"Human nature likes order; people find it hard to accept the notion of randomness."
-Burton Malkiel
As investors, the markets routinely disappoint our deep desire for order. As much as we would appreciate a normal distribution of stock price returns, that's just not how the stock market game works.
The challenge in our innate desire for order is that we often look for it in places where it doesn't exist. As Malkiel went on to write in a "Random Walk Down Wall Street":
"And likewise, in our heads, we tend to link prices to ones that came before, believing incorrectly that that which occurred in the recent past is likely to continue for the foreseeable future. If it were true, investing would be much easier. But, alas, it is not."
Robert Schiller built on this foundation of randomness at Yale when he experimented with many series of coin tosses, which he used to represent stock price moves. (Heads the "stock" goes up, tails the "stock" goes down.)
No surprise, especially for those of us who subscribe to a more chaotic view of the markets, was that seeming patterns developed similar to what we see in the stock market - head and shoulders, cup and handle, double top, death cross, etc. Except these patterns were created out of the complete randomness of doing many, many simulated coin tosses.
If you do something enough times, you will inevitably get similar patterns. That doesn't however mean there is predictability or order. For us, one of the most important things to keep in the back of our minds when investing is that there is a certain chaos to it all. Or as we like to say: Brownian motion. That is, sometimes a stock price move is simply random, especially in the absence of news or events.
Back to the Global Macro Grind…
Obviously one way in which we devised to find some order out of the chaos is our four quadrant model for analyzing the economy. The first two quarters of 2021 have been solidly #Quad2 and the key asset returns in the YTD underscore this. To wit, on a YTD basis through two #Quad2s:
- Natural Gas +41.9%
- U.S. 10-year yield +62.1%
- WTI +50.1%
- Gold -7.0%
- Copper +19.5%
Now, not every asset class perfectly fit our model's expected returns. And in the shorter run randomness often took over, but over the course of two quarters the results were largely as we would've expected.
But as always, resting on our laurels or anchoring on hindsight doesn't do us much good as stock market operators. So what is next? Well, based on our models, Q3 has a greater than 90% conditional probability of being #Quad4. While Q4 is, so far, basically a fair fight between all outcomes.
Now before you hit the sell button and get all defensive in your positioning, you have to keep in mind that not all #Quad4s are alike. The set up currently is more akin to shallow #Quad4 with easing monetary policy. In this set up, frankly the outcomes aren't a whole lot different than #Quad2, which is what our market signals (signals, not patterns) have been suggesting to us.
There is also the very unique attribute this time around that underlying organic growth will still be very strong through Q3. While it will decelerate on a rate of change basis, it is still an economy that is building back to full capacity and will be seeing very high Y/Y growth rates.
There are also innumerable extremes that have built up in the economy due to the combination of capacity being off line, demand surges, or supply chain constraints. In the Chart of the Day, we've highlighted a chart from our recent Q3 Themes Presentation, which shows retail inventory as a percentage of revenue. Simply put, inventory is almost as low as its ever been. This, of course, is very good for retailers in boosting margins to generate more earnings and free cash flow. It's also made it a heck of a period to generate alpha in retail ... just ask our colleague Brian McGough.
As we do our early morning market scans today, the concept of Brownian motion seems solidly at play. European equity markets up small for the most part to up bigish in Germany with the Dax up 90bps. Most interesting out of Europe is sentiment coming in at 117.9 for June, versus 114.5 in the prior month. This is a 20-year high! While the Delta Covid variant may give us a buying opportunity (or it may be a blip), the facts on the ground are that the European economic acceleration is now in the global pole position.
The flip side is that Asian stocks are getting beat like rented mules this morning with the Shanghai Composite down almost a full percent. To some extent this is no surprise given the results from the China Beige Book quarterly survey, which is "warning that businesses and consumers are not as optimistic about the economy ... and measures of corporate borrowing fell to the lowest level on record and expectations for loan demand dropped in the next half year." Yikes!
Our long Europe, short China theme might not be so random after all...
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 10yr Yield 1.44-1.59% (bullish)
SPX 4194-4312 (bullish)
RUT 2 (bullish)
NASDAQ 14,030-14,564 (bullish)
Shanghai Comp 3 (neutral)
DAX 15,411-15,825 (bullish)
VIX 14.04-19.08 (bearish)
USD 89.86-92.32 (bearish)
Oil (WTI) 70.27-74.78 (bullish)
Nat Gas 3.27-3.68 (bullish)
Gold 1 (bearish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research and Head of Sales
