Dangerous Theories

“For a theory is a very dangerous thing to have.”

-Nassim Taleb

I just got back from an island in the Bahamas and I’m flying to London this morning. As a result, February will be a very productive month of reading. I just finished grinding though both The Last Lion and Antifragility. I’m digging into Ike’s Bluff next.

The problem with self-education is that the more you read, the less you know. This helps contextualize how clueless the people who are trying to centrally plan your life actually are. Particularly when it comes to economic policies, I agree with Taleb that their “theories are superfragile.”

He also goes on (and on and on) to differentiate between social and hard sciences: “Physics is privileged; it is the exception, which makes its imitation by other disciplines similar to attempts to make a whale fly like an eagle.” (Antifragility, pg 116)

Back to the Global Macro Grind…

After closing up for the 6^th consecutive week, the US stock market is flying like something – and it’s not the London Whale. On almost no volume on Friday (down -21% from my YTD average for market up days), the Russell2000 made yet another all-time high.

As we like to say at Hedgeye, all-time is a long time… but now we’ve been writing about all-time for a pretty long time too. For perma-bears, this has to be leaving a mark. Last week’s II Bull/Bear Sentiment Survey saw Bears capitulate to a fresh new YTD low of 21.1%.

Other than playing with my kids in the Bahamian sun, what did I like about last week?

1. STRONG DOLLAR – the US Dollar moved back into a Bullish Formation, closing up +1.4% wk-over-wk at $80.25
2. DEFLATING THE INFLATION – the CRB Index (19 commodities) closed down another -1.3% on the week at 301
3. I discovered a tasty new beach beer, Kalik Light

I know some of our competitors keep talking about the risk of raging inflation – but that’s a Dangerous Theory to have if the US Dollar continues to make a series of long-term (40 year) higher-lows.

We’re not theorizing that Bernanke’s Bubbles (Commodities) will continue to pop from their all-time highs (2008-2012). They are already popping. Oil topped in 2008; Gold and the CRB Index stopped going up in 2011; and Food Prices put in their all-time highs in 2012.

If your theory was that the Fed would print to infinity and beyond and you bought Gold, Silver, etc. on that in 2008-2009, great call. But what happens to your theory if employment and housing #GrowthStabilizes in 2012-2013 and the Fed gets out of the way?

What didn’t I like about last week?

1. TREASURIES – US Treasury Yields stopped rising (10yr yield down 6bps wk-over-wk to 1.95%)
2. YIELD SPREAD – 10yr yield minus 2yr yield stopped expanding (down 5bps wk-over-wk to +170bps wide)
3. GLOBAL EQUITIES – both European and Emerging Market stocks closed down on the week

Since everything that matters in our macro model happens on the margin, what we call negative divergences (they do bad things when the US stock market headlines are doing good things) really matter.

Some clean-cut negative divergences vs the SP500 closing at its YTD high (1517) were as follows:

1. Friday’s highs came on down volume (you want expanding volume on the way up, not flailing volume)
2. Friday’s highs came on an immediate-term TRADE signal in the VIX for a higher YTD low of 12.42 (you want lower-lows)
3. Global Equities were down wk-over-wk = Emerging Markets -1.1%, MSCI World Index -0.4%, EuroStoxx600 -0.3%

Then, in terms of positive divergences (US Equities), some of the Bullish Style Factors we have been bulled up about got as extended as they have been versus the SP500’s +6.4% YTD return:

1. High Short Interest Stocks = +9.2% YTD
2. High Beta Stocks = +9.2% YTD
3. Top Earnings Growth Stocks (top 25%) = +9.1% YTD

Since A) I have extension (immediate-term TRADE overbought) in our most bullish factors and B) I’ve finally been issued some fairly broad based negative divergences across asset classes, my decision late last week was to take down Global Equity exposure and raise Cash.

That’s not theorizing. That’s doing it in real-time and holding ourselves accountable to explaining the decisions we make. I guess that probably makes us dangerous too. But that’s just a theory.

Our immediate-term Risk Ranges for Gold, Oil (Brent), CRB Index, US Dollar, USD/YEN, UST 10yr Yield, and the SP500 are now $1, $116.38-118.83, 299-303, $79.79-80.39, 92.67-94.41, 1.93-2.01%, and 1, respectively.

Best of luck out there this week,

KM

Keith R. McCullough
Chief Executive Officer