Too Busy Patting Myself On The Back

Via Kevin Muir of “The Macro Tourist” fame

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Like a bad parent who doesn’t love his kids equally, I have a confession. My infatuation with European stocks has stopped me from seeing clearly. For the past year I have been buying European stocks. When I started, the idea was certainly out of favour – Pretty sure I am alone in this trade. Over time, it gathered momentum, and I stuck with it – The Best Trade on the Board.

When I wrote the first piece, many of the cool kids were quite negative on Europe. George Soros was short Deutsche Bank and talk about a European banking collapse due to the problems with contingent convertible bonds filled the financial news cycle. It was lonely taking the other side of all these gurus.

But I was skated onside by an aggressively easy ECB. Gradually the narrative started to change as the wonders of free money covered up many of the issues. Actually, free money is not quite right. The ECB’s negative interest rate policy made it so many firms were paid to borrow money.

With years of European stock underperformance, combined with the absurdly easy monetary policy, the difference between the cost of debt and the cost of equity for European companies created one of the largest arbitrage opportunities in the history of modern finance.

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This arbitrage opportunity will not close easily. If I had to put on one trade for a couple of years and not touch it, long European stocks short European debt would be near the top of the list.

Yet I am about to commit one of a trader’s worst sins, and mix time frames. Not only that, I risk confusing my message, but I know my readers are a smart bunch who will understand my conflicting points.

The long European stock trade has become crowded. Big time. Whereas before, most pundits were advocating staying away from Europe, it has suddenly become a consensus trade. And nothing screams consensus more than the cover of Barrons.

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Like a mope, I have been patting myself on the back as investors have woken up to my bullish arguments, but really, instead of congratulating myself, I should have been selling. It has been a rookie mistake, and I am embarrassed that I let a love of a trade cloud my thinking. In today’s environment, it is extremely difficult to generate alpha. By the time everyone agrees on a position, it is time to go the other way. I have written about this many times – A Series of Rolling Mini-bubbles, and there are no exceptions. Trades become crowded way faster than ever before, and disappoint even more quickly.

And it’s not like I didn’t have the nagging feeling of doubt. It seemed like every portfolio manager on Bloomberg, and most of the research pieces hitting my inbox have advocated being long Europe. Yet a few brave, smart guys started questioning the long thesis. My favourite millennial trader, Klendathu Capitalist, has been highlighting the overbought nature of European stocks for the past couple of weeks.

If you don’t follow Kieran, then I suggest you get on it (click here for his blog). Yes, he is a millennial, and there will be a bunch of jokes where you might find yourself consulting UrbanDictionary.com, but he is a terrific thinker that deserves your attention (not only that, but his banter is amongst some of the best on twitter).

We just saw the largest inflow into the Vanguard European ETF ever. And it’s not like it eclipsed the previous high by a little. It has blown the cover off the ball. Investors are chasing Europe.

At this point you might be saying, “so what? It’s not like European stocks are going down.” And you would be correct.

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European stocks are treading water near the highs. What’s the worry?

Well, think about these massive inflows. Investors are pouring money into Europe, yet European stocks can’t make a new high? That’s not bullish.

And if you look at Europe on a relative basis, it is even less pretty.

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The top in the Eurostoxx / S&P 500 ratio was hit on the day of the Barrons’ “Buy Europe” cover story. Talk about selling the news.

I am bearish on equities in general, so I am in a bit of a quandary about my European stock position. I have bought all these super long dated (2024) calls that I think are cheap, but I find myself worried about the short run. My position is definitely of the Hotel California variety (you can check in but…), so I am forced to deal with a delta that I can’t easily trade out of. I have decided to hedge up my delta and get neutral. I know I am late, and I wish I was selling the news instead of reacting to sluggish price action, but I still think there is plenty of room for disappointment.

Sometime in the future I will return to my long European stock trade. But only after all these new bulls give up. This little mini-bubble-of-long-European-stock-sentiment is due for a surprise, and I don’t think of the bullish variety.

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