This note was originally published at 8am on August 22, 2014 for Hedgeye subscribers.
“There’s a lot of cash on the sidelines!”
Outspoken hedge fund manager Cliff Asness of AQR recently remarked “Every time someone says, ‘There’s a lot of cash on the sidelines’ a tiny part of my soul dies. There are no sidelines.”
Asness' pet peeve for this common saying implying “this is why the market still has room to run” based on absolute historical fund flows and equity valuations is based on a slightly different interpretation than we prefer to reference. Yet we absolutely agree with his disdain for this statement at face value (although maybe not as pointedly).
With all global market participants attempting to front-run the RELATIVE positioning of each monetary authority, finding the right RELATIVE positioning across asset classes is the key starting point for global macro risk management in today’s environment. We strongly believe that our implication of the POLICY metric into our quantitative model for pinning the convexity of growth and inflation is a key differentiator. Sticking solely with a strategy that seeks fundamental value through historical, absolute metrics has been a difficult task during the second half of this 6-year bull market.
In an interview discussing his pet peeves and preferable investment strategy, Asness went on to say that in his opinion, two of the main strategies that have worked over the long-term, are value and momentum investing and that combining those works much better than either one.
Value with a catalyst as we prefer to call it?
Back to the Global Macro Grind...
This is only his high level opinion about what works, but when we look at our own process, we believe it’s plausible to back into our own process from this simple statement. We describe our process as “a multi-factor, multi-duration model that utilizes a fundamental and quantitative approach to global macro risk management.” The quantitative sequence for buying or selling a single security is as follows:
- Is the slope of growth and inflation in those economies under the guise of central banks with the ability to print money accelerating or decelerating RELATIVE to consensus expectation as reflected in market prices?
- What is the fiscal and monetary response RELATIVE to the other central banks of the “reserve currencies” who, with the confidence of all global participants for now, tighten their credit spread by printing more money? What emerging market economies benefit or suffer?
- What do the effects of a stronger or weaker domestic currency mean for real domestic growth based on the componentry of its growth dynamics? How is this observed to confirm or discredit the tendencies in markets?
- Now with this overlay, what is fundamentally happening in a domestic economy to strengthen or weaken the outlook for growth?
- Which sectors perform better or worse under each scenario (see all four below)?
- With this sector bias, pick your long-short ideas
- MOST IMPORTANTLY, how do you execute this fundamental call (HINT: Some form of momentum?)
- By studying our intermediate-term duration, we can observe key levels of support and resistance to observe the overall TREND in the market.
- If in fact the fundamental and TREND signals match up we manage the risk of the range by buying on red and selling on green on the signals.
Generating alpha in a market that has gone straight up for the last two years is no easy task. Our best way to seek outperformance begins with #1 above. There are simply four main scenarios in our GIP model (GROWTH, INFLATION, POLICY) for real economic expansion, and front-running the inflection points allows us to pick SECTORS that outperform under each scenario:
- Growth accelerating, inflation decelerating
- Growth accelerating, inflation accelerating
- Growth decelerating, inflation accelerating
- Growth decelerating, inflation decelerating
The monetary response to each scenario and the implications for the strength of an economy’s real purchasing power is predictable in our opinion, but in this never-before seen monetary experiment, front-running the RELATIVE policy response when the centrally-planned machines of different monetary authorities are confronted with the same scenario is difficult. We believe the best- way to front run the big turns is to take in the relevant economic and market data on a day-to-day basis, and position accordingly.
Janet Yellen’s commentary on Wednesday was perceived as more hawkish than the market expected. We weren’t “trading the speech” or hanging on every word, but we didn’t get any indication she is taking a hawkish turn.
Across the pond, Europe has turned severely weaker out of a strong first-half, and the market over the last month has indicated an expectation for a RELATIVELY more dovish Draghi. The tone in his most recent speech reflected his willingness to stand ready for an ABS purchase program. In fact, he more or less said that he would implement an asset-backed purchase program (QE without the government bond and public asset purchase program) immediately if given the authority.
Both the quant signals and our GIP model suggest Europe may slow for the next three consecutive quarters and the FX and gold markets are expecting a relatively more dovish Draghi.
- The EUR/USD has backed off 1.5% bps over the last month
- USD breakout vs. EURO breakdown in our model
- Gold (USD and POLICY-denominated) is down 3% over the last month
CAN DRAGHI CONVINCE THE MARKET HE’LL BE MORE DOVISH FROM HERE? Unfortunately we don’t possess a crystal ball, but our domestic view on overly optimistic growth expectations for the full-year remains intact as it has for all of 2014.
Don’t be afraid to take up your USD exposure and put a little cash on the sidelines (When the USD is going up!)
Have a great weekend.