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“When supper time came the old cook came on deck
Saying fellows it's too rough to feed ya”

–Gordon Lightfoot, The Wreck of the Edmund Fitzgerald

This week I have been writing my morning missives from our family house on the Big Lake that the Ojibways call “Gitchigumi”, meaning "Big Water".

Thunder Bay is at the head of Lake Superior. Canadians call it The Lakehead. It’s a much safer place than CNBC. It’s quiet and you’d really have to look long and hard to find any finance oriented groupthink. That said, there are plenty of other things to worry about up here – lots of bears and Big Water.

Gordon Lightfoot wrote that the Big Lake “never gives up her dead.” We locals are always mindful of that and we’re always managing risk appropriately.

As most of you know, in addition to hockey, I’m big on metaphors. In the past week we’ve somehow successfully traversed the Big Water of a US stagflation unwind with the following Early Look titles:

“Part of Hell” = 8/26

“Ball Underwater” = 8/27

“Numb is The New Deep” = 8/28

“Duration Mismatch” = 8/31

“Circumstances Rule” = 9/1

“Danger Ball” = 9/2

This, of course, all started with one of our favorite behavioral strategists, the late George Carlin, reminding us that, “I'm not concerned about all hell breaking loose, but that a PART of hell will break loose... it'll be much harder to detect.”

We then moved toward marking our own bottom in what we’ve labeled the Burning Buck (covering our short position in the US Dollar and selling mostly everything, other than Gold, that was priced in those Dollars). Then the Ball Underwater (the US Dollar) shot to the upside, and everything else is history. The SP500 has been down for 4-straight days, correcting -3.5% from her YTD high of 1030.

Whether you agree with us or not that that the ISM Prices Paid report was a Danger Ball (stagflation preview), or that the US Dollar remains THE driving factor in global macro right now, is up to you. This morning, US Dollar down (pre-US market open) has US Equity futures indicated up, and no matter where you go this morning, there’s that Big Water again.

The Buck started to Burn again intraday yesterday (see our midday note titled “US Dollar Update: Pandering Politicians”) for 2 reasons: Tim Geithner spoke and the Fed’s FOMC Minutes were released. As predictable as the sun rising on the East of our Big Lake this morning, Geithner will trot his squirrel hunting gear out to the G-20 meetings in London and tell the world of revisionist financiers that it’s “too early” to raise rates or remove free money stimulus. Get this guy some Sapporo.

The Fed’s Minutes were just an analytical shame. There is no credibility in a currency which is dominated by a US Federal Reserve that is as politicized as this one. If you changed the script to Japanese, you wouldn’t be able to discern which bureaucratic nation penned the outlook. Bernanke’s group-thinkers said that there was “uncertainty” about nearly everything other than the Great Depression Part 2 being a certainty. Gee, thanks guys.

Yesterday, I spent most of the day covering shorts and buying equities. To be clear, I was already playing with a lead here in September and consciously opted to play that move aggressively. I was doing so with tight stops. With the US Dollar down this morning, I suspect that I might get some good prices to sell into, and I will. The $30/oz monkey chase in Gold was a little much for me yesterday, so I sold into that strength too.

When there is Big Water like this coming on deck, there are no established rules. The first Nobel Prize in Economics wasn’t handed out until 1969. This game of managing global market risk is far from an established science.

The Big Water I see this morning has nothing to do with anything other than what’s there. I’m not one of those Wall Street “strategists” who is being rained on that will say with a straight face that he isn’t getting wet.

If I end up selling everything I am long in the US this morning, I’ll probably smile and go on with my day. The Thunder Bay Firefighters Golf Classic is tomorrow, and my Dad is retiring. I’m sure I can learn a thing or two about managing risk from the boys who fight the real stuff with Big Water every night.

My risk management model hears that ole cook coming on deck saying “fellas it’s too rough to feed ya.” So I have shifted our Asset Allocation to a very defensive posture. We are long low-beta sectors and low-risk income generating macro positions (Healthcare, Utilities, TIPs, and Chinese Yuan). I think selling strength today, taking a step back from the Big Water, and watching it settle for a few days is the best way forward.

My immediate term TRADE resistance line for the SP500 is 1004. For the Nasdaq, I’m up at 1991.

Best of luck out there today,

KM

 

LONG ETFS

XLU – SPDR UtilitiesWe bought some low beta dividend yield on its lows on 9/2. Utilities traded down 1% and they should act ok during stagflation fears. 

 

XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. It’s a good one to buy into. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.

 

EWH – iShares Hong KongThe current lower volatility in the Hang Seng (versus the Shanghai composite) creates a more tolerable trading range in the intermediate term and a greater degree of tactical confidence.

 

QQQQ – PowerShares NASDAQ 100We bought Qs on 8/10 and 8/17 to be long the US market. The index includes companies with better balance sheets that don’t need as much financial leverage.

 

CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP– iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

 

SHORT ETFS

LQD – iShares Corporate Bonds Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates that bonds will give some of that move back. Shorting ahead of Q4 cost of capital heightening as access to capital tightens.

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds  If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.