For Stocks, Unchanged Seems Like the New Up

Good Evening: After once again plunging at the open, U.S. stocks were finally able to mount a rally on Tuesday. It took all day for the averages to claw their way back before finishing mixed, but given the poor headlines and the scope of the recent stock market sell off, most investors will gladly take it. The latest bit of geopolitical angst to affect global equity prices was a report that North Korea has severed ties with South Korea and is in the process of mobilizing troops. The frightening prospect of war on the Korean peninsula had investors shunning risk and fleeing to perceived quality until a rally during the final two hours of trading erased early stock market losses of approximately 3%. After seeing so many rallies fail in May, market participants were quite happy to see one finally stick. In an environment beset with so many negatives, the unchanged mark was welcomed as the new up.

It’s been two months since we first learned that a South Korean warship was sunk due to mysterious circumstances, claiming the lives of nearly four dozen South Korean naval personnel. It’s been many days since the world was first told of evidence that the Cheonan went down after being struck by a torpedo that was almost certainly North Korean. South Korea, the United States, and the international community were all rightly indignant about the incident, but what wasn’t known was how North Korea would respond.

The answer to this question came in two parts during the past 24 hours. First, a group of North Korean defectors told Western media outlets last night that Kim Jong IL has mobilized his military and ordered them to be “ready for combat” (see below). As the meaning of this bellicose action was be debated in the media, North Korea announced today that it was severing all ties with South Korea. While a full-blown conflict is unlikely, few investors enjoy the thought of war on the Korean peninsula, especially when the North is likely in possession of at least one nuclear weapon.

Stocks in Asia responded overnight with yet another of what has felt like a series of 3% down days. More rumblings about sovereign debt problems, economic weakness, and bank capital needs in Europe certainly didn’t help share prices on the Continent, nor did the latest opinion pieces about renewed banking problems in Spain (see stories below). It was all too much for U.S. equity futures, which had already been on the defensive after such a poor close yesterday. When stocks did open in New York on Tuesday, the indexes dropped approximately 3% and the VIX once again surged above the 40 level. The nervousness about what might happen next was palpable, and while many called the downdraft a buying opportunity, a few were citing the possibility of a crash.

After recovering a bit from the early whoosh, the major averages went broadly sideways during the middle of the trading session. Once a rally took hold during the final two hours, however, it didn’t relent until the closing bell rang. The levitation into the close was unaccompanied by any positive news that I could find, a situation which often leads to rallies that last more than a day — unless, of course, some fresh bad news comes along. The major averages all finished just about flat, with the S&P 500 (+.04%) nosing ahead of the others. In contrast to equities, Treasurys were sought this morning and then spent the rest of the day leaking lower before finishing with small gains. In a sign risk aversion may be peaking, today’s auction of 2 year notes fetched a Japan-like 0.769%, the lowest yield on record. The dollar index finished with a gain of 0.3%, while commodities couldn’t mount the type of comeback seen at the NYSE. Gold (and gold stocks) held in well today, but most CRB components suffered as the index itself declined 1.25%.

If not news-driven, what sparked today’s revival at the corner of Wall and Broad streets? Was it due to bargain-hunting, short-covering, or some new trading strategy by the mysterious “quants”? I have absolutely no way of knowing, but I hope the following imaginary conversation between two hedge fund traders is somewhat instructive. Just as following the momentum crowd and getting too long was an easy mistake to make in April, getting too negative may be a risk right now. The Head Trader (HT) in this fictional scenario has called over one of his junior traders (jt) during the lunch hour today to ask him about the trading positions he’s recently accumulated:

HT: Hey, junior, I see you’ve built yourself quite a short position in global equities.
jt: Yes, sir, I have.
HT: Mind telling me why it’s so large?
jt: Sir, haven’t you been looking at the screens? The news flow is awful, the fundamentals are horrible, and the technicals are even worse. This market could break wide open at any moment!
HT: Uh, huh. Tell me all the reasons why you are so bearish.
jt: Well, ever since the EU rescue package announced two weeks ago started to unravel, it looks like a number of governments might default and the euro currency could soon be history. Asia is also a mess, since North Korea might just start a shooting war with South Korea, and the U.S. might get into a trade war with China if the yuan doesn’t appreciate. Here at home, a slowdown in Europe could cause us to experience a double-dip recession, the appreciating dollar is going to hurt profit margins for our large, export-driven companies, and the Senate’s bank reform legislation looks like it might just crush our financial sector. Furthermore, the tape trades like death and all the momentum indicators are pointing south. Day after day, it seems like stocks are down 2% or more, and every rally keeps failing. Credit spreads are widening and the VIX is above the danger zone between 30 & 40. Being short isn’t just smart — it’s easy!
HT: And so you are short stocks, long puts, and short index futures — in size, right?
jt: Yes, sir, and just listing all the reasons why makes me want to press my positions even more.
HT: I’m sure it does. Now cover at least half of every position you hold — today.
jt; Cover! But why would I want to —
HT: Stop. Things might play out the way you think, but answer me the following questions: First, has any country in Europe actually defaulted?
jt: No, but…
HT: Has any country — voluntarily or involuntarily — left the euro currency?
jt: No, but…
HT: Has either North Korea or South Korea crossed the DMZ to attack the other?
jt: No, but…
HT: Has an actual trade war been started with China?
jt: No, but…
HT: Has the U.S. fallen back into recession, or have large companies started to report losses, or has bank reform legislation even reached the President’s desk?
jt: Not yet, sir, but…
HT: You’re right when you say the tape trades poorly, and stocks have indeed fallen and volatility has indeed risen, but don’t you think the momentum that is now your friend could turn on you in a New York minute?
jt: Yes, sir, but…
HT: What I’m trying to tell you is that none of the scary scenarios have yet come to pass. Stock prices are starting to reflect the risks that they could, but they haven’t happened yet. And what will happen to your positions if Mr. Bernanke panics and decides to push the QE button again? The short positions you have on need more bad news in order to keep working, so I want you to cover half of them — now.
jt: But, sir, my bonus is tied to my performance, and I think —
HT: Hang on, son; let me explain something to you. Your bonus is indeed performance-based, but this fund is a partnership and most of my net worth is on the line. What will hurt both you and me most at this moment is a big rally. Now start covering — you’ll thank me later. Besides, didn’t we have a similar conversation last month when you were out over your skis on the long side?
jt: That was the guy next to me.
HT: Whatever — the lesson is still the same. We need to be nimble in this environment, not dogmatic.

— Jack McHugh

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