🗞️ We Do Want Fries with That

WHILE YOU POUR THE JOE… ☕️
$522.5 Marks the Spot

Last week on our Twitter account, we let everyone know that the Friday close for the S&P 500 (we watch the $SPY ETF) was a very weak one. It feels like a small recovery rally after Monday’s selloff setting up for a rug pull.

Think about this for a minute. We have CPI and PPI, both measures of inflation, and since bad news is back to meaning bad news, here’s what we’re thinking:

1. Higher inflation print means a good economy but bad for rate cuts, so we sell down on the $SPY 📉.

2. Lower inflation print means a bad economy but is good for rate cuts, so we sell down on the $SPY (because of the bad economy). BUT, in case markets rally because of the rate cuts story, we are also very long on $TLT 📈 (bonds).

Ideally, I want to see the $SPY break down to $522.50 🎯 this week, especially after it struggled to break and close at $533, which is a low-volume node (English for supply).

Definitely looks like the downtrend will resume, but in case I’m wrong, I am hedged by buying bonds through $TLT.

Speaking of hedging in case you’re wrong, let’s get on with today’s email 📧…

SHIFTING MARKETS
Traders Feel Different Now

There’s a little-known report called the Commitment of Traders (CoT) report, which shows who is buying inventory and who is getting rid of it.

By inventory, I mean futures contracts in the stock market or, likewise, in bonds. Here’s how I like to look at this report, as there are two very important parties at play:

Commercials: These are the banks and other issuing houses on the exchange that hold most of the inventory most of the time. These are like the car manufacturers who gauge the market demand for these products, so where they go in their inventories typically, that’s where they expect markets to go.

Non-Commercials: These are the hedge funds, pension funds, individual large investors, or, as I like to view them, the car dealerships. They keep in touch with where the market is right now but not necessarily with where it might be headed. So, as long as there is demand for cars, dealers will hold more inventory.

So, if commercials are getting rid of inventory, but non-commercials keep buying more inventory, it only means that TODAY there is a lot of demand, but it might not be that way TOMORROW.

This is what the balance looks like for bonds, remember our $TLT trade 📈?

Go back to 2018, when commercials and non-commercials diverged right before bonds rallied by over 25% a few quarters later.

Green = Commercials, Purple = Non-Commercials

So, now that the commercials are buying up inventory again while non-commercials are selling (because nobody wants bonds right now), these commercials are getting ready for a rally so they can sell their cheaply bought inventory for a gain.

Cha-Ching 💰️, we’re going to print some cash on our $TLT positions (soon, I hope).

Now, notice something interesting: commercials (Red) started buying up heavily during 2022, and markets rallied through 2024, where they started selling out just as the non-commercials (Green) started buying. Poor devils are always chasing momentum.

What this means for us is that there is a higher confidence level in our $SPY selloff toward that key $522.50 level; at the same time, we do feel good about $TLT breaking - and staying - above $100 🎯.

I’m eating steak tonight, for sure. 🥩

WEEKSTARTER TRADE
I’m a Bit of a Scientist Trader Myself

There is a lot of controversy happening in the economy right now; some say it’s great, and some are almost done packing to get to a country where they’re better treated.

As a trader (more often an investor, but there’s barely any content there; it’s boring), I just don’t care 🤷‍♂️.

Up, down, sideways—who cares? I just want to make money. And here’s how hedge funds do it, so take notes.

This is the PMI index. It has been in contraction for 21 consecutive months, and that’s not good for the economy. The S&P 500 follows the PMI 88% of the time, with a 12-month lag.

This means that where the PMI goes, the $SPY goes a year later, so we are overdue for a correction at this point 📉.

However, this doesn’t mean you should go short the market and bet the house on a crash. Market hysteria can continue longer than you can stay solvent.

So, here’s what we learned from our collective time at investment banks: Go with the flow, but cover your ass.

This is a snippet from our monthly proprietary report on what we seek inside the economy. As you can see, the flow is definitely bearish for the industries highlighted in red. Since I went to Shake Shack recently, I decided to look into it.

This is the official statement from industry leaders. Not good at all, right?

Well

This is what Shake Shack looked like on a weekday (only half the picture; I’m an introvert). It was an over 20-minute wait for an order, which doesn’t sound like sales are lighter.

Anyway, I had reasons to believe that Shake Shack was an outlier stock, and it’s not only in customer volumes, Wall Street thinks so too.

See that bolded green name at the top of the list? That’s Shake Shack. It’s outstanding in the way markets value their future earnings, and that’s always a bullish sign 🔥.

** Quick Tip 🔎: Contrary to popular belief, a higher P/E ratio is good for traders because there’s a reason a stock is expensive.

At the bottom, though, we have Brinker International (NYSE: EAT). The markets are not paying up for that stock, and there has to be a reason for that, too. I have no idea how to check that out in person, so I’ll just take the market’s word for it.

Anyway, now I have a pretty good idea of who to bet against; that’s $EAT since I am bearish on the market and the food sector 📉.

BUT

If I’m wrong, I'd better go long on $SHAK, just in case. That way, I can’t take the blame, but I can still make some profits.

Over 8 years, both $SHAK and $EAT have a correlation of 69%, which is good enough for me to justify investigating a pairs trade here.

However, I do need to make sure that their spread (Price of $SHAK minus Price of $EAT) will create profitable behavior for me.

This is done through what’s called time series stationarity 🔎. Here’s what that means:

Essentially, if you know - on average - iPhones sell for $1,000, then you’d want to buy iPhones BELOW $1,000 and sell them ABOVE $1,000, right?

The same is true for the spread (remember, Price A minus Price B): You want to find the average and trade around it.

That's the spread over 8 years; notice how the price spends most of the time at the 0 value (average).

The green line represents the first standard deviation, and the blue dots represents the second standard deviation.

So, BUY below the mean and SELL above the mean. Thats simple okay?

Recently, the spread reached a first standard deviation down. Can you see what happened? SEE? Boom shot right back up for a net 42% return 🔥.

A-ha, how much do I buy of $SHAK vs how much do I sell of $EAT to make this trade?

Look to the Hedge Ratio

It's calculated as a Correlation of A and B * (St. Dev A / St. Dev B)

In this case, you can graph the spread on your favorite broker platform (not Robinhood) as:

SHAK - 1.5161630691328243 * EAT

Voila, you can trade this spread and say a big "I don't care" about what the markets may do since you will probably make money anyway.

And that is what a hedge fund does.

If that was too confusing or if you want to learn more about how this is done, welcome to InvestiBrew. You can email us at [email protected] with any questions, and we'll try to clarify them as best as possible 📫️.

NOW GO AND MAKE IT HAPPEN
Follow the White Rabbit

There really isn’t much content about this type of trading, so it is very - VERY - valuable since hedge funds and investment banks tend to keep the strategy a secret.

But, there are still some resources you can find out there, they may not be the same strategies, but today’s book recommendation 📖 will present you with a few you can consider and maybe adopt.

To your success,

G. 🥃