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Trade Idea: Cry for Me Brazil

05/23/2018 2:06 pm EST

Focus: STOCKS

Landon Whaley

Editor, Gravitational Edge

Trade idea: As long as EWZ trades below $47.54, then new short trade ideas can be initiated opportunistically on rallies. Depending on how much room you want to give this trade idea to move, use a risk price between $43.49 and $47.54, writes Landon Whaley Wednesday.

The NZT-48: This week our smart pill snapshot explains why the current macro environment makes shorting the iShares MSCI Brazil ETF (EWZ) a shrewd move.

Fundamentally, Brazil’s economic equation is murky, and when you toss in the political uncertainty surrounding the October election, you have a Caipirinha-esque recipe for a drawdown in Brazilian equities.

Quantitatively, all four aspects of EWZ’s underlying market structure are indicating that the most likely direction for price is lower, making EWZ a prime short candidate. Behaviorally, investors remain bullish and continue to plow money into EWZ based on last year’s performance, completely unaware of the drawdown risk that is rising.

All three Gravities are aligned and decidedly bearish, which means it’s time to put on a short trade and go huntin’ for wabbit.

As long as EWZ trades below $47.54, then new short trade ideas can be initiated opportunistically on rallies. Depending on how much room you want to give this trade idea to move, use a risk price between $43.49 and $47.54. That said, your risk price line in the sand is $47.54; if EWZ closes above that price, exit any open trades. If the trade moves in your favor, then consider closing some, or all, of your position using the price area around $36.54 as a profit target.

Because EWZ got whack-a-moled during the week of May 14, wait for a dead cat bounce to at least $39.00 before you consider initiating this trade.

Fundamental Gravity Says What?

There are two chief variables that impact the risk and return of asset prices: one is economic conditions, and the other is how central banks respond to those conditions. Together, they drive what we call an economy’s Fundamental Gravity.

On the growth side of the equation, the Banco Central has done its part with rate cuts, but households and businesses are slow to deleverage. Borrowing costs have fallen, but consumer credit growth is decelerating, and business credit growth is in outright contraction.

Brazil is also dealing with a ton of slack in the labor market and on the industrial side of the economy. Industrial output has now slowed for three consecutive months, with the latest reading showing that 14 of the 24 sectors are in outright contraction.

The one shining star is auto output, which was helped by strong exports in April. The problem going forward is that Argentina takes 75% of Brazil’s auto exports—and Argentina has just hiked its interest rate to 40% to defend its currency. Oops! Let’s just say there is a high probability that this gargantuan interest rate may have blowback on Brazil’s exports in the next few months.

On the inflation side of the equation, April saw the first monthly acceleration since inflation peaked back in October. Despite the slightly higher rate of inflation, 2.76% is historically low for Brazil. Banco Central has been as accommodating as it can be, and it still hasn’t stoked the inflation fire. The main reason is the spare capacity in the labor market I mentioned earlier.

You’re not going to see persistently higher prices as long as there is significant spare capacity in the labor market. It’s likely that the combo platter of low inflation and slowing growth will force the central bank to cut rates again, but I don’t expect more than one more cut this year.

And if the growth and inflation data isn’t enough to convince you of my bearish perspective, why don’t we toss in a little political uncertainty, just for good measure.

In October, Brazil will hold its presidential election, and right now the political environment down there feels as uncertain as your first boy-girl dance. Two things about the election will continue to plague the equity markets. First, there is no clear favorite, and markets hate uncertainty. Second, none of the candidates are considered to be “market friendly.” This political cloud will hang over Brazilian equities like the cloud that follows Pig Pen around.

The Fundamental Gravity bottom line in Brazil’s economic equation is murky, and when you add the political uncertainty surrounding the October election you have a fiery recipe for a drawdown in Brazilian equities.

Quantitative Gravity Says What?

As a quick reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is ineffective and misleading. Rather, we use quantitative measures that are based on the reality that financial markets are a nonlinear, chaotic system.

We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying pressure), and a market’s irregularity.

Social is our measure of a market’s current energy, or trend. EWZ’s Social eading is indicating it’s in a hangover. This is a bearish trend in which it has been entrenched since mid-February.

Momo is our measure of the amount of force behind the market’s current state. EWZ’s Momo turned negative on March 19 and has spent every trading day since building bearishly.

Barometric is our measure of the rate of force behind the current MOMO. EWZ’s Barometric tells us that sellers have been in complete control of this market since February 27 and the selling pressure has been building. In fact, Barometric is registering the most bearish pressure we’ve seen in EWZ in over six months.

Topo, which measures the probability of a drawdown, is indicating a rising probability of a drawdown over the next ten trading days.

When a market is rallying, then a declining Topo confirms the upswing. On the flipside, if a market is falling, a rising Topo is the confirmation signal that the downtrend is more than just a pullback.

Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price.

If you’re new to our Quantitative Gravity framework, it’s important to note that the four quantitative dimensions of a market that we monitor typically move ahead of price. Said another way, price is the last aspect of a financial market to move, quantitatively speaking.

However, price is an important factor, and my bearish thesis for Brazilian equities will remain intact as long as EWZ trades below $47.54.

The Quantitative Gravity bottom line is that all four aspects of EWZ’s underlying market structure are indicating that the most likely direction for price is lower, making EWZ a prime short candidate.

Behavioral Gravity says what?

Our Behavioral Gravity lets us evaluate investors’ perception of this market and how that perception is changing as we move through time.

Retail investors have added approximately $584MM to EWZ so far this year, with $65MM of those inflows occurring in just the last two weeks. This tells me that investors are blissfully unaware of the current Fundamental Gravity and the political risk facing the Brazilian equity market.

The Behavioral Gravity bottom line is that investors remain bullish and continue to plow money into EWZ based on last year’s performance. They appear to be completely unaware of the rising drawdown risk.

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