The title of this morning’s piece, “Avoid the Pain Trade” comes from the head of a trading desk I once worked on. Our global desk head offered us this sage advice right about the time all of us were in four or five different variations of the “Pain Trade.” While the advice offered little value with regard to trading or risk management, it did provide some good gallows humor, so we had that going for us.
The “Pain Trade” refers to the market’s uncanny ability to find a position (like being short a certain currency or commodity, or overweight or underweight duration, etc.) that a good portion of investors are in up to their eyeballs and then violently reversing course, trapping the investor (or trader) in a position that he/she valiantly tries to defend. When the first violent blow occurs, it is a natural instinct to deny that the tides have shifted. After all, the trader thinks, “I’m not in the pain trade. Only idiots get caught in the pain trade.” However, as the weakest hands begin to capitulate and other traders, not in the trade, begin to take the other side, the momentum shifts for real. If you sold something at 100, and it went to 95, it is now at 110, seemingly in the blink of an eye. Imagine Napoleon being swallowed up by Mother Russia’s winter and armies. Eventually, you surrender and close out your position and, to add insult to injury, pretty soon after, the market calms down and stops going against your position!
If we look at many of the once illustrious hedge funds that have closed this year, we can think of 2015 as “The Year of the Pain Trade.”. These managers who were clobbered are some of the best traders in the world. They had seen just about every market imaginable and yet, the pain trade found them and did them in. Therefore, it might be a smart thing to try and identify what the pain trade could be in 2016.
The obvious one for me is a reversal in commodities, particularly crude oil. I continue to believe that commodities are the driver. Everything else, including the Fed, is a derivative of what happens with the supply/demand technicals in commodities. Right now, as crude oil (I use the WTI front Crude Future) has sold off approximately 43% since June 2015, open interest in the front futures contract has more than doubled. When future prices decline sharply and open interest in the contracts goes up sharply, that means that many new shorts have come into the market.
Speaking to some of our commodity broker colleagues who trade futures and options in Chicago: when asked how short the market is on a scale from 1–10, they say 8.5. While not scientific, people who are in these markets every day have a very good idea on positioning. Therefore, a reversal in crude is most probably the trigger point (or pain trade) for a rapid increase in energy prices, a more aggressive Fed, and significant increase in interest rates across the yield curve. It could be argued that the higher oil (and potentially other commodities, get pulled up considering markets are short there as well) prices can alleviate the current strain on Emerging Market assets and U.S. High Yield.
Unfortunately, I think the market would be caught so far offsides with regard to positioning in commodities and rates (currently the rates market is pricing in about two FOMC tightenings in 2016, while the FOMC has implied four) that the price action would be too violent and create an event similar to, if not worse than, the 2013 “Taper Tantrum.”
The question is: what is the possibility for crude and commodities technical to reverse course? For me, all signs indicate that from the supply side of the equation, the supply glut will continue and probably get worse in the first half of 2016. As far as demand goes, it really does not appear that the massive amounts of monetary stimulus injected into the global financial system is sparking the kind of growth necessary to increase demand for oil dramatically. While China will most likely deploy some sort of large stimulus package, it probably won’t be as large or as effective as their 2008 package to spur enough meaningful demand. With this in mind, I believe that the Fed will be on hold for the first half of 2016 and very cautious to raise rates more than once in the second half of 2016.
Nevertheless, there is always the possibility that some event can catch the massively short oil market on the wrong foot and create the next “Mother of all Short Cover Rallies” because after all, that’s what markets do!
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