Storm Clouds on the Market Horizon

“Here’s to the pilot that weathered the storm.”

-George Canning


Conclusion: Below is a summary of some of the key risks we see heading into 2011.  Please email if you would like the 40+ page presentation that supports these ideas.


The stock market year of 2010 was a solid one by many standards.  Despite some unfettered volatility, and assuming nothing dramatic happens in the next couple of days, most major U.S. stock markets will end the year solidly in the positive.  Leading the way were small cap stocks with the Russell 2000 up more than 26%.  While the broader market trailed the small cap index, the SP500, oft considered the benchmark for U.S. equity performance, was still up over 12%, coming in slightly ahead of its long run annual average.  With 2010 in the rearview mirror, it is time to start looking towards 2011.


When contemplating the outlook for the upcoming year, the best place to start is consensus expectations.   Currently, according to a Bloomberg survey of the strategists from 11 of the largest brokerage firms in the United States, the mean consensus target for the SP500 by year end 2011 is ~10.5% above current levels.   Further, every single strategist in the survey is expecting a positive performance out of the SP500 in 2011.  Suffice it to say, Hedgeye is decidedly non-consensus heading into 2011. (I’m sure none of our subscribers are surprised by this fact.)


As it stands, we see a trinity of existent, negative fundamental macro clouds on the horizon that have yet to be properly discounted by the market, and are poised to cast a potentially long shadow over domestic equities heading into next year.  The three key risks we see to these lofty consensus expectations heading into 2011 are: global growth slowing, inflation accelerating, and interconnected risk heightening.


As it relates to GDP growth in the coming year, we believe that growth, both in the U.S. and in certain major emerging market economies, will slow sequentially, though for very different reasons.  Domestically, we believe consumer spending, which is roughly 70% of GDP, will be constrained as consumer confidence erodes alongside a further slide in home prices.  This erosion in consumer confidence combined with a high structural unemployment rate will lead to what we are calling the Consumption Cannonball.  In effect, consumer spending faces tough y-o-y comparisons, which, when combined with deteriorating consumer confidence and a continued tight consumer credit environment, will likely lead to a tough consumer spending environment in 2011.


Globally, the key growth issue is related to inflation.  As we look at some of the major emerging market economies that are fueling global growth, it is obvious that inflation is accelerating.  Most recently, China reported a 28-month high in November CPI at 5.1% and Brazil reported CPI for the same month at 5.6%.  In both instances, these measures for consumer based inflation are well above the targets established by each of the country’s respective central banks. The obvious outcome if this level of inflation is sustained, as we believe it will be, is a tightening of monetary policy, and a subsequent deceleration of growth abroad.


In fact, globally, we are already seeing a number of central banks take steps to tighten monetary policy and slow inflationary pressures.   Some of the data points we’ve been focused on over the past couple weeks include: Sweden raising interest rates by 25 basis points, Chile raising interest rates by 25 basis points, China taking its reserve ratio up by 50 basis points to 18.5%, and Brazil taking its reserve ratio to 20% from 15%.  While these are somewhat muted moves in light of some of the inflationary reports we have seen, we should expect more aggressive action in 2011, especially in light of accelerating commodity prices.  As the Chinese authorities recently foreshadowed, 2011 will be a “prudent” monetary policy year and they signaled such on Christmas morning with a 25 basis point increase on key lending rates.


The final bearish factor we are focused on heading into 2011 is the increase of interconnected risk.  This factor considers rising market and asset correlations in combination with a mispricing of a number of global macro risks.  Increasingly, over the last couple of years we have seen a strengthening correlation between major markets and, really, all major asset classes.  The implication for strengthening cross-market and cross-asset class correlations, particularly in the context of an increasingly interconnected global market place, is that a major dislocation or failure or one market is increasingly likely to reverberate similarly across other major markets.  In the U.S., we saw this manifest itself via the U.S. dollar and European sovereign debt, which served as the key drivers of various major equity markets around the globe.


The key macro risk areas in 2011 that we see looming include: the domestic municipal bond market, European sovereign debt, and the continued implosion of the Japanese economy.  As it relates to the municipal bond market, broadly speaking, we think that many are missing the combination of higher projected spending with a decline in local and state tax receipts.  In terms of sovereign debts in Europe, things will get worse before they get better and we have recently seen CDS spreads in troubled countries like Greece widen to a point that implies a default is becoming somewhat imminent.  Finally, the coming year is poised to be a critical one for Japan, which is buried in a mountain of debt and an aging population that the pension system cannot support.  All this is framed with a volatility index, the VIX, which is flashing signs of complacency at its close to year-to-date lows.


We are not being non-consensus merely for the sake of being branded contrarians, but if the last few years have taught us anything it is that when consensus is solidly leaning one direction we need to seriously consider that to be a contrarian indicator.   Regardless of the consensus of views of major strategists, storm clouds loom on the economic horizon and thus we remain justifiably cautious heading into 2011.


Daryl G. Jones
Managing Director

Cartoon of the Day: 'Biggest Tax Cut Ever'

President Donald Trump's economic team unveiled what he called last week, "the biggest tax cut we’ve ever had.” Before you get too excited about that hang on a sec. "Trump Tax Reform ain’t gettin’ done anytime soon," Hedgeye CEO Keith McCullough wrote in today's Early Look.

read more

Neurofinance: The Psychology Behind When To Sell A Bull Market

"Most momentum investors stay invested too long, under-reacting and holding tight after truly bad news finally arrives to break the trend," writes MarketPsych's Richard Peterson.

read more

Energy Stocks: Time to Buy the Dip? | $XLE

What the heck is happening in the Energy sector (XLE)? Energy stocks have trailed the S&P 500 by a whopping 15% in 2017. Before you buy the dip, here's what you need to know.

read more

Cartoon of the Day: Hard-Headed Bears

How's this for "hard data"? So far, 107 of 497 S&P 500 companies have reported aggregate sales and earnings growth of 4.4% and 13.2% respectively.

read more

Premium insight

McCullough [Uncensored]: When People Say ‘Everyone is Bullish, That’s Bulls@#t’

“You wonder why the performance of the hedge fund indices is so horrendous,” says Hedgeye CEO Keith McCullough, “they’re all doing the same thing, after the market moves. You shouldn’t be paid for that.”

read more

SECTOR SPOTLIGHT Replay | Healthcare Analyst Tom Tobin Today at 2:30PM ET

Tune in to this edition of Sector Spotlight with Healthcare analyst Tom Tobin and Healthcare Policy analyst Emily Evans.

read more

Ouchy!! Wall Street Consensus Hit By Epic Short Squeeze

In the latest example of what not to do with your portfolio, we have Wall Street consensus positioning...

read more

Cartoon of the Day: Bulls Leading the People

Investors rejoiced as centrist Emmanuel Macron edged out far-right Marine Le Pen in France's election day voting. European equities were up as much as 4.7% on the news.

read more

McCullough: ‘This Crazy Stat Drives Stock Market Bears Nuts’

If you’re short the stock market today, and your boss asks why is the Nasdaq at an all-time high, here’s the only honest answer: So far, Nasdaq company earnings are up 46% year-over-year.

read more

Who's Right? The Stock Market or the Bond Market?

"As I see it, bonds look like they have further to fall, while stocks look tenuous at these levels," writes Peter Atwater, founder of Financial Insyghts.

read more

Poll of the Day: If You Could Have Lunch with One Fed Chair...

What do you think? Cast your vote. Let us know.

read more

Are Millennials Actually Lazy, Narcissists? An Interview with Neil Howe (Part 2)

An interview with Neil Howe on why Boomers and Xers get it all wrong.

read more