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“I believe that misconceptions play a large role in shaping history.”

-George Soros

That was my favorite quote from an important speech that George Soros gave at Humboldt University in Berlin on June 23, 2010, where he warned of many of the misconceptions associated with the credibility of sovereign debt. He is one of the few global macro analysts in this game who got this latest down move right. Well done, Sir Soros. Well done.

Like any great top-down analyst, Soros started his analysis by taking a step back, looking at the timeline of the crisis of confidence in Lehman Brothers. Then he took a step forward, using past market behavior as his guide. This is what we call proactively managing global macro risk with a behavioral bent.

If you wake up every morning accepting that the Officialdoms of Wall Street and Washington are all about storytelling, you put yourself in a much better position to understand that their “misconceptions play a large role in shaping history.”

Soros formally calls this “Reflexivity”…

“Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.” (George, Soros (2008). "Reflexivity in Financial Markets". The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means (1st edition ed.). PublicAffairs. p. 66).

Hedgeye calls this Prices Rule Risk Management. We believe that marked-to-market prices are not only leading indicators for future events; they perpetuate those events. Using this framework, our daily risk management plan is to change the plan as prices change.

Now that stock market prices from China to the USA are hitting lower-lows, you can bet your Madoff that the consensus storytelling on Wall Street will become bearish (this week’s II Bullish to Bearish Survey saw the Bears rise from 31% to 33%, which still isn’t Bearish Enough, but we’re getting there).

Eventually, Washington will follow Wall Street’s lead and start fear-mongering the citizenry into a “Third Depression” so that Professional Politicians can up government spending again. In the meantime, everyone who is long and wrong will just revert to blaming the Europeans and high-frequency traders.

After the 6th US market down day in the last 7 and a fresh YTD closing low of 1041, the SP500 is down -6.6% for 2010. While that’s hardly a YTD down move of consequence when you compare it to the leaders of the 2010 toilet bowl (bottom 3 countries YTD = Greece -33.2%, China -26.8% and Spain -22.6%), the SP500 is finally teetering on what our Hedgeyes call a crash relative to expectations (a peak-to-trough drop of 20% or more).

Since its recent bear market cycle closing high of 1217 on April 23rd, the SP500 has lost -14.5% of its value. With our immediate term TRADE target for the SP500 down at 1018, we don’t foresee a crash coming in the immediate term (1018 would imply a -16.4% correction). That said, with the intermediate and long term TREND (1144) and TAIL (1091) levels in the SP500 broken, anything can happen.

In the US, the biggest misconceptions that we have been hammering on are largely concerning expectations for US growth and deficit spending. Combined, lower than expected GDP growth and higher than expected deficit spending, these 2 factors will continue to play a significant role in shaping the history of markets. History, after all, gets marked-to-market as of yesterday’s closing price.

We’ll go through our multi-factor/multi-duration risk management model in tomorrow’s Q3 Hedgeye Macro Theme Conference Call where we’ll introduce a new quarterly theme called “Bear Market Macro” (email if you’d like to participate). The slide deck will provide you with the kind of macro analysis that market practicioners use, fully loaded with probabilities, ranges, and levels.

Yesterday, we took the market’s weakness as an opportunity to cover some shorts: American Express (AXP), New York Bancorp (NYB), and Consumer Staples (XLP).  On weakness, we bought Under Armour (UA) and the Brazilian Real Fund (BZF), taking our allocation to International Currencies up to 21% from 15% (and our cash position down from 70% to 64%). We like currencies where the government that houses them (China and Brazil) respects the cost of capital.

The US market should bounce today, and you should take that as one more opportunity to take advantage of consensus misconceptions about US growth. Remember, short term bear market bounces can often be more forceful than bull market ones. Our macro model is flashing immediate term support and resistance levels of 1018 and 1085, respectively. Manage your risk around that range.

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

Misconceptions - soros