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Uncertainty and Non-Linearity

“Linearity isn’t the norm in the world around us, non-linearity is.”

-Dan Gardner

 

That’s another quote from the book I referenced last week that I am in the middle of reading – “Future Babble – Why Expert Predictions Fail and Why We Believe The Anyway.”

 

What’s interesting about both Chapter 2 (“The Unpredictable World”) and the book is that it’s really accessible for non-scientifically inclined readers. You don’t have to have a Ph.D. in fractal math or applied physics to grasp the deep simplicity of a few very important concepts – Uncertainty and Non-Linearity.

 

In Hedgeye’s Research and Risk Management Process, Uncertainty is critical to accept. Maybe that’s why our models have had very different signals than consensus during both the 2008 and 2011 Growth Slowdowns. Wall Street/Washington models tend to command some level of certainty in their baseline assumptions. Being absolutely certain about models that don’t work is a problem.

 

In the real-world of accountability, successful Buy-Side Risk Managers like Ray Dalio (Founder of $100B Bridgewater Associates) have embraced Uncertainty as a core component of what it is that they do. As Dalio says in John Cassidy’s New Yorker article (“Mastering The Machine”, July 25, 2011):

 

“I’m always trying to figure out my probability of knowing... Given that I am never sure, I don’t want to have any concentrated bets.”

 

I love that.

 

Defining Non-Linearity is a little more complex. But, essentially, that’s the point – and why we’ve built all of our models and processes on Complexity (or Chaos) Theory.

 

Clients often ask me for reading primers on Chaos Theory. Here are a few:

  1. Complexity – The Emerging Science At The Edge of Order and Chaos”, by M. Mitchell Waldrop
  2. Deep Simplicity – Bringing Order to Chaos and Complexity”, by John Gribbin

After having consumed both of these books, you’ll realize that neither contain any applied market models. And that, too, is the point. Accepting Uncertainty and Non-Linearity in your risk management process is something that you have to really come to embrace in principle before you apply it to what it is that you do.

 

In “Future Babble”, Gardner doesn’t do Chaos Theory like I do, per se, but he does simplify the difference between Linear and Non-Linear systems. “Gravity, for example, is linear in mass. Double the mass and you get twice the gravity” (page 39). “A common component of non-linear systems, feedback, involves some element of the system looping back on itself…” (page 40).

 

I like that explanation because it’s simple. To a degree, Non-Linearity also rhymes with what George Soros calls “reflexivity.” And, again, in principle, it takes a fundamental acceptance that this is what drives market prices, volumes, and volatilities before you can really apply it to what it is that you do.

 

Back to the Global Macro Grind

 

What it is that the US stock market continues to do is go down. Last week, with the SP500 closing at 1123 (its lowest weekly-closing-low of 2011), across all 3 of our core risk management durations (TRADE, TREND, and TAIL), US stocks are bearish/broken:

  1. TRADE (3 weeks or less): resistance = 1166
  2. TREND (3 months or more): resistance = 1294
  3. TAIL (3 years or less) = resistance 1256

When Perma-Bulls call this a correction, I’m not quite sure what they mean.

  1. Since its 2007 bull market cycle-high of 1565, the SP500 is down -28.2%
  2. Since its 2011 bear-market rally to a lower-long-term high of 1363, the SP500 is down -17.6%
  3. For 2011 YTD, the SP500 is down -10.7% (the Russell 2000 is down -16.8%)

Now before the bulls get to point #3 they’ll be jumping out of their seat saying, ‘but, the SP500 is still up +66.1% from its March 2009 closing low.’ OK. It really would be ok if the Perma-Bulls were in 100% Cash at the 2009 low and bought everything for their clients right then and there – but I’m pretty sure that didn’t happen.

 

In Q3 of 2008, I took the Hedgeye Asset Allocation Model to 96% Cash.

 

In Q3 of 2011, I’ve now taken the Hedgeye Asset Allocation Model to 70% Cash (versus 64% at the beginning of last week).

 

I guess that makes me relatively bullish compared to 2008!

 

Into Friday’s straight up move in Gold and Silver, I took our Commodities allocation back down to 0% (I sold our entire Silver (SLV) position). There are no rules against buying that or a long position in Gold back. Long-term returns are cumulative and gains compound. The market doesn’t particularly care what I own on any particular day.

 

Making money starts with not losing money. And while I am painfully aware of how hard it is to actually execute on that strategy at the end of bear market rallies (2007 and 2011), I’m also very respectful that long-term returns in this business are both Non-Linear and Uncertain.

 

My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1, 79.84-84.69, and 1108-1166, respectively.

 

Best of luck out there this week,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Uncertainty and Non-Linearity - Chart of the Day

 

Uncertainty and Non-Linearity - Virtual Portfolio


The Cavalier Cowboy

This note was originally published at 8am on August 17, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The American Republic will endure until the day the Congress discovers it can bribe the public with the public’s money.”

-Alexis de Tocqueville

 

I have my doubts that Texas Governor Rick Perry has ever read Alexis de Tocqueville.  This is not to say that he is not an intelligent and well-read person, but he just doesn’t strike me as a person who really cares what a Frenchman wrote about America over 150 years ago.  Regardless, de Tocqueville and Perry certainly share common ground on their suspicion of government.

 

In his kick off speech this past weekend, Perry went directly to the heart of his view on government:

 

“That’s why we reject this President’s unbridled fixation on taking more money out of the wallets and pocketbooks of American families and employers and giving it to the central government.  ‘Spreading the wealth’ punishes success while setting America on a course to greater dependence on government.”

 

As the early and vitriolic attacks from the left have shown, The Cavalier Cowboy has them right rattled only a few days into his campaign.  Meanwhile over on the political right, if his political competitors haven’t shown they are rattled publicly, they will soon.  A recent Rasmussen poll shows Perry with 29% support for the Republican nomination, Romney at 18%, and Bachman running a distant third at 13%.  As they say in Texas: Yeee-haw!

 

Clearly, Perry is experiencing a post-announcement bump in popularity and his poll numbers are likely to come down over the coming days.  On the other hand, if the first few days are any indication of the campaign Perry will run, his rhetoric is more than likely set to accelerate.

 

Perry has proven himself to very quotable early into his entrance into the campaign.  His most notable quote was a not-so-guised criticism of the Federal Reserve and Chairman Ben Bernanke.  Actually, forget guised critique, the cowboy from Paint Creek, Texas took a double barreled shotgun to the Fed with the following statement at a campaign event in Iowa:

 

“If this guy prints more money between now and the election, I dunno what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas.  Printing more money to play politics at this particular time in history is almost treasonous in my opinion.”

 

Perry could have chosen his words more carefully, but the interesting takeaway is that he is currently the front runner in the Republican field, could realistically become President, and has in one of his earliest campaign appearances taken a direct shot at the Federal Reserve.  Historically, a critique of the Federal Reserve has been left to the devices of more fringe candidates (enter Ron Paul), as the Fed has become an accepted institution in America.  Not so anymore.

 

Whether the nature and organization of the Federal Reserve truly becomes a central campaign issue over the next 18+ months is yet to be seen, but if it does Americans should welcome it.  With the proliferation of Keynesian economists in America over the last eighty years, the majority of Americans have largely accepted the role of the Federal Reserve in their economy despite the contra voices of economists such as Milton Friedman.

 

In Friedman’s classic, “Money Mischief: Episodes in Monetary History”, he wrote about the Fed:

 

“I have observed that non-economists find it almost impossible to believe that twelve people out of nineteen – none of whom have been elected by the public – sitting around a table in a magnificent Greek temple on Constitution Avenue in Washington have the awesome legal power to double or halve the total quantity of money in the system in the country.”

 

After both an extended and continued period of the lowest interest rates in U.S. history and two rounds of quantitative easing, monetary stimulus over the past two years have been largely ineffectual in promoting the Fed’s dual mandate of lowering unemployment and creating price stability.  In fact, the only real growth we’ve seen is in the size of the Fed’s balance sheet.  Time will tell whether The Cavalier Cowboy will have the staying power to win the Presidency, but in mainstreaming questions about the Fed, even if poorly worded, he is already doing a service to the country.

 

The other role that Perry will likely play is as a headwind to incremental monetary easing.  Our view currently is that the Fed will not implement another round of quantitative easing until we see at least three months of negative employment data, which places the potential timing for incremental easing into late 2011, at best.  Perry’s heightened rhetoric will only increase both scrutiny of the Fed and questions by certain Fed Governors of the real benefit of incremental easing, which could serve to lengthen the time frame on implementation of additional easing.

 

As the Fed continues to play the wait and see game related to lagging economic indicators, back in the market economy data continues to deteriorate.  Specifically, the high yield market has had it worst month in over twenty years.  High yield yields have backed up by more than 9% over the last thirty days and were up more than 14% at their peak. 

 

In the Chart of the Day, we emphasize this point by showing an index of credit default swaps on high yield bonds over the last year.  Credit default swaps on high yield bonds are now at yearly highs and are up more than 30% in the last thirty days.  Given that the Fed has explicitly stated that interest rates will not increase well into 2013, it is not interest rate risk the high yield market is signaling . . .

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

The Cavalier Cowboy - Chart of the Day

 

The Cavalier Cowboy - Virtual Portfolio


THE HBM: SBUX, SAFM, TXRH, BWLD AND FSR EPS REVISIONS

THE HEDGEYE BREAKFAST MENU

 

Notable macro data points, news items, and price action pertaining to the restaurant space.

 

MACRO

 

International beef trade continues to be a big factor in this year's record cattle prices. During the first half of 2011, 10.3% of U.S. beef production was exported and imports equaled 8.1% of production. U.S. beef exports during June were up 19.6% while beef imports were down 16.7% compared to a year ago. The biggest foreign buyer of U.S. beef in June was Japan.

 

SUB-SECTOR PERFORMANCE

 

The Food Processors significantly underperformed last Friday as corn prices continued to rally.

 

This weekend’s Barron’s argues SAFM looks overpriced as it notes that high corn and soybean prices, low chicken prices, low chicken demand as well as an upcoming slack season could mean 25% downside. 

 

THE HBM: SBUX, SAFM, TXRH, BWLD AND FSR EPS REVISIONS - hfbrd

 

QUICK SERVICE

 

  • Coffee stocks (ex SBUX) underperformed the group, but on low volume.
  • Last week QSR stocks underperformed the S&P 500 last week by 180bps

 

FULL SERVICE

  • TXRH outperformed as it announced a $50M increase in stock repurchase authorization
  • BWLD outperformed on positive comments from a broker
  • DRI - Olive Garden has rolled out its annual Never Ending Pasta Bowl limited-time offer for $8.95 this week.
  • Last week FSR stocks underperformed the S&P 500 by 240bps
  • Casual dining sales trends, as indicated by Malcolm Knapp’s Knapp-Track Casual Dining Sales Index, sequentially accelerated on a two-year average basis in July.  The better top line trends are not enough to offset the significant increase in commodity prices.  As a result EPS estimates are under continued pressure.

THE HBM: SBUX, SAFM, TXRH, BWLD AND FSR EPS REVISIONS - fsreps

 

 

THE HBM: SBUX, SAFM, TXRH, BWLD AND FSR EPS REVISIONS - qsr

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Howard Penney

Managing Director

          

 

Rory Green

Analyst


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KNAPP TRACK TRENDS HOLD STRONG

Casual dining sales trends, as indicated by Malcolm Knapp’s Knapp-Track Casual Dining Sales Index, sequentially accelerated on a two-year average basis. 

 

Malcolm Knapp recently released estimated casual dining comparable restaurant sales for July.  The sales environment remained strong overall and, while we expect a slowdown in headline Knapp numbers deeper into the back half of the year, the trend in July sequentially improved from June. 

 

Estimated comparable restaurant sales growth in July was +1.4%.  Final June comparable restaurant sales growth was +2.6% (versus the prior estimate of +2.4%).  The sequential increase from June to July, in terms of the two-year average trend, was 25 basis points.

 

Comparable guest counts in the casual dining space grew +0.3% in July on a year-over-year basis.  The final June guest counts growth number was +0.8% (versus the prior estimate of +0.5%).  The sequential gain from June to July, in terms of the two-year trend, was 65 basis points.

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst


KEITH MCCULLOUGH GUEST HOSTING SQUAWK BOX TOMORROW MORNING

Valued Client,

 

Tomorrow morning from 6:00-9:00am EST, our CEO Keith McCullough will be guest hosting CNBC’s Squawk Box. Per usual, Keith will be facilitating the debate with his latest thoughts on a wide variety of topics including financial markets, the global economy, and both monetary and fiscal policy.

 

Enjoy the rest of your weekend and best of luck next week,

 

The Hedgeye Macro Team

 

About Keith McCullough

Prior to founding Hedgeye Risk Management, Keith built a track record as a successful hedge fund manager at the Carlyle-Blue Wave Partners hedge fund, Magnetar Capital, Falconhenge Partners, and Dawson-Herman Capital Management. He got his start as an institutional equity sales analyst at Credit Suisse First Boston after earning his Bachelor of Arts in Economics from Yale University, where he captained the Yale Varsity Hockey Team to a Division I Ivy League Championship. Keith is also a Contributing Editor to CNBC TV, Fortune Magazine and author of Diary of a Hedge Fund Manager (Wiley 2010).


Weekly Asia Risk Monitor

As usual, we’re keeping it brief. Email us at  if you’d like to dialogue further on anything you see below.

 

THEME

Both market prices (particularly across Asia’s fixed income markets) and economic data are confirming that consensus is not yet bearish enough on U.S./global growth.

 

PRICES

Inclusive of this morning’s sell-off, Asian equity markets had a pretty mixed week – the first non-homogenous wk/wk price action we’ve seen MTD. Still, red outweighed green and the larger countries such as China, India, Japan, and Korea were leaders to the downside. Week-over-week price action in Asian FX markets echoed a similar tale of heterogeneity and the -1.4% decline in the New Zealand dollar led the way to the downside.

 

In Asian fixed income markets, 10yr sovereign yields declined broadly across the region on a wk/wk basis, supportive of growing concern about the outlook for global growth. A noteworthy callout remains the fact that the entire term structure of Australia’s sovereign yield curve is trading below the RBA’s policy rate of 4.75%. We saw mixed signals from a credit perspective; CDS declined broadly throughout the region while spreads over similar maturity U.S. Treasury debt mostly widened wk/wk.

 

In the interest rate swaps market, the key callout this week is China’s +14bps back-up in 1yr swap rates – indicating that market-based interest rate expectations have inflected, on the margin. We continue to think the PBOC remains on hold and, like the RBA, their next move is likely to be dovish rather than hawkish. The timing of each event will be a critical risk to manage. We remain bullish on Chinese equities and bearish on the Aussie dollar over the intermediate-term TREND.

 

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KEY CALLOUTS

 

China: Chinese officials announced three measures to spur cross-border yuan investment. Though not wholly original or earth-shattering, the cumulative impact of each additional measure inches the Chinese yuan one step closer to becoming a dominant currency in the international FX market. The measures include: a Hong Kong equity ETF vehicle for mainland investors, a $3.1B extension of the Qualified Foreign Institutional Investor Program (QFII), and a general relaxation of controls in the dim-sum bond market.

 

Elsewhere in the Chinese economy, Commerce Minister Chen Deming reiterated what Singaporean officials did last week by revising down his estimates for Chinese 2H trade growth, citing “shrinking Western demand”. Slowing growth in China remains 20 months old and we continue to highlight that we’d be long of Chinese financials and consumer stocks vs. all other things equity-related right now (we’re still long the CAF in our Virtual Portfolio).

 

Japan: Real GDP growth came in faster in 2Q on a QoQ SAAR basis (-1.3%), but flat on a YoY basis (-1%) due to a “suspicious” deceleration of the GDP deflator (-2.2% YoY). On a nominal basis, the economy is back at trough levels last seen since 1991. While consensus remains long of Japanese equities on earthquake reconstruction, our models suggest growth slows even further in 2H11. Japan’s sequentially-deteriorating July trade data (exports down -3.3% YoY; trade balance down -¥715.7B YoY) and the compressing JGB curve (10yr-2yr spread at a nine-month low of 85bps) is supportive of our view. The list of bearish data points and catalysts grows seemingly by the week; we remain the bears on Japanese equities for the intermediate-term TREND.

 

As the world’s third-largest economy remains mired in recession (starting in 4Q10 when we introduced our Japan’s Jugularthesis), Finance Minister Yoshihiko Noda reiterated that he’s ready and willing to “surprise” the FX market with “bold action”.  While this is certainly a risk to our bullish outlook for the yen in the immediate term, Global Macro fundamentals will continue to drive the yen higher over the intermediate term. His leak that the central government is considering cutting spending by 10% in the upcoming fiscal year certainly does not help his cause.

 

India: Growth in India’s wholesale price index (India’s benchmark inflation gauge) slowed in July to +9.2% YoY. Our models continue to point to an August peak in this metric and then a sticky deceleration over the intermediate term. Recent commentary out of Indian officials is supportive of this view: “India’s inflation rate may peak in August around 10%... Until December, inflation will stay around the same levels,” according to Kaushik Basu, the chief economic advisor to India’s finance ministry. Moreover, the most recent central bank survey showed 3Q11 inflation expectations out of the Indian household sector declined on the margin to +11.9% YoY. Indian equities remain on our short list of Asian long ideas when our models signal to us that it’s time to increase our international equity exposure.

 

Australia: We put out a report last month titled: “We Wouldn’t Want to Be Glenn Stevens Right Now” which highlighted the confusing setup for the Reserve Bank of Australia’s monetary policy committee. On one hand, Australian economic growth is slowing. On the other hand, official inflation metrics continue to accelerate, like the country’s wage cost index (+0.9% QoQ in 2Q). We continue to side with Australia’s fixed income market by anticipating an RBA rate cut(s) over the intermediate term (see commentary above). As such, we remain the bears on the Aussie dollar over the intermediate-term TREND. Interestingly, Australia’s interest rate swaps market is pricing in -153bps of rate cuts over the NTM – down from a YTD high of +47bps (rate hikes). If Global Macro fundamentals do indeed take a turn for the worse, the AUD/USD has a great deal of Winner’s Risk (up +28.3% since last June) due to the fact that investors in distress typically sell what they can (book gains) vs. what they should (cut their losses).

 

Singapore: Prime Minister Lee Hsien Loong unveiled plans to expand public housing and medical benefits, as well as details on how Singapore will slow the intake of foreigners. While we do not like the Singaporean government caving in to populist demands, the details of the initiatives do indeed confirm that Singapore isn’t tinkering too much with (arguably) the world’s best organic growth model.

 

Elsewhere in the Singaporean economy, we saw that July export growth contracted the most since Oct ’09 (-2.8% YoY) as plunging global demand for Singapore’s electronics (-16.9% YoY) weighed on overall shipments. We continue to highlight risks to consensus forecasts of a 2H rebound in global growth with such nasty trade and production data coming out of Asia – the world’s key manufacturing hub.

 

Thailand: Thailand’s newly elected prime minister Yingluck Shinawatra confirmed that her government will fulfill a campaign promise to purchase (and hoard) unmilled rice at 15,000 ($502) baht per ton in the November harvest – an increase of +51.5% from the current market rate of 9,900 baht per ton. The scheme is designed explicitly to sustainably push up global rice prices by reducing supply on the global rice market (per the USDA, Thailand is the world’s number one rice supplier at roughly 32.2% of total exports).  Asia, which accounts for roughly 87% of global rice consumption, is particularly at risk from a food inflation perspective and may ultimately limit the amount of monetary easing Asian central banks can pursue in the event the current global economic slowdown takes a turn for the worse.

 

Malaysia: Real GDP growth slowed -90bps in 2Q to +4% YoY from +4.9% YoY in 1Q, while CPI slowed -10bps in July to +3.4% YoY from +3.5% YoY in June. This 9:1 ratio of slowing GDP vs. slowing CPI highlights a key point we’ve been making in recent weeks – global growth is slowing while reported inflation remains sticky. Our call for furtherDeflating the Inflation across the commodity complex will eventually be passed through global supply chains to end-consumers, but the timing of that is something we are exercising caution on. Being early = being wrong.

 

New Zealand: New Zealand’s 2Q PPI reading is also supportive of our call on the lead/lag time of global supply chain dynamics, with input price growth (+0.9% QoQ) slowing by a marginal rate greater than 4x the sequential decline in output price growth (+1.4% QoQ). Shifting gears, the slowdown in New Zealand’s producer prices weighed on market interest rate expectations, with New Zealand’s interest rate swaps market pricing in -14bps less rate hikes over the NTM since the PPI report date. This goes a long way towards explaining the drastic underperformance of the Kiwi dollar this week.

 

Taiwan: Not all news out of Asia this week was sour: Taiwanese export orders growth accelerated in July to +11.2% YoY (vs. +9.2% YoY in June). Whether this is a red herring for bulled-up consensus expectations for 2H global growth remains to be seen. Still, as one of the few positive data points coming out of Asia in recent months, it’s worth flagging.

 

Darius Dale

Analyst


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