“The brain highlights what it imagines as patterns; it disregards contradictory information. Human nature yearns to see order and hierarchy in the world. It will invent it where it cannot find it.” - Benoit Mandelbrot
As many of you know by now, one of our favorite mathematicians is Benoit Mandelbrot. His contributions to the field were many and he is recognized as coining the term "fractal." Using fractal math, he determined that many things we thought were a “mess” actually had a fundamental order to them.
As a result of his access to IBM’s supercomputers, Mandelbrot was one of the first to use computer graphics to create and display fractal geometric images, leading to his discovering the Mandelbrot set in 1980. He highlighted how visual complexity can be created from simple rules. In his view, things that were typically considered chaotic, like clouds, shoreline, or snowflakes, actually had a degree of order.
If you think about the idea of finding order in chaos, that is essentially what we are doing as market practioners each day. Regardless of your particular investing style and approach, you are attempting to find order, via some level of math, in the market.
At Hedgeye, on a fundamental level, our search for order starts with our Quad model on global economies. In effect, we are trying to determine where growth and inflation are slowing (or accelerating) and then whether the Fed is loosening or tightening. Like most systems, it’s not perfect. However, it does have a strong track record of “front running” interest rate policy moves and concurrent / subsequent moves in major asset classes.
On a related note, we recently reviewed an interesting paper from UCLA Anderson’s David Aboody and Brett Trueman on stock sentiment. They looked at the overnight moves of stocks from 1992 to 2013 after the market closed and determined that most of these price moves were driven by retail investors.
According to the study:
“The researchers found that, over the following 12 months, the stocks in the highest decile of overnight returns in the short term “significantly” underperformed the stocks in the lowest decile of overnight returns. The implication is that misplaced excitement over stocks often led investors to overprice those shares in the short run, leading to disappointing returns as that excitement wore off.”
In fact, using a strategy that shorted the largest positive overnight movers in the top decile and went long the the worst performers in the bottom decile of movers, generated returns over a 12-month period that outperformed the market by more than 7%. That return that would make most institutional investors downright gleeful.
As the study above indicates, we aren’t alone in our quest for order in the complex system of global markets. The most important takeaway? Order exists, albeit imperfectly. Starting with a framework such as our Quad Model hopefully enables you to have some amount of confidence, or edge, as you approach the trading day.
Back to the Global Macro Grind ....
Speaking of overnight returns, the returns of Netflix (NFLX) aren’t making its stockholders happy this morning. The stock is getting hammered. Incidentally, one of our top young analysts Andrew Freedman, recently launched coverage on the communications sector. With some level of brazen confidence, his first idea was to publish on Netflix as a "Best Idea" short idea. He was one of three analysts (out of 40) short Netflix into the quarter.
Andrew’s thesis wasn’t based on randomness, but rather an in-depth view of the content obligations, emerging competition and most importantly, proprietary trackers that looked at real-time subscriber growth at Netflix. It was this last metric that seems to have come to fruition this quarter.
In the Chart of the Day below, we show a chart from his June note flagging a meaningful drop off in NFLX app downloads. FYI Andrew will be hosting an update on his thesis and review of the quarter at 10:00am ET this morning. You're invited to join.
Click here for special, one-time complimentary access.
Moving along... Netflix isn’t the only asset showing slowing growth this morning. Despite the presumption of Chinese growth bottoming in June, we have data from Japan and Australia (two economies closely tied to China) this morning suggesting that might not be the case. Japanese exports came in at -6.7% year-over-year and Australian employment decelerated by 50 basis points.
Sticking with our quad framework for economies, you should know what decelerating growth gets you ... more interest rate cuts (aka Cowbell!). We got just that from the Bank of Korea and Bank of Indonesia both cutting repo rates by 25 basis points. In terms of total global rate cuts in the YTD, we are now at 300 basis points. This is likely early innings if most interest rate cut cycles are a guide.
Meanwhile, the ECB is also doing their part this morning. According to a Bloomberg report, the ECB is actively evaluating whether the 2 percent inflation target is appropriate. In effect, this trial balloon that was floated on the morning of a number of major earnings misses (ironically enough) would give the ECB the flexibility to be above or below the 2 percent target, with an emphasis on the above. Unsurprisingly, the Euro spiked down and European equities spiked up on this news.
It would seem we are getting to a point where the ECB and Fed are going to have actually deliver the real goods ...
Luckily for you global asset allocators, not all is amiss in global growth. Russia, an economy that we have in Quad 1, again reported reasonable economic numbers overnight with retail sales up 1.4% and real wages up 2.5%. With any meaningful move in oil, Russian equities could be off to the races.
Lastly, in the world of trade deal rhetoric, it’s being reported that Trump and Xi are making little to no progress. It’s hard to get a deal done when you don’t talk and the two “leaders” have had one call since June, with no plans to meet. Trade deals and trade negotiations may be the one area we are happy to park in the random camp. If anything, the headlines and scuttlebutt tend to create short-term market mispricings that allow us to reload on our favorite assets (and sell /short our least favorite).
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND signals in brackets) are now:
UST 10yr Yield 1.98-2.16% (bearish)
SPX 2 (bullish)
RUT 1 (bearish)\
NASDAQ 8040-8285 (bullish)
Utilities (XLU) 59.98-61.25 (bullish)
Financials (XLF) 27.44-28.31 (bearish)
Shanghai Comp 2 (bearish)
Nikkei 21135-21780 (bearish)
DAX 123 (bullish)
VIX 12.05-16.15 (neutral)
USD 95.85-97.39 (neutral)
Oil (WTI) 54.95-61.04 (bearish)
Gold 1 (bullish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research