The inefficiencies that are at the heart of macro investing are permanent, as they relate to the inherent uncertainty of the future. The vast majority of the data required is publicly available. The differentiating factor is the ability to analyze and thematically organize the information into coherent theories. The starting point of our investment process is complete independence of analysis and thought. We do not set out to be either consensus or contrarian, but instead to be independent. What’s important is that we are agnostic in our analysis, rather than ideological; and empirical, rather than dogmatic.
We share excerpts from Stray Reflections below, which highlight some of our key macro calls and investment recommendations since inception.
“Since the US 10-year bond yield hit a secular low of 1.43% on June 1, 2012 (its lowest level ever), it gained 113% to 3.05% on January 2, 2014. This was the fastest rate of change increase over an 18-month period in the past 30 years. Such a quick and sharp adjustment higher in rates has nearly always preceded a drop in stock prices. It would be prudent to build a protector portfolio concentrated in US Treasurys.”
Russell 2000 peaked in March and fell 14% to an October low. The US 10-year yield declined from above 2.7% in February 2014 to 1.65% by January 2015. It was one of the biggest “surprises” of 2014.
“Social network stock prices have seen a more than three-fold surge since mid-2012. These basket of stocks are trading at 12 to 13 times sales, almost equivalent to valuation levels at the peak of the tech bubble… Hot money flows into the biotech group have driven up valuations to nosebleed levels. A sizeable price decline is probably around the corner and we have initiated a short position in both social network and biotech stocks.”
Biotech stocks peaked on February 25th and fell 21% in next two months; and social network stocks peaked on March 7th and fell 25% in next two months.
“We think the downside in Chinese equities is much less than what people currently anticipate. In our view, Chinese stocks are probably late in the process of completing a massive de-rating… We are perhaps among the few who actually see the weakness in Chinese equity markets as providing a special opportunity to establish strategic long-term positions.”
Chinese stocks were the best performing asset class over the 12 months since our recommendation, returning 120%.
“Solar stocks can be classified to have experienced one of the greatest bear markets of the 21st century—from an all-time high in May 2008 to the low in November 2012, an incredible collapse of 95%. We believe rising electricity prices, lower solar costs, and widening adoption and scalability will turn this group into a real winner in the long-run.”
We booked 30% gains in our Solar ETF investment in the next 12 months.
“The real China story is taking place online. E-commerce is booming. The number of Chinese online shoppers has surged to 300 million, more than doubling in three years. We are enthusiastic about the long-term prospects for Chinese internet stocks and believe China’s rush toward consumerism will lead to outsized gains for the best-positioned players.”
Our preferred Chinese e-commerce pick, Jd.com, rose approximately 50% over the 12 months since our buy recommendation.
“What makes us nervous [about oil] is speculative positioning in the CFTC oil futures market, which stands at a record extreme and has previously led to sharp price declines.”
Oil prices peaked only days earlier, and July marked the beginning of the oil crash.
“The attitude of policymakers in Japan has firmly changed and we expect to see that reflected in the public and corporate Japan before long as well. The aggressive monetary actions and supportive fiscal measures will result in a viable turnaround in the nation’s attitude. We don’t believe Japan’s equity re-rating is complete. We are witnessing a secular shift in mood in Japan and we feel stocks will stand-out to be the clear winners. Japan has one of the most favorable micro tailwinds in the world.”
Japanese stocks rose over 20% in the next year. Corporate profits are at an all-time high, and return on equity is on the rise, now at 8.3%, up from 5.7% two years ago. In 2014, Japanese companies increased dividends by 19%, while share buybacks rose 55%.
“Investor enthusiasm for euro denominated assets has dampened, but we feel this is only temporary. Our analysis leads us to conclude that the risk of a major deflationary bust in Europe, while not exaggerated, is likely to recede and that economic indicators should improve, even if it takes time. We believe another buying opportunity will soon emerge in European equities as risk appetite wanes over the next two to three months.”
European stocks bottomed the next month in October, and rose 27% in the next six months. German stocks rose 40%.
“The macro environment is turning against risk-seeking behavior: global growth estimates are being downgraded on an almost weekly basis, world inflation keeps creeping lower, liquidity and momentum are rapidly fading, copper and oil are breaking down, and markets around the world are starting to act wobbly. It is the month of October. Historically, it has been one of the most unkind months to investors.”
US stocks peaked in September and fell sharply in October. The S&P 500 lost 7% and the Russell 2000 was down 11%.
“Everyone believes that the oil-price decline is temporary. It is assumed that once oil prices plummet, the process is much more likely to be self- stabilizing than destabilizing. We believe we are entering a “new oil normal,” where oil prices stay lower for longer. Our analysis leads us to conclude that the price of oil is unlikely to average $100 again for the remaining decade.”
Brent was at $84 then. It fell to $45 by January.
“In the past, higher resource prices increased the occasions for military conflicts as nations would scramble to secure necessary supplies. Going forward, however, we firmly believe lower oil prices pose a greater risk of escalating current geopolitical challenges.”
Saudi Arabia launched airstrikes against Yemen in March to bring political regime change. Tensions between Saudi Arabia and Iran have increased further. Syria remains in conflict.
“We believe the dollar is now vulnerable to a re-widening of the current account deficit on the back of stronger household consumption. The temporary fillip to the current account from the shale oil boom, weak import demand, and lower interest rates should reverse in the next five years… America will struggle to attract the same amount of external capital as it has in the past.”
In March, it was reported that the US current account deficit widened sharply in Q4 2014, and that it was the largest shortfall since 2012. In May, it was reported that the demand for US government securities sold at auction declined in Q1 2015. The bid-to-cover ratio was 2.75 in 2015, down from 2.87 in 2014 and the record 3.15 in 2012. Sales of Treasurys by official foreign entities accelerated since 2Q14.
“The commodity cycle peaked with the blow-off move in silver in April 2011, and we suspect the cycle has troughed with the crash in the oil market. The oil futures curve is now steep in contango, which was last observed during the 1998 and 2008 bottoms.”
Oil bottomed in March and rose 47% from its lows.
“Once the shock of the speed of the recent drop in oil prices is overcome, we could see a major mindset change in the bond market. This will probably be one of the biggest macro surprises this year.”
US 10-year yield rallied from a low of 1.65% in January to 2.5% by June. German 10-year bund yield fell from 0.3% in February to below 0.1% in April, and then rallied sharply to above 1% in June.
“As globally inter-connected risks accumulate, we see a non-trivial possibility of an ugly carry trade unwind. We expect the Japanese yen to experience a violent counter-trend rally. The yen short trade is extremely crowded with position and sentiment uniformly bearish.”
USD/JPY peaked in June at 125 and fell below 100 over the next 18 months.
“The dollar bull-market has followed a rotational pattern. The first up-leg was primarily driven by a falling Japanese yen in 2012, followed by a decline in EM FX in 2013 after the taper announcement, a crash in commodity FX in 2014 with the oil market rout, and recently the fallout in the euro in 2015. Could the Chinese renminbi be the final shoe to drop?”
China surprised the world with a “mini-devaluation” in August. The renminbi has weakened 6% since our call.
“We expect a “price reset” in 2015—facilitated by an equity market correction— that will attempt to flush out the prevailing deflationary psychology, and set the macro stage for the next several years.”
Global stock markets peaked in May and fell 20% over the next nine months. This was the biggest “deflation scare” since 2008.
“The ECB has commenced QE, and we wouldn’t be surprised if markets copy and paste the post-Fed QE implementation script—higher euro, higher yields.“
The euro made a multi-year low on March 16th at 1.048 and rose to 1.17 by August. German bund yields bottomed on April 17 and experienced the biggest upward climb in a quarter of a century.
“The fact that EM stocks (in dollar terms) have only moved sideways since 2010— despite US stocks trading at all-time highs, European stocks trading at 52-week highs, and a 75% rise in Chinese stocks in the past nine months—suggests that asymmetric risks are tilted to the downside. We are betting on a major breakdown in EM stocks before a long-term buying opportunity emerges.”
Emerging market stocks peaked in April and fell over 30% in the next nine months.
“For exceptional returns in 2015, it is not enough to just be bullish on non-US stocks, you must also short US bonds. There is a major revaluation risk to owning government bonds at this stage of the investment cycle.”
As the US 10-year yield approached 2.5% in June, we booked a 20% gain in our short Treasurys position from January.
“In Elliot Wave terms, Chinese stocks are late in the process of completing a powerful 3rd wave rally from the 2014 low. We would not be surprised to see the Shanghai Composite enter a multi- month consolidation phase. We anticipate an increase in volatility going forward.”
The Shanghai Composite Index peaked on June 12th and fell over 40% in the next six months.
“Much of the extreme overbought readings in global government bond markets have promptly been unwound. We expect bond yields will now transition to a sideways range, ahead of an eventual move higher.”
US 10-year yield reversed course from the 2.5% peak in June and has consolidated in a wide-range between 1.6% and 2.2%.
“We believe odds are shifting in favor of higher oil prices over the next year. The global oil supply/demand imbalance picture is probably at its worst point during this cycle. This means oil prices are close to an important low.”
Oil bottomed on August 24th at $38, and rallied to $50 by October.
“The recent market volatility has been disconcerting, but it does not impact the big picture or our macro themes and positioning on a 6 to 12 month horizon. We think that we are in the late stages of a valuation-driven correction, rather than in the early stages of a prolonged bear market.”
After a successful retest of the August lows in late-September, stocks were up 10% in October.
“We advocate removing short exposure to commodity-related assets. Our research points to the fading influence of headwinds, which should result in a positive reassessment of commodities in the coming quarters.”
Commodities bottomed in the first quarter of 2016 and have since risen 25%. Glencore, the commodity bellwether, is up 180% off the lows.
“It is well known that gold and inflation are joined at the hip. Inflation has continued to fall over the past four years and shows little sign of a sustainable turnaround. That said, headline inflation should recover in the coming year as the base effects from the strong dollar and oil collapse wear off. If gold is to rise, the time is now.”
Gold bottomed in December and rose 30% in 2016. Gold miners were up over 100%.
“Although we suspect the correction lows are in place for the broader markets, we are skeptical that biotech stocks have seen the lows. As it has been one of the leading sectors, this suggests that another downleg is possible and that volatility should resurface in the coming weeks.”
Biotech stocks fell almost 30% in the next two months, while the S&P 500 held previous lows.
“Yellen will soon embark on a slow moving, but sustained, tightening campaign. We expect her to raise the Fed funds target rate next week, with two or three more hikes in 2016.”
The Fed hiked rates in December for the first time in eleven years. Markets are now pricing two rate hikes for 2016, from none earlier.
“Fiscal policy is now more paramount than monetary policy for economic growth and financial markets. Consequently, finance ministers are more important than central bankers. The golden era of central banking is over.”
At the G20 meeting in February, finance chiefs from the world’s top economies committed their governments to doing more to boost global growth amid mounting concerns over the potency of monetary policy. The Group of 20 said “we will use fiscal policy flexibly to strengthen growth, job creation and confidence.”
“The fundamentals underpinning stocks are more positive than investors are currently discounting… we have not reached the constraints of the bull market, when secular bear influences take over. The bull market is simply coming of age. If our analysis is correct, unlike Icarus, the stock market can soar to even newer heights.”
The S&P 500 bottomed in February and rose 20% to new all-time highs by the summer.
“We believe the market is exaggerating the extent of capital flight out of China. If we are correct in our analysis, reserve depletion will gradually wane. … Financial markets will adapt to greater volatility in the USD/CNY cross rate.”
China’s foreign exchange reserves increased by $10.2 billion to $3.2 trillion in March, compared to a $28.6 billion fall in February and a $99.5 billion decline in January. China’s reserves have been stable for the last six months. A modestly weaker yuan in 2016 has not been disruptive to markets.
“The last drop in oil prices was not supported by supply or demand trends, and is likely a final capitulation by investors. With global production falling and consumption continuing to grow, oil markets should rebalance by mid-2016.”
Oil prices bottomed in February and surged nearly 100%.
“China’s latest five-year plan, looser monetary conditions, extensive fiscal stimulus, and ambitious structural reforms aimed at reducing excess capacity should help build a floor under Chinese growth expectations. This could lead to a period of outperformance by beaten up emerging market (EM) risk assets.”
March was the best month for EM currencies in eighteen years. EM stocks have outperformed developed peers by 5% since our call. EM debt has done even better.
“At current high yield spread levels, valuations remain generous and compensate investors for rather extreme scenarios. We think high yield spreads will compress further… Despite the numerous headwinds facing emerging economies, we are enticed by the high coupons in EM debt, offering decent return potential if the US and global expansions remain intact as we expect.”
High yield bonds and EM debt are up 7% since April.
“The upswing in the US labor force participation rate is food for the economic expansion and equity bull market. Discouraged workers are rejoining the job market given the brightened employment picture. This should relieve investor concerns that we are at the end of the business cycle, even if payrolls growth naturally slows.”
There was consternation the May payrolls number, at 38k, foreshowed the end of the economic expansion. But US created 287k jobs in June and 255k in July, well above market expectations. Initial jobless claims fell to the lowest level in nearly 16 years. Leading economic indicators point to moderate but steady US growth ahead.
“This is an earnings-driven stock market and the earnings picture is about to get a whole lot better. As the drag from dollar strength and oil price weakness abates, the new earnings trajectory will once again be supportive of stocks.”
Q2 earnings reports confirmed that the profits recession is over and overall EPS growth is at an inflection point.
“The long run return prospects for Treasurys, and by extension most bond proxies, remains unappealing as evidence continues to pile up that we are close to a major turning point in yields.”
Treasury yields bottomed in July and are moving higher across the curve. The utility sector has fallen 7% since our call.
“The Fed is running out of excuses not to raise interest rates. Stocks and bonds are at all-time highs, oil prices are stable, and financial conditions are considerably easier than at the beginning of this year. While we believe a rate hike will be good news for markets and the global economy, investors would not see it this way, at least initially.”
Fed chairwoman Janet Yellen admitted at Jackson Hole the case to hike rates is getting stronger. Fed Vice Chairman Stanley Fischer said an increase in interest rates is possible in September. The global rally in risk assets lost momentum on hawkish remarks from Fed officials.