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Markets
Monday
Nov072016

The US Presidential Election Is Not A Brexit Moment

There have been a number of comparisons drawn from the event risk around the upcoming US presidential election and the Brexit referendum earlier this year. There are a number of similarities, most notably in the market reaction to changing poll numbers prior to the vote, but also a significant number of crucial differences which make trading strategies around the US election different from those around Brexit. 

 

Trump Victory Triggers Risk Off 

The reactions of financial markets to polls that suggest an increased probability of a Trump victory have seen traditional “Risk Off” moves; sell stocks, buy bonds, higher implied volatility, buy gold. We are not going to discuss if these moves are reasonable, the pattern has been consistent and therefore it is reasonable to presume that in the short term this is highly likely to be the reaction we will see on Election Day as the results trickle in. 

This is similar to the reaction caused by increased probabilities of a “Leave” vote into Brexit, with risk assets also under pressure. As the votes came in with a significant bias towards “Leave”, risk assets were heavily sold, and this increased as the result became clearer. To put the move into context, interest rate futures began to price in a chance of a cut from the FOMC, when just days before there were calls for a hike at the next meeting. 

Black Swan Event

We have been asked a number of times, “How can we prepare and protect against a Black Swan event like a Trump victory?” It is not a Black Swan event. A Black Swan cannot be predicted. The very fact that one is discussing how to deal with a Trump victory means it is not a Black Swan. 

It is not even a “tail risk”. A tail risk is the risk of a very unlikely event according to a probability distribution. For example, the stock market moving 10% in a single trading session, since most observations have movements lower than 10%.

 

 

However, we are discussing an election with two parties in a race that’s perhaps 65-35. That is hardly a tail risk. The chance of some outlandish extreme policies from the candidates once they take office is perhaps a tail event, but this is at a minimum many months away. So this is not a tail event, and certainly not a Black Swan. Rather it is merely a period of volatility in markets that needs to be treated with the appropriate level of respect, but not undue scaremongering with respect to the consequences.

Reduced Consequences

A major difference in the dynamics of Brexit compared with the election is the potential consequences. This week we could see a change of government in the USA. Brexit was a complete change in how the UK would be governed for years to come. It signalled the exit of a major country from one of the largest political and economic unions ever seen. Most importantly, the process after the vote around how this would occur was (and perhaps still is) largely unknown. More than anything markets fear uncertainty.

Whilst there may be uncertainty around what the future may hold for the US if either Clinton or Trump wins, this uncertainty pales in comparison to the questions being asked in the Brexit aftermath. This arguably reduces the potential downside scenario and at the margin leaves us more inclined to “buy risk” on the dip.

Tougher Numbers

Whilst the “Leave” campaign only required >50% of the vote to trigger Brexit, the hurdle is much larger in the US. Even if Trump takes the “must win” states such as Florida and North Carolina, mathematically the Republicans still need to turn a Democrat state red in order to realistically be in with a chance of victory. Some polls have put the candidates very close to 50-50, but there is so much more at work than simply the popular vote.

Most predictions have something like a 35% chance of a Trump victory. This may appear low but is close enough to have the market jittery. The average margin of error is enough to make the result to close for comfort, as seen in the price action in equities this last week.

How To Trade On The Day

In our view the market will get increasingly concerned if Trump wins Florida and North Carolina. At the margin he is expected to win these states, but a Clinton victory in either effectively sinks his chances completely. Therefore the market will likely become concerned as the election is kept live. 

If there is a traditional risk off move on these results then we would fade it. A combination of the following would be our vehicles; Selling gold above $1350, buying the S&P 500 below 2050, or short selling VIX above 25 (VIX December futures above 22). 

 The right trade post Brexit was to fade the move, therefore even if a Trump victory does follow, the move is likely to reverse as markets realise the consequences are not as dire as they initially feared.

Conclusion

With respect to the prior bias of skews around the election, as well as other factors, we have been running small short positions on the S&P 500 and long positions in gold. These have performed well, however the next opportunity is to fade any risk off move this week, particularly intraday as the results come in. We are looking at entering short equity volatility trades prior to the election should volatility spike. The trade has merits on a standalone basis as well as complementing our current positions. For more information on the trades we are making please susbcribe via either of the buttons below. It is important to remember that despite the wave of media coverage and sensationalism, there are more factors at play for markets than this election. The FOMC and ECB meetings next month will likely be far more critical for markets than this week’s events, which as we hope to have demonstrated above, are not in the same ball park as Brexit or even tail risks, and certainly not Black Swans.

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Thursday
Feb182016

What is the Best Trade on the Gold Mining Sector?

Gold prices soared last week when market pricing went to extremes, with bond prices indicating that there was next to no chance of a rate hike in the next twelve months. We have covered the cause of this irregular pricing, which was the stopping out of 2016 consensus macro trades, in a previous article, so we will not repeat ourselves here. For the purpose of this analysis it suffices to say that gold prices were heavily overbought when they challenged $1250 and that the currently high levels are unsustainable.

As gold spiked to one year highs the precious metals mining sector followed suit and tore ahead. The HUI increased more than 60% in value from its January lows to triple the performance of gold. With this strength many have been calling to load up on precious metals miners while they are "cheap".

However, we are not so hasty to jump on the band wagon due to the historic underperformance of the gold mining sector and the underlying fundamentals for gold, which remain bearish over the long term. Therefore in this article we analyse the risk reward dynamics involved with the precious metals mining sector.

The mining sector faces increasing costs

The significant decline in oil prices have led some to believe that the costs of production for mining companies will also fall. While energy costs are likely to be lower, these are far from the only cost facing mining companies. One of the most significant and threatening to the mining industry is the increase in debt costs.

In 2013 Hecla Mining raised capital to fund the takeover of Aurizon Mines, selling bonds with a coupon rate of 6.875%. In 2015 the yield on these bonds had risen to around 9%. Today these bonds offer a yield of over 17%. Hecla Mining is not the only company facing extremely high borrowing costs, Coeur d'Alene is another miner whose debt offers close to a 20% yield. While the bonds for much larger miners, such as Barrick, offer lower yields, the fact remains that borrowing costs are high and increasing for the mining industry.

Of course, these companies may not need to borrow and the high yield on their current debt may not be an issue as the pay the lower coupon rate. However, any miner looks to borrow in the next five years will almost certainly be subjected to higher costs. This means that miners will struggle to expand into new projects, as the increased cost of borrowing will makes these financially inviable. This means that any undeveloped assets in the ground are unlikely to be greenlit, and therefore any expected increase in earnings from those projects are unlikely to eventuate.

Perhaps more importantly is the cost of rolling over debt. If Hecla Mining needs to roll over their current debts, then they would have to do so at almost three times their current borrowing rate. This means if Hecla Mining wishes to refinance any of their debt in the next five years, it will almost certainly be at a higher rate. This means that they are locked in to their current rate, as are many of the mining companies.

Borrowing is just one of the many costs that face the mining industry. One can make the argument that these are unlikely to flow over to some of the larger miners, but this holds little water. Newmont Mining, one of the largest and best performing mining stocks in 2015, had an all-in sustaining cost (AISC) of $999 per gold ounce in Q4 2015, compared to $927 the previous quarter. The numbers do not lie. Oil and commodity prices may be in a rout, but the miners costs are still going up.

Take a look at the earnings

In terms of earnings per share, last year Newmont Mining Corp was one of the best performers in the gold mining sector. In fact, of the top 10 largest holdings in the GDX fund, Newmont was the best performer with earnings per share of 3.83% its current stock price. By taking a closer look at the figures, we can paint a rough picture of how the company will be likely to perform going forward.

The first figure that stands out here is that of their 2015 gold reserves, which were calculated at a gold price of $1,200. However, the average realised gold price was $1084, which means that the estimation for the value of reserves is based on figure more than 10% over the price achieved. Of course, the price of gold fluctuates and the metal has been off to a roaring start in 2016, so it is not impossible that the average realised gold price could be $1200 in the first quarter this year.

However, it is highly unlikely that such a level can be sustained in 2016, and over the next five years it would be close to impossible to secure an average realised gold price of $1200. Gold has only closed above $1200 four times this year and is likely to continue falling back as market pricing returns to more normal levels. This means that going forward the value of reserves is likely to fall, which means that earnings over the long term will be lesser.

There is also the matter of production costs to consider here as well. As mentioned above, Newmont had an AISC of $999 per gold ounce last quarter, which means they made a profit of $85 per ounce. A crude deduction from this means that if the average gold price, not the spot, for this quarter drops $86, then Newmont will be lose money.

Admittedly, the currently high gold price means that this is unlikely to happen this quarter, perhaps not even this year. However, it is likely that over the second half of 2016 and beyond we will see the Fed hiking rates and this will almost certainly drive gold into the triple figures, which means that unless costs somehow fall Newmont Mining could be facing losses.

Now, recall that Newmont Mining was the best EPS performer in 2015 out of the top 10 GDX holdings. If a titan of the gold mining industry, that faces much lower borrowing costs than many, will be near certain to lose money if gold falls into the triple figures, then how vulnerable is the rest of the sector?

With long term gold prices likely to be lower than expected and costs rising across the industry, we believe that the gold miners are heavily overbought at current levels. Further to this, it is likely that they were in fact overvalued before gold prices rallied. This means that once the short term spike in gold passes, the gold miners are likely to fall to new lows.

Trading arguments against holding gold stocks

The recent spike in gold and its miners, along with the calls from the bulls to back up the truck on "cheap" gold stocks, may tempt some into getting long the mining sector. We are not so easily convinced. These companies face increasing costs against falling revenue and downward revisions in the value of their assets. This means that the trade is not buying gold miners.

Even if one were bullish on gold, the trade would not be to buy gold mining companies. There exist a number of varied ETFs that offer direct long positions on gold that can be easily traded. GLD is single long gold, DGP is double long, and UGLD is triple long. This means that if one wanted a position that outperformed a gold long by triple, as miners did in the recent spike, then one could easily get that by buying UGLD. This trade would achieve the desired returns if the bullish view is correct without any of the risks involved with gold mining companies.

Suppose that one insisted on having long exposure to the gold mining sector. Buying gold stocks would still not be the best way to go in terms or risk reward dynamics. Consider Hecla Mining, whose debt yields over 17% a year. For a long position on the company's shares to outperform their bonds over a 5 year period, HL would have to more than double in value. Even in one of the best 5 year periods for gold, 2007 - 2011, gold mining stocks did little more than double. How can one reasonably expect them to perform better than this in an environment where gold is a third lower and more likely to fall than rally?

This is not to mention that in the case that one's bullish view on gold stocks is wrong and the company starts to lose money. In this situation, the debt has first call on the company's assets. This means that your downside risks are much higher when holding the stock versus holding that same company's debt. Given that long debt exposure offers a considerably higher expected return and much lower potential losses, holding gold stocks has poor risk reward dynamics even if one insists on having long exposure.

Therefore, we recommend not holding any long exposure to shares of gold mining companies. It is our view that there is no reasonable situation in which long trades on these companies can offer positive risk reward dynamics. Long trades are simply not compensated well enough for the risks being taken.

What is the trade?

If not long, is the trade to get short? We believe the answer is yes, and that one can do so in an exceptionally attractive way. Double or triple short ETFs, such as DUST, are not our favoured vehicle here. The way these inverse vehicles move does not make them suitable for longer term investment in our view.

We also do not believe the right trade is to short the miners, or a long gold miners ETF such as GDX, outright. This type of trade involves unlimited potential risks, and although we believe the probability of these risks being realised is low, we would not be achieving our top goal of prudent risk management if we took on such a position.

It is our view that the best risk reward dynamics for any trade on the gold mining sector come via options. The versatility of options allow one to take a low and limited risk position with significant upside potential. We have used options to tailor positions to exactly fit our views on gold mining stocks and have issued these trades to our subscribers. If you wish to find out the exact details of these trades, please subscribe via either of the buttons below.

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Monday
Feb152016

Consensus Macro Trades Stop Out: Gold Has Made A Near Term Top

Macro consensus trades into 2016 have not worked well, at all. This week saw a large flush out in positioning across financial markets. There are three consensus trades that we feel have been particularly squeezed and what we believe was a final clearout of these position sent other assets, such as gold, to extreme levels that present a number of trading opportunities.

The Fed Will Hike, Others Will Not

This was the premise of most consensus trades into 2016. Whilst the market was not convinced that Yellen was going to increase rates as much as the dot plot suggested, hikes were expected nonetheless. This dynamic shaped a number of trade ideas into 2016 across asset classes. We were not convinced of such hikes, which we wrote about extensively in late December, based a widening of credit spreads seeing real borrowing costs increase, reducing the need for hikes. However we did not anticipate that the market would so vigorously discount all chances of any hikes this year.

Equities – Financial Stocks To Outperform

In the stock market there was a view that banking stocks would outperform the wider index this year. An increase in the Fed Funds Rate would improve margins and see financial stocks outperform other sectors. This consensus trade has been doubly hit.

Firstly, the Fed hikes have not come, and expectations of them coming any time soon are near zero. Secondly, the widening in credit spreads that we highlighted in December have spread across a number of sectors. What began as a few energy companies struggling with a collapse in oil prices, flowed on to other materials and mining companies, selling fuelling more selling, and eventually leading to credit concerns at some major European banks.

Currencies – USD To Strengthen

In sympathy with the view that “the Fed will hike, others will not” were major bets that the USD would continue to strengthen versus other major currencies. In no pair was this consensus view stronger and positioning larger than in USD/JPY.

The vicious gold spike mid-week was mainly caused by a weakening of the US dollar versus the Yen. A consensus trade going into 2016 was that the US dollar would strengthen compared to the Yen, given that the BoJ was loosening monetary policy while the Fed was hiking rates. This view was turbocharged with the BoJ announcing negative rates not so long ago. However, this trade has been proven wrong, as the US dollar has in fact fallen considerably against the Yen.

With many exiting this trade, after being proved wrong, the market moved too far. This has pushed USDJPY notably below the US dollar index as a whole. Thus the US dollar has been dragged lower, which has pushed gold higher.

Bonds – Prices To Fall As Fed Hikes

As yields rise, bond prices fall. With many expecting a number of Fed hikes this year, investors sold bonds expecting prices to fall. As Fed hikes appeared less and less likely, investor’s scrambled to buy bonds and this has fuelled a major rally. As a result, bonds priced out almost all chance of a rate hike in the next 12 months and gold consequently soared. The pricing for future rate hikes has now returned to less extreme levels with bonds falling back from their rally mid-week.

However, gold has not followed bonds lower, which means the metal is likely to fall from here. Bond pricing currently implies that gold should now be around $1190, which is approximately a $50 decline from the close on Friday.

Consensus Trade Stopping Sends Gold Too High, Too Fast

We believe gold has now come too far, too fast. The scramble to stop out of the macro consensus trades so far this year has sent gold on its biggest rally in recent years. The largest of bounces in gold since the peak in 2011 prior to the current was following the end of the bull market and the break in April 2013. The current bounce has moved marginally higher than this in percentage terms.

Other technical factors also show gold to be too high. The RSI finished the week at 82.13, but on Thursday moved to the highest level since the peak in August 2011, when the Eurozone was on the brink of collapse and the Fed was engaging in massive QE. Even in these massively bullish conditions gold still sold off after the RSI approached 90. Therefore it is highly likely that gold will be sold off in the near term. The next $50 move in gold is lower.

Mining Stocks Getting Giddy

Just as we are of the view that gold has come too far too fast, mining stocks have done the same if not more. We do not think this move is sustainable. A spike in spot gold does not magically remedy many of the underlying issues that gold mining companies face. We are particularly wary of companies with debt that need to be rolled over in a poor credit environment. We have touched on some of the detail with our subscribers this week and intend to cover this in a dedicated article for publication shortly.

Trading Strategy

Having held the view for all of 2016 that there was minimal risk of a fall in gold prices we now have the opposite view. Gold will not fall to re-test the lows, but the next $50 move is down, and our positioning reflects that view. We are positioning for a bounce in general stocks, but a drop in gold miners. It’s been a rough and rocky ride this month, but that only creates trading opportunities and in this environment we believe options are key to limiting downside and optimizing risk-reward dynamics. You may see our full trading record here and you can subscribe via either of the buttons below.

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Wednesday
Feb102016

How Far Can Gold Go?  

Gold has broken higher through its long term downtrend line with the most recent rally. This break begs the question of how much longer gold can continue rallying. In this article we analyse the technical situation for gold to determine at what level gold is likely to cease rallying, the fundamentals in play, and what would have to change to cause a new bull market in gold.

The Technical Limits for Gold

The peak in gold prices came in 2011 and trended lower after this, but the technical gold bull market did not break until April 2013. Since this break and the beginning of the bear market gold has had upward resistance from a downtrend line that has held steady despite a number of rallies in gold. However, gold has now moved above this resistance and, more importantly, closed above it.

Now that this level is broken the next major resistance is at $1275, then close to $1400 with the downtrend line that has been in place since the all-time highs were made in 2011. The question is, can gold challenge these levels?

The above graph shows every bounce that gold has made since it peaked and the magnitude of each bounce. The largest of the bounces saw the yellow metal rally 18.06% and gold is currently up 13.28% from the lows made last year. This means that if gold moves above $1250, then we will be in the strongest period for gold prices since 2011.

The Cause of the Current Bounce

For gold to sustain its strength and continue rallying above $1250 there will have to be a significant shift in the fundamental situation.  The current movement can be accounted for by the removal of a key bearish catalyst: The Fed hiking.

Fears around China’s currency devaluation and a lack of inflationary pressures has caused a risk off tone in markets. While these volatile conditions persist the Fed will not hike rates, and will instead take a dovish stance as they did at their January Meeting. As a result market pricing for a single rate hike by the end of year has fallen to only 21%. This is in stark contrast to the situation following the rate increase in December, when the markets had priced in between two and three hikes and the Fed predicted at least four hikes would be required.

Without the bearish catalyst of a new hiking cycle to drive gold prices lower the metal has recovered considerably. However, the removal of the bearish catalyst does not mean that a bullish catalyst is now in place. Gold could simply trade sideways until economic and market conditions allow the Fed to hike again. Accordingly, for gold to rally above $1250 there would have to be a new, heavily bullish factor would have to come into play.

Dovish Policy is the Only Long Term Bullish Catalyst

Any event that causes safe haven buying, such as increased geopolitical threats, are likely to drive gold higher. However, these rallies are generally reversed once the risks decreased and those who bought gold as a safe haven asset exit their positon. This means that although safe haven buying has the potential to drive gold higher, it will not be a catalyst for a new bull market.

We believe the only factor that can drive a sustainable bull market in gold is more dovish monetary policy from the Fed. The strong inverse relationship between gold and real rates implies that any major dovish action would drive gold higher. This includes targeted quantitative easing measures, such as QE3 and the programs currently being used by the ECB. Although these types of programs have not been bullish for gold, any measures that would drive US interest rates lower would fuel a bull market due to the strong inverse relationship.

Therefore, although gold prices are currently rallying hard, we believe that their momentum is unlikely to be sustained as there is no bullish catalyst to ensure that prices rise over the longer term.

How Far Can Gold Rally?

Gold is limited technically by its past performance and specifically by its bounces since the peak, which implies a technical limit around $1250. Before then gold will have to push through resistance at $1225 and overcome any profit taking triggered by the RSI showing the metal to be considerably overbought.

To overcome those technical limits the fundamental situation would have to change. This means the introduction of a new bullish catalyst for gold, such as new easing or rate cuts from the Fed. Although the conditions in the financial markets and the inflationary outlook are bleak, the Fed does not have a reason to ease policy at this point. Clearly they have reason to not tighten, but we are not yet at a point where new easing is needed.

Even if the situation continues to worsen from here and a rate hike becomes entirely priced out for 2016, this does not mean the Fed would start new easing. It is likely that the economic situation would have to severely weaken to see this take place. Given recent economic data, such as the employment report last Friday that showed wage inflation rising, we believe that it is unlikely that the Fed will need to ease policy.

Therefore, we believe the limit for gold is $1250. This means that aggressive long positions on the yellow metal currently hold poor risk reward dynamics. Rather, we are targeting topside protection trades and conservatively bullish trades on the metal. With gold highly unlikely to break $1250, but also unlikely to fall significantly, it makes sense to take on these types of trades. If you wish to receive the trading signals with the details these trades, you can become a subscriber via either of the buttons below before we close our doors on February 20th.

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Tuesday
Feb092016

SK OptionTrader Closes to New Subscribers in Less Than 10 Days

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Since inception its inception in August 2009 the SK OptionTrader model portfolio has returned a massive 1358.82% profit, boasting an annualized return of 52.31%.

To date we have closed 182 trades with a 91.21% win rate, with more than 10 of those wining trades having at least doubled in value. We have outperformed gold, the S&P 500, and the Barclay Hedge Fund Index more than 10 times over!

How is it that we have been able to generate such incredible returns? Careful timing and tailored trading strategies. The clearest example of these in action are on one of our previous Hecla Mining trades.

We held the view that Hecla Mining was heavily overvalued when it was trading above $5 in February 2013 and that it was likely to fall towards $4 in the near term. We therefore looked to short the company, but a direct short held poor risk reward dynamics. We would have made meagre gains of only 20% if we were right, whereas we risked unlimited losses.

Our view was that HL would fall rapidly in the near term, which led us to put options on HL. These allowed us to tailor our position to directly reflect our view. September ’13 HL puts with a $4 strike offered limited risk with potentially massive upside suited our view perfectly. So we waited until Hecla Mining began to break lower, meaning our predicted drop was imminent, and then signalled our subscribers to buy these puts.

As the above graph shows, the trade returned an enormous 212.50%. This meant that we outperformed a direct short trade more than 10 times over as we tripled our investment in less than three weeks.

The accuracy involved in this trade, the tailored nature of the position, are applied throughout our portfolio. This has allowed us to ensure that our risk is always prudently managed, ensuring that any risks we take on are always justified. Consequently, our model portfolio has grown 14 times its original size.

Owing to this immense success the demand for our services have steadily increased. At a given number of subscribers the quality of our services would become diluted, and therefore we are closing our doors to new clients to ensure that this standard can be maintained. The currently increasing rate at which demand is increasing indicates that we will have reached our subscriber limit by February 20th, if not sooner.

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