“Have a rule. Always follow the rule, but know when to break it.”
-Lasse Heje Pedersen
That’s an important quote to qualify from a good finance book I’ve recently cited called Efficiently Inefficient. From a portfolio manager’s perspective, I like it because it makes you think about what it is that you do within the context of what other people do.
After melding fundamental research with a quantitative overlay, my rule is to be Bayesian. As the data and market signals change, I need to consider changing my position. Rule #1 is don’t lose money. Rule #2 is break most of the Old Wall’s linear forecasting rules.
Maverick Capital’s Lee Ainslie (fundamental long/short equities) explained to Pedersen that they “built a quantitative system that informs their fundamental process and helps manage the risk” (pg 11). I’d say that’s pretty consistent with most “fundamental” investors we meet with these days. Mistaking the Dollar driven #Deflation Rules for “value” crushed lots of fund managers this year.
Click here to join Hedgeye CEO Keith McCullough live on The Macro Show at 9am.
Back to the Global Macro Grind…
The sexiest thing you can do on the long or short side of a security is pick a top or bottom. Been there, done that. Nailed a few – been nailed by more than a few. Along the way, I have come to realize that I’m not sexy.
Tops and bottoms are processes, not points. To understand how the biggest macro risk factor of the last 2 years bottoms, it’s critical to educate yourself on what the causal factors were driving #Deflation to begin with. (hint: start with the US Dollar)
As you can see in today’s Chart of The Day (slide 41 in our current Global Macro Themes deck), inflation expectations hit an all-time high in 2011-2012 as Ben Bernanke devalued the US Dollar to a 40-year low.
That, you see, was the key to Bernanke’s storytelling – not creating real, sustainable growth – but creating the illusion of growth (commonly called inflation). With that expectation in hand, the world’s asset inflation chasers built massive oversupply.
Priced in devalued Dollars, 2 of the top “asset classes” one would chase if expecting perpetual inflation are:
- Commodities that settle in US Dollars
- Leverage (Debt) linked to inflation expectations
That’s why our recommended asset allocation to both Commodities and Junk Debt has been right around 0% for the last 18 months. That’s also why we have been telling our clients to avoid Style Factors linked to #Deflation like:
- High Debt to Enterprise Value Equities
- High Beta Small Cap Stocks (with bad balance sheets)
- High “yielding” stocks with inflation linked cash flow expectations (like levered upstream E&P MLPs)
On the short side, that’s why Rule #1 (don’t lose money) was as important as any rule you should have followed this year. It’s also why the opposite of those Style Factors made for championship seasons for some of you, on the long side:
- Low Debt to Enterprise Value Equities
- Low Beta Large Cap Stocks (with good balance sheets)
- Unlevered Growth Equities that saw revenues accelerate as GDP slowed
And that brings us to the next obvious question: how do we A) not blow up those gains in 2016 (Rule #1) and B) have another good year of compounding returns? While the sexiest answer might be calling a bottom in #Deflation, I don’t do sexy.
We do process.
The data (in the rate of change process) says that October’s counter-TREND bounce in everything inflation expectations was (like it was in July) another head-fake.
Notwithstanding that US and Global Consumption slowing right now (bigger component of GDP) is more important than the recession you’ve seen develop in cyclical/industrial PMIs for the last 12 months, the PMIs themselves still sucked in November:
- US (Chicago) PMI tanked to 48.7 in NOV (yesterday’s report) vs. 56.2 in OCT
- China’s made-up PMI remained below 50 in NOV at 49.6 vs. 49.8 in OCT
- UK’s PMI slowed to 52.7 in NOV vs. 55.5 in OCT
Sure, there were some other 4-handles on PMIs (4 = contraction/recession reading) in places like Switzerland (49.7) and Norway (47.6) this morning. But anyone who isn’t sleeping in a cave realizes that #Deflation has been priced in, to a degree, in their markets.
Priced in? Those are two of the sexiest words a “value investor” who wants to pick a bottom can hear. That said, if you start to buy a crashing asset price, you better have more capital to average in.
As the great value-investor, Marty Whitman, says: “a bargain that remains a bargain, is no bargain.”
Value with a catalyst? Yep. That’s what I’m looking for. And, while it’s been wrong since July, maybe that’s why the “PMIs have bottomed” call has been so sexy – everyone is looking for something to love.
In November all we measured were more bearish worldwide demand (read: #GrowthSlowing) signals on both the industrial and consumption side of the ledger. With the US stock market only having 5 up days in the last 18, Mr. Macro Market saw that too.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.18-2.28%
Oil (WTI) 40.69-43.15
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer