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“By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and Third, by experience, which is the bitterest.”

After experiencing my worst performance day of 2008, yesterday was indeed my “bitterest.” In thinking through my mistakes, I would be a hypocrite not to cite the same wisdom of a philosopher whose thoughts summarized where I thought this US market could go next. Confucius emphasized transparency and sincerity. I have no excuses this morning. I was leaning far too bullish on the edge of another bear market trap. I was sucked into the vacuum of politically inspired hope. Hope is not an investment process.

So what do I do when I am wrong? Point fingers and whine about it? No. I take a good long hard look in the mirror and stare at who made the call. Then, I review my notebooks, calendar catalysts, and macro models. Then I start over, remembering that as Confucius said, “no matter where you go, there you are…”

As the facts changed yesterday, I did. As the S&P500 broke my “Braveheart line in the sand”, my first move was to get smaller. We now issue our ‘Hedgeye Portfolio Allocation’ levels to you every morning at the top of the ‘Early Look’. What is that exactly? Good question. That’s $100,000 in an E-Trade account that I put there at the beginning of the year (when that’s all the FDIC would insure, and my best “idea” was being in cash). In that account, I don’t trade around in any stocks that our sector analysts are writing about. I predominantly use it to manage portfolio level asset class allocations using indices and exchange traded funds.

Getting smaller is what I always do when I am wrong on the fundamentals. That’s another piece of portfolio management wisdom that I had to learn the hard way. When I was younger, more brash, and inexperienced, I would sometimes add to my losers, irrespective of my potentially being dead wrong on the fundamental change in facts. That was, is, and will continue to be, the gravest capital mistake you can make in this business.

“Getting small” means selling down gross exposure. Yesterday I took my 33% allocation to US Equities down to 20%. I sold my SPY’s (S&P 500 index), and our Research Edge Macro clients saw that, real time, on the ‘Hedgeye Portfolio’ portal. I am 100% accountable to being transparent to our subscribers. Wall Street doesn’t do that. That’s their problem, not mine. The “New Reality” that I spoke to yesterday is going to demand transparency/accountability from market participants in the very near future.

The US Futures are getting smacked around again this morning, and they should. Albeit on low volume (bullish signal), yesterday’s technical breakdown in the US market was a bell ringer for anyone with a legitimate risk management process. For me, losing over 200 basis points of performance in one day is unacceptable. When that happens, it’s always because I am leaning too far to one side of the boat and the market breaks what I refer to as the “shark line.” If you have ever been shark fishing, you know how scary it is to be on the edge of the boat with a live and large monster still in the water – that image is what you should be thinking about when the S&P500 gets there. Yesterday I called it “line in the sand” because I was getting too cute with a Braveheart metaphor, but it’s the same idea, and the same line – the one you don’t want penetrated. This morning my model flashes that line in the S&P500 at 977.

Everything that matters in my risk management model occurs on the margin. If we close above 977, it’s bullish – below that shark line, your longs get eaten. Last night, Asian and European stock markets reflected the quantitative waters being bloodied. I have more red in my notebooks this morning than I have had since mid October. Is it time to panic? No. Is it time to take a deep breath and find your bearings? Big time.

Hong Kong led Asia lower, closing down a stiff -7.1%. One of the positive moves I made in the last 48 hours was selling our EWH (Hong Kong etf) into the strength of its 6 day +30% up move. Chinese stocks outperformed last night, closing down -2.4%, and we remain long its domestic market via the FXI etf. India closed down for the second day in a row, finishing -3.8%, and we are hedged in Asia this morning via our long standing bearish position in the India Fund (IFN). Not surprisingly, after squeezing the shorts for a +35% one week move, Japanese stocks were shark bitten last night, closing down -6.5%. I am embarrassed for not being short EWJ (Japan) here.

European markets are trading down -4% across the board. We are long Germany and Switzerland (EWG and EWL), and short the UK (EWU). The main reason why I was amped up and leaning over the boat’s edge yesterday was that the Europeans were, and are, going to be cutting interest rates this morning – AGGRESSIVELY. If the reaction to the most aggressive European rate cuts that we have seen in 2008 is negative, I will change my positioning in Europe alongside those facts. Countries that are on my short list are Italy, Austria, and Spain. These countries have leverage characteristics that are to be shorted. I want to own liquidity – and as boring as they are, the Germans and Swiss give me that, on a relative basis.

I’ll take a man or woman of wisdom onto our team all day long over a whiner. Citi and Goldman are firing another 12,000 people right now. There are plenty of winners in that group that we are interviewing. The problem with ‘Investment Banking Inc.’ is their Captains, not their people. Captains who whine and point fingers don’t have a process for winning.

The best thing about today is that yesterday is behind us. My feet were on the floor 3 minutes earlier than they were yesterday. My chin strap is done up. No matter where we go from here, “there you are.”

Good luck out there today,

Long ETFs

JO – iPath Coffee – Heavy rains in Vietnam’s highland region continue, increasing harvest delays.

EWL –iShares Switzerland- Swisscom AG traded down yesterday after reporting Q3 profit decline of 32% y-o-y, and warned that the Franc’s rise it may prevent it from reaching its full-year sales target.

EWA –iShares Australia- Employment numbers came in surprisingly strong, with over 34,000 jobs added in October. The Central bank expanded the list of securities it accepts for repurchasing operations to include AUD commercial paper, asset-backed commercial paper and high rated debt securities rated AAA.

EWG – iShares Germany – Porsche will seek enforcement of an EU court ruling that Germany must amend the law that gives the state of Lower Saxony control rights over Volkswagen as part of its plan to take full control over the company. Adidas was down almost 10% today after reporting earnings for the third quarter.

FXI – iShares China – Obama’s public stance on Yuan policy is placing pressure on policy makers in advance of December’s U.S.-China Strategic Economic Dialogue. Among many heavy industrials curbing production, Aluminum Corp. of China, today announced it has idled 38% of capacity.

VYM – Vanguard High Dividend Yield ETF – The Ambac ratings downgrade to Baa1 by Moody’s sparked higher corporate CDS prices globally on anticipation that some holders will be forced to unwind positions hedged by the insurer.

Short ETFs

UUP – U.S. Dollar Index – The Euro declined against the dollar on anticipation of EU rate cuts.

EWU – iShares United Kingdom – BOE CUTS BENCHMARK RATE BY 150 BASIS POINTS TO 3% U.K. House prices fell at the fastest pace in at least 25 years according to monthly HBOS data - the average cost of a home dropped 14.9% y-o-y in October the most since the index began in 1983.

IFN – The India Fund – Wholesale inflation numbers registered at 10.7%, higher than anticipated by Indian leaders, which suggests that rate cuts could continue.

Keith R. McCullough
CEO & Chief Investment Officer