This note was originally published at 8am on December 09, 2014 for Hedgeye subscribers.
“It solved practical questions that were unanswerable by any other means.”
-Sharon Bertsch Mcgrayne
That’s how Sharon Bertsch Mcgrayne summarizes using a Bayesian approach to problem solving in an important book for your risk management library – The Theory That Would Not Die.
“Although Bayes’ Rule drew the attention of the greatest statisticians of the 20th century, some of them vilified both the method and its adherents, crushed it, and declared it dead… In discovering its value for science, many supporters underwent a near-religious conversion yet had to conceal their use of Bayes’ Rule and pretend they employed something else.”
Much like during Bayes’ revolutionary times (18th century), where “mathematics was split along religious and political lines” (pg 4), today we are at the crossroad for the same in economic analysis. If you tell me what someone’s political and/or financial motivation is, I can usually predict their answers. If you’re Bayesian in your approach, your answers are far less certain.
Back to the Global Macro Grind…
We hosted an astute group of RIAs (Registered Investment Advisors) at HedgeyeHQ after the close yesterday where I gave a teach-in on our #process. One of the main examples I like to use is Bayes trying to locate a billiard ball’s location (blindly) on a table…
Each incremental throw gives you more information on where the ball is not. After multiple throws, you can narrow the probability of the ball’s location to a probable range. I call this the Risk Range. And I have no business telling the table where the ball has to be.
What happens if there are multiple competitors at the table, all racing to figure out where the ball is at the same time? That’s what makes a market. Whether you like my competitive style or not, I fully intend on coming out of the room with the ball (read Diary of a Hedge Fund Manager for details!).
If you want to beat your competitors in this game, not only do you need to play your game (read: #process), but you need to understand where the other players at the table are positioned and why. One really simple way to look at this from a consensus hedge fund positioning perspective is through CFTC Non-Commercial net LONG/SHORT futures/options.
I cite the rate of change in this Bayesian information as frequently as I can, but whether I do in a timely fashion or not doesn’t mean that the information ceases to exist. Yesterday’s rip (higher) in the Long Bond (TLT +1.2%) and drop in the SP500 (SPY -0.73%) can be (partly, but importantly) explained by the Consensus Macro’s net positioning as of Friday’s close:
- SP500 (Index + Emini) net LONG position ramped +61,389 week-over-week to +59,263 contracts
- Long Bond (10yr Treasury) net SHORT position got way shorter (-91,399 contracts) to a net short position of -173,755
In other words, into the “everything is awesome” jobs cheerleading report:
- Consensus Macro ramped to the highest NET LONG position (in SP500 futures/options) terms of 2014, and…
- They took the NET SHORT position in the Long Bond to a fresh YTD high
“So”, no matter what you think consensus is… that’s what it was - and the next Bayesian probabilities to weigh have everything to do with why consensus is positioned that way. Isolating why on both GROWTH and INFLATION, here are a few A/B tests (toss the ball):
A) On GROWTH, they must think US growth, employment, wages etc. are fixing to achieve some sort of “escape velocity”…
B) Or they realize that even if they are wrong on growth… that the Fed, BOJ, and ECB bails them out anyway
While its perverse, that B) scenario is credible. It’s the levered-long heads you win, tails you win bet – throw the ball anywhere on the table (other than the Russell 2000 and Energy stocks) and you win, right? How about we roll the queue ball on INFLATION?
A) As #deflation expectations accelerate, consensus must think the Fed is going to raise rates into that? …
B) Or that consumption growth is going to be so strong that the Fed will dismiss #deflation as a risk and hike anyway
The problem with what we call the #Quad1 scenario: A) US growth accelerating B) on inflation decelerating is that it’s a theory, not yet a reported reality. And that’s the thing about theories – they are for people who are smarter than me that don’t need to keep taking more reps with the uncertainty ball. They just need a survey confirming their pre-determined belief.
What if McDonalds (MCD) reporting a down -4.6% year-over-year same store sales number for November has something to do with the non-Wall Street economy that still has no wage growth? What if the recent Retail Sales, real personal consumption growth, and jobless claims numbers reported by the government are right (they’ve been slowing)?
Well, that will make Friday’s Consensus Macro position in SPY vs TLT wrong… and it might remind some of us that practical questions are unanswerable by any other means than by embracing the uncertainty of each risk management day.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.16-2.32%
WTI Oil 61.27-68.02
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer