This note was originally published at 8am on October 15, 2014 for Hedgeye subscribers.
“Pretend inferiority and encourage his arrogance.”
On this day in 1815, Napoleon Bonaparte began his exile on the island of St. Helena. For the next six years, mostly in isolation, Napoleon would write his memoirs before eventually succumbing to what most physicians now believe was stomach cancer. Despite an ending that was less than triumphant, Napoleon had a pretty stellar career for a short guy.
At the age of 29, when most of us were just finishing with our MBA studies, or just finishing the third level of the CFA if we were really contrarian and didn’t get an MBA, Napoleon took control of France via a coup d’etat and named himself First Consul. Four short (no pun intended) years later, Napoleon named himself Napoleon I, Emperor of the French.
Over the next decade he would lead France in the Napoleonic wars and eventually conquer most of continental Europe. It is believed that Napoleon fought 60 battles and lost only seven, a record of conquest that is almost unprecedented. So much so that the great English General Wellington, when asked who the greatest general of the time was, he responded:
“In this age, in past ages, in any age, Napoleon.”
But, alas, even the great Napoleon eventually had an off day of performance. While he was eventually and finally defeated at the famous battle of Waterloo, his off performance actually came a few years earlier in the Invasion of Russia. Although French troops were able to beat back the Russians past Moscow, by the time Napoleon’s army returned to France its numbers had dwindled down to some 40,000, despite starting at more than 400,000.
Speaking of performance, Blackrock recently published a report that showed in aggregate the hedge fund industry has produced negative alpha for the first half of the year. Similar to this, a recent report by eVestment showed “in the first seven months of the year, 79.58% of the overall portfolio volatility within the 30 largest hedge funds in its data universe could be explained by systemic or market risk.” Levered beta anyone?
If there is a moral of the story it is that even the best generals have off days. So if this year has been challenging from a performance perspective . . . channel your inner inferiority complex, go back to your contrarian roots, and fight on!
Back to the Global Macro Grind…
We’ve obviously been tooting our revolutionary horns fairly loudly on the concept that the economy is, or has, entered #Quad4, which is characterized by slowing growth and decelerating inflation. For those that are holding out that the economic growth may be better than expected, they point to the U.S. employment picture, which, admittedly, has been strong.
In the Chart of the Day, which is titled “Payroll Growth That Would Even Make Napoleon Proud”, we highlight the dramatic improvement in the labor market, but the caveat of course is that the labor market is unlikely to get much better from here. As my colleague Christian Drake (@HedgeyeUSA ) wrote when posting the note with this chart in it:
“At +1.93% YoY, Nonfarm payrolls in September recorded their fastest rate of improvement since April 2006. The current pace of improvement is inline with peak growth in the last cycle and may be as good as it gets given the demographic and labor supply headwinds and the secular slowdown in employment growth over the last 30 years.”
In terms of global growth, the Bank of Korea this morning lowered their domestic growth forecast for 2015 and cut rates to a four year low. While Korea certainly doesn’t yield the economic power of the U.S., it is still one of the largest 15 economies on the planet and this is just another sign that growth expectations are being lowered globally.
With global growth continuing to decelerate and U.S. growth and employment likely peaking at best, the only risk to the Fed not getting incremental dovish is inflation. Unfortunately, signs of inflation are benign at best. One of the best commodity proxies for inflation, oil, is down more than 10% in a straight line over the past two weeks (making our MLP Short thesis even juicier!). As well, 10-year break evens shrank to 1.9%, the narrowest spread since June 2013. #Quad4 anyone?
The question, as always, of course is where to find the alpha even if we are right on the economy. One area that we believe continues to be ripe with short ideas, as noted above, is the Upstream MLP Sector. Our Energy Sector head Kevin Kaiser will be doing a conference call this coming Wednesday to provide his updated thoughts on the sector. With oil in free fall and likely to decline further due to U.S. production growing and global demand at five year lows, cash flow coverage will be very, very tight for MLPs. If you’d like to join the call, please ping firstname.lastname@example.org.
The other area we’ve been pounding the table on in terms of finding shorts is the small cap space in general. Interestingly, according to a Bloomberg article this morning the most shorted stocks in the Russell 2000 have fallen 15% in the last month, which is almost three times the underling gauge.
Even as the Russell 2000 has underperformed dramatically in the year-to-date, it is important to note that stocks in the Russell are trading at 24.8x P/E versus 15.6x for the SP500. Given that valuation dichotomy, the Russell may well still be the Waterloo of small cap growth investors this year who try to buy the dip.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.19-2.36%
WTI Oil 80.07-86.20
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research