“Hold fast to dreams,
For when dreams go,
Life is a barren field frozen with snow.”
-Langston Hughes
It hasn’t been much of a winter in Connecticut. In fact, until the last 12 hours we had at most a few flurries in the Nutmeg State this winter. Last night we had maybe an inch or two and most of it melted. Nonetheless, many school districts in the Stamford area have called a “Snow Day”. Kids and teachers are celebrating, while we parents are preparing to hold down the fort at home.
When it snows, I’m always reminded of fractal patterns. As Telluride magazine wrote in an article titled, “Why Are Snowflakes Beautiful?”:
“Part of the magic of snowflake crystals are that they are fractals, patterns formed from chaotic equations that contain self-similar patterns of complexity increasing with magnification.”
Even in the chaos of nature, and even more chaotic Snow Days, patterns emerge.
This is a concept we focus on regularly at Hedgeye. Specifically, the idea of looking for similar sets within the chaotic and seemingly random nature of markets. Just like running a household during a Snow Day with four school age kids, it is no easy process to look for and identify similar sets within markets.
One of the cornerstones of our work in this area is Benoit Mandelbrot’s book, “The Misbehavior of Markets: A Fractal View of Financial Turbulence”. Many professional stock market strategists and risk managers would have you believe that price movements are random, unpredictable, and independent, but ultimately there is an order just not in the normal bell curve distribution sense.
The fractal view of markets, and I’m obviously simplifying, is that while price moves can be unpredictable, they are ultimately not mutually independent and randomly distributed. In fact, patterns develop that become much more scalable than many market participants believe is possible. Just like Mandelbrot writes about, and we focus on, these scalable patterns often emerge out of volatility clusters.
In fact, Mandelbrot was a leader in demonstrating “volatility clustering”. In essence, this was the discovery that calm market days – those with price moves less than 3% - tend to be followed by more tame days. In contrast, “wild days” tend to be followed by more of the same.
As a result of this scalability of volatility clustering, we get bubbles, crashes, and six sigma events occurring with some regularity. Theoretically, a six-sigma event should occur once every 796 years. In practice, these events occur much more frequently.
Back to the Global Macro Grind…
One pattern that is emerging in global economic data is the reacceleration of global inflation readings. We had more evidence of that this morning:
- France February CPI re-accelerated to 6.2% Y/Y from 6.0%; and
- Spain February CPI re-accelerated to 6.1% Y/Y from 5.9%.
This comes on the back of recent PMI reports that indicated prices are re-accelerating, U.S. PPI and CPI that surprised to the upside, PCE re-accelerating, and aggregate Eurozone CPI that re-accelerated.
As a result of this data over the past few weeks, yields have moved up and central bankers have gotten incrementally hawkish. As shown in the Chart of the Day, this is reflected in Fed Funds Futures, which has priced in an additional 0.96 hikes since the last FOMC announcement in late January.
The challenge with this cycle for investors is that the pattern builds on itself. Inflation stays higher for longer than investors expect, central bankers raise rates for higher and longer than expected, and ultimately the economic slowing is greater than expected.
The real-time mechanism for measuring this impact of rate hikes and expectations for hikes is the housing market. We saw this last week Weekly Mortgage Applications coming in at -18.1% W/W and -41.3% Y/Y, which took the index to 147.1 and its lowest level in some 28 years. A +60bps ramp in rates in a week is doing what it should do . . . drying up demand in the most interest rate sensitive parts of the economy.
This scalability in fractals is something Keith indirectly alluded to this morning in his top three things where he wrote:
“RATES – both 2s and 10s fell post another US #Growth Slowing Durable Goods & Capex report for JAN, but the net of it is that the Short-End of The Curve remains pinned with HIGHER-HIGHS in play as the Long-End signals LOWER-HIGHS, which equates to a nasty Yield Curve Inversion; meanwhile Germany’s 10yr Bund Yield is up another +5bps to new 12 year highs this morning.”
The concepts of higher highs, lower highs, and yields hitting multi-decade highs speak to developing volatility clusters and emerging patterns that aren’t following a normal distribution.
Now none of this is to say there we are on the precipice of a once in a 796 year market calamity. That said, if the last few years have taught us anything it should be that those 4, 5, or even 6 sigma events happen with much more regularity than the models of the Old Wall predict.
It should be no surprise that we continue to be positioned conservatively. As of yesterday, these were our Top Macro ETFs By Rank:
- FDRXX, GLD, IIGD, UUP, ITA, VIG, BTAL, GRID, IAK, BNDD, KWEB, SLV, KMLM, GDX, SQQQ
So yes, we are prepared for more “snow days” in our volatility future.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets
UST 30yr Yield 3.79-4.01% (bullish)
UST 10yr Yield 3.73-4.03% (bullish)
UST 2yr Yield 4.54-4.84% (bullish)
High Yield (HYG) 73.24-75.41 (bearish)
SPX 3 (bearish)
NASDAQ 11,201-11,770 (bearish)
RUT 1 (bearish)
Tech (XLK) 132-140 (bearish)
Shanghai Comp 3 (bullish)
VIX 19.60-23.96 (bullish)
USD 103.12-105.41 (bullish)
EUR/USD 1.052-1.074 (bearish)
USD/YEN 133.04-136.98 (bullish)
GBP/USD 1.192-1.212 (bearish)
Oil (WTI) 73.38-77.83 (bearish)
Nat Gas 2.09-2.78 (bearish)
Gold 1 (bullish)
Copper 3.92-4.26 (bullish)
Keep your head up and stick on the ice,
Daryl G. Jones
