Making Sense of the Nonsensical

RIDICULOUS - There are many times when trading markets that price action makes little sense and is difficult to reconcile. And for the most part, you chalk it up to the fact that this is what markets do and it's just a part of the game. But sometimes, there are days when the price action is so wacky that it becomes hard to accept the explanation that 'this is what markets do.' Monday was one of those days. We got a NO vote in the Italian referendum which initially produced a sensible but well contained decline in the Euro and risk assets. And then out of nowhere, the market reversed course. The Euro broke up to a two week high, while stocks surged and GOLD sunk. Now, we had talked about the event being priced in, but this type of a reaction was absurd. 

THE CATALYST - It's very hard to make sense of the fact that stocks are back towards record highs, the US Dollar is all of a sudden under pressure and GOLD is sinking, all after the Italian referendum produced a NO vote. For this event to be the catalyst for such a move makes no sense at all! So what happened? Why did markets move the way the did on Monday? I believe the answer is that the catalyst for the move on Monday was less the Italian referendum and more the initial risk off price action that we saw in the immediate aftermath. This is to say that there has been a very clear pattern in recent years of 'buying the dip.' Each and every time there is a significant pullback in risk, the market is supported in a big way. 

COMMON THREAD - There have been so many events that have knocked risk on its back in recent years and each and every time we get sizable pullbacks in a very short window, the response is an aggressive 'buy the dip' response. Two recent examples are the EU referendum and US election. In both of these cases, the result was risk off and in both of these cases the market went into intense risk liquidation mode on confirmation of the result. But as quickly as the market dropped, in both cases the market came roaring back, more than offsetting the declines. And these are just two of the more recent examples. This has happened time and again over the past several years. OK, so now we know why, but who is buying so aggressively when the events don't justify such aggressive buying? 

THE ROBOTS - Well, the answer to this one is the best I can offer that would reconcile this type of wild pattern that defies logic. The answer is the systematic, model type funds that have taken on a much larger role in markets over the past ten years. The amount of money trading on systems is so large that it has an overwhelming influence on the direction in markets. This money has no emotion and is not sensitive to any fear or uncertainty that comes about from these events that knock risk assets. These models don't live in the world of logic and emotion. The only thing these models see are dips within longer-term trends that are opportunities to buy back into the prevailing trend. And so, until we see a pullback in risk that takes the market a little further down and lasts more than a few hours, these models will continue to look to take advantage and buy the dips.

INFLECTION POINT - Now, I do believe we are at that inflection point where these models are going to start breaking down and when that happens, the fallout is going to be nasty. There is going to be a day in the not so distant future where the market starts to drop and doesn't recover as it has done each and every time in the past. And when this day comes, these funds will be forced to abandon their strategies. This will not only result in a failure for the market to recover into a dip, but it will also result in a massive rotation away from this trade and intense collapse in risk assets.

GRAVITY - In my opinion, there is no denying the overinflated and artificially supported nature of these record high asset prices and what goes up must always come down. So this emotionless dip buying phenomenon may go on for a little while longer, but I don't think that much. I think Monday's price action will soon be reversed and stocks will be lower again, GOLD will be much higher and the USD will be back in demand.

STRATEGY - As far as trading goes, I'm happy with my positions despite them being out of the money. Just yesterday they were both basically in the money and they can easily be back in the money that quickly. While I am as big as I want to be with the SPX500 short, I still have room to add to GOLD and will do so into another dip. Ultimately, I believe GOLD holds above $1130 and starts to make another big push higher. That's all for now. Have a good one today!