This note was originally published at 8am on August 14, 2013 for Hedgeye subscribers.
“Does man live from inside out or from outside in?”
-Erich Maria Remarque
I just got back from Thunder Bay and have that quote underlined in a post WWI German inflation novel that one of our clients in London gave me – The Black Obelisk. When I read it, I immediately thought of Global Macro investing legend, Ray Dalio.
Dalio’s signature quote about risk management is also a question: “What is the truth?” And whether it’s his, pardon the pun, All-Weather Fund’s issues, or performance problems most of us have faced over the course of our careers, there’s one thing that tends to answer all the questions we never knew we should have asked – it’s called volatility.
The number one thing that has created draw-down risk in every major hedge fund strategy since the beginning of time has been, and will continue to be, volatility. If your strategy assumes the wrong volatility parameters, you are assuming risks that you do not understand. On a percentage basis, did the biggest q/q change in 50 years in Treasury yields matter? Big time.
Back to the Global Macro Grind…
Slides 15, 16 and 17 of our current #RatesRising Global Macro Theme deck outlined how massive outflows from Fixed Income related securities plays out:
1. Quantitative Signal (Slide 15) – we show what we coined “The Waterfall” of rate risk as 10yr US Treasury Yields broke out across all three of our core risk management durations (TRADE, TREND, and TAIL – with the TAIL risk line = 1.92%)
2. Causal Factor (Slide 16) – we show how unconventional Fed policy exacerbated a bond bubble (Fed Balance Sheet vs 10yr Yield over the last 10 years = R-square of 0.795)
3. Correlation Factor (Slide 17) – we show that on a % basis, the most recent rate of change in the 10 year US Treasury Yield (quarter-over-quarter) was the largest in the last 50 years
Call us lucky or call us right. The truth is that we cut our asset allocation to Fixed Income to 0% for the aforementioned reasons alongside many more that were driving a regime change in terms of how our model values growth versus slow growth allocations.
When we were bearish on growth (until November of 2012) we were long US Treasuries; when our views on the slope of growth changed from slowing to stabilizing, we started to move to the dark side (in bonds).
This is no victory lap. I just feel that it’s important to show people what it is that we do in a transparent, open, and accountable forum of debate. The only all-weather protection against volatility ripping is getting out, before it rips.
Throughout the last 9 months (as US growth went from slowing to stabilizing to accelerating) markets have provided us plenty of opportunity to get into growth related asset classes and out of slow growth ones. August to-date is no different:
1. Utilities (XLU) are the most overvalued slice of the slow-growth equity pie (with hyper-overvalued securities like MLPs within this Sector Style Risk). XLU is down -1.38% for August to-date (versus SPY +0.5%)
2. Tech (XLK) and Basic Materials (XLB) are up the most for August to-date at +2.11% and +2.45% respectively. Both are traditionally considered “growth” sectors but for very different reasons. AAPL is not CAT.
There’s a lot of risk in assuming that long-cycle cyclicals (like mining related stocks) are in the right spot from a “growth” investor’s perspective. Then there’s GARP (“growth at a reasonable price”) where mining stocks might look “cheap” too. Just don’t forget that the Mining Capex Cycle was a decade long bubble. The risk here is grounded in the volatility of the underlying commodities.
Where could we be wrong? Our research on something like Caterpillar (CAT) has been bearish, but now the market signal is stress testing our conviction in maintaining that position. If CAT were to close above my long-term TAIL risk line of $88.67 and hold that level on some real volume, my risk management process stops me out of the position.
Do I live my market life from looking inside our portfolio of ideas or from the outside looking in? The truth is that I do both. It’s a learning process. Whenever I ignore the outside, top-down, macro market signals, I will be reminded that volatility lives on the other side of my position’s underlying assumptions. And not in a good way.
Our immediate-term Risk Ranges are now:
UST 10yr 2.64-2.75%
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
THE MACAU METRO MONITOR, AUGUST 28, 2013
LVS TO PAY $47.4MM TO SETTLE FED PROBE AP
LVS has agreed to pay $47.4 million after failing to flag millions of dollars in money transfers made by a gambler linked to drug trafficking. In return, the U.S. Attorney's Office in Los Angeles will not seek an indictment against LVS. The deal, finalized late Monday, also brings the government's criminal investigation to a close, but requires LVS to boost its efforts to monitor suspicious financial transactions for the next two years.
The investigation centered on Chinese-Mexican businessman Zhenli Ye Gon, which prosecutors describe as a high-stakes player who gambled at several major casinos, including the Venetian between 2004 and 2007. In that period, Ye Gon lost more than $125 million at multiple casinos, including $84 million at the Venetian, according to the settlement agreement filed by prosecutors. Ye Gon's Venetian losses also included $36.5 million in credit that the casino advanced to him and that was later written off as bad debt.
Investigators concluded that LVS failed to comply with a federal law requiring casinos report suspicious financial transactions involving customers.
SJM'S SLOT MACHINE PARLOR TO BE REMOVED IN NOVEMBER Macau Daily News
SJM Holdings executive director Angela Leong said that the group has always abided by the government policy and their slot machines parlors in residential areas will be removed gradually. Leong said that the slot parlor in Canidrome will be moved in November. She stressed that the company will relocate gaming facilities affecting citizens, but the evacuation cannot be accomplished in one go as the company needs time to make changes on the operations side, such as human resources issues.
MORE PASSENGERS COMING THROUGH GONGBEI BORDER Macau Daily News
Gongbei immigration recorded a historical high at 320,000 border crossings on a single day yesterday with summer holiday coming to an end soon, and Hengqin port also recorded a daily high of over 220,000 border crossing. Gongbei checkpoint said that since last month, it has eight consecutive weekends that break the single-day traffic 300,000 record.
VIETNAM DOES U-TURN ON CASINO BAN FOR LOCALS; WILL INVESTORS BITE? Thanh Nien News
In a surprise twist, Vietnam’s top leadership has given the green light for locals to enter one of the country’s casinos for a trial period. The Communist Party’s decision-making Politburo has allowed Vietnamese meeting certain criteria to gamble in a casino to be built in the Van Don Economic Zone in Quang Ninh Province bordering China, deputy speaker of the National Assembly, Nguyen Thi Kim Ngan, said at a meeting of the house Standing Committee held August 15 to debate a bill on betting and gambling. But since last year the government has been saying that this issue is off the table, even enacting a law last month to slap fines of up to VND200 million ($9,500) on casinos who let locals in.
Minister of Finance Dinh Tien Dung maintained that position at the August 15 meeting, saying the ban needs to be in place to limit the impact of gambling on social safety and stability. But, given the entrenched gambling culture in the country, the ban on entering casinos at home sends droves of Vietnamese across the border into Cambodia to gamble in casinos there.
It is not clear, however, when the full house will debate the bill on betting and gambling and approve it. Of the licensed casinos, four are in the north – one each in Lao Cai and Quang Ninh provinces bordering China – enabling Vietnam to pull in increasingly affluent Chinese gamblers, experts say. But they otherwise remain skeptical about the locations of the northern casinos, which they say are not convenient for international visitors.
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“The noise can be deafening.”
When he wrote that in Knowledge and Power, Gilder was referring to government interference (in markets). He also went on to make the critical, but often overlooked, behavioral link between simple market signals (like interest rates) and central planning noise.
“Interest rates are critical for information-theory economic analysis because they are an index of real economic conditions. If the government manipulates them, they will issue false signals, breeding confusion that undermines entrepreneurial activity.” (pg 24)
That pretty much sums up what I think all of us are struggling with today. Inclusive of yesterday’s drop in interest rates (oil ripping new highs is an economic headwind), the bond market is becoming as good a leading indicator of the slope of US economic growth’s TREND as anything I can back-test. At the same time, we have to deal with the deafening impact of central planning commentary.
Back to the Global Macro Grind…
Yesterday’s 1-day drop in the US stock market was deafening too. It came on a legitimate Information Surprise (Oil ripping on Syria) and the rotation you’d expect to see when expectations for growth fall (bond yields and US growth stocks have a positive correlation).
How did that deafening drop (there was no volume) fair within the context of the Top 3 biggest 1-day drops since April?
#EOW (end of world) type stuff, I know.
In both of the prior 1-day freak-outs (which were bigger in terms of both magnitude and volume), fear spiked (front-month VIX) to higher levels than what you saw yesterday too. In other words:
That’s why we do the multi-duration risk management thing. How else are you going to contextualize the immediate-term TRADE noise of Mr. Market if you don’t have anything to signal the intermediate-term TREND?
Since we are raging bears on Emerging Market Equities (EEM), this morning’s discussion is more focused on how to interpret US market noise (US markets include big stuff like the currency and bond market). Here are the other two Big Macro Signals I care about most:
And yes, the TREND is your less noisy friend, until he/she isn’t – I get that. I also get that Oil prices steadily rising from here could cut US consumption growth in half, sequentially. So there’s a lot to think about (including whether this will be the YTD high in oil altogether).
But while I think, I have to try hard to take the emotion out of the decisions I make on what to do next. That’s why my immediate-term TRADE signals determine my short-term risk management decisions. I’ve tried the feel thing – and it ends up not feeling good.
When running money in a bull market like this for US growth stocks, not selling the lows is one of the most important decisions you can make. What if you read Zero Hedge, capitulated to your emotional state, and sold the April 15th and/or June 20th lows?
Can you wait 3 more days to see if this noise settles? Or are we all high-frequency blog freaks now? By August 2nd 2013 (when the SP500 hit its all-time closing high of 1709) you’d have been up +11% and/or +8.6% in SPY, respectively. Just saying.
Maybe the world is going to end this time. I started making that call around this time in 2007 (and it almost did end). But this is not 2007, and not one of the people and/or risk management processes that called it last time is making that call this time either.
Maybe everyone who didn’t call the 2007 topping process is going to nail it this time. But maybe not. All I can tell you is that the noise of #PTCs (professional top callers) since April of 2013 has been deafening.
Our immediate-term Risk Ranges are now as follows:
UST 10yr Yield 2.70-2.93%
EEM (Emerging Markets) 36.91-38.49
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – August 28, 2013
As we look at today's setup for the S&P 500, the range is 45 points or 0.58% downside to 1621 and 2.18% upside to 1666.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team