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"Though we thought we were well prepared, we were as worried about being right as we were about being wrong.”
-Ray Dalio, on having proactively prepared his clients’ portfolios for 2008 

That’s one of my favorite one-liners from Ray’s best-selling book Principles because it reminded me that it’s ok to have conviction in one’s process and in the analytical rigor born out of that process. 

Along those same lines, “…that we’re actually more right than I think we’re going to be” has become my new favorite retort among Keith’s evolving collection of pointed one-liners articulated in client meetings of late. I think it’s a perfect response to the age-old question, “Where could you be wrong?” 

To be clear, anything we state about the future in a meeting, in print, and/or on @HedgeyeTV could be wrong, hence our perpetual thanks to both our respective Gods and our growing audience for the opportunity to wake up each day and challenge our premises with incremental data. Making mistakes publicly is as humbling as learning from them is rewarding. 

Back to the Global Macro Grind… 

The only thing more rewarding than learning from highly-publicized mistakes is having avoided making them altogether. It’s so easy for investors – ourselves included – to psych ourselves out of the winning trade(s), which is why we all clamor for the conviction associated with having done a tremendous amount of work on a particular security or macro theme. 

What If We’re Right? - zhed

As Ray alludes to in the quote above, his team was well-prepared for the carnage of 2008 because they did the work. What if my team and I did the work too and are well-prepared for more #Quad4? Moreover, what if we’re right on our call for U.S. corporate operating margins to contract for broad swaths of the market on a multi-quarter (and potentially multi-year) basis? 

This I do know: Our current Macro Themes presentation has 125 slides, with the first and fifth quintiles representing our Process Overview and Appendix, respectively, with the former section describing the models we employ daily to help prospectively reduce our probability of being wrong and the latter section detailing what we consider to be known-knowns for bean counters and students of macroeconomic history. The 75 slides sandwiched in the middle feature investment themes that build upon what the aforementioned processes are currently signaling in the context of the cyclical and secular realities we expose in the appendix. Trust me, it’s a lot of work to create and update these slides on a regular basis. 

With respect to more #Quad4, we’re hearing a lot of, “Nice call, but how do we know it’s not already priced in?” 

The answer is blatantly obvious when you look at derivatives markets: 

  • The current +248k net LONG position in S&P 500 + e-mini futures and options contracts held by non-commercial market participants is just off a three-year high and good for a TTM Z-Score of +2.0x. It’s worth highlighting the +369k to -381k 10-year range of this net exposure to further contextualize the aforementioned bullish bias.
  • The 30-day implied volatility PREMIUMS of +18-32% for #Quad4 shorts like Tech (XLK), Industrials (XLI), Energy (XLE), and Financials (XLF) on the 10/29 lows have given way to DISCOUNTS of -20%, -25%, and -28% for the SPY, QQQ, and XLK, respectively, on largely similar levels of 30-day realized volatility.
  • That the aforementioned signal is occurring in the context of the broader equity market (SPX) having tapped the top end of its 2 @Hedgeye Risk Range this morning implies investor consensus is about as complacent buying the dip as it was in the late-summer. With the SPX and VIX registering as bearish and bullish TREND, respectively, our process says this is definitively not a buy-the-dip market. Those signals could obviously change, but it’s unclear to me why they would so quickly with six months of #Quad4 just beginning in reported data terms. 

Clearly investor consensus thinks #Quad4 is priced in already – months before Headline GDP prints a likely 1-handle in late-January amid ongoing monetary tightening. Mind you, this is the same investor consensus that failed to appropriately position for the #Quad4 hurricane to begin with. In fact, as the Chart of the Day below highlights, market participants largely came into Q4 with some version of the worst possible asset mix, which explains why October ’18 was the worst month for hedge fund performance since August ’11. 

Obviously, many of you reading this probably felt some or all of that pain, so the point of that statement isn’t at all intended to mock you. It’s to alert you to the fact that your competition is as bullish as they were heading into the aforementioned economic regime shift. If that isn’t at least cause for concern, I don’t know what is. 

With respect to corporate margin contraction, we’re hearing even more of, “I hear you, but I’m long of structural growers that are largely immune to the cyclical risks you’ve identified – especially if you’re not calling for recession.”  

To be clear, we are not calling for a recession at any point in our NTM forecast horizon. But as we learned in 2000-02, corporate margin contraction has the potential to cause an economic downturn from similar levels of indebtedness and financial tightening as experienced today (slides 7, 10-11 HERE), depending on the pace and severity of said contraction (slides 20-24 HERE).

Along those lines, we are keen to highlight the median YTD peak-to-present decline of the 10 S&P 500 industry groups we prospectively identified as having the most operating margin risk to the downside in a Strong Dollar, rising wages, and domestic and global #Quad4 scenario of -15.4%, which equates to roughly 2.5x the decline in the broader market from its 9/21 ATH. 

I take that as clear evidence that profit warnings from these names are having the negative impact we anticipated. Moreover, investors would be remiss to assume these are the only companies that are set to experience a noteworthy reduction in operating efficiency in the quarters ahead. 

Lastly, I wanted to briefly mention the record $5 BILLION-plus spent on campaigning in yesterday’s mid-term elections. I take that as evidence that politicians from this side of the country to the other have never before thought they mattered more to our lives and our financial markets. Thank God for Ray Dalio for giving us the confidence to continue largely ignoring them in lieu of sequencing rate of change data: 

“I knew which shifts in the economic environment caused asset classes to move around, and I knew that those relationships had remained essentially the same for hundreds of years. There were only two big forces to worry about: growth and inflation.”

In GIP Modeling we trust. And the “P” does not currently – nor will it ever – stand for “politics”. 

Our immediate-term Global Macro Risk Ranges are now: 

UST 10yr Yield 3.05-3.22% (bullish)
SPX 2 (bearish)
VIX 17.06-26.38 (bullish)
USD 95.53-97.05 (bullish)
Oil (WTI) 61.06-67.54 (bearish)
Gold 1 (bullish) 

Keep your head on a swivel, 

DD 

Darius Dale
Managing Director

What If We’re Right? - Chart of the Day