Trading positions

I ll start today providing macro trades that fits within the investing process developed in perspective with the conceptual approach described below. This is a global macro trading oriented strategy. While I have long term thematic positions, I trade around to increase the sharp ratio of each trades. Trading for risk management is 100% price action oriented.
I ll provide at each month end the gross performance of the portfolio with NAV at 100 at of today.

Few characteristics of the portfolio : Portfolio annual net target return 20% - net monthly maximum drawdown : 3%. Adding risk back to full 100% only after recovering losses.

As of March 21st. Open positions (in % of nominal capital) - I ll provide cash market level instead of futures for you to follow levels more easily. For reasoning behind the below trades, pls contact me and I ll provide you the full multidimensional explanation

NEW POSITION
Long 25% Italian MIB (via futures STM3 Index) :
opened at cash index level 15850 today. Sell stop at 15500 (trailing ATR adjusted) Target 17000
NAV at risk : 0.6%
Trade profile : 2.2% risk vs potential gain : 7.2%
Trade duration expectation < 2 months

Short 10% EURCAD - trade could have been implemented via option to lower portfolio VAR
opened today at cash level of 1.325. Buy stop at 1.343 (trailing ATR adj) Target 1.26
NAV at risk 0.18%
Trade profile 1.8% loss vs 4.4% potential gain
Trade duration expectation > 3 months

Short 10% KRWUSD
opened on the 19th of March at 1110.9. Buy stop at 1095 (trailing ATR adjusted) Target 1200
NAV at risk : 0.12%
Trade profile : 1.2% loss vs 6.5% potential gain
Trade duration expectation : 3-4 months

Short 10% EURUSD
opened on the 19th at 1.2938. buy stop at 1.318 (trailing ATR adjusted) Target 1.26
NAV at risk : 0.18%
Trade profile 1.75% risk vs 2.5% potential gain
Potential "value added" as negative correlation with other trades in portfolio


BOOKING PART OF EXISTING POSITION
Long 40% Nikkei via futures (NKM3 Index) - Core long
opened at 12200 on the 19th of March. Sell stop 12050 for 50% position and 11850 for balance. Target 16000
NAV at risk at full position (40% of NAV) : 0.95%
Trade profile : 2.4% risk for 30% gain
Trade duration expectation : 8-12 months
TODAY: booking of 50% position for a 3.3% net gain of 20% of NAV (0.66%)

End of day position : 25% Long MIB, 10% short KRWUSD, 20% long NKY, 10% short EURUSD and 10% short EURCAD
Portfolio NAV at risk : 1.65%

What (I think) drives market moves - or a small conceptual piece on investor s psychology.

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Price is reality; price is the most objective data investors see, price is what influences the most market participants.

I believe there are three key factors behind market price evolution that are structurally inter-linked:

1. Marginal change in macro data (namely economic activity and financial conditions) in perspective with a specific macro context

2. “Market resonance” or echo

3. Price Inertia.

A. Change in macro data

Change in macroeconomic data is a consequence of change in the business cycle and aggregate demand which ultimately impact companies earnings, commodities prices etc..

Macro data are often considered by “fundamental investors “ as useless as their release is most of the time disconnected from market movements.  This is probably because data that matters evolve with the macro and price action context. I believe that investors need to define first what type of macro data is important in a specific macro context. Which means that investors need to define what is the main “macro risk” for the market. For example, in a low growth / low rate environment, change in economic growth expectation will impact more market sentiment than change in financial conditions expectation (lower rates for ex). In a high growth environment, change in financial conditions will be more important. Currently in the US, as economic growth is growing at a relatively stable pace (upside surprise unlikely), I believe that change in financial conditions will be the key data to look at.

Moreover, the market needs to be in a position to “listen” to the marginal change – i.e the market consensus (price action) needs to be positioned to either continue a trend or reverse it – for ex, now in the US, unless there is a massive positive change in financial conditions (probably fiscal at this stage), each market correction will attract buyers at these levels of economic growth.

B. “Market resonance”

I believe that the market needs to be in the “mood”, the “right context” to listen to the new additional data; Let’s use an example to be clearer: let s imagine we are friend, and I know very well the type of music you like, we actually share the same tastes for music. Now let’s say I m in my car, the weather is grey, it is the autumn and someone just announced me over the phone that my old dog, loyal guardian of my countryside house, died. As a result I feel sad - then great blues music is played by the radio and I feel a specific emotion listening to it. I like it so much that I m using Shazam to download it. Back home, you visit me, you just come back from a tennis match that you won against a challenging opponent and you had the chance to play during the only sunshine moment of the day. You are clearly very happy. I would like to share with you my latest music find and put it on my huge HI-FI, absolutely certain that you will love it as well. But... you laugh at me! You tell me that this is music for looser... Why is that? 

Well this is because when I listened to the music I was in the "mood" to like it, I was pre-conditioned to like it. Whereas, my friend was absolutely not in the same emotional conditions.

I believe we can apply the same process to market behaviour - in a low inflation environment and low rates environment AND more importantly after a significant downtrend that is fading, the market will resonate quite positively with "any" type of positive macro news that concern economic activity: even a pause in the bad macro news momentum will trigger a market reversal - or at least, we can say that the probabilities are at their highest to trigger a market reversal. So the context is both coming from the macro environment but most importantly coming from the market price trends.

C. Then prices inertia kicks in: as prices rise despite the still bleak economic pictures, pundits yelling on CNBC that the end of the world is coming, market participant will start to try to rationalize the upward move. They will overtime, become biased by the price movement – looking at macro data in another way - and position themselves accordingly which will force more market participants to do the same, which will ultimately create a new up trend. Now, the uptrend will not last long if the next marginal change in macro data is large and on the other side.

In the absence of news, or in a long range trading market the probability of success are lower for directional macro trades and investors need to wait for the market to move in one direction to take positions/increase their exposures. In such a context, investors can get help from the level of the macro context – where the market might tend to go down to attract buyers at a lower level as macro did not change and price offer a cheap buy opportunity for market participant.

There is NO need to go against the market; there are ALWAYS opportunities with high probability of success.  We just need some patience and not forget to stay objective.

Why the European Monetary Union is structurally flawed

 I wanted to start this blog with a short note on Europe. I too often read in financial and general media different explanations on why "Europe is great" or "why Greece or Portugal has to exit" etc…. To my opinion all these views miss the big picture. To better understand the issue, one needs to understand the roots of the current recession, its nature and more importantly the difference between a modern fiat monetary system such as the US and a fixed-exchanged rate system (or countries financing themselves in a foreign currency) such as the EMU.

The developed world is experiencing a very specific and rare type of recession: a balance sheet recession. The Japan has been going through such a recession since the collapse of the real estate bubble in the early 90s. A balance sheet recession is created when the private sector is bearing excessive level of debt and starts saving to pay down debt, usually following an economic shock triggering waves of defaults. As a result, aggregate demand decreases sharply as the private sector save instead of spending and if the government does not offset the loss of spending from the private sector – i. increase the public deficit - the economy shrinks for years and can even fall into a deflation spiral (like in Japan in the 90s). The economy will not exit recession until the private sector desires to save is satiated (usually last several years). Current austerity measures aiming at reducing deficits in Europe are ill-timed and illustrate perfectly the reduced flexibility – by design - of the EMU.

During the 60-80s the G7 economies where roaring. The focus of economists shifted from full employment (Keynes in the 30s) to controlling inflation exclusively with monetary policies (Friedman). Fiscal policies where forgotten to the benefit of monetary policies that became the new paradigm. Theories such as NAIRU, advocated that an unemployment buffer is necessary to control inflation… Politicians (Clinton for ex), helped by strong economic backdrop focused on running budget surplus to follow their ideological views. Ultimately it pushed the private sector into debt. A fiscal surplus means that the government is spending less than it is taxing and as a result puts a drag on aggregate demand limiting the ability of the economy to grow. As the US private sector financial balance was low, for income to be stable, the private domestic sector had to spend more than they earned. Remember the basic equivalence:  (S-I)+(X-M) = (G-T) where (S-I) private sector financial balance (spending-saving) + (X-M) net export = government balance (spending-tax). If the external sector is flat like in most EU countries and the private sector is spending less than it saves, the government has to spend the”spending gap” to keep the GDP stable.

Moreover, in the late 90s neo-liberalism pushed politicians to deregulate the financial sector with the idea that the market will self regulated itself. The financial sector had the liberty to invent and distribute whatever product they wanted and to invest in all sorts of products without close scrutiny of their balance sheet exposures. The private sector looking to keep their income stable bought into debt-structured products to compensate the loss in government spending while banks where leveraging themselves like never before. This created the roots for the next decade’s debt driven recession.

The wide adoption of neo-liberal economic theories and misunderstanding of the mechanism of a modern fiat monetary system lead the consensus to continue to believe that a government is like a household: its debt must be managed in order not to be “over indebted”. This absurd myth is also probably a heritage of the “gold standard”monetary system where the issuance of money was controlled by the amount of gold held by the Central Bank.

To debunk this myth, we have to discern between two types of monetary systems:

1. Fixed-exchange rates countries or countries that have debt issued in foreign currency, does not have “real” full monetary and fiscal sovereignty.  Their peg or their obligation in foreign currencies limits the amount of money they can spend (otherwise their funding will be cut or currency devaluated). This is the case of Europe where member countries effectively finance themselves in a “foreign currency “! Indeed, the ECB is managing the interest rate focusing on inflation and does not have any fiscal role - moreover, EMU members does not have any fiscal (nor monetary obviously) flexibility as they have to respect the treaty limits of debt/gdp, inflation etc.. Which means that even if EMU members have different business cycle or different private sector financial balances they have to live with the same monetary and fiscal (non-existent) policy!

2. Modern fiat currency systems:  governments can never run out of money, do not need to finance themselves as they have the monopole of money issuance. This is the case in Japan for example. While much criticized by economics observers in the 90s ( “the lost decade”) Japan Gov actually understood the power of fiat money system and used it to fight against their balance sheet recession – that is why they have 230% debt/gdp ratio (and no inflation). Should they have followed an European route for example, their economy would be in a much worse state. Despite the huge fiscal and monetary stimulus they are barely out of recession (stimulus amounts where not enough to offset the spending gap). The US or UK are also perfect examples of modern fiat monetary system. Debates about public debt are made to limit public fear of high government debt which is ideologically linked to additional tax burden in the future that leads household to spend less. In reality, the US or UK debt does not exist per se – debt issuance is a system created to regulate the short term rates via the management of commercial bank reserves – I ll come back in details on this points in later blogs.

Think about it minute, if the government does not spend, how would we spend money to create a company, buy a car etc..? This is because the government “raise debt” that we are able to spend. Spending create income, that create output that create employment. In a modern fiat currency system, the government (and the central bank) role is to control the flow of money in the economy and optimize it in function of aggregated demand and output to create the maximum employment/growth while limiting inflation.

Obviously there is a limit to the amount of money that can be spent by the government in order not to create inflation. Inflation arises when the aggregate demand outpaces available output. In developed economies operating well below potential level of output (with 11% (France) or 25% (Spain) unemployment rate) how can politics fear inflation?? (keeping limit at 2.5% at Maastricht arbitrary level).

In Europe, as government spending is expected to shrink (!), the external sector is the only option to revive growth – as it was the case for Latin American countries in the 90s that were borrowing money to the IMF…But this is actually worse in EU than it was for these emerging countries at that time because the EMU countries cannot improve their international competitiveness by exchange rate depreciation and as a result they have to engage in “internal devaluation” to improve their international competitiveness, which means they have to cut real unit labor costs. In a nutshell, the EMU system is in a worst position than for example Argentina in 2001…

So, I hope you understand by now the powerful economic (and social) tools of a modern fiat monetary system and the fact that the EMU - by structure and treaty - does not have them. This weak and obsolete structure coupled with the general misunderstanding of modern monetary system and different political agenda is driving the EMU into economical abysses. Without EU governments increasing aggressively deficits for years via fiscal stimulus to support the economy while the private sector fixes its balance sheet – there will not be any economic recovery and deflation specter will continue to hang around.

Apart from an obvious break up of the EMU, what are the solutions?  The creation of a fully federal system (with money transfer) would be the ultimate solution for the construction of a more modern fiat monetary system. But with large and growing difference in economic growth and structure such a system would need significant time and resources. Eurobonds would be a good first step, as they would represent a “joint-increase” in government deficit to create growth (a sort of EU New Deal). A simple short-term fix option would be the ECB saying “ we guarantee all EMU sovereign bonds” – it would reduce significantly borrowing rates for EMU members and provides with time to think about the future while limiting or canceling austerity measures. The ECB will be forced at one point to use - at least in a statement - the unlimited financial surface provided by its money printing ability.

In the short term, social unrest will continue to develop until the economic and social deterioration will be such that it will force EU political elite to propose reduction in austerity measures (like recently in Spain, Italy, Greece and most recently with the election of France). Germany's economic performance is to be followed closely if one wants to anticipate Merkel's move to join the “growth coalition”. It will probably be the first step toward a “conjectural pause” in this structural crisis.