"Learn to fail with pride - and do so fast and cleanly. Maximize trial and error - by mastering the error part."
-Nassim Taleb
The only thing worse than NOT doing global macro, is then doing it, and coming to the wrong conclusions! When Taleb refers to "mastering the error part", he doesn't mean compounding one colossal mistake with making another one. Masters of Herd Island read on...
The New Reality is that there are a lot of leaders in the financial services industry who didn't "do macro", who are now, rightfully, looking to incorporate macro into their process. While I'd like to say that they are embedding macro into their risk management process, I can't - some of these said financial savants didn't have one of those either.
As the financial facts change, we are big supporters of risk managers changing - but we are also very aware that there is compounding risk associated with rookies making what they think are "prudent risk management decisions" that are really based on erroneous premises.
Let's take Morgan Stanley's fearless leader, John Mack, as a case and point. Sometimes being fearless equates to being recklessly wrong. Morgan Stanley's brass, not unlike a lot of Portfolio Managers who got sucked into the Depressionista camp, took the point of view that markets were not going to recover. Now, understanding that this what we refer to as "making a macro call", realize that the reason a lot of guys like Mack never did macro to begin with was simply because they never HAD to get it right.
So what happens when a whole bunch of ex-levered long PMs and horse and buggy whip CEOs think they are "managing risk" AFTER they didn't see the crash coming? Well, you get the mother of all short squeezes in everything from Chinese to US Equities in a very compressed period of time.
Having had my clock cleaned plenty of times in this business, I have to side with Taleb's conclusion that managing risk requires trial and error. However, managing risk needs to be embedded, objectively, into one's portfolio management process on BOTH the upside and downside of markets. Is there risk in getting chomped on by one great white we affectionately refer to at Research Edge as Squeezy The Shark? You bet your Madoff there is!
So let's throw on the junior stock market operator's risk management pants and take a walk down that path. What's changed most obviously in the last 6 months?
1. The Volatility Index (VIX) has been hammered for a -53% peak-to-trough drop over the course of the last 6 months
2. The TED Spread (counterparty risk measure), has narrowed by 400 basis points (or 80%!) since the Oct/Nov crashes
3. The Yield Curve (US Treasuries) steepens almost on a weekly basis and is now 200 basis points wide (10yr rates vs. 2yr)
Junior stock market operator? Why Junior? Aren't the likes of Mack to Madoff very rich and Senior? Aren't "Senior Partners and Managing Directors" on Wall Street supposed to know what they are doing? Who needs this Junior Hockey head, McCullough's, point of view? You tell me...
On this score, The New Reality isn't a new one at all. We're finally just being privy to the proverbial Wizard's of Wall Street Oz being undressed here. As the tide rolls out, you see that plenty of these guys were not only swimming naked on the way down, but remain in the nude now on the way up.
Bernstein's stand up financials analyst Brad Hintz said he was "humiliated" by his earnings estimates for Morgan Stanley, whereas Fast Money's Pete Najarian said that "conservative trading held Mack's numbers back." We're getting down to the nitty gritty here in America Idol season folks - who are you going to vote for between these two gentlemen in terms of how they addressed being wrong on MS yesterday?
Mr. Hintz, you need not be humiliated. There are plenty of men and women in this business who are posing as the renewed faithful of risk management who have plenty of that to accept for you. Your being transparent and accountable is to be commended. The Research Edge team salutes you.
As you're thinking through how you incorporate global macro into your proactive risk management processes, always remember this: "Learn to fail with pride"... "do so fast and cleanly" ... and never manage risk using a consensus macro call that's in your rear view.
This market's range remains as proactively manageable as any I have seen in at least 6 years. I have an immediate term upside/downside range in the SP500 that is only 44 points wide this morning. Buy 830 and sell 874 on that index, and smile every time someone tries to tell you that they now do macro and that "we're overbought"...
Best of luck out there today,
KM
LONG ETFS
EWG - iShares Germany-The DAX is up 12.4% month-to-date. We bullish German fundamentals, especially as a hedge against financially levered and poorly managed Switzerland. While the automotive industry is ailing, the strength of Germany's labor unions will preserve jobs and maintain a slower rate of sequential acceleration in unemployment. Compared to most of Western Europe, Germany has a positive trade balance and will benefit from Chinese demand, especially if the Euro can stay below $1.32. The ZEW index of investor and analyst expectations for economic activity within six months rose to +13 in April from -3.5 in March, the highest reading since June 2007. We're bullish on Chancellor Merkel's proposed Bad bank plan to clear toxic bank assets and believe the country will benefit from a likely ECB rate cut next month.
EWZ - iShares Brazil- Brazil continues to look positive on a TREND basis. President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. The Central Bank cut 150bps to 11.25% on 3/11 and likely will cut another 100bps when it next meets on April 29th. Brazil is a major producer of commodities. We believe the country's profile matches up well with our re-flation theme: as the USD breaks down global equities and commodity prices will inflate.
XLY - SPDR Consumer Discretionary-TRADE and TREND remain bullish for XLY. The US economy is showing faint signs the steep plunge in economic activity that began last fall is starting to level off and things are better that toxic. We've been saying since early January that housing will bottom in 2Q09 and that "free money" for the financial system will marginally improve the US economy in 2H09, allowing early cycle stocks to outperform. The XLY is a great way to play the early cycle thesis.
EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months. With interest rates at 3.00% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.
TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%. We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.
USO - Oil Fund-We bought more oil on 4/20 after a 9% intraday downward move. We are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.
DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold.
GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.
DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.
SHORT ETFS
VXX - iPath VIX- The VIX is inversely correlated to the performance of US stock markets. On 4/20 the VIX shot up 15.5% intraday, an overcorrection we want to be short as we believe US indices will make higher highs and the volatility is currently overbought.
LQD - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.
SHY - iShares 1-3 Year Treasury Bonds- If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.
EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials. Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.
UUP - U.S. Dollar Index -We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro up versus the USD at $1.3065. The USD is up versus the Yen at 98.3200 and down versus the Pound at $1.4564 as of 6am today.
EWJ - iShares Japan -We re-shorted the Japanese equity market via EWJ on 4/22. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-the government cut its forecast for the fiscal year to decline 3.3%, and we see no catalyst for growth to return this year. We believe the BOJ's program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".
XLP - SPDR Consumer Staples- Consumer Staples is breaking down through the TREND line again. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.