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This note was originally published at 8am on August 06, 2014 for Hedgeye subscribers.

Opportunity is missed by most people because it is dressed in overalls and looks like work.

-Thomas Edison

I recently picked up a new book called, “A Mind for Numbers”.  The book is written by Dr. Barbara Oakley, a professor of engineering at Oakland University, who, like many people, struggled with math and sciences while in high school.  Unlike most people with these struggles, she went on to become a very prominent professor in a very math oriented field.

The essence of the book is really about how to make a break through while studying any subject.  In doing so, the book proposes on relying on the two modes that our brains naturally work in: focused and diffused.  In focused thinking your brain logically works through problems in a careful and attentive manner. Meanwhile, diffused thinking occurs more in the background, your brain processes while you are doing other things like jogging, driving, playing sports, and so on.

Some of the most productive thinkers of our time actually systematically shifted theirs brains between the two modes.  In particular, Thomas Edison had a unique trick for shifting how his brain was operating.  Edison was known for his focus and work ethic, but he would also often take “cat naps” during the day.

During these small naps while sitting in a chair in his laboratory, Edison would hold a steel ball in his hands. As he would nod off into a deeper and deeper sleep, Edison would drop the ball and it would fall to the floor and naturally wake him. Thus Edison was able to switch into diffusive thinking, without getting into a much deeper sleep that would potentially make him groggy and slow his efforts.

Now for many of us stock market operators, a mid-day nap on the trading floor is probably not practical, but as Oakley writes in her book:

“The key is to do something else until your brain is consciously free of any thought of the problem.”

In effect, you need to distract your brain, so you can shift into diffusive thinking, so that the big picture part of your brain can kick into gear and help you solve the problem at hand. 

Diffusive Thoughts - EL chart 2

Back to the Global Macro Grind . . .

Like many of you, we tend to get in early and grind away at Hedgeye, but lately we have also been doing some diffusive thinking. On this front yesterday, my colleague Darius Dale prepared a 50 page presentation yesterday (after some long walks around our office park) that is titled, “Are You Prepared for Quad #4?”

As most of you know already, we look at economies based on our propriety GIP model (growth, inflation and policy).  In our view, as supported by historical studies, asset price returns are driven by shifts in growth, inflation and policy within an economy.  In the Chart of the Day, we highlight this graphically with a definition of the four quadrants.  Quad 4 occurs when growth slows and inflation decelerates, which typically elicits a dovish policy response.

If you’d like to see the full length presentation, please email your institutional sales contact or simply email sales@hedgeye.com.  Also CLICK HERE for a short video that Darius did on HedgeyeTV going through the key points.

A key catalyst for a shift in our thinking, aside from long walks or baths, has been the break out in the U.S. dollar. As Darius notes in the presentation, the investment conclusions from a shift into Q4 for the domestic economy are as follows:

  • Bonds over stocks;
  • Defensive equities over cyclical equities;
  • Late cycle investments over early cycle investments;
  • Buy U.S. dollar and short commodities.

As it relates to translating this directly into what we would recommend selling and owning under this scenario, we’d focus on the following:

  • Long – Long term treasuries (TLT), Muni Bonds (MUB), Healthcare (XLV), and Old China (FXI)
  • Shorts (or Underweights / Sells) – Russell 2000 (IWM), High-yield credit (JNK), Homebuilders (ITB), Regional Banks (KRE), Retailers (XRT), and Eurozone (EZU)

On the last point of selling the Eurozone, over the last month European equities have been getting crushed.  Every major European equity index is down over the last month ranging from the U.K. down -4% to Russia down -14%.  Germany is also clearly in the midst of a World Cup hangover as German benchmark equities are down -9.5% and now down over 5% for 2014.

Speaking of Germany, German factory orders were an unmitigated disaster for June.  Consensus expectations were for an increase of 0.9% from May and the actual number came in at -3.2%.  On a year-over-year basis, the numbers were just as abysmal as factory orders that declined -2.4%.  This marked the largest decline since September 2011.  For those long of Germany, hopefully Oktoberfest is a positive catalyst!

Switching gears for a second, our Restaurant and Consumer Staples Sector Head Howard Penney has had a very successful alpha generating year within the restaurant sector and after rolling up his sleeves, focusing, and then taking a break (yoga?) to diffuse the thoughts, he has a healthy pipeline of Best Ideas in the Consumer Staples Sector.

The next idea he is rolling out will be a short call on Hain Celestial Group (HAIN).  We added the idea to our Best Ideas list as a short on Monday and the deep dive call on the name will occur on Thursday August 14th at 1pm eastern.  If you’d like the materials for the call, please email sales at Hedgeye (this call won’t be pro bono though, alpha doesn’t come cheap!).

Keep your head up and stick on the ice,

Daryl G. Jones

Director of Research

Diffusive Thoughts - Chart of the Day