Uncertainty and Non-Linearity

This note was originally published at 8am on August 22, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“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 $1788-1866, 79.84-84.69, and 1108-1166, respectively.


Best of luck out there this week,



Keith R. McCullough
Chief Executive Officer


Uncertainty and Non-Linearity - Chart of the Day


Uncertainty and Non-Linearity - Virtual Portfolio

Grim Irony

“That the earth would give way beneath his feet was a grim irony for Mickey Mantle.”

-Jane Leavy in “The Last Boy


The end of Summer 2011 is approaching. I’m packing up my family for Thunder Bay. And I’m smack in the middle of a Twittersphere debate about arrogance, confidence, and success.


Some people think confidence and success is fleeting because, for them, it really is. Winning is hard – but great teams find a way to make it both achievable and repeatable. I wake up every morning not only accepting the Uncertainty associated with being right in this business, but swallowing the adversity that each market day and competitor brings.


Tired old processes that refuse to evolve are threatened by us. We get it. I’ve seen my fair share of Grim Irony in the arena of life. Whether accountability was my being punched square in the face in a Canadian Junior hockey barn or reality was being fired 5 days before the birth of my 1st son, I get it. No one owes me anything in life and there’s plenty of earth to give way beneath me yet.


Back to the Global Macro Grind


Mickey Mantle was the son of a lead miner. His Dad, Mutt Mantle, died young. Before his death, as a Yankee rookie The Mick had already blown out his knee and faced plenty of adversity both on the field and from tiring veteran teammates (DiMaggio). The lesson learned from Mutt though was simple – out of sight, our of mind - play the game that’s in front of you.


And so we will this morning…


I took down my Cash position yesterday from 70% to 64% as there were some asset classes on sale that I continue to like – Corporate Bonds (LQD) and Precious Metals (SLV).


The Hedgeye Asset Allocation Model positioning is currently as follows:

  1. Cash = 64%
  2. Fixed Income = 21% (Long-term Treasuries, US Treasury Flattener, Corporate Bonds – TLT, FLAT, and LQD)
  3. International Currency = 6% (Canadian Dollar – FXC)
  4. International Equities = 6% (China and S&P Dividend ETF – CAF and DWX)
  5. Commodities = 3% (Silver – SLV)
  6. US Equities = 0%

I didn’t buy Gold yesterday (I might today – immediate-term TRADE support = $1705/oz and I’d like to see that critical risk management line of support hold before I try to play hero – for our Gold levels, see the Chart of The Day by Darius Dale attached). Instead, I bought back the Silver position that I sold on August 19th at $41.37 (SLV).


Being able to buy something that you sold higher is a wonderful feeling. A lot of people in this business call that “market timing.” And a lot of those same people say that “you can’t time markets.” Trust them on that – most of them can’t.


But if you could hit a baseball 734 feet (Mantle on May 22, 1963 at Yankee Stadium) or you could revolutionize the way people consume Apples (personal computing), why wouldn’t you try? While everyone else is whining, why wouldn’t you try it confidently?


Confidence breeds success. Success breeds confidence.


I’m certainly not suggesting Hedgeye is Mantle or Steve Jobs. But I am explicitly saying that Hedgeye is the greatest investment team I have ever had the pleasure and privilege to play on. We’re young. We’re evolving. And we have just as good an opportunity as any great Wall Street firm that has come before us to change the way this game is played. That’s exciting.


Until yesterday I had a ZERO percent asset allocation in the Hedgeye Asset Allocation Model to both US and European stocks and the entire Commodities complex. On one of those two things (Commodities), that was a good thing. On another (Stocks), it wasn’t – until China closed up big overnight (up +2.9% - we’re long Chinese Stocks) and US stock market futures are indicated down, again.


Again is as again does.


Over and over and over again, the Perma-Bulls have been buying stocks and changing their thesis as to why as they go. At the end of 2007 (the SP500 is still down -24.8% since then, fyi), it was because “stocks were cheap” and corporate America was “awash with liquidity.” Today, I guess their portfolios are still awash with US Equity exposure and stocks are getting cheaper.


But what does all of their storytelling and finger pointing really do for this country? People don’t trust this economic system or the people who manage it. If calling opacity out on the carpet is “arrogant”, I’ll happily be transparency’s child. America trusts winning and the Grim Irony of all of this back and forth about who is “perma” this and “perma” that is that very few have been Perma Right.


My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1, $81.24-89.23, and 1108-1191, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Grim Irony - Chart of the Day


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The Macau Metro Monitor, August 25, 2011




Changi Airport handled 4.17MM passengers in July, a 13.6% YoY increase.




TODAY’S S&P 500 SET-UP - August 25, 2011


With the exception of inflation in Vietnam being reported at +23% y/y for August (US centric stock market people will say that’s not inflationary, for them), global economic data around the world this morning is very light. 


For the immediate-term TRADE, Gold down and UST Yields up is the same trade. Both are screaming that La Bernank is in a box and won’t be doing QE3 tomorrow (that’s a good thing for America). We are not short the SP500 yet, but very well could be by day’s end.


As we look at today’s set up for the S&P 500, the range is 83 points or -5.91% downside to 1108 and 1.14% upside to 1191.




Yesterday’s rally, put the XLU positive on TRADE and TREND.









  • ADVANCE/DECLINE LINE: +1173 (-946)  
  • VOLUME: NYSE 1109.47 (-10.58%)
  • VIX:  35.90 -1.02% YTD PERFORMANCE: +102.25%
  • SPX PUT/CALL RATIO: 1.73 from 1.78 -2.99%



  • TED SPREAD: 31.94
  • 3-MONTH T-BILL YIELD: 0.02% +0.01%
  • 10-Year: 2.29 from 2.15    
  • YIELD CURVE: 2.06 from 1.93

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30 a.m.: Initial jobless claims, est. 405k, prior 408k
  • 9:30 a.m.: IMF bi-monthly press briefing
  • 9:45 a.m.: Bloomberg consumer comfort index, est. -49
  • 10:30 a.m.: EIA natgas storage, est. +74
  • 11 a.m.: Fed to purchase $250m-$500m TIPS
  • 1 p.m.: U.S. to auction $29b 7-year notes



  • Greek spreads vs Bunds hit record highs on bailout concerns
  • Hurricane Irene is passing over the Bahamas and may be near North Carolina this weekend and New England next week
  • ECB “stands ready” to ease tensions in U.S. dollar funding of European banks if they arise, Bundesbank’s Andreas Dombret says
  • Bernanke unlikely to promise new action by Fed - WSJ


  • GOLD –We can look at yesterday’s move this with a fresh pair of risk management eyes; the Hedgeye immediate-term TRADE line of support has not yet been breached ($1705) and we will likely buy it there if all else remains intact.





  • Tony Hayward Gets a Life Post-BP as Investors Write Blank Check
  • Hurricane Irene Strikes Bahamas on Path Toward U.S. East Coast
  • Glencore First-Half Profit Rises 57%; Asian Demand ‘Strong’
  • Gold Drops for Third Day After Margin Boost as Equities Advance
  • Comex Increases Gold Margins After Sharpest Drop Since 2008
  • Oil Trades Near Two-Day Low; Standard Chartered Cuts Forecasts
  • Driver Shortage Shows Gain in U.S. Truck Cargo: Freight Markets
  • Rising Potash Means Lower Debt Cost for Uralkali: Russia Credit
  • Burger King Adds Mom-Friendly Food as Whopper Lovers Lose Jobs
  • Gasoline Use at Nine-Year Low as Economy Falters: Energy Markets
  • Irene Threatens North Carolina Prompting Evacuations From Coast
  • Copper Gains for Third Day as Data Reports Boost Demand Outlook
  • China Bonded Copper Stockpiles Fall About 50%, Glencore Says
  • Crude Futures Advance on Fed Speculation, Supply Decline in U.S.






  • EUROPE/GREECE – the country isn’t going away, but their bond and stock markets are – and what I mean by that is that no one real invests in illiquidity like this; and this is how the Fiat Fool story ends. Greece down -48.5% since FEB and hitting new lows…
  • Germany Sep GfK consumer sentiment 5.2 vs consensus 5.2 and prior revised 5.3 from 5.4





  • ASIA/CHINA – big short squeeze in Chinese stocks overnight of +2.9% (that’s the only equity market worldwide that we are long, and we are nervous about it), but the rest of Asia didn’t follow – Korea is still in crash mode and Indonesia, India, Thailand, and Malaysia all closed down on the session. Global growth continues to slow.








Howard Penney

Managing Director

PSS Quick Hit


Q2 results are indeed messy, but considerably better than we expected. We thought EPS would be secondary to one of two things that had to happen, either a) the company said nothing about its strategy, or b) the board stood up like a big boy and showed the investment community that it's taking the bull by the horns and actually does have a plan. We clearly got the later.


There will be plenty more to chew on after the call, but with over 25% of the shares short this one will be up sharply.



Here are a few takeaways from the results: 

  • Top-line came in up +4.9%, the most robust growth the company reported since the acquisition of Stride Rite in 2007. It looks like this was largely driven by aggressive pricing in an effort to clear inventories.
  • Comps came in slightly better than expected down -0.7% (vs. our -2%E) with International up +3% and Domestic down -2% reflecting sequential improvement both on a 1yr and 2yr basis.
  • PLG came in strong up +25% and the company is guiding to 20% growth again in Q3.
  • Gross margins (adjusted) down -360bps were worse than expected, but makes sense given that the company got even more aggressive on pricing during the quarter to reduce inventories.
  • SG&A (adjusted) was down -2% excluding severance though it's not entirely clear what's in that number.
  • Inventories were up +16% on 5% sales growth. While at face value this appears horrible, it's a sequential improvement from 1Q and again reflects a more aggressive posture towards clearing the balance sheet. While there is more work to be done here, the sales/inventory spread at -11% was the best it’s been in the last four quarters and significantly better than -24% posted in Q1.


PSS Quick Hit - PSS quick hit part1 8 11


PSS Quick Hit - PSS Quick hit part2 8 11


PSS Quick Hit - PSS Sigma 8 11







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