The Trader's Edge

Recently two of the most prominent hedge fund managers of our time closed up shop. Stanley Druckenmiller and Paolo Pellegrini decided to call it quits. Both were not having good years after long periods of market out performance.

In trying to understand why it is my belief that they had lost their "edge". That is not to imply that they are not excellent at what they do but it appears to me that over the past few years the rules of the game have changed. With the advent of quant funds that use super computers to execute trades at lightning speed there has been a massive spike in the volume of trades on all markets while the market capitalization of the S&P 500 has remained relatively flat for the same period (I looked at the last 10 years).

These funds have taken control of the markets and are running rampant at the expense of the "old school" investors. This is why there are days when ever hourly tick is a measured move higher with no draw downs. Only trades placed by computers with no rational thinking would continue to buy as prices increase only to offload all at once, as in the flash crash, when certain trigger points are hit.

The regulators have turned a blind eye to these trades as they make up the bulk of the stock exchange revenues, but it is my view that this is delaying another bad ending. Rather than being proactive and fixing the problem now the regulators are waiting until their gravy train is gone before supposedly helping the general public (after the public's portfolios have been decimated).

So what to do? Either you can close up shop as the managers above did or you can adapt to the "new" market order. As there has recently been a huge exodus from these funds mainly because the "safety" that they offered proved to be fleeting it is my opinion that the market is now on the verge of a very violent push lower. To take advantage of this, buy deep out of the money puts for ten to fifteen cents each and capture a huge windfall if my theories prove correct. If I am wrong you have only risked a small portion of your capital. While you wait for the market to implode read the book "The Black Swan" by Nassim Taleb.

The Dichotomy of the Market

It appears that there are two markets. There is the market for the high flier stocks such as Salesforce.com (ticker CRM) with a price to earnings ratio of 195. Then there is the market for small cap stocks like SinoHub (ticker SIHI) trading at a price to earnings ratio of 3.

Now it appears obvious to me that you should buy the cheap stock and short (or sell) the expensive stock (which I have done). Certainly there is more to fundamental analysis than this high level approach, but for the purposes of this blog I want to keep it simple to make a point.

The market however continues to support the price of the high fliers while continuing to sell the cheaper stocks. I expect that this trend will reverse itself at some point and this will be a signal that the momentum has shifted and that growth stocks are out of favor.

The key point here is that growth stocks normally fair well during a bull market if that bull market is occurring on the back of a solid economic base while value plays normally hold up far better during a bear market. As it is my view that due to weak economic fundamentals we are still in a secular bear market. Furthermore I expect that the lows of March 2009 will not hold and therefore I would advise you to exit any of your high fliers and, if you need to replace these with new stocks, look for value plays.

Racheting Down Growth Forecasts

Today JP Morgan became the latest casualty of forecasters when they racheted down their predictions of US economic growth for the second time this year. The numbers were huge. They reduced GDP growth for the third quarter down to 1.5% from 2.5% and for the fourth quarter down to 2.0% from 3.0%. For those of you not too up on mathematics that equates to a 40% reduction in growth for the third quarter and a 33% reduction in growth for the fourth quarter.

Furthermore they increased their expectation of the unemployment level to 10%. Previously they had estimated that unemployment levels would drop to 9.6%. The reality of the weak underlying economy is starting to show up these overly optimistic forecasts and I expect that this will start to be reflected in the stock market.

Already today the market is off more than 1.5% and I expect that this is just the start of a very long drawn out demise in the value of all stocks.

The Chinese Are Coming

This week there was a very important event that the press and most analysts seem to have completely missed. The Chinese have begun to issue international bonds denominated in yuan. This is an incredibly important step towards becoming a player in the global financial markets.

At present the markets are controlled by the major exchanges in Europe, Japan and the United States. The dollar is the reserve currency of the world and because of this status the United States has the ability to print money in an uncontrolled fashion and get away with it. This is all about to change.

In order for the Chinese to establish a credible currency that could one day challenge the dominance of the dollar they need to have a large float of the currency. The first step towards this is to open their markets to international investors by selling bonds to foreigners. Creating the first bonds this week is a step in that direction.

While it will take time to supplant the dollar, the Chinese have shown their intent and dislike of being controlled by fluctuations in United States policies. Now I am not suggesting that the yuan takes the place of the dollar outright but I do believe that in the not too distant future the dollar will be replaced as the currency of choice in certain parts of the world and that accepting yuan, euros or dollars will be just as acceptable as the dollar is today.

Once that happens, the United States will lose its ability to print money recklessly and will need to become far more austere in order to keep its place in the global hierarchy. When this happens the pain of repayment will be upon us. Let us hope that our leaders can preempt this and begin to implement the measures that we require today - but I doubt it.

QE2

Now this is not the ship we are talking about, it is the next round of Federal Reserve quantitative easing. As round one has officially not worked, they are extending their holdings of treasuries and other securities. Effectively this is the second round of quantitative easing.

Currently the market is rejoicing but I feel that this will be short lived. Investors need to realize that if the $1.75 trillion did not work in round one, there is no reason to believe that it will work in round two. Once the market realizes this the rubber will meet the road and it is my expectation that this will end badly.

You do not repair a debt problem with more debt and you do not create more jobs by burning the dollar. This will result in inflation and the Fed will have no-where to go. It is officially over (although the market may rejoice) and beginning later this month or early September I would be short the market and long gold.