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This note was originally published at 8am on October 05, 2012 for Hedgeye subscribers.

“Shocks create change.”

-Myron Scholes

Ex the Nobel Prize thing, Mr. Scholes and I have a few things in common. We’re both Canadian-American economists. We’re both from Northern Ontario (he’s from the home of the Timmins’ Benjamin Bears). We’re both ex-hedge fund managers!

Admittedly, Scholes’ 1998 blow up of Long-Term Capital Management was more shocking than ours at Carlyle in 2007. His team got a bailout. Ours didn’t. But we’ve both had an opportunity to learn from our mistakes.

In one of the most timely chapters of The 4% Solution, “Not All Growth Is Good”, Scholes made some of the simplest but relevant risk management points I have read in a while: “We have to encourage success (and allow for failure), because that is how we grow… we need to remain flexible… adapt to changing circumstances… let’s not let a good shock go to waste.” (page 115)

Back to the Global Macro Grind…

I was on the road this week in both Denver, Colorado and Kansas City, Missouri. I love the road. It’s where I became both an athlete and an investor. As a risk manager, the road is where I get a non-groupthink pulse in this country.

Every cab I got into in Kansas City yesterday was blaring Rush Limbaugh. Every cabbie was all fired up about the debate. No matter what your politics, Mitt Romney shocked the country yesterday. That’s what this country (and market) needed.

Bobby Valentine got a little shock of his own last night too. I’m guessing Red Sox fans probably appreciate the accountability assigned to wins, losses, and leadership.  That’s the America I immigrated to in the 1990s. I think it’s the one we all love too.

Shocks create change

Or at least, in free-market economy, they should. Could a change in overall US Growth Expectations shock the country? You tell me. If my macro model gets as much as a whiff of a +3% US GDP Growth probability that’s greater than 33%, I may have to dress up as a bull for Halloween.

That’s scary.

And so was the Old Wall’s March 2012 consensus that the USA would see +3-4% GDP growth with all this debt and uncertainty. While I have had no problem leaning longer in the last 3 weeks, I’ve had even less of a problem selling on green.

Why? Because #EarningsSlowing is going to continue to shock the bulls in certain stocks throughout earnings season. That starts next week. So, no matter where we go on a made-up and politically massaged government number today, there we will be.

What if Romney’s Rally wasn’t a one off?

  1. Financials (XLF) could continue to shock you to the upside (Financials lead the market in October at +3.0%)
  2. Energy stocks (XLE) could continue to shock you to the downside (Energy lead losers in October at -0.4%)
  3. Strong Dollar, Strong America (higher long-term lows for the USD) could surprise the world

What if Romney continues to build momentum, but Earnings Season is worse than I expect?

  1. I don’t know
  2. But the bond market could continue to be right in 2012, with bond yields making lower-lows
  3. And, on mean reversion risk alone, the SP500 could drop to 1419 (-3%) in a day

A 3% down day? Never. It’s different this time. Right?

Right. Right. Until it isn’t, I guess. India’s stock market (the Nifty) dropped -16% this morning on “erroneous orders” and they had to halt trading for 15 minutes. Imagine that happened here? It has. So you don’t have to imagine too hard.

This market is as laden with both risk and opportunity right now as I can remember. I like to be shocked the right way. But I fully expect to be shocked, at any given moment of my centrally planned day, the wrong way.

And that’s all I can say about that.

My immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr UST Yield, and the SP500 are now $1770-1794, $108.41-111.89, $79.29-80.13, $1.29-1.31, 1.59-1.73%, and 1446-1466, respectively.

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

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