Our Risk Management Process & The Great Recession

Below is an important letter from our Senior Macro analyst Darius Dale discussing how Hedgeye’s differentiated and repeatable research process helps investors generate alpha.

But before we get to that letter.

If you’ve followed Hedgeye for more than a nanosecond, you know prudent risk management is engrained in our DNA.

• Our risk management models signaled bearish ahead of the Great Recession (click here).
• Our risk management models signaled bullish in 2009, right near the bottom of a truly epic bull market (click here).

The hallmark of our fundamental research process is our Growth, Inflation, Policy (GIP) model.

To demonstrate how serious we are about risk management, Senior Macro analyst Darius Dale recently backtested our current GIP model to look at how it would have performed during the Great Recession. The results are staggering in their predictive value. (Long-time Hedgeye subscribers can skip ahead to read Darius’ entire analysis below.)

For those of you who want a brief primer on our GIP process, here goes…

We find two factors to be most consequential for forecasting future financial market returns: economic growth and inflation. We track both on a year-over-year, rate of change basis to better understand the big picture, then ask the fundamental question: Are growth and inflation heating up or cooling down?

From there, we get four possible outcomes, each of which is assigned a “quadrant” in our Growth, Inflation, Policy (GIP) model and the typical government response as a result (neutral, hawkish, in-a-box or dovish):

1. Growth accelerating, Inflation slowing (QUAD 1);
2. Growth accelerating, Inflation accelerating (QUAD 2);
3. Growth slowing, Inflation accelerating (QUAD 3);
4. Growth slowing, Inflation slowing (QUAD 4)

After building this base of knowledge, we can now select what we “like” and “don’t like” based on our historical back-testing of the different asset classes that perform best in each of the four quadrants.

“In QUAD 1, for instance, where growth is accelerating and inflation is slowing, that has historically been really positive for both equity and credit data across all sectors of the U.S. economy,” Senior Macro analyst Darius Dale wrote recently. “Whereas when you think about QUAD 4, in which growth and inflation are slowing concomitantly, that has historically actually been quite negative for both equities and credit.”

Now, to Darius’ analysis…

Dear Investor,

I just wanted to quickly get the following analysis in front of you – which I think is pretty cool, if nothing else. It’s born out of a couple of prospective clients in NYC and Chicago asking us some version of the same question last week, which was effectively, “How do long-term investors like us incorporate your macro views into our process?”

Our reply is simple: risk management. Our primary goal is to help our clients avoid getting blown up by the big stuff. If we can help steer you into our preferred factor exposures on the long side, that’s great too, but we assume you guys and gals have already developed a robust process for your security selection.

I think the preponderance of observers would agree that the most relevant risk management exercise in our firm’s history is having helped investors risk manage 2008 by being appropriately bearish into and throughout the bear market. As you may know, CEO Keith McCullough started the firm in 2008 after getting fired from Carlyle in late-07 for being “too bearish”. Obviously we didn’t have the same degree of computing power and model-building expertise then, but the modeling premises were indeed the same – i.e. Bayesian inference, comparative base effect driven, etc.

As such, I had our model(s) generate an out-of-sample U.S. Growth, Inflation, Policy (GIP) Model outlook for CY08:

Here are the three most important callouts from this analysis:

1. The model perfectly explains the epic short squeeze seen from mid-AUG through early-OCT of 2007 (i.e. #Quad1);
2. Our forecasts were, at the very least, directionally accurate from a rate-of-change perspective throughout 2008; and
3. Bloomberg consensus was out to lunch on growth – particularly when then sh!t hit the fan in 2H08. The #OldWall would’ve had investors completely offsides for the pending financial market carnage.

This exercise highlights the importance of having a repeatable and robust modeling framework that doesn’t just extrapolate recent trends in the data. While we might not nail GDP or CPI prints to the basis point 3-4 quarters into the future, we can at least have a reasonably accurate estimates that are even more accurate once directionality is factored into the equation. There’s an enormous difference between telling clients to anticipate #Quad1 in 3Q08E (our competitors) and helping them proactively prepare for #Quad4 (us).

All told, I welcome any pushback you may have with how I set up this analysis. My goal isn’t to cherry-pick or come off as “salesy”. It’s to hammer home the point that we made in our recent meeting: differentiated processes lead to differentiated perspectives… and differentiated perspectives help investors generate alpha.

Warm regards,

DD

P.S. We timed the bottom in ’09 pretty well too: CLICK HERE

Timing indeed matters big time.

Darius Dale

Managing Director