-Morgan Freeman, Shawshank Redemption
Earlier this week, I raced a 95 year old lady down the Merritt Parkway on my way home from work.
To review: while driving north from our new HQ in Stamford, I watched in my rearview mirror as a navy blue Mustang darted back & forth between lanes before pulling up beside me, then speeding ahead.
After racing to catch-up for a confirmatory, second look…90 is, apparently, the new 25.
The age was undeniable, but there were no coke bottle glasses, no cautious, granny-fied 3 o’clock- 9 o’clock hand positioning, no squinty eyed lean forward, no Buick or Oldsmobile.
Just a sharp gaze and tangible life energy.
The experience was a pleasant surprise and a welcomed contrast to the latest, consuming iteration of beltway brinksmanship – which, unsurprisingly, lacked both pleasantness and originality.
Back to the Global Macro Grind…..
I don’t know granny’s life recipe for sustained physiological alacrity – but the ‘pleasant surprise’ of her apparent vitality dovetails nicely with one of our top 3 Macro Investment themes for 4Q: #GetActive
Without giving away the full, institutional macro alpha thunder, our call for an increase in active investment management is predicated on a few key points:
1. Big Government Intervention: Our fiscal policy creation process remains a circus and the new golden boy in the monetary policy arsenal – the “communication tool” – remains in beta testing and breeding decidedly more market uncertainty than price stability at present. Collectively, we expect policy intervention to continue to perpetuate Market/Currency/Economic Volatility. Volatility breeds both opportunity and a heightened probability for an expedited drawdown in equities and …
2. Active Management outperforms in down markets: Historically, on average, the HFRX Equity Hedge index outperforms the SPX in down markets and that outperformance increases as the magnitude of negative monthly S&P500 performance increases. At extremes of negative market performance, the HRFX has outperformed by ~800bps on a monthly basis. Hedge funds apparently hedge after all.
3. Sector Picking will Matter: As the Chart of the Day below illustrates, the variance in sector performance this year is near a historic low Put differently, it hasn’t really mattered what sector you bought – beta has been the new alpha and simply buying the market was the best allocation decision. Over the intermediate term, a mean reverting breakout in the variance of sector returns is almost a guarantee. Consider the performance delta between Financials and Utilities in the quasi-analogous post-1994 period, after Greenspan began his rate raising campaign. Financials returned 50%, 32%, and 45% in 1995, 1996, and 1997 respectively. Utilities returned 25%, 0%, and 18% over that same period. A 3Y CAGR of 42% for Financials vs 14% for Utes.
In truth, #GettingActive is really just an investment euphemism for Trading.
Trading generally gets a bad rap because it doesn’t fit the canonical ‘stocks for the long-term’ dictum, it doesn’t market well and, well, it’s hard – the recent multi-year trend in collective hedge fund benchmark underperformance hasn’t been a siren song for incremental actively managed AUM either.
Keith has actively managed market risk in the Hedgeye portfolio for 5+ years, actively manages the Hedgeye HFT (High Frequency Tweet) machine and is probably more” active” than constrained in opining on markets, policy and policy makers.
To the latter point, sometimes I think the punditry of the Early Look prose occasionally belies the reality of our risk managed positioning.
For instance, while we were highlighting an increased likelihood for a policy induced deceleration in domestic growth back on Oct 9th/10th, at the same time, we were taking up both our gross and net long positioning into the back end of the 4% market correction.
From a process perspective, our conviction level rises and we typically get louder about an idea when both the research (fundamental) view and the quantitative risk management signal are both in agreement.
But what if there is no fundamental data?
The gov’t shutdown the last two weeks has served as an illustrative example of how our risk management process works in practice – primarily because there was no incremental fundamental data to inform our marginal macro view, leaving the risk management signal as our principal signaling mechanism for driving portfolio decisions.
Contrasting yesterday’s price signals and subsequent allocation decisions with those made a week ago exemplifies the process.
What were the market and price signal dynamics back on Oct 10th and why did we buy the dip:
With all the price signals in agreement, the highest probability swing was to get longer and play for the 24 handles of immediate term upside.
Yesterday’s price signals were very similar:
Down Rates + Down Dollar + Rising Policy Uncertainty is not a factor setup we want to be long of over the intermediate term, but we kept the portfolio unchanged at 6 Longs, 3 short into the close. Why?
So, we didn’t buy the rip or tighten up net exposure.
What will we do today? I don’t know – and that’s largely the point. As always, we’ll let the market signal tell us which way to lean.
Does timing matter? Implicit in allocations to active strategies is a belief that it does.
As Keith queried on twitter yesterday afternoon:
“If timing didn't matter, why are you watching Twitter right now?”
Similarly, are markets efficient or irrational and reflexive?
Fama won the Nobel prize for “proving” the former. At the same time, Shiller won for proving the latter. Seems about right.
Activity/Variety is both the spice of life and nature’s most potent cerebral exfoliant.
Take a different route to work in the morning, eat dinner with your left hand, simplify a few radical expressions, invest some incremental capital in the growth inflection happening across the pond, turn down CNBC and turn on #tweetshow today at 3pm.
Switch it up, Get Busy.
Our immediate-term Risk Ranges are now:
UST 10yr Yield 2.55-2.67%
Enjoy the Weekend.
Christian B. Drake
This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.
TODAY’S S&P 500 SET-UP – October 18, 2013
As we look at today's setup for the S&P 500, the range is 50 points or 2.20% downside to 1695 and 0.68% upside to 1745.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance
FOUR SEASONS PREMIUM MASS
SINGAPORE RC VOLUME
Investors do not seem very negative on the outlook for CAT’s 3Q earnings for an odd reason. They tend to think that everyone else thinks that CAT will miss, limiting the relevance. Investors are also looking for an announcement on structural cost actions at Resource Industries, which may cloud the 2H outlook. Our view is that CAT has an end-market demand problem, not a cost problem.
CAT is also expected to issue preliminary sales and revenue guidance for 2014. Many expect that it will be the Industrials guide of the quarter. We think not – few analysts take guidance from CAT seriously anymore. Remember “steady as she goes” for the 2013 outlook given in 3Q 2012? Sales and revenues were supposed to be “roughly the same as 2012, in a band of about plus-or-minus 5%.” Recall that 1Q 2013 sales and revenue were actually down 17.3%. Following some short-term reaction, the market is likely to take a 2014 outlook with an excavator full of salt.
We generally do not bet on quarters – it is a tough game. A change in assumptions for warranty or accounts receivable allowances could leave even the best estimate off target. A simultaneously announced buyback or acquisition could render the reported results old news before they are even read. That said, there are a number of reasons why we expect weaker results this quarter.
While we will be ‘surprised’ if results do not disappoint, we are not ‘in’ CAT for this quarter’s results. Rather we are focused on the long-term down-cycle in resources-related capital spending. In the long run, resources-related capital spending requires rising commodity prices to remain far above maintenance-type levels. Currently, resource-related capital spending is well above the levels needed to support long-term demand growth.
CAT Inventories: CAT has guided flat company level inventories for 2H 2013, meaning that inventory levels at year end should be roughly the same as at the end of 2Q 2013, as we understand it. However, in the third quarter “inventory could come down some as we have many of our Northern Hemisphere facilities take vacation shutdowns during the months of July and August.” The company level inventory headwind should have continued into 3Q 2013, but consensus doesn’t seem to reflect it. Dealer inventories are also expected to decline through 2H 2013.
Can CAT Get To $6.50? That inventory outlook intersects poorly with the implied margin in current guidance. Here is what we wrote on 8/9/2013 - our view is unchanged:
To hit guidance, CAT’s margins in 2H would need to improve ~30% vs. 1H with NEGATIVE MIX and NEGATIVE PRICING in Construction Industries and Resource Industries. Sure, that might happen – and 795F Trucks might fly. As we have written repeatedly – CAT is letting us down easy (gradually) and we have a tough time getting to $6.00 in 2013 EPS. This is just a rough sketch of guidance - not what we expect, which we published here.
Current consensus has margins at about 11.5% in the back half of the year, which would also represent a substantial and unlikely improvement in profitability from 1H. Given the expectation of continued inventory reduction in 3Q, we are not sure why consensus expects margins to expand. A guide down seems quite likely.
Not Just Resource Industries: CAT management admonished us not to hyper focus on mining capital spending, shifting investor attention instead to Power Systems. That may not be a great plan. We have long expected the resource-related capital equipment portions of Power Systems to also experience meaningful pressure. The most recent dealer statistics (below) show declining sales in Power Systems. That seems consistent with our broader definition of resource-related capital spending. It is also not a great set-up for 2014 sales and margins.
Construction Industries: In a noticeable omission, CAT does not fully discuss the >500 basis point drop in Construction Industries margin in 2Q 2013 YoY. It apparently relates to dealer inventory reductions, too, but that explanation does not fit the ‘it’s just a mining equipment demand drop’ narrative. CAT’s construction equipment division participates in an intensively competitive business, but we are a bit surprised by the recent weakness. As we understand it, lower capacity utilization in Resource Industries impacts the other divisions as well, given shared platforms, and that is a very hard problem to isolate or correct.
3Q and 4Q Expectations: Forecasting quarterly earnings for CAT is challenging, in no small part because we do not know how much revenue will come out of the backlog. Last quarter, CAT emphasized inventory headwinds, but not the draw on backlog and the likely favorable pricing in it.
Other Indicators: While we do not rely on these sort of tea leaves, secondary indicators for CAT are do not suggest an approaching inflection point:
We continue to see CAT as exposed to a significant, multi-year decline resources-related capital spending through both its Resource Industries and Power Systems segments. Investors appear to be hoping for a cost reduction plan capable of resolving a lack of demand/cyclical downturn problem. We continue to expect CAT shares to underperform through the down-cycle.