credit conditions are deteriorating in the speculative end of the bond market, stock speculators will start taking their profits and go to the sidelines before the exit doors there get too crowded.
In addition to shorting the high-yield bond market, I’m also preparing my paid subscribers for that eventuality… which will be unfolding sooner than most investors realize.
Q: Will you please tell me what ETFs I can use when the markets go down?
~ Tony D.
A: When I’m bearish and want to bet stocks are headed lower, I generally like buying inverse ETFs based on the major market indexes.
ProShares Short Dow 30 (NYSEArca:DOG) for the Dow Jones Industrial Average, ProShares Short S&P 500 (NYSEArca:SH) to short the S&P 500, and ProShares Short QQQ (NYSEArca:PSQ) to bet the Nasdaq is headed lower.
If I’m extremely bearish, and I believe stocks are going to fall hard today or tomorrow, I’ll sometimes buy a leveraged short inverse ETF like the ProShares UltraPro Short S&P 500 (NYSEArca:SPXU). SPXU is a 3X-leveraged inverse ETF. That means if the S&P 500 goes down 1% today, SPXU would go up 3% today.
But leveraged ETFs are only meant as short-term trading vehicles. That’s why I said “if I believe stocks are going to fall hard today or tomorrow.” Because of the way leveraged ETFs are priced, they’re “re-set” every day – they’re not good long holds. In a perfect world, if you are right and you buy a leveraged inverse ETF and stocks go down right away, and they keep going down for multiple days in succession, you’ll be a very happy camper.
I’m not greedy. If I have a straight run for a few days holding an inverse leveraged ETF, I’d take my profits as soon as I think the selloff is over. I wouldn’t wait another day, I’d ring the register and be happy. If I own an unleveraged inverse ETF like DOG, SH, or PSQ, I’d probably use a 5%-10% stop to get out if the markets rallied. If you take small losses, you can get out and figure out where stocks are going and get back in if your timing was off but you think they’re going down again.
Q: What leveraged ETFs do you think are best when gold bottoms?
~ Mark J.
A: There are lots of leveraged gold ETFs. Here’s a good list to check out. Just remember what I said about holding any leveraged ETF, they’re very short-term trading vehicles.
Another way to “leverage” gold on the upside (betting bullion is going higher) is to buy miners. Mining stocks move up a lot faster than gold itself in an up-trending gold market.
Q: What are the best ETFs I can use when the euro goes down?
~ Sam P.
A: Don’t forget, you can’t just short one currency… all currencies are “priced” in terms of another currency. They always trade as a “pair.” If you think the euro is going down relative the U.S. dollar, you can actually sell short the CurrencyShares Euro ETF (NYSEArca:FXE). If you want a leveraged (2X) way to bet the euro is going down relative to the U.S. dollar, you can buy a popular inverse leveraged euro/dollar ETF, the ProShares UltraShort Euro (NYSEArca:EUO).
Q: Why not TVIX? It seemed to outshine everything in the last credit crisis.
~ Oscar S.
I’ve got nothing against VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca:TVIX), if you get into it and the move you expect, a dramatic drop in prices and a spike in volatility, happens right away.
Here’s the problem with TVIX.
It’s a leveraged ETF – so if you don’t get a sustained move down pretty soon after you buy it, and you sit with it a few weeks, or worse, a few months, it loses its value quickly. Bottom-line, it’s a leveraged ETF and great if you get the timing right, get in and get a sustained move in your direction.
Q: I´ve been buying VXX, and I´d like to know how you would split the amount you´d wish to invest between VXX and your present protection alternatives.
Also, what would be the most convenient EEM and DBB options prices to choose?
~ Henry R.
A: I’m not a huge fan of the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca:VXX) because it’s based on VIX futures. VXX is thought of as an ETF (which it isn’t, and I’ll get to that), so understand that as an “ETF” it has its own supply and demand dynamics and its own bid-ask spread dynamics. But it’s based on two sets of futures that have their own “valuation” dynamics based on rolling first- and second-month futures contracts.
Furthermore, VXX isn’t an ETF, it’s an ETN (which is a note, not a fund, meaning what you think of as an ETF is actually a derivative), which adds up to a lot of moving parts and is hard to arbitrage and “value” properly.
But if you’re going to use VXX, I’d suggest you add a one-quarter dose of it to whatever other protection you have on. Just keep in mind, if markets settle down and stocks flatten out and go sideways, the VIX and VXX will drop a lot quicker than non-leveraged inverse ETFs you might have on for protection. My favorite way to play a spike in volatility is to buy calls on the actual VIX.
When I’m playing options I generally like to buy options three to six months out. I always prefer further out options because it gives me more time, but you have to weigh the time against the higher price or premium you have to pay for them.
That’s why I look at three to six months out and incorporate how much volatility I expect over that three to six months. If I expect a spike in volatility sooner rather than later, I’d opt for the cheaper, near-term options. If I run out of time but I still think I’m right, I’ll roll into the next three-month out options.
In a perfect world, if you KNEW the move you expected was going to happen in a couple of weeks and last a week or two, you wouldn’t waste money buying further out options and pay for time you wouldn’t need. But it’s not a perfect world and I’m very often right, but I can get stung because my options expire and I hesitate rolling out to the next few months and get sick when the move I expected all of a sudden happens and I’m not in the trade.
Q: Why not just use a stop-loss/stop-limit order instead of just a stop-loss order? Set the stop-loss price at, say, $50.00 and the stop-limit price at, say, $48.50. If the price drop blows through $50.00, you don’t sell if goes below $48.50. My broker allows this. Doesn’t everybody set stop-loss orders this way?
~ Mike D.
A: That’s fine IF the stock doesn’t fall way below your limit. What if it drops to $45, or $40, or $30 and you’re not out? What if the stock doesn’t recover?
The problem with a limit is you may not get filled there and experience a greater loss because you’re not out. Then you have to deal with that additional pain, which is where a lot of people get into trouble.
Too often people lose more than they expected and figure they’ll hold on because the stock “has to bounce at some point” and it may not. Of course, it may bounce. But the problem is sitting on a losing position for a long, sometimes LONG time. Think about all the trades and money you could have made if you had that capital available.
Q: Shah, I’m close to retirement and most of my savings are in “401k land.” With everything that’s been happening, I’m ready to move to all gold and silver shares in my 401k. Am I wrong?
~ Susan S.
A: While I can’t give any personal advice here, I can say that we all will make a LOT more money in stocks than we ever will by buying just gold. Gold hasn’t done anything lately, so why put all your eggs in that kind of a basket? Gold isn’t what it used to be. Sure, it could have a nice move (but I’m not waiting for that to happen because I have no idea when or if that will ever happen) but so can a LOT of different stocks.
I’d never put all my eggs in one basket.
The bare, naked truth is that investment-wise, the best way to make money these days, and for the foreseeable future, is by being in the stock market. That doesn’t mean just buy and hold. That means hedge when you should (yes it may cost you, but so what, you pay for insurance that you don’t need until you really need it, don’t you?) and learn to play the market when it goes down.
If you aren’t that kind of investor, learn how to look at the market that way. Learn how to put on defensive positions using inverse ETFs, for example. By becoming more and more comfortable with increasingly volatile markets you can learn to make money on the way up and on the way down and “hedge” the positions you don’t sell and want to keep, hopefully because they are go-to, all-world companies that pay a really good dividend.
Q: Can a small investor utilize IEX at the present time?
~ George N.
A: No, not at this time. Your broker-dealer may be a member and it’s possible they could let you trade through IEX, but the way IEX is set up now (like a dark pool, but a fair one), I doubt a small investor would trade enough size for their broker-dealer (brokerage) firm to get them direct access.
I’m sure they’re working on it, because we should all have access to trade on a level playing field. I’ll call Brad and ask him what his plans are for helping “small investors” and follow up with you here.