Might I have been a tad too optimistic?

Some of my friends ask the above question. I would say yes and no. Yes in the sense that I may have interpreted what the central banks with eventually do to be what they will do the next few months. Even the central banks may eventually go full force to unlimited QE, maybe with an inflation target, like I have argued since at least 2010, it may take quite a while during which their resolves will be seriously tested. No in the sense that I never think the risk on and off period is over and I would hold my current position for a long long time (I could for most of the trades, but that is not without suffering a lot volatility in between).

For example, is it possible that long term T bond could rise sharply in price? Yes of course. Any of the risk events that I mentioned in the last email, and many I was not able to mention, will leave to that, and that could happen in the next few months. So be flexible in your philosophy or religion of investing and be prepared for more risk on and offs.

The first milestones in turning the tide around; still underappreciated by markets

The actions of ECB and the Fed cannot be underestimated. They are the first milestones in turning the tide around to help the global economy fight out of the Great Recession.  They effectively guarantee that deflation will not happen. More central banks, like Bank of England and Japan, will follow the steps. This is exactly what I have predicted when I said to turn around the bearish trade on June 15

 (http://xlpartners.blogspot.hk/2012/06/like-always-if-all-central-banks-are.html).

I hope you have paid attention and have not completely missed the rally.

By now, markets are still not fully appreciating the significance of these actions. So I have been out of the pair trading of buy S&P and shorting China related EMs a couple of weeks ago. I have gained max exposure to US small and mid caps, gold producers, Brazil, Spain, Thailand (hope no flood this year), and Norway. Even for S&P, there could be another 10-15% ahead to the end of year. I am also short long term T-bonds.

The ECB actions are implicitly supported by Merkel. Even though opposed by German voters, Merkel is likely to throw the implicit support to ECB before her reelection. To get reelected, ECB is the only institution that would provide enough firepower to prevent the collapse of the Eurozone, and German economy. After her likely reelection, I have hopes that she will be more explicitly supporting ECB. The negative news that would happen in the next few months will be the classical ones when one only relies on monetary stimulus but not fiscal ones. The peripheral economies could deteriorate further, and Greece probably will leave Eurozone next year.

The Fed actions are significant in the open-end nature of QE3, though if you track by blog, you would know that I still think it should come much earlier and in much bigger magnitude. By August 2010, I have argued for even more drastic actions

 (http://xlpartners.blogspot.hk/2010/08/future-intellectuality-of-stimulus.html).

Now we finally have some form of what I advocate, I would get out of long term T-bonds unless for some protections against events such as Greece leaving Eurozone. We are much less likely to have as dramatic risk on and risk off cycles from now on.

Is the coast all clear? Not really. Only having monetary stimulus is like fighting the battle with one hand. ECB in particular will need fiscal backstop of Germany badly to expand its bond purchases substantially. We may still have limited growth even though central banks have guaranteed that deflation will not happen. Further, Greek departure from Eurozone could still bring a lot of disruptions. U.S. fiscal cliff early next year could be highly disruptive even though its impact may have been exaggerated a bit. Maniacs (at least in rhetoric, and may be adopted to cater to their conservative base) like Romney and Ryan could still be elected (if they do, and if they implement policies they advocate so far, e.g., moving even slightly toward gold standard, it would be great time to leverage long term T-bond exposure and short equity big time).

Whatever will happen to the rest of the world, China, and the countries with big exposure to its growth model, will keep slowing down substantially from next year and on. Their equity markets will keep lagging or dropping until all the investors slowly come to terms of this fact. I expect the shorts to be set up late in the first quarter of 2013.

Some more legs for the markets

Have been quiet for a while. Partly very busy, partly due to the uncertain nature of the Fed QE. Having said that global central banks will start QE soon on July 27, which is positive news for the markets, it is very uncertain what they will do specifically. It is a good surprise that ECB has done QE in the form of vaguely defined unlimited bond buy for short term bonds of peripheral countries, which naturally boost up the markets. However, what ECB can eventually do will depend on their testing of boundaries under the resistance from Germany. Today’s employment news for the U.S. should substantially increase the likelihood of the Fed for further QE in September, which is likely the last chance that the Fed would do QE before the election. So there are probably more legs for the markets, even though the good news should have been fully prices; the markets always overshoot.

Why the markets did not tank today?

Some of my friends are asking this question. First, the Fed did build up even greater expectation that they will likely intervene soon. September will be the likely date; otherwise any later day would make Republicans blame Bernanke, who is a Republican, for helping Obama. This effect will hold the market for the next month so as not to completely fall out of bottom. Second, Draghi has built up high expectations of ECB intervention and has had some effect. They are expected to clarify tomorrow, but I am sure it will be some boilerplate stuff again when push comes to shovel.

Headless chicken to the short term bounce

As I have been telling friends over the last month, the markets will be more or less like headless chicken before the Fed meeting at the end of this month. I still think the Fed will likely do QE3, at this coming meeting or the next one, given how weak the US economic numbers are. The only problem is that the numbers are not bad to provide a complete political cover for QE3 yet. I would still suggest an increased exposure to risky assets before the Fed decision next week. However, the rally probably won’t last that long. It would be a good time to buy more LT T bond and set up shorts of equities sometime in the next few months.

Having finished a 7 stop 22 day trip to China, I realize that China’s current economic situation is much direr than the government headline GDP numbers or housing prices would tell you. There is still room for infrastructure; for example, most cities need subways, and a lot of them, and high speed rail could still expand in some segments so that the speed is really all high speed (i.e., 200 miles / hour). But the speed and amount of investment probably won’t create much growth from the already humongous investment level. We should have a little bounce (but not that strong, and certainly much weaker than 2009 bounce, as I predicted at the start of this year) in the second half. But the situation will likely to be worse next year and much worse the year after in terms of headline GDP numbers. China’s housing prices, stock prices, and many asset prices will be sharply lower in the next decade.