I’m sitting here in Toronto simply in awe of the markets. When I packed up my computers in Ulaanbaatar before the open on Friday, gold was 1750 and silver was 36.5. Now a trading session later, gold is 1540 and silver is struggling to stay over 27. The age of inhuman volatility (as named by 13-D research), is now upon us.
With a few exceptions, financial markets tend to price off of slow moving indicators. Economic indicators are released weekly or monthly. Earning reports are released quarterly—often with mid-quarter guidance to bridge the reporting gap. Even changes in political parties and new laws adjust gradually. As the data series are updated, participants can adjust accordingly and extrapolate future changes. Markets tend to be forward looking anyway. Often, by the time a data report is released, investors have already figured it out and priced it in. For this reason, sudden price movements are rare. Of course, companies frequently will miss earnings and collapse in price, but for the broader market or for various commodities and currencies, big moves just don’t happen frequently. This is because all scenarios are constantly being assessed into forward prices.
Now, everything has changed. Earnings reports and valuations are meaningless. Currency and interest rate movements are arbitrary as you never know when a central bank will intervene. Even worse, the broader equity markets are in pandemonium. In essence, only two data points matter any longer: When will QE3 start? Will the Germans or the Greeks blink first in their game of brinksmanship?
I cannot recall a time in trading when the world markets hinged on just two data points. However, these two will set the precedent for the next few years of economic activity around the world. If you get it wrong, you are positioned wrong for the next few years. For this reason, every bit of news-flow is meaningful and hundreds of billions of capital are re-positioned based on every data point.
For months, I have repeatedly stated that I am waiting for QE3 before doing anything in the markets. I am still waiting and I have a big cash hoard that I want to deploy. I feel pretty confident that QE3 is coming, but I also think that the markets need to feel some real pain first. Otherwise, it will not be politically possible to implement. Have we felt enough pain? Is there more to come? No one knows the answer. However, when they’re ready for QE3, they’ll start dropping hints. This will be the mother of all Quantum Easings. Will they print money or do unorthodox things? Could they buy defaulted homes? Could they make NINJA style sub-prime loans? Could they go speculate in the equity markets? Expect the unexpected. However, they can’t start until people are willing to accept that only QE can save the world. They need some more fear. Stay liquid, but get your buying list ready. Why am I not buying more in anticipation? There’s a small chance that they never do QE. If they don’t, we could drop substantially from here. It’s just too binary of a situation for me to step in now. Many equities are cheap, but they’re not cheap enough if there isn’t QE. I intend to buy back some large cap miners on tomorrow’s dip, but that’s about it. I’m waiting and patient.
Greece is an even bigger quandary. The Greeks are in the driver seat here. They are forcing Europe to give them money that the Greeks are then wasting on social programs and corrupt bureaucracy. The Greeks are threatening that they will default if they don’t get more money. At first, European leaders thought that this was a one-time event. Now everyone in Europe understands the joke. The Greeks NEVER intend to repay these debts, but the European leaders are too scared about the consequences of stepping back. If they do, what will the rest of the insolvent nations do? If Greece defaults it would be catastrophic. If Spain and Italy go, it will take the whole financial system down with it. Extend and pretend seems to be increasingly less effective. What will the ECB do? No one knows and it is the reason that every minor statement can create such mayhem in the markets. The final decision will produce one of the biggest moves in market history in many financial products. Are you positioned right? No one really knows.
So, I’m sitting here, jet-lagged, watching the illiquid night-time trading in the metals. I’ve always believed that markets are pricing mechanisms and markets tend to be approximately correct over time. Of course, there are small movements, but that is how markets re-price themselves in relation to events and small supply and demand inefficiencies. Suddenly, we have a new paradigm. Markets cannot price in binary events when the outcomes are this extreme. It’s the reason that we can have 200 point moves in gold and 30% 2-day moves in silver. The price-discovery mechanism is now broken because the risks of being wrong are simply too high.
In the past, traders would take the other side of large moves and even out the volatility. There was always the risk of an exogenous event like an earthquake, but these are rare and traders could take such chances. Now, how can any sane trader take the other side of these moves? If you bought silver on the close on Thursday, you’d be annihilated. You can’t even use stop losses as half of the move has happened overnight. Who would want to take on this sort of risk? Every single day is an exogenous event.
The lesson from all of this is to play smaller and have more spare cash. Always be ready for arbitrary movements. The world we once knew will not reassert itself until they figure out QE3 and Greece. Until then, get used to the inhuman volatility.