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This note was originally published at 8am on April 07, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I bear a charmed life.”

-William Shakespeare

How bearish are you? I know I’m bearish at a price, but I don’t think I am Bearish Enough. Some people on the Street might say they are bearish – but unless they run their own firm, I highly doubt they are bearishly positioned.

When I say Bearish Enough, I don’t mean whatever being “underweight” means. I mean having either 50-75% of your assets in cash and/or running with a net exposure of -20-30% net short. Those are not consensus positions. Neither, in most cases, are they allowed.

Does the market owe us a return? Do we have to chase yield? Or is this the biggest failure that hasn’t yet been realized by the institutionalization of our industry that’s coming down the pike – Too Big To Perform?

These are serious questions associated with a serious problem that has not been fixed alongside this +98% two-year inflation of the US stock market. When I started in the hedge fund business 12 years ago, the correlation of returns between funds was approximately 0.3-0.4. We made money in down markets (2000-2002). We didn’t whine. Since 2007, returns have reverted to the mutual fund industry’s 0.7-0.8. That’s a problem. It’s called over-supply.

In his illuminating interview with CNBC earlier this week, hedge fund pioneer Michael Steinhardt made this point in a way that only a man (without a boss) who has been in the hedge fund business since 1967 could - “it aint an elite business anymore.”

How charming…

No matter where you go this morning, there it is  - a massively understated correlation risk to global markets – the risk of everyone doing the same thing … at the same time…

Qualitatively, anyone who has managed real-time market risk prior to 2008 gets this. Quantitatively, for those of you who are new to this globally interconnected game of risk, here is some data to chew on this morning:

  1. Hedge fund net leverage in February 2011 hit its highest level since October 2007 (the last market top)
  2. Hedge fund net-long exposure to Commodities has eclipsed the prior 2007-2008 peak in 2011 (special thanks to The Bernank)
  3. Institutional Investor’s Bullish-to-Bearish weekly survey just tanked to one of its lowest Bearish readings ever

When we talk about ever, no matter whether it is in terms of leverage, asset class concentration, or net exposure, we think of ever as a very long time. I’m obviously in the business of getting paid by the industry, so I have no compensation incentive to walk you through this over-supply problem other than being right.

When I think about an investment and/or risk management idea (they aren’t the same things), my team’s baseline model has 3-factors: Supply, Demand, and Price (I learned that running a grass cutting business in Thunder Bay, not at Yale). Using that simple framework, this over-supply call and its related risks to market prices is a trivial one to grasp.

That said, as a practical matter, it’s not always easy to hedge this industry’s oversupply/correlation exposure in your portfolio. However, not having an easy answer to a big problem doesn’t mean that the underlying risk associated with that problem ceases to exist. Remember, the market doesn’t owe us anything. That’s why markets crash.

I’m not calling for a crash this morning, but I am explicitly flashing amber lights. I called for a correction and the heightening probability of a crash in mid-February – and I got both. The 6.5% correction came in US Equities. The crash came in Japan.

Now before you jump out of your screen at me on Japan – don’t worry, I get it - natural disasters aren’t things that you can “make calls” on. However, what you can do, from a risk management process perspective, is make calls on the increasing or decreasing probabilities that a person, company, or country is putting itself in to crash. Anyone want to be levered long of Charlie Sheen because he’s going up?

That’s been the slow moving train wreck associated with 1,000,000,000,000,000 YEN in Japanese sovereign debt (that’s what a quadrillion looks like in real-life). That’s Portugal this morning. That’s a debt-financed-deficit movie coming to an American theatre near you.

Everyone knows this now. That’s progress. Not everyone is allowed to be positioned for it. That’s risk.

I have a 27-factor Global Macro risk management model that dynamically re-weights for real-time market price, correlation, and volatility risks. I can show you the heat that’s associated with seeing what I see – it’s right here on my screen. If you want to shrug it off because you don’t understand it – that’s cool. I didn’t in Q2 of 2008 when I went to 96% cash. And I sure as heck won’t now. I started this firm so that I could be allowed to make these calls.

The most important question I need to ask myself on the way to my danger zone SP500 price level of 1342-1346, is why am I only in 43% cash today?

The last time I signaled this risk (February 14th, 2011), weekly sentiment on the Bear side of the II Bullish/Bearish survey had dropped -31% in a week to register a reading of 18% (in other words, only 18% of the pros in the survey admitted they were bearish in mid-February). Three weeks later, the SP500 lost -6.39% of its price inflation.

This week’s drop in weekly Bear sentiment (week-over-week) was -32%. Only 15.7% of the Bears are left. How charming…

My immediate-term support and resistance levels for oil are now $106.16 and $110.98, respectively. My immediate-term support and resistance levels for the SP500 are now 1325 and 1342, respectively.

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

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