The Pain Trade

By: Guy Lerner | Wed, Apr 21, 2010
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A trading buddy and I frequently talk about the markets, and as always, the conversation turns to the "hardest trade". The "hardest trade" is that trade that has the potential to inflict a lot of pain, but ultimately in the end, it is the right trade. The pain trade is the hardest trade and the trade that yields the best results.

My trading buddy believes the pain trade is to go long equities right now. His rationale for this being the pain trade (but right trade) is that everyone is expecting equities to rollover. After all, equities are overbought, overvalued, and over subscribed too. So, if everyone is all in but has their finger on the eject button, then the pain trade must be to go long equities as no one really believes equities can go higher. The argument has merit especially since very little has derailed the rally. So far my trading buddy is right.

From my perspective, the pain trade has been and continues to be short equities. The ARL Advisers real time portfolio has been short the S&P500 for almost 7 weeks now. This trade has been painful especially since it has been nothing but downhill. The only "hope" this trade has had is the 1 day Goldman induced sell off. Other than that it has been "fugly" for the shorts. This is the pain trade because I am living it. And the that's all that matters.

But more specifically, I never look at betting with the consensus as the pain trade. Why? Because if you bet with the consensus and lose, you are just like everyone else. Your performance is no different than the market's and everyone else's. On the other hand, if you bet against the consensus and lose, you lose 2 fold as the market is going positive while your portfolio is going negative. You are left out of the party standing at the window watching everyone else have fun. Ouch!

So I still believe in this trade for the following reasons:

1) the market is overbought and while overbought can get more overbought, I believe the market has gone through that phase already; in other words, this trade has already incurred the worst draw down it is going to suffer.

2) investor sentiment remains extremely bullish indicating that "everyone" is all in; while extremes in bullish sentiment have worked poorly in predicting turning points over the past year, I still don't believe fear and greed have disappeared from the markets; while the current price move has been strong, it still remains within the extremes of prior moves; see "Is It Time To Short the S&P500?"

3) trends in gold, treasury yields, and crude oil are strong and this is a headwind for equities.

4) this is a low volume rally.

5) the current rally has a "mentality" that there is a rush to buy; a market that doesn't correct or sell off is not a healthy market.

In summary, the pain trade is the non-consensus trade. At this point in time, it is my contention that this really is the best trade. For me and my portfolio, it has been the pain trade. I have experienced it for the last 7 weeks. From this perspective, the factors for betting against the market remain in place, and the fact that the market has moved higher over the past 7 weeks despite these dynamics makes the short side even more compelling at this time.

In the ARL Advisers' Real Time Portfolio, I am long the Ultra Short S&P500 ProShares (symbol: SDS), and this is a 2x ETF that bets against the S&P500.



Guy Lerner

Author: Guy Lerner

Guy M. Lerner

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