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Nonrandom Patterns

This note was originally published at 8am on January 08, 2015 for Hedgeye subscribers.

“All fixed patterns are incapable of adaptability. The truth is outside of all fixed patterns.”

-Bruce Lee

 

For those of us who embrace the non-linearity and uncertainty of Global Macro markets, how good is that quote? I can’t believe it took me this long into my career to find it. The more I read, the less I realize I really know.

 

Non-fixed market patterns. They are dynamic and constantly testing consensus narratives. Some of the best Bayesians in our profession get this. While they aren’t in the business of providing us their #process, they do make a lot of money front-running market truths.

 

“In 1993, Renaissance Technologies hired away from IBM a Bayesian group of researchers… searching for nonrandom patterns that will help predict markets, RenTech gathers as much information as possible. It begins with prior knowledge about the history of prices and how they correlate with eachother…”The Theory That Would Not Die (pg 237)

Nonrandom Patterns - 99

 

Back to the Global Macro Grind

 

What an excellent start to 2015! It’s been years since I’ve seen so many great long and short ideas across the Global Macro universe. If your portfolio mandate is diversified and flexible (across asset classes), I think you can have a crusher of a year!

 

Pardon? Yep, those who have been chasing single-factor #MovingMonkey models aren’t quite down with my optimism. But hey, I’m an optimistic guy – I’ve always thought that those who evolve their #process and adapt the fastest will ultimately win.

 

At 1PM EST today I’ll review our Global Macro Themes for Q1 of 2015 (ping sales@Hedgeye.com if you’d like access). In customary hash-tag style, our current themes are as follows:

  • Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds (TLT, EDV, ZROZ, etc.)
  • #Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.
  • Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014.  2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex. 

While commercializing my research and risk management process will continue to take time, after 7 years of doing this from an independent research provider perspective, I think we’ve made significant progress.

They key word in that statement is we.

 

Our Macro Team is not only up to 6 analysts at this point – they have matured into a very cohesive unit of selfless grinders who not only work very well together, but question one another’s premise, so that we keep finding ways to front-run consensus market truths.

 

As legendary Macro maven Ray Dalio likes to ask, “what is the truth?”

 

Well, on yesterday’s US stock market bounce:

 

  1. Healthcare (XLV) led the rally +2.4%
  2. Consumer Staples (XLP) wasn’t far behind at +1.7%
  3. And Energy Stocks (XLE) continue to suck wind (+0.2%)

 

And, if all you do is US Equities, that’s precisely the Macro Playbook (ask sales for our daily note on that with Top/Bottom 5 ETFS, long/short) we have for you while we are still in #Quad4 reporting season (December and Q4 GDP data all gets reported in January).

 

As we roll out of that into Q1, we think you should be tilting to early-cycle (LONG) and late-cycle (SHORT). I’ll explain both asset-class-rotation and catalysts/timing as best I can on our 1PM call today. We hope you can find the time to dial in.

 

If I’m wrong on the timing and patterns of behavior born out of my macro calendar catalysts, I’ll do the only thing a humble servant to Mr. Macro Market knows – adapt to the prior, so that I can best position for the next posterior.

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.91-2.12%

SPX 1195-2046

Nikkei 16884-17488

YEN 118.11-121.27

Oil (WTI) 47.22-52.63

Gold 1195-1225

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Nonrandom Patterns - 01.08.15 chart


P: International Opportunity?

Takeaway: Prohibitive costs + lower monetization potential = unprofitable opportunity for an unprofitable company sitting on a powder keg.

KEY POINTS

  1. PROHIBITIVE COST STRUCTURE: One of the major reasons why P hasn’t expanded internationally past Australia/New Zealand comes down to cost.  There isn't a royalty-setting board internationally, meaning P would need to negotiate on an individual label/country basis on licensing rates, which the company currently deems as "prohibitively expensive".
  2. LOWER MONETIZATION POTENTIAL: Much smaller international ad budgets vs. a much larger internet population means each International user is worth considerably less than a domestic user.  In short, sell-through would prove more challenging, and Ad RPM would be inherently limited.
  3. TOO MUCH RISK AT HOME: We don’t believe there is a viable and material international opportunity for P outside of potentially Australia/New Zealand.  But even if there was, any further expansion would be dependent on a favorable outcome on Webcaster IV.  As we’ve mentioned previously, anything short of a best case scenario on that front could derail P’s entire business model.  

 

PROHIBITIVE COST STRUCTURE

The international opportunity is something the sell-side has been touting for some time, but has yet to come to fruition for P outside a small venture in Australia & New Zealand.  One of the major reasons is cost.  According to P’s filings, the company suggests that international expansion could be prohibitively expensive and not commercially viable. 

 

One of the major reasons is that is there is no statuary licensing entity comparable to the CRB internationally.  That means P would have to enter into direct license agreements with performing rights organizations/copyright owners in order to stream music; something it hasn’t been able to do domestically that would likely prove more difficult/costly on a individual label/country basis.  We can debate the merits of whether P will ever be able to negotiate reasonable royalty rates, or we can point you to the bigger issue… 

 

LOWER MONETIZATION OPPORTUNITY

We initially published this analysis for TWTR, but it applies to P as well.  In short, the international user is worth considerably less in terms of per-capita advertising spend, which is the source of ~80% of P’s current revenues. 

 

The math is fairly simple.  International digital advertising spend is considerably lower than that of the US, but there are considerably more international internet users.  In turn, the ad monetization potential is considerably less for each international user than it is for domestic users; making sell-through on those listener hours tougher to achieve, and the ultimate RPM (revenue per thousand listener hours) that much lower. 

 

P: International Opportunity? - Advertising   Per cap digital by region 

 

TOO MUCH RISK AT HOME

It’s important to remember that P is a marginally profitable company (at best), that hasn't been able to achieve operating leverage to date.  P’s model can barely support its domestic operations, so any further international investment would just lead to heightened cash burn.

 

P: International Opportunity? - P   Operating Leverge CF

 

More importantly, Webcaster IV remains a overhang into 2016.  The major point of contention is P’s ad-supported royalty rate, which applies to roughly 90% of its listener hours, of which, P is monetizing less than half of them.  P and SoundExchange are worlds apart on what they are seeking, so anything short of a best-case scenario for P could derail its entire business model.  That likely means P would have to to curb usage, either through more stringent listener caps or market exits altogether.  See the note below for more detail.

 

P: Webcaster IV = Powder Keg

01/13/15 02:49 PM EST

[click here]

 

P: International Opportunity? - P   Web IV proposals

 

We don’t believe there is a viable and material international opportunity for P outside of potentially Australia/New Zealand.  But even if there was, P isn’t likely to expand internationally unless it receives a favorable outcome on Webcaster IV.  And even if that were to happen, expansion would be a slow process that wouldn’t start until 2016 at the earliest, with monetization more likely a 2017 event at the very earliest.  Long-story short, we wouldn’t bet on the international story.

 

 

Let us know if you have any questions, or would like to discuss further.

 

Hesham Shaaban, CFA

@HedgeyeInternet 


Cartoon of the Day: Draghi vs. Deflation

Cartoon of the Day: Draghi vs. Deflation - Deflation cartoon 01.21.2015

Is Draghi preparing to act against deflation? Or is deflation preparing to act against Draghi?


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Keith's Macro Notebook 1/21: Japan | #Deflation | Swiss

Hedgeye CEO Keith McCullough shares the top three things in his macro notebook this morning.

 

Sign up for Hedgeye's Market Marathon on January 27: http://live.hedgeye.com/market-marathon/



Hedgeye Morning Macro Call Replay: Look Out If Draghi Doesn’t Deliver the Cow Bell

On this morning’s institutional Macro Call, Hedgeye CEO Keith McCullough navigates through myriad growing market and economic risks around the world, highlights some of his favorite (and least favorite) ideas, and warns that if the ECB’s Mario Draghi disappoints investor expectations tomorrow, beware of market nastiness.

 


THE HEDGEYE MACRO PLAYBOOK

Takeaway: We're inclined to expect a pullback in cross-asset beta on further consolidation in the USD/JPY cross amid a bullish TREND in volatility.

THEMATIC INVESTMENT CONCLUSIONS

Long Ideas/Overweight Recommendations

  1. iShares U.S. Home Construction ETF (ITB)
  2. Health Care Select Sector SPDR Fund (XLV)
  3. Consumer Staples Select Sector SPDR Fund (XLP)
  4. PowerShares DB U.S. Dollar Index Bullish Fund (UUP)
  5. iShares 20+ Year Treasury Bond ETF (TLT)
  1. LONG BENCH: Vanguard REIT ETF (VNQ), Utilities Select Sector SPDR Fund (XLU), Vanguard Extended Duration Treasury ETF (EDV)

Short Ideas/Underweight Recommendations

  1. iShares TIPS Bond ETF (TIP)
  2. iShares MSCI Emerging Markets ETF (EEM)
  3. Industrial Select Sector SPDR Fund (XLI)
  4. SPDR Barclays High Yield Bond ETF (JNK)
  5. CurrencyShares Japanese Yen Trust (FXY)
  1. SHORT BENCH: SPDR Oil & Gas Exploration & Production ETF (XOP), CurrencyShares Euro Trust (FXE), WisdomTree Emerging Currency Fund (CEW)

 

QUANT SIGNALS & RESEARCH CONTEXT

Barring a Positive ECB Surprise, Expect a Pickup in Cross-Asset Volatility Following Today’s Disappointing BoJ Announcement: Overnight, the Bank of Japan concluded its two-day monetary policy meeting. The takeaways were unspectacular – for Japanese yen bears, that is:

 

  • No change to the existing QQE program, which targets an ¥80T annual increase in JGBs, a ¥3T annual increase in ETFs, a ¥90B annual increase in J-REITs, a ¥2.2T annual increase in commercial paper and a ¥3.2 annual increase in corporate bonds.
  • Marginal adjustments to their Stimulating Bank Lending Facility (i.e. increasing individual allotments to ¥2T from ¥1T; increasing the total allotment to ¥10T from ¥7T) and their Growth-Supporting Funding Facility (i.e. expanding the base of institutions that can access the program). Both programs were extended by one year.
  • The key incremental data point is the BoJ’s sharp revisions to its growth and inflation forecasts, which were set back in October. Like the FOMC, the BoJ updates its economic outlook 2x annually (in April and October) and revised them 2x annually as well (in January and July). The net result of today’s revisions is a dramatically lowered probability for QQE expansion in the near term (i.e. ~2-3 months).
  • On Real GDP growth, the BoJ revised up its FY15 and FY16 forecasts by +60bps and +40bps, respectively, to +2.1% and +1.6%. The board cited a large tailwind from energy price deflation as the primary reason for the material shift higher. Clearly they are not paying attention to U.S. retail sales data…
  • On Core CPI – which excludes both the prices of fresh food and the effects of the consumption tax hike – the BoJ revised down its FY15 forecast by -70bps to +1%. It nudged up its forecast for FY16 by +10bps to +2.2%, citing a reflationary tailwind of [assumed] higher wage growth on the strength of what they anticipate as the start of a self-perpetuating cycle of consumption and wage growth.

 

THE HEDGEYE MACRO PLAYBOOK - 1

Source: BoJ

 

THE HEDGEYE MACRO PLAYBOOK - 2

Source: BoJ

 

It’s worth noting that we [continue to] strongly disagree with just about every assumption they make in their economic forecasts.

 

On growth, the base effect alone will prevent Japan from even sniffing its GDP target for FY15. In our Bayesian prior/posterior forecasting process, a probable draw-down in 1Q15 GDP growth will likely set the Japanese economy back in a material way ahead of a likely 2H15 recovery:

 

THE HEDGEYE MACRO PLAYBOOK - JAPAN

 

THE HEDGEYE MACRO PLAYBOOK - GDP COMPS

 

On inflation, #StrongDollar commodity price deflation and a brutal demographic outlook continues to weigh on both reported CPI and structural inflation expectations in Japan:

 

THE HEDGEYE MACRO PLAYBOOK - JAPAN BREAKEVEN

 

THE HEDGEYE MACRO PLAYBOOK - JAPAN 35 54 YEAR OLD

 

Net-net, the BoJ will remain well shy of its “+5% Monetary Math” mandate over the intermediate term (i.e. the ~NTM):

 

THE HEDGEYE MACRO PLAYBOOK - FIVE PERCENT MONETARY MATH

 

So what happens next? We think the both the USD/JPY cross and the Japanese equity market are at risk  of consolidating meaningfully over the next ~2-3 months as investors are forced to delay their expectations for QQE expansion – which we now see April as the most likely timeframe:

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. MSCI JAPAN

 

This is especially true in the context of the crowded net lean in the latter index throughout the buy-side; it won’t take much JPY appreciation to smoke the Nikkei down 5-10%:

 

THE HEDGEYE MACRO PLAYBOOK - EXTREME SENTIMENT MONITOR

 

All told, market participants – ourselves included – who are stuck on the wrong side of the Abenomics trade here should strongly consider hedging a probable pickup in volatility over the near-term. Our intermediate-to-long-term call for 135-147 on the USD/JPY cross and ~25k on the Nikkei remains intact, however.

 

Beyond that, the knock-on effects of a potential ~2-3 month consolidation phase on the USD/JPY cross would be many:

 

EM equities up?

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. MSCI EM INDEX

 

EM FX and EM USD debt up? Or down if JPY appreciation perpetuates cross-asset volatility as it has been known to do (per the most immediate-term correlation):

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. EM FX

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. EM OAS

 

Commodity prices up? Or down if JPY appreciation perpetuates cross-asset volatility as it has been known to do (per the most immediate-term correlation):

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. CRB INDEX

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. CRUDE OIL

 

U.S. equities down?

 

THE HEDGEYE MACRO PLAYBOOK - JPYUSD vs. SPX

 

With the VIX smack dab in the middle of our 16.66 to 23.06 immediate-term risk range, it’s tough to have a concrete call on the spillover effects today. That being said, however, we’re definitely inclined to expect a pullback in cross-asset beta on further consolidation in the USD/JPY cross as the TREND in volatility remains bullish:

 

THE HEDGEYE MACRO PLAYBOOK - VIX

 

***CLICK HERE to download the full TACRM presentation.***

 

TRACKING OUR ACTIVE MACRO THEMES

Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds.

 

More Cowbell!  A Roadmap Ahead of the ECB’s Thursday Meeting (1/20)

 

#Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.

 

The Hedgeye Macro Playbook (1/16)

 

Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014.  2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex.

 

HOUSING: Builder Confidence Still High Despite Recent Weakness (1/20)

 

Best of luck out there,

 

DD

 

Darius Dale

Associate: Macro Team

 

About the Hedgeye Macro Playbook

The Hedgeye Macro Playbook aspires to present investors with the robust quantitative signals, well-researched investment themes and actionable ETF recommendations required to dynamically allocate assets and front-run regime changes across global financial markets. The securities highlighted above represent our top ten investment recommendations based on our active macro themes, which themselves stem from our proprietary four-quadrant Growth/Inflation/Policy (GIP) framework. The securities are ranked according to our calculus of the immediate-term risk/reward of going long or short at the prior closing price, which itself is based on our proprietary analysis of price, volume and volatility trends. Effectively, it is a dynamic ranking of the order in which we’d buy or sell the securities today – keeping in mind that we have equal conviction in each security from an intermediate-term absolute return perspective.      


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