CHART OF THE DAY: The Reflation Trade Looks Pretty Weak

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye CEO Keith McCullough. Click here to learn more.


"... Let’s review an example of something Trump might call you-ge! in Macro for the last 3 years – being The Bear in Commodities:

  1. CRB Commodities Index (19 commodities) was between 300 and 310 in both Q1 of 2013 and 2014
  2. After multiple chart chases, the CRB Index got cut in HALF by the low we just saw in Q1 of 2016
  3. At 155 on February 11th, 2016, the CRB Index hit a 3yr low

Then it “bounced”, for a month… and we’re back in a commodity bull market? #Cool."


CHART OF THE DAY: The Reflation Trade Looks Pretty Weak - 03.24.16 chart

Trend Following

“Cut short your losses… and let your profits run.”

-David Ricardo


Ricardo didn’t run a quant fund (or a CTA), but he certainly inspired many. He was one of the popular 18th century British economists that professors call “classical.” One of his most important teachings was Trend Following.


In his chapter titled “Managed Futures”, Lasse Heje Pedersen cites the aforementioned Ricardo quote and links it to “traders who are most directly focused on trend-following” (managed futures hedge funds and commodity trading advisors, or CTAs). “Such funds have existed at least since Richard Donchian started his fund in 1949, and they have proliferated since the 1970s.” (Efficiently Inefficient, pg 208)


“Time series momentum is a simple trend-following strategy that goes long on a market that has experienced a positive excess return over a certain look-back horizon and goes short otherwise. We consider 1-month, 3-month, and 12-month look-backs…” And I’m calling this out this morning as it’s one of the main factors whipping people around these days in macro markets.


Trend Following - Whiplash cartoon 03.26.2015


Back to the Global Macro Grind


It’s as obvious that CTAs are popular in commodity bull markets as it is that modern day quant funds chasing price momentum kill it on the way up. The thing about chasing price (or charts that “look good”) is that the look-back periods keep getting shorter.


Why are the look-back periods getting shorter?


  1. We have an oversupply of money managers trying to beat the same performance bogeys at the same time
  2. We have massive short-term performance pressures (weekly, monthly, and quarterly) due to lack of performance
  3. We have machines that simply make all of this happen faster and faster


Those are some very basic reasons for short-term performance (and chart) chasing. There are, of course, many more. But my point here is that A) this is part of playing today’s game and B) there have been massive intermediate-term risks associated with it.


Note that I wrote intermediate-term risks. In other words, there are huge TREND and TAIL duration risks associated with immediate-term (TRADE) trend-following! And that’s really the point – 1, 2, and 4 week chart chasing aren’t TRENDs – they’re TRADEs.


If you use our multi-duration and multi-factor macro model, you’ll recall the big buckets of duration we use are:


  1. TRADE = 3 weeks or less
  2. TREND = 3 months or more
  3. TAIL = 3 years or less


That’s why all of our Macro Themes live in the 3 month to 3 year space. Getting the big stuff (Macro TRENDs and TAIL risks) right over longer-term time horizons (vs. where our industry’s performance anxieties reside) has really helped put Hedgeye on the map.


Let’s review an example of something Trump might call you-ge! in Macro for the last 3 years – being The Bear in Commodities:


  1. CRB Commodities Index (19 commodities) was between 300 and 310 in both Q1 of 2013 and 2014
  2. After multiple chart chases, the CRB Index got cut in HALF by the low we just saw in Q1 of 2016
  3. At 155 on February 11th, 2016, the CRB Index hit a 3yr low


Then it “bounced”, for a month… and we’re back in a commodity bull market? #Cool.


Set aside the super-short-term performance pressures of some of your peers and think long and hard about A) what’s happened in the 3-month to 3-year time series vs. B) the 40yr USD Devaluation (Fed) Cycle and C) the last 3-4 weeks:


  1. CRB Index “bounced” +14% from that FEB low to 177 with the US Dollar Index -3%
  2. USD Index +0.5% yesterday = Down Day of -2.2% for CRB Index
  3. CRB Index TAIL risk (resistance) = 201; US Dollar Long-term TAIL support = 92.11


Just to answer the super-short-term question first… where do you think the Commodity “Bull” and/or reflation trade will be if the US Dollar Index ramps another +3% from here? (hint: the 2wk inverse correlation between USD and CRB is -0.96!)


How about the intermediate-term TREND questions?


  1. What if the Fed raises and/or signals a June rate hike at the April meeting?
  2. What happened 3 months ago when the Fed tightened (in Dollars) into a US slowdown?
  3. If the industrial/cyclical/commodity economy really is “back”, why doesn’t the Fed hike 5x this year?


It’s a good thing most people who are invested with fund managers have no idea how all of this works. Can you imagine if the average American actually understood why the Fed is constantly being pressured to reflate assets by devaluing the purchasing power of their hard earned US Dollars? Or are they smarter than the average perma asset inflation bull and getting angry? #Trump


Not only is it crystal clear that both the Industrial #Recession isn’t over but that important #LateCycle components of the US economy are no longer accelerating. Despite fantastic weather on the East Coast in FEB, New Home Sales dropped -6.1% year-over-year. We now have a trifecta for the former Housing Bulls (turned Bears) @Hedgeye – Pending, Existing, and New Homes – all DOWN year-over-year in rate of change terms!


Ah, you get it now. If the US equity bulls were straight up with you about it, what they really need to keep the “reflation” rally going (for more than a month off its 3yr low) is the TREND of a slowing US economy (maybe a #Recession?) and more Fed easing (Dollar Down).


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 1.84-1.97%

RUT 1056-1110

VIX 13.11-20.28
USD 94.68-97.17
Oil (WTI) 36.38-42.97


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Trend Following - 03.24.16 chart

Early Look

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Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.

Is the EM Relief Rally Nearing Its [Eventual] End?

Takeaway: We now believe EM assets are generally priced quite richly relative to our intermediate-to-long-term fundamental outlook for the space.

Our sincerest congrats to anyone who’s nailed this low-quality relief rally across global financial markets in which nearly everything levered to reflation, excessive leverage, and/or illiquidity risk led. While we’ve been the axe on the bear side of emerging markets since early 2013, we wrongly missed getting out in front of the aforementioned short squeeze with a tactical short covering view.


With respect to EM asset class returns specifically:


  • The MSCI Emerging Markets Equity Index has gained +20.6% from its 1/21 YTD trough;
  • The JPMorgan EM FX Index has gained +7.7% from its 1/21 YTD trough;
  • The Bloomberg EM Local Currency Sovereign Debt Index has gained +5.4% from its 1/20 YTD trough; and
  • The Bloomberg EM USD Corporate Bond Index has gained +6% from its 1/20 YTD trough.


These are the kinds of wildly impressive ~two month returns you can make your year on – especially if you don’t give it all back. We do, however, see mounting risk of investors “giving it all back” over the intermediate-term. Moreover, our long-term call on EM remains ultra-bearish for a variety of reasons, most recently highlighted on our recent conference call titled, “Is This a Generational Buying Opportunity in Emerging Markets?” (3/16).


CLICK HERE to access the video replay of the call, as well as the associated 105-page slide deck in PDF format.


The three key conclusions of the call were as follows:


  1. We see further downside at the primary asset class level, as well as elevated risk of material bankruptcy cycles in a number of key emerging market economies.
  2. While we remain explicitly and overtly bearish on the Chinese economy and RMB, we believe investor consensus is far too bearish on both. Most of the analysis we’ve seen inappropriately analyzes the Chinese financial sector from the perspective of Western economies; nor does it include the full range of potential outcomes – including a secular bull market in the Chinese currency and Chinese equities.
  3. On the long/overweight side we like Emerging Europe (i.e. Poland, Hungary and Czech Republic), South Korea and Thailand. In terms of short/underweight candidates, we think Latin America (specifically Brazil, Mexico and Colombia), Indonesia and South Africa are most at risk for #PhaseIII of our #EmergingOutflows theme – i.e. a wave of bankruptcy cycles.


As we take this opportunity to pound the table on the latter risk, there remains a large compendium of investors that believe EM assets are both “cheap” and a “crowded short”. We do, however, continue to believe that valuation and sentiment are not catalysts for sustained recoveries in asset prices or economies.


Is the EM Relief Rally Nearing Its [Eventual] End? - MSCI EM Index EV to EBITDA Ratio vs. MSCI World Index


On the contrary, we view the following as likely catalysts for ongoing economic deterioration and asset price declines across the emerging market space:


  1. Intermediate-term (2-3 quarters): a cyclical recovery in the U.S. dollar; and
  2. Long-term (2-3 years): a meaningful NPL cycle across key emerging market economies.


Regarding the former risk, we think a 2nd quarter delta into #Quad4 in the U.S. followed by what is likely to be two consecutive quarters of #Quad2 in 2H16 (assuming the U.S. economy is able to avoid an outright recession) may prove fundamentally bullish for the DXY – which has been consolidating in both market price and speculative net length terms for over a year now. Recall that quadrants two and four have historically proven most positive for the USD vs. peer currencies.


Is the EM Relief Rally Nearing Its [Eventual] End? - UNITED STATES


Is the EM Relief Rally Nearing Its [Eventual] End? - U.S. Dollar Index


Is the EM Relief Rally Nearing Its [Eventual] End? - EXTREME SENTIMENT MONITOR


Regarding the latter risk, we continue to see elevated risk in any buy-and-hold strategy in EM assets ahead of what is likely to be a material bankruptcy cycle that ripples across many EMEs. Per IIF data, outstanding debt in EM economies across all sectors reached $62 trillion (or 210% of GDP) in 2015. Roughly 40% of that stockpile of debt is in the nonfinancial corporate sector – which is especially exposed to structurally depressed commodity prices (read: perpetually lower FCF absent a material and sustained recovery in commodity prices).


Is the EM Relief Rally Nearing Its [Eventual] End? - CRB Index vs. MSCI Emerging Markets Index EPS


Per our analysis, we haven’t seen anything yet in terms of a meaningful NPL cycle across emerging markets. The median and mean NPL ratios across the 20 emerging market economies covered by our proprietary EM Crisis Risk Index are 3% and 3.6%, respectively, which compares to the 1 EM bankruptcy cycle peaks of 12.4% and 14.2% – which were both recorded in 1999, respectively. Moreover, those NPL ratios are only beginning to trend higher off all-time lows as a spread to the mean and median NPL ratios across advanced economies. This would imply a substantial degree of pain is yet to come.


Is the EM Relief Rally Nearing Its [Eventual] End? - EME NPL Ratio vs. AE NPL Ratio


Is the EM Relief Rally Nearing Its [Eventual] End? - EME NPL Ratio vs. AE NPL Ratio Spread


Don’t get piggy on the long side of emerging markets. Keep a [great] trade a trade out there.




Darius Dale


Cartoon of the Day: The Fourth Turning

Cartoon of the Day: The Fourth Turning - demographics cartoon 03.23.2016


Demographic trends are radically reshaping the U.S. economy.

QUICK TAKE: How To Risk Manage Gold | $GLD

QUICK TAKE: How To Risk Manage Gold | $GLD - gold bar

Bullish on Gold? We are.


Here's some key short-term trading advice via our Macro team:


"... Gold is up ~19% for the year, the USD going up and interest rates going up could cause gold to fall. Around 1,225 is an interesting spot to buy more gold but we are going to be a little more patient in the face of all the rate rise commentary. The immediate-term risk range for gold is 1225-1279."


Hedgeye CEO Keith McCullough sent out a key signal in Real-Time Alerts Monday warning subscribers about inherent risks to gold given current macro trading.


Check out McCullough's recent interview with bestselling author Jim Rickards, "Why Gold Is Going To $10,000."

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