Wednesday, April 21, 2010

The Pain Trade

A trading buddy and I frequently talk about the markets, and as always, the conversation turns to the "hardest trade". The "hardest trade" is that trade that has the potential to inflict a lot of pain, but ultimately in the end, it is the right trade. The pain trade is the hardest trade and the trade that yields the best results.


My trading buddy believes the pain trade is to go long equities right now. His rationale for this being the pain trade (but right trade) is that everyone is expecting equities to rollover. After all, equities are overbought, overvalued, and over subscribed too. So, if everyone is all in but has their finger on the eject button, then the pain trade must be to go long equities as no one really believes equities can go higher. The argument has merit especially since very little has derailed the rally. So far my trading buddy is right.

From my perspective, the pain trade has been and continues to be short equities. The ARL Advisers real time portfolio has been short the S&P500 for almost 7 weeks now. This trade has been painful especially since it has been nothing but downhill. The only "hope" this trade has had is the 1 day Goldman induced sell off. Other than that it has been "fugly" for the shorts. This is the pain trade because I am living it. And the that's all that matters.

But more specifically, I never look at betting with the consensus as the pain trade. Why? Because if you bet with the consensus and lose, you are just like everyone else. Your performance is no different than the market's and everyone else's. On the other hand, if you bet against the consensus and lose, you lose 2 fold as the market is going positive while your portfolio is going negative. You are left out of the party standing at the window watching everyone else have fun. Ouch!

So I still believe in this trade for the following reasons:

1) the market is overbought and while overbought can get more overbought, I believe the market has gone through that phase already; in other words, this trade has already incurred the worst draw down it is going to suffer.

2) investor sentiment remains extremely bullish indicating that "everyone" is all in; while extremes in bullish sentiment have worked poorly in predicting turning points over the past year, I still don't believe fear and greed have disappeared from the markets; while the current price move has been strong, it still remains within the extremes of prior moves; see "Is It Time To Short the S&P500?"

3) trends in gold, treasury yields, and crude oil are strong and this is a headwind for equities.

4) this is a low volume rally.

5) the current rally has a "mentality" that there is a rush to buy; a market that doesn't correct or sell off is not a healthy market.

In summary, the pain trade is the non-consensus trade. At this point in time, it is my contention that this really is the best trade. For me and my portfolio, it has been the pain trade. I have experienced it for the last 7 weeks. From this perspective, the factors for betting against the market remain in place, and the fact that the market has moved higher over the past 7 weeks despite these dynamics makes the short side even more compelling at this time.

In the ARL Advisers' Real Time Portfolio, I am long the Ultra Short S&P500 ProShares (symbol: SDS), and this is a 2x ETF that bets against the S&P500.

9 comments:

D-man said...

Hi

Precisely on this point

"4) this is a low volume rally."

I read here and there that no lasting top (even intermediary) is forming on low volume; at the end of the moves (down or up) the volume intensifies; so here we have no volume, hence no top. I tend to agree with this as it is supported by data!

On this point

"5) ... a market that doesn't correct or sell off is not a healthy market."

You need proof from the data to state this; the idea here is not if the market is healthy or not (how do you define a healthy market? by what metrics? a one which is selling off is healthy? why?) must be supported with data. I read here and there that the buying is broad and the breath of the market is very healthy.

On market strength
http://www.tradersnarrative.com/sp-500-cumulative-advance-decline-at-new-high-3924.html

http://www.tradersnarrative.com/market-breadth-leads-the-market-higher-3841.html

Opinions?

I'm long various stocks and short indices; I've been in this posture since summer of 2009, readjusting my portofolio which is still positive despite the strong advance in indices. But I tend to go with your buddy; everyone seems to hate this rally; whether or not being long is the most painful, I don't know :)

D-man said...

I lost my idea here

"You need proof from the data to state this; the idea here is not if the market is healthy or not" but whether your position is a winning position; as your metrics suggest "warning" but prices goes against you for so long, isn't that there is a problem with the metric?

Just a thought...

Anonymous said...

Always enjoy your observations Guy and yes I feel your pain. No one thought the market would ever stop going down a year ago but funny how changing a few bank accounting rules can alter perceptions (and trends). I have a sneaking suspicion this Goldman thing could be a similar game changer in reverse, regardless of its legal merits.

Guy M. Lerner said...

D-man

I appreciate the feedback as always...

I should have used the word anecdotal observation would suggest that low volume rallies are not good and this rush to buy is bad....

Very perceptive on your part that my metric suggests warning; this is very true; the mistake I made in pulling the plug early on equities and going short was attempting to anticipate the price confirmation that never came....price has gotten further and further from that point but it isn't too extreme and because from a portfolio perspective, I sized my position well, I am not too bad off.

With regards to market breadth I generally have several issues with such: 1) the cumulative a-d line depends upon where you start; 2) utilizing advancers/ decliners is not a great metric because an advancer by 1 penny is the same as an advancer by 1 dollar; 3) new highs are diverging - so what does that mean; 4) cumulative volume is diverging - what does that mean? 5) breadth is only confirmatory and it is mixed here; 6) you don't need breadth when price will do the same thing

You can look at breadth all you want but if you do so then you are saying you would have sat on the sidelines for much of the bull run from 1998 to 2000 because large cap, SP500 breadth was poor....you cannot have it both ways

In the end: pick your time frame; pick your entry and exits; don't stray too far from the data; try your best to be datacentric

Anonymous said...

The market can remain irrational far longer than you can remain solvent.

I like your point about contrarian investing - how, when you're wrong, you get punished twice as bad.

Anonymous said...

Well, I don't see a buy until 29.90 or above the last high of 30.16 with a stop at 28.70. 4% risk for what looks to be a 5% gain before this market finishes a correction and continues up. I think shorting the 10 & 30 yr would be more productive.

Anonymous said...

Rule #1 is never short a bull market. Semantics aside, a market that keeps climbing with 20 day above 50 day and 200 day moving averages is in bull mode. The reality is that shorting hard enough, especially in the above conditions, because your timing has to be right on the button. If you're uncomfortable with the market, better for most to go to cash or use shorts to hedge long positions only.

Guy M. Lerner said...

Last Anon:

I would disagree with your rule #1; many bull markets (i.e., gold in the last couple of years) have had pullbacks on the order of 20 to 30%.

The flip side to your point: are you willing to sit through a 15% draw down on your equity to find out if a pullback is just that or something more ominous?

Lastly, I suspect that a strategy that buys a market when the 20, 50 and 200 day MA are in "bull mode" and sells that market when those averages turn down would severely underperform.

Ray said...

I attempt to keep my philosophy simple. Buy good value and stocks that are under accumulation showing positive volume and price patterns.

As much as being a contrarian is theoretically promising it also carries with it the greatest risk profile.

Identifying trends early and following them makes the most amount of money for the average trader.

If you have hedge fund deep pockets then a contrarian approach to a top or bottom can resemble building a position slowly over time.

Every time I have let a bias without basis cloud my judgement I have lost money.

Frankly I prefer letting the market tell me where I should be. I have spent 30 years or so learning to read charts and their nuances. If I take the time to read them and head their signals they will tell me everything I need to know, entry and exits points along with investor interest as seen in volume.