One aspect of being a global macro investor that I enjoy is the mandate to go both ways. To capitalize on this, I want to be long Mexican equities via iShares MSCI Mexico ETF (EWW), while short Brazilian equities via iShares MSCI Brazil ETF (EWZ), says Landon Whaley.
No, I’m not talking about a Fifty Shades of Gray scenario.
I’m talking about trading from both the long and short side of markets.
A lot of people in this game, especially those residing in the U.S., are entirely focused on being long. They will only evaluate opportunities in which an asset class can increase in value. This myopic focus greatly inhibits their performance and risk management, and causes them to miss trades with much better risk profiles than simply being long.
Sometimes, when I feel frisky, I go both ways at the same time. Right now, I’m feeling frisky about Latin ‘Merica and a trade with the potential for a much better risk-reward setup than anything I’m seeing in the States.
Join me as we head south this week: pack your passports, my friends, and make sure you have a wad of pesos and reals in your wallet.
Senor Frog’s
The very best opportunities in financial markets occur when investors’ perception of a given market diverges from that market’s Fundamental Gravity.
These opportunities typically reveal themselves when an economy’s Fundamental Gravity shifts direction after having lingered in one type of FG for a prolonged period. When this type of shift occurs, investors are notoriously slow to update their viewpoint of the underlying economy or an asset class. This presents an opportunity for those of us who are quicker on the uptake.
Right now, investor perception of Mexican equities is being shaped by the poor economic growth trend that’s been in place for over a year. Since GDP growth peaked in Q1 2017, Mexico’s economic growth has been cut in half.
By the end of last year, Mexico’s economy was growing at the slowest pace since 2013. This growth scenario has played out in Mexican equities: they are off 10% from their 2017 high, and nearly crashed last year when they declined 17% from August to November.
But as they say, “That was then, this now.”
Make no mistake, Mexico’s economic growth will be driven primarily by private consumption, and those metrics are starting to trend in the right direction. Retail sales growth has accelerated for two consecutive months after hitting a three-year low in December. Consumer confidence is finally showing signs of life after falling for three consecutive months. Business confidence has improved for four consecutive months and is now at a three-year high.
Couple all these new positive trends with an acceleration in the average hours worked per person, and you’ve got a formula for continued improvement for the Mexican consumer, and a tailwind for economic growth.
On the inflation side of the economic equation, both consumer and core inflation have slowed for three consecutive months. Both readings are now sitting at two-year lows. This trend is our friend because there is no more conducive environment for equities than when growth is improving alongside slowing inflation.
Based on the latest Behavioral Gravity reading for the iShares MSCI Mexico ETF (EWW), investors are only slightly bullish. If they understood the impact this Fundamental Gravity shift will have on the equity market, they would be far more bullish.
EWW’s Quantitative Gravity is also backing my bullish bias, despite EWW’s 5% pullback in the last week.
Momo, which measures the force behind the trend, is neutral, but has been building bullish momentum for two weeks.
Barometric, which measures the rate of force (buying/selling pressure), indicates that sellers are in control but their strength is waning.
And finally, Topo is indicating a decreasing probability of drawdown risk.
We have all the makings of a nice long trade. Fundamental Gravity shifting from bearish to bullish for equities, check. Behavioral Gravity says investors are unaware and benignly positioned, check. Quantitative Gravity is signaling a rally is in the works while price is falling, check.
Carnaval in Brazil
If we take a nine-hour flight southwest, we see the same divergence between investor perception and Brazil’s Fundamental Gravity, only in the opposite direction.
Brazilian economic growth has accelerated for eight straight quarters since its wicked recession ended in January 2016. The Brazilian equity market, as represented by the iShares MSCI Brazil ETF (EWZ), has been richly rewarded over the last two years, gaining 144% (versus just 44% for the S&P 500).
Unfortunately for bullish investors, it’s now 2018, and I see chinks in the Fundamental Gravity armor that underpinned EWZ’s meteoric rise.
On the growth side of the economic equation, there are several troubling developments. Industrial production has been slowing since October. The Composite PMI, which is a combo platter of manufacturing and service sector activity, is now showing signs of a slowdown. Retail sales growth peaked in September and has now fallen for three consecutive months. Formal sector employment is also sitting at the lowest level in six years. The bottom line is that private consumption just isn’t there, despite low inflation and low borrowing costs.
Add the political cloud hanging over Brazil to this bearishly trending data and you have a recipe for slower growth and, most importantly, a weaker equity market.
Brazil’s economic recovery hinges greatly on the outcome of the 2018 presidential election, which occurs in October. The way I see it, we’ve got five months to ring the “short Brazilian equities” chamois dry before the economy has any hope of finding firm footing.
You don’t have to take my word for it: Brazilian equities are already starting to price-in this growth-slowing scenario. The U.S.-listed (USD denominated) EWZ has already declined 10% from its January 25th peak.
Based on the latest Behavioral Gravity Index reading, investors are still leaning to the bullish side, despite the current correction and the shifting Fundamental Gravity. In fact, investors have added over $500MM in new cash to EWZ in the last four months alone!
In addition, EWZ’s Quantitative Gravity is telling me that the downside movement is just getting started. Momo, which measures the force behind the trend, is bearish and getting more so by the day. Barometric, which measures the rate of force (buying/selling pressure), indicates sellers are in control and that bearish pressure continues to build. And finally, Topo is indicating an increasing probability of drawdown risk.
Here again, we have all the makings of a nice trade, this time on the short side. Fundamental Gravity shifting from bullish to bearish for equities, check. Behavioral Gravity says investors are unaware and still bullishly positioned, check. Quantitative Gravity is signaling that the downtrend in EWZ is just getting started, check.
The Mechanic
To capitalize on this opportunity, I want to be long Mexican equities via the iShares MSCI Mexico ETF (EWW), while shorting Brazilian equities via the iShares MSCI Brazil ETF (EWZ).
This is where I channel my inner Jason Statham and discuss the precision required to trade this Macro Theme correctly. Whenever you go both ways at the same time, it’s important to adjust the size of each trade based on the individual volatility of the two instruments in question.
In this instance, we want to trade the appropriate number of shares in both EWW and EWZ so that the overall position is as close to volatility-neutral as one can get.
I feel compelled to broach this topic of volatility-adjusting trades, but I can’t possibly cover all the nuances of this subject in one commentary. I encourage you to seek out any resources you can to learn more about effectively putting long and short trades together in a manner that is risk conscious. Once you’ve educated yourself, test your knowledge with a virtual trading platform. I can’t stress this enough, never trade a new approach with real money. Educate yourself first, then trade in a simulated environment with no risk and finally, move to real-time trading with real money.
The Bottom Line
Remember, financial markets are composed of human beings making human mistakes. Those mistakes often relate to a lack of understanding in the Fundamental Gravity for a particular market.
Most investors have limited insight into what’s really happening from a fundamental perspective. Furthermore, any Fundamental Gravity-based knowledge that could potentially guide their investing decisions is often obscured by their emotions, or what we refer to as their “humanness.”
Applying my Gravitational Framework to over 200 markets in 27 economies globally allows me to gain insight into opportunities and risks that are missed by most investors.
Being long Mexican equities and short Brazilian equities is one such opportunity.
New long trade ideas can be initiated on pullbacks, as long as EWW trades above $49.05. If EWW closes below this risk price, exit any open trades. On the short side, new trades can be initiated on rallies, as long as EWZ trades below $44.32. If EWZ closes above this risk price, exit any open trades.
