Stepping On Cocaine

This note was originally published at 8am this morning, November 16, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Sean: See you Monday. We'll be talking about Freud and why he did enough cocaine to kill a small horse.”

-Good Will Hunting

Yesterday, the Italian police reported intercepting 1 ton of pure cocaine inbound on 4 tractors from Brazil.  The street value was estimated at 250 MILLION Euros ($341M USD). That’s a lot of Fiat currency. That’s a lot of coke.

Since it was the largest intercepted transaction of cocaine in 15 years, I figured I’d start to analyze the matter. After all, Quantitative Guessing (QG) has many unintended consequences, not the least of which are moral.

Like creating “sugar highs” in markets for those who are levered-long of them, cocaine is a stimulant of the central nervous system. It suppresses the addict’s appetite to manage reputational risk. When it’s uncut, or “pure”, some really wild and crazy stuff starts happening post consumption.

According to one anonymous tweeter with knowledge in the crystalline tropane alkaloid space, pure cocaine “has no filters to increase the weight of the product. Dealers will usually “step on” their product to the tune of 30 or 40% of some other substance (usually Demerol, baby laxative, or B12) to increase their profits.”

As I dug deeper into my research, I couldn’t help but remember that this is exactly what 18th century Coin Clippers used to do to the their citizenry’s currency. Before we had central banking dealers clean up the messaging and delivery of the coin clipping business it was, per Wikipedia, “considered by the law to be of similar magnitude to counterfeiting, and was occasionally punishable by death.”

The good news here is that Americans are starting to figure this whole matter of feeding free money to debt addicts out. It actually didn’t take very long for consensus to come to realize that QG and Burning The Buck are bad things. This is progress.

We’re long the US Dollar (UUP) here and covering some of our US Equity short positions, not because we trust the alchemy of Alan Greenspan or Ben Bernanke, but simply because we are starting to see some of the cocaine highs of the last few weeks wear off. After all, over time, a stronger sovereign currency that isn’t being clipped by charlatans of government sponsored volatility is a good thing for America.

As risk managers, we are tasked with measuring real-time market prices, volatilities, and volumes. The output of this research results in probability-weighted market timing. As correlations and r-squares change, we start to change our positioning.

Today is November the 16th. To understand where markets can go next, we have to contextualize where they came from. So let’s look back at global macro correlation risk relative to the US Dollar on a THEN and NOW basis versus October 16th…

THEN (immediate term TRADE correlations to USD):

  1. SP500 = -0.80
  2. CRB Commodities Index = -0.88
  3. Brazil’s Bovespa Index = -0.92
  4. Oil = -0.91
  5. Gold = -0.96
  6. Copper = -0.95

NOW (immediate term TRADE correlations to USD):

  1. SP500 = -0.29
  2. CRB Commodities Index = -0.20
  3. Brazil’s Bovespa Index = -0.60
  4. Oil = -0.11
  5. Gold = -0.08
  6. Copper +0.10

The way to read this is very straightforward. Copper is undergoing the most glaring mathematical change, swinging from an INVERSE correlation of -0.95 to a POSITIVE correlation to the USD Dollar of +0.10 in only one month. This is a major new development in the risk management landscape.

While I wasn’t brave enough to buy Copper yesterday, I did buy-back my long Gold (GLD) position (email sales@hedgeye.com if you’d like my intraday note titled “Gold Diggers: Gold Levels, Refreshed”).

Last Tuesday, my asset allocation to Commodities was a Bernanke (ZERO percent). This morning, after seeing the CRB Commodities Index correct by -4%, the Hedgeye Asset Allocation to Commodities is back up to 6% (GLD = 3%, CORN = 3%). Managing your cash position dynamically isn’t rocket science. It’s called contrarian sobriety.

One of the most critical lessons I’ve had to learn in making global macro calls on markets is that the derivatives, correlations, and divergences embedded in the math are never perpetual. In other words, once it gets so easy that a coke-head can do it, it ends…

The SP500 is down for 5 out of the last 6 days and should test a critical level of immediate term TRADE support this morning. In the Hedgeye model, that line of support is 1190. If it holds, that’s bullish. If it breaks, that’s bearish. My immediate term TRADE line of resistance is now 1212.

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

Stepping On Cocaine - coke