Polar Perspective

This note was originally published at 8am on November 19, 2013 for Hedgeye subscribers.

“Difficulties are just things to overcome, after all.”

-Ernest Shackleton


Sir Ernest Shackleton was one of the principal figures of a period known as the Heroic Age of Antarctic Exploration.  Initially, this period was most identified by Roald Amundsen reaching the South Pole in December 1911.  Shackleton decided to try to one up Amundsen and launched an expedition to cross Antarctica from sea-to-sea over the pole.


In 1914, Shackleton began fundraising for this “Imperial Trans-Antarctic Expedition”, which was eventually launched in September 1914 despite the outbreak of World War I.  Misfortune struck Shackleton and his crew early in the trip when their ship, the Endurance, was frozen into an ice flow in the Weddell Sea.  The ship eventually had to be abandoned.


For the next almost 500 days, Shackleton and his men were stranded in Antarctica.  They had no contact to the outside world and routinely faced temperatures that dipped below -50 degrees Celsius.  Eventually after an almost impossible trip to a nearby whaling station, the entire crew was rescued.  While the expedition fell short of its goal, Shackleton and his colleagues certainly gained some polar perspective.


Back to the global macro grind...


Similarly, for many hedge fund managers this has been a year to gain perspective, if not outperformance.   As an example, as of the end of October 2013 the Hennessee Hedge Fund Index was up 9.9%, which paled in comparison to the return of the SP500 of north of 23%.  Now to be fair, returning close to 10% on 2 and 20 money isn’t the worst thing in the world, but undoubtedly for many underperforming a passive strategy by more than 1,000 basis points is frustrating.


Keith touched on this yesterday, but a key reason for the underperformance of hedge funds is the outperformance of heavily shorted stocks.   Specifically, heavily shorted stocks are outperforming the SP500 by some 570 basis points this year.  That’s enough to make any great short seller bi-polar!


Long / short equity managers likely aren’t the only investment managers going a little bi-polar this year. As an example, the PIMCO Total Return Fund has returned a capital eroding -0.87% in the year-to-date.   Clearly, the big bond boys at PIMCO are having some performance issues (not to say that it would at all be easy to steward that much capital!).


The broader issue with bond managers of course is how far afield they eventually have to search for yield.  Just like Shackleton and his crew in Antarctica, who eventually found land, the question for bond managers is ultimately: what is the cost of this search for yield?


As it relates to the PIMCO Total Return Fund, prospective underperformance may even be more concerning given the fund’s holdings and where the managers have gone to find yield.  According to analysis by our Financials Team, almost 34% of PIMCO Total Returns holdings are in agency mortgage backed securities.  In the Chart of the Day, we highlight the spread of agency MBS to the 10-year Treasury Yield.   As the chart highlights, prior to the financial crisis this spread was ~126 basis points, but has now narrowed to ~68 basis points.


The almighty chase for yield has effectively priced mortgage backed securities to one of the lowest levels of risk that we’ve seen in the asset class.  Even if the spread for Agency MBS just normalized by 50 basis points to pre-crisis levels, it would have a meaningful impact on the market.  By our estimation, allowing for modified duration, a 50 basis increase (reversal of tapering for instance) in yield would lead to 5% downside in the Agency MBS market.


The issue for firms like PIMCO is that a 5% correction in one of its more significant asset class exposures is likely to lead to continued underperformance and accelerated outflows.   Outflows and decreased liquidity, of course, are only likely to exacerbate any move in price in the MBS market.


The Financial Times this morning emphasized this point even further in an article looking at managers of collateralized loan obligations.  According to the article, managers of CLOs have increased the proportion of risky loans that their investment vehicles are allowed to buy to the highest level on record.  Currently, 55% of new leveraged loans come in the covenant lite form, which eclipses the 29% reached shortly before the financial crisis. 


Covenant lite loans are fine, in theory, if the economy is stable, but if there is volatility in economic activity, these loans get much more difficult to repay for many corporates.  A good analogy is probably Shackleton and his crew in -50 degrees Celsius weather in Antarctica.  You know weather that cold is dangerous but it is survivable, until the wind starts to blow and wind chill sets in . . .


To dig further into the topics of asset allocation, our Financials Team will be hosting a call his Thursday November 21st at 11am with Carl Hess who is the global head of Towers Watson’s investment advisory services that provides asset allocation recommendations to more than $2 trillion in assets under advisement.  We think this call will provide an interesting perspective on asset allocation and active management, and if you’d like details on how to get access to the call, please email


Given the challenges faced by large asset allocation funds that rely heavily on yield for performance, going forward it might be prudent that managers of these funds search for analysts for their investment teams with a similar advertisement to what Shackleton used to find his crew:


“Men wanted for hazardous journey. Small wages. Bitter cold. Long months of complete darkness. Constant danger. Safe return doubtful. Honour and recognition in case of success.”




Keep your head up and stick on the polar ice,


Daryl G. Jones

Director of Research



Polar Perspective - chartofday


Polar Perspective - Virtual Portfolio

#BlackFriday Musings (And More)

Takeaway: And the retail fight for your Benjamins begins...

Shoppers' Black Friday Weekend Spending Falls 3% (Wall Street Journal)


#BlackFriday Musings (And More) - blackfriday

  • "Total spending from Thursday through Sunday fell 3% from a year earlier to $57.4 billion, with shoppers spending an average $407.02, down 4% from $423.55 a year earlier, according to the National Retail Federation."
  • "The retail trade group said the number of people who went shopping over the four-day weekend that kicked off with Thanksgiving rose slightly to 141 million, up from 139 million last year."
  • "As retailers offered some of their biggest promotions a day earlier, store traffic on Thanksgiving Day jumped 27% to 45 million shoppers. As a result, traffic on Black Friday rose just 3.4% to 92 million shoppers."
  • "Online shopping continued its steady rise over the Black Friday weekend, accounting for 42% of sales racked up over the four-day period, up from 40% last year and 26% in 2006, the trade group said."

Takeaway:  The problem here? Retailers are in a massive fight for Black Friday market share -- instead of 4Q profitability. The fact that sales were up over 2% on Friday when every sell-side analyst was out there declaring victory based on their one mall visit (out of 1,100) is laughable. The reality is that the retailers drove traffic by offering ridiculous deals that in effect borrowed from full price sales that would have happened later in the month. Will these guys ever learn? Doubtful.


Online Thanksgiving sales top $1 billion for the first time (MarketWatch)


#BlackFriday Musings (And More) - compx

  • "Retailers’ extra push for online Thanksgiving sales this year...have managed to send online sales on Turkey Day to a record…"
  • "For the first time ever, Thanksgiving itself generated $1.06 billion in online sales, an 18% increase from last year, and the first time the day topped $1 billion online. That’s according to Adobe, which says nine out of the top 10 U.S. retailers are its clients and that more than 70% of online spending at the top 500 U.S. retailers goes through its Adobe Marketing Cloud system."
  • "Adobe’s data showed a record 20.9% of online spending was made through mobile devices, with $152 million spent via tablets and $70 million via smartphones. Apple Inc.’s iPad alone accounted for $130 million of online sales, it said."

Takeaway: Not a surprise whatsoever. Though 18% growth is big, it's not huge when talking about online. We are going to see a step up in online sales with six fewer days people can spend in the physical stores. Bullish for AMZN.


* * * * * * * 

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Early Look

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Takeaway: Heading into China's 3rd Plenary Session, we are looking for concrete solutions (if any) to China’s ongoing credit binge and financial risks

This note was originally published November 08, 2013 at 14:22 in Macro

Editor's note: This is a complimentary sample of Hedgeye Risk Management research. For more information on what we do here and how you can begin benefiting from our analysts' acumen click here.




  • This weekend top-ranking officials will convene in Beijing for the Third Plenary Session of the 18th Communist Party Central Committee (NOV 9-12).
  • Historically, the 3rd Plenary Session has been one of great change with respect to economic and financial market reforms that have ultimately shaped the Chinese economy in the years and decades following. Bold promises for meaningful reforms out of President Xi would suggest 2013’s version is likely to not disappoint.
  • While a number of key socioeconomic strategies will be debated and outlined (such as rural land rights reform, nationwide social security, etc.) we are strongly of the view that some reforms are more impactful than others as it pertains to our long-term TAIL duration (i.e. 3Y or less). On that note, we are keenly focused on concrete solutions (if any) to China’s ongoing credit binge and financial risks.

“Hi I’m China, and I have a problem…”



For much of the spring and summer months, we held an explicitly negative view on China’s structural economic growth potential. Specifically, we believed that a persistent rise in non-performing assets across the financial system would effectively tighten liquidity across the financial sector, at the margins, thus acting as a sustainable drag on incremental credit creation.


To review that thesis:


We first noticed pervasive risks in China’s financial sector upon completion of our proprietary EM Crisis Risk Model in mid-APR:












Digging deeper into the weeds confirmed much of what we already knew – Chinese credit growth has grown far too fast in recent years and a sizeable portion of that credit has done little more than support asset prices or existing liabilities in lieu of marginal economic activity:










The aforementioned dynamic has caused Chinese economic growth to slow, with the +7.7% YoY run-rate of headline GDP in the YTD threatening to claim the title of China’s slowest expansion since 1999. Moreover, forward-looking expectations for Chinese growth are even more lethargic:




We backed away from the short side of China in early SEP (click HERE and HERE to review why) and followed that up with an incrementally more sanguine tone in the subsequent months, as the Shanghai FTZ looked to be a meaningful enough catalyst to offset the aforementioned financial sector headwinds, at the margins (click HERE and HERE to review why).


With only 157 firms holding a combined capital of $829M having registered for the Shanghai FTZ (mostly in the trade and services industries) as of OCT 23, it’s pretty clear the aforementioned catalyst has not yet addressed our initial concerns surrounding the structural lack of liquidity in the Chinese banking sector.


Specifically, we thought there would be significantly more activity regarding the importing of fresh capital into China’s financial system; thus far, results have been largely disappointing on that front.



Now that we have reestablished the facts of China’s financial sector headwinds, we can now focus on what Chinese policymakers must do to overcome them – especially if China is to achieve what Premier Li has recently termed, “a golden mix” of structural reform and economic growth.


Simply put, if Chinese policymakers are going to avoid seeing GDP growth slow materially from here in the coming quarters and years, they absolutely have to outline [and eventually execute upon] specific and credible strategies that are expressly designed to relieve the banking sector of its structural liquidity constraints.


I’ll be the first analyst to tell you openly and honestly I have absolutely no idea what they plan to do with regards to this key issue, nor am I able to accurately gauge the momentum (or lack thereof) for meaningful changes on this front. All I know is that China must do something.


“Something” would include, but is not limited to:


  • Step 1: admit the country has a problem (i.e. it’s addicted to cheap credit);
  • Step 2: clearly delineate which institutions and corporations are to be saved and which would be allowed to ultimately fail or forced to sell/restructure;
  • Step 3: liberalize deposit rates so that weaker financial institutions are ultimately priced out of the market and forced to delever (CLICK HERE for more color on the threat deposit rate liberalization poses to China’s economy and general financial stability);
  • Step 4: recapitalize the remaining or systemically important banks and concomitantly force banks to write down non-performing loans that are currently being systematically rolled over (the aggregate loan-loss provision ratio of 279% of NPLs at the Big Four banks is well in excess of the 150% regulatory requirement and only begins to highlight the magnitude of China’s current problem with evergreening);
  • Step 5: introduce rigid targets for provincial-level GDP growth and subdued quotas for credit allocation to various industrial sectors so that banks don’t take steps 2-4 as a signal to inflate new bubbles; and
  • Step 6: allow for corporate defaults, the proliferation of financial insurance products and a dramatic expansion of the mutual fund industry so that Chinese financial markets can eventually learn to appropriately price, hedge and allocate risk across the system.


With the convoluted structure of bank and securities market regulation in China – the CBRC, CSRC, MoF and PBoC all operate largely independently of each other – we have little faith that such a wide-ranging reform process would be able to be implemented quickly.


That said, we’d settle for Chinese policymakers simply admitting to the fact that the country has a structural liquidity problem and subsequently outlining credible strategies to address it over the long-term TAIL. If they do not, we’d argue that Chinese tail risk – or a “hard landing” as it is more commonly referred to – should and would eventually heighten dramatically in the eyes of global investors and capital allocators.



Lastly, for those of you looking for answers with respect to our intermediate-term TREND duration, please review our OCT 24 note titled, “IF YOU HAVEN’T YET HEARD, CHINA IS TIGHTENING MONETARY POLICY”. Specifically, the PBoC’s recent tightening of monetary policy is in-line with our call for China to take a brief trip to Quad #3 (i.e. #GrowthSlowing as inflation accelerates) within our proprietary GIP framework here in 4Q13.




It’s worth noting that Chinese property price pressures have continued to accelerate since then, with the latest data out from the China Real Estate Index System’s nationwide property price index (100 cities) showing prices up +10.7% YoY on average in OCT vs. +9.5% YoY in SEP. Moreover, OCT marked the 17th consecutive month of sequential appreciation (+1.2% Mo M vs. +1.1% MoM prior). Moreover, property price trends in China’s 10 major cities continue to outpace the national averages, with prices up +15.7% on a YoY basis and +2% on a sequential basis.


On that note, both Shanghai and Shenzhen have recently taken a page out of Beijing’s playbook by lowering peak LTV ratios on mortgages for 2nd homes to 30%, down from 40% prior. Perhaps that’s a signal that this weekend’s plenum may bring about broad-based tightening in the property market. The implementation of a nationwide property tax – while a huge positive for currently impaired local government finances over the long term (as would be expanding the muni bond market) – would obviously be serve as a meaningful blow to demand in this key segment of the Chinese economy.


All told, the 3rd Plenary Session has historically been one of great change with respect to economic and financial market reforms that have ultimately shaped the Chinese economy in the years and decades following. Bold promises for meaningful reforms out of President Xi would suggest 2013’s version is likely to not disappoint.


While a number of key socioeconomic strategies will be debated and outlined (such as rural land rights reform, nationwide social security, etc.) we are strongly of the view that some reforms are more impactful than others as it pertains to our long-term TAIL duration (i.e. 3Y or less). On that note, we are keenly focused on concrete solutions (if any) to China’s ongoing credit binge and financial risks.


Please feel free to email us with any follow-up questions; have a great weekend,




Darius Dale

Associate: Macro Team


Takeaway: Below we rank our top read notes from November. Click the note title for access.


  1. 11/07/13 – The Casual Dining Bubble
  2. 11/19/13 – PBPB: Not Worthy Of The Multiple
  3. 11/25/13 – MCD: Testing The Espresso-Based Beverage Theory Early
  4. 11/27/13 – New Best Idea: Short Bloomin’ Brands
  5. 11/06/13 – Casual Dining Comps: Mgmt Commentary & Hedgeye’s Take
  6. 11/13/13 – YUM: October China Comps Beat Expectations
  7. 11/08/13 – MCD: #Growth Slowing
  8. 11/22/13 – Commodity Chartbook
  9. 11/04/13 – Top Read Notes: October 2013
  10. 11/12/13 – Dial-In & Materials: Can McDonald’s Get The Coffee Consumer In 2014?

Feel free to contact us if you have any questions, or would like to discuss any of our work in more detail.




Howard Penney

Managing Director


Raging Bull? SP500 Levels, Refreshed

Takeaway: Alongside this no-volume raging bull comes an increasing amount of mean reversion risk – so just know that.

If all you do into year-end is buy-the-damn-bubble #BTDB on dips, you’ll probably keep getting paid. But alongside this no-volume raging bull comes an increasing amount of mean reversion risk – so just know that.


What was best about today’s rip to new all-time highs was that it came on what’s really been driving the US stock market for the better part of the last 10-11 months. The ISM report’s growth components once again surprised on the upside (NOV's New Orders = 63.6 and Employment of 56.5 were the best monthly readings, respectively, of 2013).


Rates UP, Dollar UP today – and you know I like that. But the Fed doesn’t. Makes them look silly for not tapering (that’s what not being data dependent gets you into – a good ole politicized pickle!). So prepare for more @FederalReserve storytelling as they continue to pander to the Bond Bull Lobby @PIMCO.


Across our core risk management durations, here are the lines that matter to me most:


  1. Immediate-term TRADE overbought = 1816
  2. Immediate-term TRADE support = 1782
  3. Intermediate-term TREND support = 1726


In other words, now you have 90 $SPY handles of mean reversion downside, or -5%, to my 1726 @Hedgeye TREND line. And every time it feels like we’re not going to correct, that’s about how much we’ve corrected (3 separate 5% corrections in 2013 YTD).


So keep your eyes on your fries and keep moving out there,



Keith R. McCullough
Chief Executive Officer


Raging Bull? SP500 Levels, Refreshed - SPX

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