A Monday Dozen


The thing to do is watch the market, read the tape to determine the limits of the get- nowhere prices, and make up your mind that you will not take an interest until the price breaks through the limit in either direction. ~ Jesse Livermore

Every weekend I scroll through probably a 100+ charts. I figured I’d try sharing a dozen of the more interesting ones that catch my eye. Let me know if you find any value in this.

1. USDCAD has broken below a major support line (chart is a weekly).

2. Small-caps (IWM) bounced off their lower Bollinger Bands this past week (chart is a weekly).

3. As did crude (CL_F) (chart is a weekly).

4. Crude’s skew is at extremes suggesting a bottom is near (chart via @MacroCharts).

5. Total spec positioning in commodities futures at RECORD low levels (chart via @MacroCharts).

6. 10-year USTs (ZN_F) are trading above their monthly Bollinger Band. Reversal coming soon?

7. Consensus Inc. UST 10yr bullish sentiment nearing overbought levels.

8. AAII Net Bull/Bear Sentiment near Dec 18’ lows despite recent rally in stocks.

9. Investors continue to pile into credit after record outflows in December. This is a bullish sign for stocks as credit tends to lead equities.

10. NAAIM Exposure Index shows that investors are not buying this rally.

11. Morgan Stanley’s US Cycle indicator recently entered the “Downturn” phase.

12. Silver (SI_F) broke out of a descending wedge last week on strong volume. Commercial hedgers are net-long silver for only the second time in history.


Macro Ops 2019 Mid-Year Performance Review


To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes. ~ George Soros

I learned that everyone makes mistakes and has weaknesses and that one of the most important things that differentiates people is their approach to handling them. I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, i.e. a principle that I could use to reduce my mistakes in the future. ~ Ray Dalio

Alex here.

Every six months we sit down and pore over our trade logs, journal, and public writings from the previous two quarters. We review what we thought markets would do, how we placed and managed bets on these opinions, and then compare them to how reality actually unfolded.

It’s a ruthless study of our mistakes; in thinking and in execution.

Like Dalio says, embedded in each mistake is a puzzle, and a gem”.

Pain + Reflection = Progress.

This is without a doubt the most valuable exercise we do.

Sharing this review process is unusual for a trading site. We’re one of the few services that are transparent with our performance. I know of many that tout their BS records by pulling gimmicks on a paper account, claiming nonsense 80% win rates, 350% annual returns, etc…   

We’re traders first and foremost. And as traders, all we have is our risk-adjusted P/L.

One of our principles when starting MO was to be completely forthright… to bare our warts and all (sometimes I feel like a leper). At the end of the day, like you, we just want to become better at the game of markets. Being fully transparent helps us do that.

The Palindrome (George Soros), one of the best to have played the game, had a win rate in the mid-30s. That means on average every 2 out of 3 trades he made were losers. Yet, the guy was a perpetual money machine over three decades. He knew how to lose and still win. Being good at being wrong is one of the most important skills a trader can develop.

One of my favorite market technicians, Ned Davis, put it like this.

We are in the business of making mistakes. The only difference between the winners and the losers is that the winners make small mistakes, while the losers make big mistakes.

Our job as speculators is to learn to make smaller and smaller mistakes by mercilessly studying our big ones. This is how we continuously refine our process in a way that increases the positive asymmetry of our trading approach over time.

This is akin to Josh Waitzkin’s concept of “making smaller and smaller circles”.

He notes.

It’s rarely a mysterious technique that drives us to the top, but rather a profound mastery of what may well be a basic skill set.

I’ve spent years dissecting the habits and practices of the greatest traders. And I can tell you that there’s no secret to anything they do.

They are just incredibly efficient at executing the basics:

  • Cutting losses short and protecting capital
  • Knowing when to sit on hands and letting winners run
  • Mental flexibility, strong opinions weakly held, respecting price as the final arbiter of truth

Now let’s look at our numbers for the past 6-months and see where we can make smaller circles.


Macro Ops Portfolio

  • Return Metrics *Through June 7th, 2019
  • YTD: 11.7%
  • Inception (Jan 1st, 2016): 43.7%
  • Annual Vol: 13.18%
  • Sharpe Ratio: 0.83
  • Max DD from NAV ATH: -17.5%

These are so-so returns and to be honest I’m not happy with them. Here’s where I screwed up.

Successful trading and investing can be boiled down to how well one does just two things:

  1. Analysis
  2. Trade management

Everybody focuses on analysis and trying to “pick winners” but it’s the latter, trade management, where the REAL money is made.

If you have good trade management you can get most of your analysis wrong and still make money. If you have good analysis but fudge your trade management then it’s a total crapshoot whether you come out on top and over the long-haul, you’ll almost certainly end up poorer than when you started.

A good example of this is an on-going experiment that one of our Collective members is running and which he’s been sharing in our internal group. He’s built a random trading system that picks entries in a wide number of assets completely by random (hence the name). The only part of the system that isn’t randomized is the position sizing and exits.

This system has been crushing it since inception.

For the last six months (well, 9 months really) our analysis has been on point but our trade management has been meh… We’ve called nearly every major turning point in a number of markets such as buying bonds at the start of November, going long stocks at the end of December, staying long stocks until the end of April, and then issuing a sell signal at the end of April calling for an extended decline before issuing a buy call last week.

But all of that is only good for 11+% year-to-date because of mediocre trade management. I only hope that our Collective members have profited from our analysis better than we have.

So what does this mean? What can we pull from this?

Well, first we have to make sure that we’re not falling into the trap of what poker players call resulting. This is where you assign meaning to statistical noise (aka randomness). It’s dangerous to make broad assumptions about skill and strategy based off of a few hands instead of many cycles at the table. So it is for traders and investors, where perfectly effective strategies can hit bad streaks that last weeks, months, and sometimes years.

Determining what time frame is appropriate for teasing out signal depends on one’s strategy, trade frequency, and a host of other variables. And even then, we never truly know what’s due to skill or luck — or bad luck.

That’s why we have to rely on logic and a certain amount of faith until we can compile enough data — experience enough cycles — to be able to pull valuable lessons from our results.

This brings us to an important point. And that’s that as a speculator, you will spend the vast majority of your time in a drawdown from NAV highs. This is a reality of all trading strategies that look to exploit convex opportunities.

The returns for these strategies are inherently bunchy. They follow natural power laws, like Pareto’s 80/20 distribution — or really it’s closer to 90/10 in markets.

This means we should expect 90% of our profits to come from 10% or fewer of our trades, with the rest canceling each other out. We can’t know beforehand when these bottom-line trades will come. We have to accept the fact that we’ll spend most of our time grinding away, taking strikes, hitting singles, and fouling out until we catch a fat pitch.

I’m confident that we’re not resulting and that our trade management was just crappy.

I’ve spent the last few weeks really thinking about this and searching for areas where I can improve my process. There are a number of obvious reasons why I’ve been less on the gun this year: I recently moved cross country, have been having to travel a lot internationally for work, am just finishing up going through a divorce, and experienced some health issues earlier in the year.

These things took up mind-space. They pulled me away from the screens for extended periods of time. They’re obvious performance detractors.

A good thing going forward is that my health is now better, I don’t plan on getting divorced again anytime soon :p, and I’ve purposefully reduced my traveling schedule so I can buckle down and manage our book more effectively.

After analyzing my trade management errors over the last 6-months I’ve concluded that my failures can be bucketed into the following:

  1. Being slow on the trigger leading to too much slippage and poor entries
  2. Being too loose with profit management in a volatile macro regime (ie, failing to take chips off the table once our stack has grown large)
  3. Just flat out not following up on our own calls (a symptom of being busy or away from screens).

We were up over 23% on the year in April but we ended up giving a handful of our profits back because I failed to fully carry out our call to significantly reduce risk + we’re holding a sizable amount of DOTM positions which naturally experience wild swings.

These are all easy fixes of better managing my schedule and getting personal things in order. I know for a fact that this area isn’t going to be a detractor of performance going into the rest of the year.

The more challenging problems are going to be improving our quantified rules and processes for managing trades, such as when and how to take profits. There’s a lot of room for improvement in this space and that has me really excited. I’ve been spending a good of time over the last few months working on this problem and I’ve had a number of a-ha! moments. We’ll be codifying these into our process in the coming weeks and writing up a long report laying out the changes and sharing this with Collective members. I’m excited…


Excellence is an art won by training and habituation. We do not act rightly because we have virtue or excellence, but we rather have those because we have acted rightly. Excellence, then, is not an act, but a habit. ~ Aristotle

We started MO just over three years ago with the aim of building a trading service/site that we always wanted but which didn’t exist.

We plan to continue busting our asses improving and evolving our value offered so that it stands head and shoulders above the other services out there; we want to be the best when it comes to research, education, trade theory, analysis tools, trading returns, and quality of our community.

We don’t aim to grow into a giant Motley Fool-type business because that would mean serving the common denominator. We want to foster a community of diehards — of traders and investors, who, like us, are single mindedly focused on becoming the best.

If you want to join us on our journey, then give the Macro Ops Collective a look.

The Collective is a solid community that continues to grow and compound its network — more ideas, better trades, bigger profits. If you’re serious about playing the game of markets well, then check it out below. To sign up, scroll to the bottom of that page.

There’s a 60-day money-back guarantee too. As I said, we’re always upfront with our community. That’s why we give you the opportunity to try the Collective for two full months before making a commitment. Come in, kick the tires around a bit and if at any time you feel it’s not a good fit, we’ll refund your money right away. No questions asked and no hard feelings.

We’re only keeping the doors to the Collective open till June 9th at midnight EST. After that, enrollment will shut down. Please take advantage before then.

Click Here To Learn More About The Macro Ops Collective!

Genghis John and the Ultimate Mental Model for Markets



A loser is someone — individual or group — who cannot build snowmobiles when facing uncertainty and unpredictable change;


A winner is someone —  individual or group — who can build snowmobiles and employ them in an appropriate fashion, when facing uncertainty and unpredictable change.


I’ll explain in a minute.

First… Let’s talk about the man who wrote the above words — it’s part of a slide deck to a briefing that he spent much of his adult life working on.

That man is John Boyd. He’s one of the greatest fighter pilots who ever lived and a military strategist on par with the likes of Sun Tzu, Clausewitz, and Jomini. He perhaps has had more of an impact in shaping US military strategy than any American in history, and yet few know his name.

We’re going to discuss the immense philosophical contributions of Boyd and how we can use them to our advantage in markets — we’ll learn how to build snowmobiles and more. And as we’ll see, this is a timely discussion as markets have entered a period of large macro divergence and dissidence where coming trends will be affected by the Game Masters (political and monetary authorities) as much as the fundamentals.

We’ll use Boyd’s framework to analyze and synthesize current markets to discover what we think are the greatest opportunities, as well as the greatest risks…

And with that, let’s dive in.

We have to start with some background of the man to fully appreciate his insights, credibility, and accomplishments. It also helps that he was an extremely colorful figure whom tops the list of historical people you’d want to grab a beer with.

Back in the 1950s, Boyd was known as the best fighter pilot in America and perhaps the world. He flew for the US Airforce and reached the rank of Colonel. His first nickname (of many) was “40-second Boyd” because while working as a flight instructor at Fighter Weapons School, he had a long-standing $40 bet with all comers that he could put them on his “six” then outmaneuver them to reverse positions for a kill in under 40 seconds. Never once did he lose.  

Grant Hammond, the author of the original book on Boyd, The Mind of War, describes the complex man like this:

To one senior Air Force four-star, Boyd was “a 24 karat pain in the ass.” To a Marine four-star, he was “the quintessential soldier-scholar.” While one fellow student called him “the ‘cussingest’ man I ever met,” another four-start called him “Christ-like.” To those in the Pentagon whose ire he garnered, he was “that f @*#ing Boyd.”

He was known by various names including “the Mad-Major,” “The Ghetto colonel,” and “Genghis John.” To those who believed in him and his causes, he was more than a hero he was a virtual saint and they would have followed anywhere and taken on any foe, regardless of the odds.

How did one man inspire such radically different opinions? Boyd was both brilliant and a misfit who was his own worst enemy. He did not do things by the book or play by the rules. He did not care much for shined shoes, immaculate uniforms, or protocol niceties. On a visit to the Air Force Academy driving with his host, he noticed the superintendent in the car behind him on base. Boyd rolled down the window in the cold and snow and started pumping his middle finger in the air at the car behind, in front of several dozen cadets. His host, appalled by the action, tried to stop him, but Boyd said, “Aw hell, we were in pilot training together and this is just a fighter pilot greeting.”

Boyd was both vilified and respected by those who knew him. To many, he was not very likable. He smoked smelly cigars, talked loudly, and got right in your face when he argued with you, spittle flying. He was pushy, arrogant, and profane in the extreme and would frequently end run his boss, or his boss’s boss, up to, and including, the secretary of the Air Force and the secretary of defense. He had the courage to state his views—and defend them regardless of consequence. His supporters admired and respected his integrity and willingness to challenge and persevere. He was totally incorruptible, had little use for money, and refused to cash dozens of TDY reimbursement checks for speaking engagements after he retired. He inspired intellectual respect and virtual awe, intense loyalty, and unbounded compassion for those who became “the acolytes” of Boyd’s small but intense following on his various crusades.

Boyd was able to get away with being a “24-karat pain in the ass” and avoid court-martial only because he was brilliant.

In the late 1950s, he taught himself enough calculus to work out the formulas for describing his unique view of the maneuver-counter maneuver aerial dogfight. He published his findings in a secret document titled Aerial Attack Study. The document was so revolutionary it ended up spreading throughout Western military culture, essentially becoming the bible for air combat.

In the 60s, on his own initiative, he taught himself advanced mathematics and physics and then stole millions of dollars worth of government computer time using dummy accounts so he could study the comparative flight performance envelopes at different speeds, altitudes, and G-forces for every American fighter and plot them against every Soviet fighter.

Boyd did this because he wanted to answer the question as to why the F-105’s 10 to 1 kill ratio versus MiGs in Korea collapsed to 1-1 in Vietnam when US pilots seemed to lose their air-superiority.

Once the Air Force brass found out about his expensive theft they pushed for a court-martial. Luckily Boyd had uncovered fundamental truths about aircraft build and aerial warfare which led to his creation of Energy-Maneuverability theory, EM theory for short, which went on to completely change aeronautical design and how fighter jets were tested and built — eventually culminating in the creation of the F15 Eagle and F16 Fighting Falcon, two of the most successful fighter jets in history.

So instead of a court-martial, the Air Force was forced to give him two commendation awards instead.

Following his retirement from the Air Force in the mid-70s, Boyd went into self-imposed exile to study and prepare for the next phase in his evolution.

A former friend and coworker of Boyd, Frank Spinney, shared the following about this period in Genghis John’s life, during a speech given at the U.S. Naval Institute.

All this was the stuff of legend in 1973 when I met Boyd, who was living modestly with Mary the Saint and their five children in a run-down apartment complex in Northern Virginia. He was well into his third mutation: the Ghetto Colonel. Like Immanuel Kant, he was an austere man of intense rectitude, whose life had become devoted to the study of science, philosophy, and the humanities in a small room. Like Kant, Boyd was obsessed with understanding how the mind creates knowledge, or in modern parlance, how it creates theoretical models of the real world — how new observations make existing theories obsolete, and how the mind replaces old theories with new theories in a never-ending cycle of destruction and creation.

To this end, he devoured books on physics, mathematics, logic, information theory, evolutionary biology, genetics, cognitive psychology, cultural anthropology, sociology, political science, economics. Between 1973 and 1976, he poured his intellectual energy into producing a 16-page double-spaced, type-written paper describing his theory. Entitled “Destruction and Creation,” this abstract treatise describes how a dialectical interplay of analysis and synthesis destroys and creates our mental images of the external world. It describes what pressures drive this mental process, and how internal phenomena naturally regulate it in a never-ending dialectic cycle, which takes on the outward manifestations of disorder turning into order, and order turning into disorder.

At the heart of Boyd’s theory of knowledge was a natural regulation mechanism that he discovered by unifying for the first time certain aspects of the Incompleteness Theorem of Mathematics and Logic discovered by Kurt Godel, an Austrian mathematician; physicist Werner Heisenberg’s Uncertainty Principle; and the Second Law of Thermodynamics. Typically, he did not even try to publish his paper, although he did vet it through many distinguished scientists and mathematicians — none of whom was able to poke any holes in it.

“Destruction and Creation” became the intellectual foundation of his monumental study of competition and conflict — although at the time, he had no idea where his philosophical musings might take him.

Looking back at those four years between 1973 and 1976, I now understand that they were a period of intellectual refueling for the next campaign in Boyd’s war against a bureaucratic establishment that had lost sight of its goal. For unlike Immanuel Kant, Boyd worked in the Pentagon, a moral sewer dedicated to using other people’s money to feed the predators in the Hobbsean jungle known as the military-industrial-congressional complex.

Viewed from this perspective, the Ghetto Colonel’s lifestyle was much more than an aesthetic philosopher’s quirk. It was a deliberate choice reflecting that bureaucratic warfare in the Hobbsean jungle had replaced the aerial dogfight as his first love.

Boyd loved a good skunk fight and he played for keeps — instinctively applying Napoleon’s dictum of preparing a circumspect defense before unleashing an audacious attack. He built up his defenses by eschewing careerism and materialism, which left the generals and bureaucrats nothing to work on, no opportunity to gain leverage on him, no bait to tempt him into corruption. The Ghetto Colonel became an impenetrable fortress, a bastion of moral power in a way that Mohandas Gandhi would have easily understood. From the perspective of the bureaucracy’s authoritarian mentality, however, the man was certifiably insane; even worse, he was completely out of control.

I once asked him why he lived this way. He got in my face, the ever-present cigarillo clenched between his teeth, its hot tip popping up and down a quarter of an inch from my nose, and amidst a gush of suffocating smoke, he explained: “The most important thing in life is to be free to do things. There are only two ways to insure that freedom — you can be rich or you can you reduce your needs to zero. I will never be rich, so I have chosen to crank down my desires. The bureaucracy cannot take anything from me, because there is nothing to take.”

This statement went to the core of a puritanical ethos. For the Ghetto Colonel, life revolved around a simple choice: To be or to do? He could be somebody, with all the shallow accouterments of power and small achievements — high rank, a big office in the Pentagon’s E-ring, and a big post-retirement job with a defense contractor — or he could do important things and make a real contribution to society. The Ghetto Colonel was more interested in doing things than in being somebody, so he cranked down his needs. His choice really was very simple and logical, if somewhat bizarre and indecipherable to the inhabitants of Sodom on the Potomac.

There’s so many good bits in there that we could spill gallons of ink and burn through mountains of paper discussing them. But this is a report on markets, so I’ll save the broader philosophical discussions for another day and get to the meat of what we’re here for today.

Boyd’s decade long study into the nature of reality and how we interact and compete within it culminated in a 370 slide presentation titled A Discourse on Winning and Losing. The briefing covers a lot but at its core is an operating framework for how to survive and thrive in our complex reality.

The operating framework is what I’m sharing with you today. And underlying this framework is what Boyd referred to as his scientific trinity of Gӧdel, Heisenberg, and the Second Law of Thermodynamics.

Gӧdel proved that it’s impossible to embrace mathematics within a single system of logic so that any consistent system remains incomplete. In Boyd’s words, this means that “Gӧdel’s proof indirectly shows that in order to determine the consistency of any new system we must construct or uncover another system beyond it. Over and over this cycle must be repeated to determine the consistency of more and more elaborate systems.”

Meaning, there is always something beyond our contrived systems. No explanation is fully self-contained. Heisenberg’s Uncertainty Principle states that it’s impossible to know both the position and velocity of subatomic particles with accuracy. We can know either but not both at the same time. Boyd took this to mean that uncertainty lies at the foundation of our physical universe and therefore should be embraced by our attempts to understand and interact with it.

And the Second Law of Thermodynamics states that all closed systems increase in entropy over time (ie, chaos spreads). Boyd explained it like this, “entropy is a concept that represents the potential for doing work, the capacity for taking action or the degree of confusion and disorder associated with any physical or informational activity. High entropy implies a low potential for doing work, a low capacity for taking action or a high degree of confusion and disorder. Low entropy implies just the opposite.”

This is an oblique way of saying that in order to decrease entropy one must maintain an open system (open to new information, experiences, patterns etc…).

Hammond wrote in The Mind of War that Boyd’s thinking is:

…based on the synthesis of those three insights. It is cosmic in its sweep and fundamental in its insight. It is an elegant yet simple proof of how we learn and why one must be able to destroy before one can create. Boyd proved to himself that logic, mathematics, and physics all proffered explanations of the same basic notion. Taken together these three notions support the idea that any inward-oriented and continued effort to improve the match-up of a concept with observed reality will only increase the degree of mismatch. Boyd saw Godel, Heisenberg, and the Second Law as keys to how to think, how to compete successfully, and how to adapt and survive.

Boyd’s belief was that to compete in an uncertain reality — and all reality is tinged with varying degrees of randomness —  one had to constantly perform destructive deduction and creative induction with the mental models we use to interpret and interact with reality.

This means that we need to routinely dissect and analyze our beliefs, aims, and strategies (destructive deduction) where we can take note of, and discard faulty assumptions and biases. And then follow up with creative induction where we take our disparate analyzed data and models and then synthesize and combine it into something new, something novel, something that’s in better alignment with reality.

We need to build a snowmobile.

This was Boyd’s favorite metaphor for what we’re talking about. A snowmobile is a mismatch of various components from unrelated devices. It has the rubber treads of a tank, skis from a ski slope, the outboard motor of a boat, and the handlebars of a bicycle.

The individual parts of these unconnected objects (models) come together to create an entirely new creation, one that is better suited for its environment than any of the objects from which its parts are derived.

Scientist and author of one of my favorite books Consilience: The Unity of Knowledge, E.O Wilson put it like this:

We are drowning in information, while starving for wisdom. The world henceforth will be run by synthesizers, people able to put together the right information at the right time, think critically about it, and make important choices wisely.

Turning back to Boyd’s friend, Spinney:

Each of us bases our decisions and actions on observations of the outside world that are filtered through mental models that orient us to the opportunities and threats posed by these observations. As Konrad Lorenz and others have shown, these mental models, which the philosopher of science Thomas Kuhn called paradigms, shape and are shaped by the evolving relationship between the individual organism and its external environment.

In conflict, each participant, from the individual soldier, trying to survive to the commander trying to shape strategy, must make decisions based on his orientation to reality — his appreciation of the external circumstances which he must act on. Boyd argued that one’s orientation to the external world changes and evolves, because it is formed by a continuous interaction between his observations of unfolding external circumstances and his interior orientation processes that make sense of these circumstances. These interior processes take two forms activity: analysis (understanding the observations in the context of pre-existing patterns of knowledge) and synthesis (creating new patterns of knowledge when existing patterns do not permit the understanding needed to cope with novel circumstances).

The synthetic side of the dialectic is crucially important to one orientation because it is the process by which the individual (or group) evolves a new worldview, if and when one is needed to cope with novel circumstances. But as Kuhn and others have shown, the synthetic process can be extremely painful, because its nature is to build a new paradigm by destroying the existing one.

A big part of our job as speculators is to inch by inch try and pull back the curtain on a constantly changing complex reality. We do this by ripping apart our beliefs and rebuilding new ones, creating Munger’s latticework of mental models, from which we can pull from when the environment calls for it.

Some of the models we’ve shared for example are: 

What Boyd gives us, which is so incredibly valuable, is a strategic framework from which to effectively use these models and operate from.

The framework is called the O-O-D-A Loop which is an abbreviation for Observe, Orient, Decide, Act.

The OODA Loop is the ultimate compression of Boyd’s philosophy. Hammond writes that for Boyd, “the OODA Loop is a composite of how we think and learn, the source of who we are, and the potential we possess. It is a profoundly simple explanation of the nearly infinite variety that is possible. It is a shorthand for life itself, a model for how we think, and the means by which we both compete and collaborate.”

Boyd describes the centrality of the OODA Loop as this:

Without our genetic heritage, cultural traditions, and previous experiences, we do not possess an implicit repertoire of psycho-physical skills shaped by environments and changes that we have previously experienced.

Without analysis and synthesis across a variety of domains or across a variety of competing independent channels of information, we cannot evolve a new repertoire to deal with unfamiliar phenomena or unforeseen change. Without a many-sided implicit cross-referencing process of projection, empathy, correlation, and rejection (across many different domains or channels of information), we cannot even do analysis and synthesis.

Without OODA Loops, we can neither sense, hence observe, thereby collect a variety of information for the above process, nor decide as well as implement actions in accord with these processes. Or, put another way, without OODA Loops embracing all the above and without the Ability to get inside other OODA Loops (or other environments), we will find it impossible to comprehend, shape, adapt to, and in turn be shaped by an unfolding, evolving reality that is uncertain, ever-changing, and unpredictable.

The entirety of the OODA Loop process looks like this:

Notice the continuous feedback loops at each step of the process. Ever stage of the OODA Loop informs the other and so on. The process is more organic than it is mechanical. Never is it static but rather it’s constantly fluid; always updating, reorienting, evolving.

Now how does all of this apply to markets?

For one, prediction is not only futile but completely misses the point of the game. Prediction only works in linear environments whereas markets are a natural system, and thus are dynamic, non-linear.

Just like in war you don’t set a strategy, execute, and pray to Mars that you chose wisely. No!

You Observe what’s going on, and then Orient off what you see as key information, then make your Decision using existing mental models for interpreting reality and finally Act… You then repeat and repeat over and over… constantly observing and reorienting to not only new information but new interpretations of that information — ruthlessly trashing your bad assumptions —  and then hopefully evolving your models of reality, deciding what to do next, and following through ad infinitum…

If you study the trading greats you find that they did the OODA Loop process instinctively.

Take the Palindrome, George Soros, for example, who’s said:

My approach works not by making valid predictions, but by allowing me to correct false ones.

The reflexive nature of human relations is so obvious that the question I would like to ask is, why has reflexivity not been properly recognized? Why, for instance, did economic theory deliberately ignore it? [And the answer is because] it cannot be reconciled with the goals of analytical science, which is to provide determinate predictions and explanations. Reflexivity throws a monkey-wrench into the works by introducing an element of uncertainty.

As an investor, I find statistical probability of limited value; what matters is what happens in a particular case. The same applies with even greater force to historic events. I cannot make reliable predictions about them; all I can do is formulate scenarios. I can then compare the actual course of events with the hypothetical ones. Such hypotheses have no scientific validity, but they have considerable practical utility. They provide a basis for real-life decisions.

Or Bruce Kovner:

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

These guys can build snowmobiles!

What is strategy? A mental tapestry of changing intentions for harmonizing and focusing our efforts as a basis for realizing some aim or purpose in an unfolding and often unforeseen world of many bewildering events and many contending interests…

To discern what is going on we must interact in a variety of ways with our environment. We must be able to examine the world from a number of different perspectives so that we can generate mental images or impressions that correspond to that world.

We can’t just look at our own personal experiences or use the same mental recipes over and over again; we’ve got to look at other disciplines and activities and relate or connect them to what we know from our experiences and the strategic world we live in. By an instinctive see-saw of analysis and synthesis across a variety of domains, or across competing/independent channels of information, in order to spontaneously generate new mental images or impressions that match up with an unfolding world of uncertainty and change. ~John Boyd

Leonardo da Vinci once said, “He who loves practice without theory is like the sailor who boards a ship without a rudder and compass and never knows where he may cast.”

Markets are tremendously complex systems. As traders/investors we play a game of uncertainty, filled with endless possibilities, that we must try our best to effectively weight probabilistically. Mental models give us a scaffolding to hang our experience on and help us navigate violent waters. Boyd’s OODA Loop is one of these models that once you begin using, to then discard would feel like drifting about without “rudder and compass”.

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Playing The Player Update: Another Major Buy Signal


The best trades are the ones in which you have all three things going for you: fundamentals, technicals, and market tone. First, the fundamentals should suggest that there is an imbalance of supply and demand, which could result in a major move. Second, the chart must show that the market is moving in the direction that the fundamentals suggest. Third, when news comes out, the market should act in a way that reflects the right psychological tone. ~ Michael Marcus

Michael Marcus is one of the original market OGs. He cut his teeth at Commodities Corp where he was one their star traders alongside PTJ, Kovner, and Ed Seykota.

Marcus combined fundamentals, technicals, and sentiment — what we refer to as the ‘Marcus Trifecta’ — to analyze markets. This allowed him to turn $30,000 into $80 million over a 20 year period. Not too shabby.

This is the approach we use here at MO to view markets. In this piece, I’m going to share an excerpt from two Market Briefs that went out to members of our Collective recently. The hope here is to first show you some of the tools and processes we use to assess markets. And secondly, to give you an update on what we’re currently seeing through this ‘Trifecta’ lens (this is complimentary info to the note we sent out yesterday).

The following excerpt is from our Brief titled “A Roadmap” published May 29th.


Let’s quickly layout where we are and how we got here. And then we’ll get to where we’re headed in the weeks ahead.

In our April 23rd Brief “Japan Going On Leave” we began noting how the rally had gotten “long in the tooth” and there were increasing “signs of growing complacency and technical divergence”. We talked about how the Russell small-cap index had “failed to confirm the broader market rally” and that not only had credit and spreads “turned over a bit” but sentiment and positioning were becoming stretched, writing:

The majority of investors have been on the outside looking in at this rally since the start of the year. We’ve talked about how this move will persist until it finally creates enough FOMO (fear of missing out) to suck in these players who’ve been sitting on the sideline.

While we likely have a bit more to go before we get total capitulation from the bears. There’s an increasing number of signs that we’re getting close. Take the NAAIM Extreme Exposure Index which measures the top quartile of investor’s weighting to risky assets. It recently pierced the 80 level (horizontal red line). Readings above this point suggest a number of investors are getting over their skis a bit which makes the market more susceptible to a pullback.

Then in our following Brief “Creeping Complacency” we pointed out that “ Our 10-day moving average Total Put/Call indicator crossed below the 0.8 level (marked by the horizontal red line below) triggering an official sell signal on Friday.  Investors are buying less downside protection and are becoming complacent. The lower this indicator moves the greater odds are that we’ll see a sizable correction in the coming weeks.”

We concluded with “My general market take remains the same. The rally is getting long in the tooth and there are some increasing signs of FOMO — note the resurgence of the “Melt-Up” narrative that last became popular in the runup to the Jan 18’ blow off. But momentum and technicals still favor more upside for the time being.

The move here is to stay long but begin to trim risk and take some profits off the table. Once momentum fades and more technical cracks appear we’ll move to more aggressively reduce our equity exposure and put on some shorts.

The following week we wrote in the MIR that “The Forward PE ratio of the SPX is back up in the 17+ range. A level which has caused some instability for the market in the past.”

And ended with:

My indicators are telling me that we’re headed for a broader market correction in the coming weeks. I’m not expecting this to be a big selloff like the one we experienced in Q4 of last year but it could be significant in some of the individual overstretched names.

…We’ve been writing since last December that the majority of the market has been on the outside looking in at this rally and that the time to get defensive will be when those on the sidelines begin giving into FOMO and piling stocks. It looks like that is starting now. Momentum may carry us higher for a bit longer but we’ll be taking this time to begin reducing our exposure to some of our more richly valued growth names and allocating more to our value names above.

Sentiment, technicals, and macro… The “Marcus Trifecta” is a very useful approach for hitting broader market turning points. The signs for this current selloff were there for all to see who knew where to look.

***Here’s the conclusion to our most recent Market Brief “The Market is Teeing Up…” from which yesterday’s macro indicator discussion was pulled.***

…. We have macro fundamentals which are slowing but still positive and far from signaling a recession is nigh. Depressed yields fatten the risk premia on offer from risk assets, making stocks appear more attractive. The consensus earnings estimates have been driven down to very manageable levels which should make for easier ‘beats’. Sentiment, positioning, and technicals are all pointing to a significant market bottom in the coming weeks. On top of all this, we have a US dollar that looks like its breaking down. A lower dollar = a tailwind for US earnings and easier financial conditions for EM stocks, not to mention a big positive for commodities.

Back at the end of March, I wrote There’s a Big Macro Move Brewing in Markets noting the record low asset volatility we were seeing in major dollar pairs and precious metals. I laid out how these compression regimes usually lead to expansionary ones (ie, BIG TRENDS). I think we’re going to see that start very soon.

There are a number of trades setting up that are making me excited. There are energy and shipping names trading at 1x normalized free cash flows and I’m seeing signs that investors are FINALLY starting to allocate money to the sector — I’ll write more about both soon. There are fantastic shorting opportunities lining up in the overvalued tech names. And we have bonds that are in the process of putting in what looks like an intermediate blow-off top.

I’ll be putting out a series of notes and trade alerts for Collective members in the coming weeks to update you on things as they unfold and as we make moves in our portfolio.

 There is a tide in the affairs of men,
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat,
And we must take the current when it serves
Or lose our ventures.

Time to take the current…


Honma Munhisa, the 18th-century Japanese rice trader who invented Candlestick charts, is believed to have amassed a fortune of over $100B in today’s money trading rice futures. He learned early on that making money in markets is as much about “Playing the Player” as it is about understanding the fundamentals. He wrote:

When people run to the West, I turn to the East. When the rice price starts going up, orders rush in from everywhere all at once, and soon the Osaka market becomes part of the show as well. The rice price goes up faster when people place orders even for stored rice and it becomes more evident that a buying spree is taking place. But when you wish to be in the position to place buy orders like everybody else, it is important to be on the side of those who place sell orders. When people move in unison, running towards the west with determined intention to be part of the rally, it is time for you to head to the east and you will discover great opportunities.

Looking at the market it seems like there are a lot of people crowding to one side or “running to the west”.

The last time I saw sentiment hit similar levels relative to the fundamentals was in late December of last year. On December 18th, I wrote the first of many bullish notes titled “The Bullish Case for US Stocks” commenting on the extremes in sentiment and narrative, ending with “I believe US stocks are setting up for an extraordinary buying opportunity in the next 1-3 weeks. I see a LOT of amazing deals in stocks and I’ll be putting out our Macro Ops shopping list later this week.”

The Trifecta of data tells me we’re about to see a similar bottom very soon.

It might be time we start running to the East

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The Market is Teeing Up…


The following is an excerpt taken from our latest weekly note that was sent to Macro Ops Collective members.

We’re going to cover a lot in this week’s report. We’ve got trade wars, trade wars, and some more trade wars… Regulatory action against tech giants… A look at sentiment and technicals which are setting up for a significant bottom… And finally, we’ll walk through the major macro indicators to dispel the nonsense being peddled about an impending recession… Oh, and then we’re going to cover some trades that are teeing up… Pour yourself a fresh cup of joe, strap in, and let’s get cracking.

I don’t know about you but I want me some of whatever President Trump is smoking. The Donald has been non-stop these last few days.

Growing bored with an escalating trade-war with China he — apparently on a whim — decided to start one up with our Mexican Neighbors in an effort to get them to do something about their porous borders. Despite the fact that we just signed a major trade deal (USMCA or New Nafta) with them last December which took over a year of negotiations to hammer out.

Not wanting to stop there he then decided to remove India’s “special trade status” which exempted the country from US tariffs and followed that up with an effort to hit that thieving Australia with tariffs of their own before being talked back amid fierce opposition from military officials, as well as the State Department.

It looks like Trump has become besotted with the total discretionary authority that tariffs give him. No checks and balances, no going through Congress; he can wield near instantaneous economic force from his smartphone. Macro Hedgie Mark Dow summed up the implications of this well, tweeting:

Goldman Sachs shared their revised expectations of the trade war’s impact this weekend, writing:

We now expect a 10% tariff rate by July on both the final $300bn of Chinese imports (60% subjective odds) and on all Mexican products (70% odds for the first 5%, and just over 50% odds for the step-up to 10%).”  For China, this represents a middle ground between our previous assumption of a delay following the G20 summit in late June and the full 25% across-the-board tariff proposed by the US Trade Representative.

Additional tariff rate increases or an across-the-board auto tariff are also possible but not our base case. We still expect deals with China and Mexico to lead to a removal of the tariffs, but not until late 2019/2020.

We don’t have an edge in figuring out what the Trump admin or those on the other side of his trade fury will do. GS’s expectations are as good as any. They calculate that this base case will impact inflation, where they see it “climbing from 1.57% in April to 2% in August and to 2.3%-2.4% in early 2020” and dinging GDP growth in the second half by roughly 50bps.

Precise numbers aren’t that important here, in my opinion. What matters more is how this continues to widen the Cone of Uncertainty, not only for investors but for participants in the real economy. This is where the real risks lie, which are two-fold. These are (1) that this trade war escalates and creates a bear market of unnecessary stupidity which, due to the financialization of the economy, then leads to a recession and/or (2) private fixed investing (capex) collapses due to an inability for businesses to plan which then leads to a profits recession in accordance with the Levy-Kalecki framework.

As an example. Here’s some comments included in the recent Dallas Fed Manufacturing Survey (emphasis mine).

Primary Metal Manufacturing

  • The possible increases in tariffs related to China will negatively impact our agriculture customers and put further pressure on a segment that is already experiencing cyclical lows.

Nonmetallic Mineral Product Manufacturing

  • There are many unknowns due to tariffs.

Machinery Manufacturing

  • There has been a sharp decline in orders, and pricing has taken a huge dive as well. Competition has pushed pricing to near-guaranteed losses.
  • With all the tariff fees pouring into the U.S. Treasury, when should we expect a tax break?
  • We are seeing steady business that should begin to grow again if a China trade deal is reached.
  • China tariffs were already causing significant price increases, and the latest escalations will raise our costs even more—probably our prices, too—and make us less competitive on the world stage where we export 70 percent of what we produce.

Computer and Electronic Product Manufacturing

  • Trade talks with China could have a longer-term impact but have no impact at this point.
  • Growth is robust and would be even stronger without current supply chain and labor constraints, but we aren’t complaining.
  • With our government’s intention to resolve issues with Iran and China and also introducing the “Deal of the Century,” it adds warranted risk to our future business that we can’t ignore.
  • There is significant uncertainty.

Transportation Equipment Manufacturing

  • We are changing our business model to increase volume, with pricing based on wholesale margins versus retail margins. This change is to be phased in over six months.
  • Our primary customer is the U.S. government. We continue to be concerned regarding the volatility of the decision-making processes at the higher levels.

Net investment is what drives profits over the long-term. Growing regulatory and trade uncertainty makes operators less willing to make long-term investments. Private fixed investment is still growing at a healthy clip of 5% in the most recent quarter. But it’s also rolled over from its most recent high reached in Q2 of last year. If the trade war escalates and we see this number continue to fall then we’ll maybe want to start battening down the hatches.

The Regulators are Encircling the Tech Giants

Here’s a few sections from a recent article by Reuters (link here).

(Reuters Breakingviews) – At some point, antitrust investigations of Google and Amazon.com AMZN.O become a no-brainer. As a step in that direction, the Federal Trade Commission and Justice Department, which police U.S. competition issues, have divvied up responsibility for the tech giants, according to news reports. That could create ammo for future fights. Facebook FB.O ought to worry too.

… Splitting jurisdiction between the FTC and DOJ – which have overlapping remits – is a logical way to clear the decks. It avoids overloading one agency, duplication of work, and bureaucratic infighting. It will also leave each to explore different approaches to big questions like how troves of data on users and suppliers affects competition – something on which regulators worldwide are feeling their way.

Politics also raises the stakes, notably at the DOJ, which was already scrutinizing social media firms for alleged bias against conservatives after pressure from President Donald Trump. Antitrust scrutiny of Google has been informed partly by competitors’ complaints, including those by Oracle ORCL.N, whose Co-Chief Executive Safra Catz served on Trump’s transition team.

In the past, U.S. regulators have failed to make a dent on Google and software giant Microsoft MSFT.O, and they may achieve little again. These investigations could, however, establish important precedents that, a few years from now, inform more dramatic skirmishes.

The popular high-growth tech names are getting hammered on this news. This thread does a good job of laying out the implications of this. Basically, high-growth tech/SAAS plays have been the ONLY game in town these last few years. They’ve become hedge fund hotels where positioning concentration has reached ridiculous levels + when you couple that with the rather low volatility and high momentum we’ve seen in many of these names, you get a ‘fire in a crowded theatre’ type scenario where a bunch of weak hands end up clambering for the exit at the same time.

I wrote about the shift that’s underway from growth to value in last month’s MIR (link here). [For access to this content sign up to the Macro Ops Collective by Monday June 9th!]

Here’s one of the charts from that report showing the cyclical swing between growth/value on a momentum basis.

We’ll be looking to put out shorts in a few of these Icarus stocks in the coming weeks.

Slowing Growth but NOT a recession…

It’s been a few weeks since we’ve taken a macro fundamental look at the US market. And since I’ve seen a lot of screaming and hollering about an impending recession I thought I’d dust off a few of our mainstay recession indicators to see if that’s a high-probability risk. The short answer is, of course, no.

Let’s start with the Conference Board Leading Economic Indicator (LEI). The LEI is a composite of 10 leading economic and market indicators. You can read more about it here.

The LEI has given an advance signal of all eight recessions since its inception in 1959. It peaks on average of 10.5 months before a recession comes. The graph to the right shows the average returns per state of the LEI.

The chart below, which exhibits the LEI on an absolute and YoY basis, shows that the indicator is still heading up and to the right, though at a more muted pace.

Let’s turn now to labor. There’s a lot of ways to slice the jobs market but we’ll look at two of the stalwarts that I prefer — the other labor indicators I keep an eye on tell the same story.

The first is the Conference Board Employment Trends Index which, like the LEI, is an aggregate of eight labor market indicators (you can read more on it here).

The chart below shows that it peaked on an absolute basis back in August of last year and has flat-lined since but is still positive on a 12-month basis. We shouldn’t be worried though until this indicator turns negative.

Then we have Temporary Help Service Payrolls on a monthly, quarterly, and yearly basis. After a brief soft-patch at the start of the year, the data is back in the black showing positive growth. This indicator will turn over and begin to bleed a lot of red before a recession rolls around (see 00’ and 07’).

Inflation-adjusted Retail Sales are another reliable leading indicator for the economy and though growth has slowed it’s still positive. If it rolls over and continues lower from here then we’ll have to start getting concerned.

Lastly, let’s take a look at financial conditions (aka. liquidity). Like the labor market, there’s a lot of ways to gauge liquidity. We’ll look at a few of my favorites like this one, the Kansas Fed Financial Stress Index (KFSI) which is comprised of 11 financial market variables (read more here).

The KFSI is very muted, showing easy financial conditions. This indicator will turn and spike higher in the lead up to a recession, as it did in the summer of 07’ and 99’.

The Chicago Fed Adjusted National Financial Conditions Index (ANFCI) summarizes 105 indicators of financial activity (read more here). Like the KFSI, this indicator is trending sideways and near very low levels, showing easy financial conditions despite the recent bout of market volatility.

So we have uptrending LEIs, a strengthening labor market, positive real retail sales, and easy financial conditions. The bears will say “what about the inverted yield curve!?”.

A yield curve inversion does have a reliable track record of predicting recessions but my answer to that is threefold (1) an inverted curve should not be dismissed, but we need to look at the evidence in its totality and not just select one data point that confirms our bias (2) the signaling utility of parts of the curve may be somewhat less reliable this cycle, as I’ve noted here and (3) parts of the curve are still positive, such as my go-to, the 10-2s.

With all that said, our base case is that growth will continue to slow (we predict real GDP growth for the year to come in around 1.5%).

Slowing growth is not a recession and a low growth / low inflation economy is not a bad environment for risk assets as Stanley Druckenmiller has pointed out numerous times.

The major thing we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going… Once an economy reaches a certain level of acceleration… the Fed is no longer with you… The Fed, instead of trying to get the economy moving, reverts to acting like the central bankers they are and starts worrying about inflation and things getting too hot. So it tries to cool things off… shrinking liquidity… [While at the same time] The corporations start having to build inventory, which again takes money out of the financial assets… finally, if things get really heated, companies start engaging in capital spending… All three of these things, tend to shrink the overall money available for investing in stocks and stock prices go down…

Oh… I also want to point out the trend in US Profit Margins and Return on Equity (ROE). Both are important to watch as they directly drive equity valuations.

Starting with ROE, we can see that following an extended contraction that began in 12’ it’s actually begun to trend back up after bottoming in 17’. ROE will typically compress in the lead up to a recession.

Net US Profit Margins also peaked in 12’ but are still holding up pretty well. Like ROE, we will see margins compress in the lead up to a recession.

In our next piece, we’re going to cover the Market Trifecta: Fundamentals, Technicals, and Sentiment.

We’ll discuss how consensus earnings growth expectations have been walked down to much more manageable levels, then I’ll show you how key markets are nearing major support levels, and finally finish with a look at sentiment and positioning which is indicating that we’re nearing a significant bottom (ie, a big buying opportunity is setting up).

I’m seeing a LOT of wildly asymmetric trading opportunities that are teeing up. We have energy and shipping names trading for 1x normalized FCF, major FX pairs that are about to break out of significant compression zones, and bonds which are keyed for a big reversal. I’ll write more about these in a coming note for Collective members.

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Boom-Bust Barometer Biffs Badly


Yardeni’s Boom-Bust Barometer (BBB) pitched to 18-month lows last week (dotted red line below).

The BBB is comprised of the CRB industrial raw materials spot index divided by the four-week average of initial unemployment claims. It’s a fairly reliable stock market indicator which makes sense seeing as how rising raw material prices and a strengthening labor market typically equate to an environment that’s supportive of stocks, and vice-versa.

The BBB turned over and trended lower in the lead up to the 2015 market sell-off as well as the equity rout last Fall. Of course, there’ve been a few false signals such as the spike lower in 17’ but which was quickly reversed.

We’ll have to keep an eye on the BBB in the weeks ahead. The net-bullish sentiment reversal we saw recently in the AAII survey, along with the short-term oversold conditions of certain sectors (see semis), has likely bought this up-swing in the market a bit more time.

Looking past a few weeks out though I think it’s odds on we see another leg down in the market. Between the upcoming weak seasonals, decelerating global growth, escalating trade conflict, and stubbornly high consensus earnings estimates for Q2 onwards, there’s not a lack of catalysts to cause another major dislocation.

This company looks cheap, that company looks cheap, but the overall economy could completely screw it up. The key is to wait. Sometimes the hardest thing to do is to do nothing. ~ David Tepper

It’s a good time to show some prudence, derisk some, and wait for another dislocation to buy in again.

Market Update: Expanding Cone of Uncertainty


(Note: This is an excerpt from a note sent to Collective Members earlier today.)

I want to share some quick notes on this selloff, the trade war and potential risks, some portfolio updates, along with an earnings update from our value guy, Mr. Bean, on Construction Partners (ROAD) latest quarter.

Let’s start with the trade war.

We often write about how the market reflects the aggregate range of reasonable opinions about what the future will look like (here’s a link to one of our writeups on the topic). In visual form, the concept looks something like this.

What happens when things like a trade war intensify is that the range of plausible outcomes expands. Uncertainty goes from looking like this.

To looking more like this.

Uncertainty and volatility drive each other in a feedback loop as the market adjusts to new competing narratives as it seeks out a price that more properly reflects the new range of reasonable opinions. This is why analyst estimate dispersion tracks volatility. Both react to increased uncertainty over plausible and possible future outcomes.

The breakdown in trade talks and the tit-for-tat that is now taking place with Beijing recently stating they will raise tariffs on roughly $60bn worth of US imports after June 1st, is widening that cone of uncertainty and will continue to drive volatility higher until (a) the US and China make convincing progress on a deal or (b) the market reaches a price level, that along with sentiment and positioning, better reflect the expanded range of probable outcomes.

We talked in this week’s Brief how this ‘readjustment’ also happens to coincide with our indicators clearly showing stretched levels of bullish sentiment and complacent market positioning —  as these events often tend to do. This will make the readjustment particularly volatile.

We should see the market bounce over the next week or so, seeing as how oversold it is on a short-term basis. But I want to reiterate that this rally should be sold into, not bought.

It’s likely we see this down-leg continue until the percent of stocks trading above their 50-day moving average moves near the 20% level (green area below).

The major risk here is that the ensuing bout of market volatility feeds into the real economy and dampens consumer behavior enough that it tips us into recession. This is the whole “financialization of the economy” risks we’ve talked a lot about. The market “tail” now wags the economy “dog” which is why we saw such crappy data in January/February with retail sales falling through the floor. Consumers got spooked by the Nov/Dec market selloff and pulled back in their spending.

Considering the inflated GDP print last quarter that was due to a buildup in inventories and where growth in the US is headed now, the economy is skating on increasingly thin ice. A market shock could be the thing that plunges it through. Not saying that’s going to happen. But it’s certainly worth keeping in mind.

Moving on to our portfolio.

We’re taking profits and closing out the rest of our long Facebook (FB) position. Growth stocks should continue to get needled in this new regime, as I talked about in our most recent MIR. On that same note, our value plays are holding up much better than the broader market which is a good sign we’re seeing a rotation out of growth and into value happening.

We also got stopped out on our Gaia Inc (GAIA) trade yesterday. The bullish thesis is unchanged but that thesis is kaput until the market starts agreeing with it. In hindsight, I mismanaged the trade by sizing too large at 1% risk with too tight of a stop. My conviction behind the trade skewed my better judgment and as a result, our portfolio is the poorer for it. I plan on putting out a more extensive review of the trade soon.

Construction Partners (ROAD) came out with earnings recently and crushed it. Here’s Mr. Bean’s comments on the report (link here). ROAD is roughly 10% of our portfolio. I want to eventually build it into a 15-20% position.

Precious metals have been getting a bit of a bid the last few days. From a technical standpoint, they aren’t completely out of the woods yet. We need to see a higher swing low before I feel comfortable adding to our silver and AngloGold (AU) positions. There’s risk we see the dollar pop here which would likely stop us out of our starter positions.

Also, keep watching oil. It’s bouncing around its 200 and 50-day moving averages but, as we talked about in the Brief, positioning is stretched and due for a reset. 

That’s all I’ve got for now.

Something That Everyone Knows Isn’t Worth Anything…


The pendulum of the mind alternates between sense and nonsense. ~ Carl Jung

Politics is a pendulum whose swings between anarchy and tyranny are fueled by perennially rejuvenated illusions. ~ Einstein

Stephen Buhner wrote in his book “The Secret Teachings of Plants” the following:

The physical Universe is an aggregate of frequencies. – Buckminster Fuller

All living organisms receive electromagnetic signals all the time. And like the signals received by our radios, many of them contain extremely large amounts of information, which can be used for a great many things. These range from regulating the opening of little doors in cells to let food in and waste out, to healing, to the beating of the heart, to birds orienting themselves to the magnetic lines of the Earth when migrating, to the communication between pollinators and their flowers, to the communications between members of the same family who have bonded with each other — and, of course, a great deal more.

Electromagnetic spectrum signals, like those we know as a particular radio station, can and do contain very large amounts of information… Every time life flows through a frequency in the electromagnetic spectrum, it fractalizes that wave differently, because the flow of life is always nonlinear. What is interesting is that unique information is always embedded or encoded within the way the oscillating sine wave is fractalized.

Fractalized sine waves seem to be encoded into the very fabric of our reality; like the Golden Ratio and the second law of thermodynamics. They appear throughout the universe on nearly every level of scale and function. It’s no surprise then that they underlie the very structure of our market, which is just fractalized sine waves overlaid on fractalized sine waves of various temporal scales.

This makes intuitive sense because a sine wave is just a continuous pendulum swing. And crowd dynamics naturally follow the path of a pendulum, swinging from one local extreme to another.

The market is in effect a large complex information transmission system. All acting participants make bets using their particular knowledge set which then in aggregate moves the market, providing new information for the actors to incorporate into their decision-making process where they then make new bets. Creating a neverending information feedback loop.

The infinite feedback loops in the structure of the market, not to mention the way group psychology evolves, necessitate this constant back and forth, like that found in every natural system.

Every rally sows the seeds for a reversal and every reversal sows the seeds for a rally. Ad infinitum.

Michael Mauboussin discussed a critical driver behind why this process plays out in his recent paper titled “Who is on the other Side?”. In it, he shares work done by economist Blake LeBaron which animates this concept using an agent-based model (here’s a link to the original paper).

The model is computer generated and the “agents” are imbued with decision-making rules and objectives similar to those that drive market participants (i.e., make money, try not to lose money, don’t underperform the average for long periods, etc…)

Here’s a section from the paper (emphasis by me):

LeBaron’s model replicates many of the empirical features of markets, including clustered volatility, variable trading volumes, and fat tails. For the purpose of this discussion, the crucial observation is that sharp rises in the asset price are preceded by a reduction in the number of rules the traders used (see exhibit 5). LeBaron describes it this way:

During the run-up to a crash, population diversity falls. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market. The economic mechanism here is clear. Traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies. In the Walrasian setup used here, this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity.

Because the traders were using the same rules, diversity dropped and they pushed the asset price into bubble territory. At the same time, the market’s fragility rose.

Mauboussin goes on to note the important lessons this model underscores about our market structure, which can be broken down into three primary points.

  1. Falling agent diversity initially leads to agents making more money which creates a feedback loop of higher prices -> agents in the ‘herd’ make more money -> less agent diversity -> higher prices… This is why fighting trends, even ones based on faulty prepositions, can be so dangerous over a short timescale.
  2. A reduction in agent diversity is non-linear. Meaning, as diversity falls, market fragility rises exponentially. This is more often than not initially obscured by rising market prices. But, as Mauboussin points out “crowded trades work until they don’t” and eventually an incremental change in diversity will lead to an outsized drop in market price. This is the age-old liquidity problem. When a large portion of the market is using the same buy and sell rules there conversely becomes a disproportionately small population to sell into and the market needs to drop significantly for prices to clear.
  3. Lastly, the model highlights the importance of understanding how beliefs propagate across a network. Like a disease, a belief’s level of virality is based on its contagiousness (how compelling it is), its degree of interaction (how many high-density nodes in a network adopt it), and the degree of recovery (how supported is the belief by the unfolding reality).

The Palindrome George Soros was perhaps one of the best at playing the player and identifying these belief-diversity cascades when in his prime. He applied an entirely new vocabulary to financial markets with terms like reflexivity, feedback loops, false trends and so on.

Soros would break down reality into three sub-categories:

  1. Things that are true
  2. Things that are untrue
  3. And things that are reflexive

He said that “Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited.”

Soros was exceptional at reading where the market was in its pendulum swing (i.e., gauging the level of extremity of  consensus narratives and their subsequent positioning) relative to the quality of assumptions in which they are based on (true, untrue, reflexive).

An example of the type of pendulum swing Soros would try to exploit is the clear narrative shift in bonds last year.

Remember back in the middle of 18’ how the popular belief had become that “we’re in a new secular bear market in bonds”.

Both “Bond Kings” we’re shouting about the “game changer” in rates….

Here’s a few excerpts from a Bloomberg article in October of last year when the bearish bond narrative reached its pitch — which also happened to be right when yields peaked. The article is aptly named “Bond Bears Popping Champagne Say U.S. Yields Have Room to Rise”.

Thirty-year Treasury yields pushed above the 3.25 percent level that fixed-income veteran Jeffrey Gundlach identified as a “game changer.”

“Solid data releases, higher oil prices and a technical backdrop that suggests there are not a lot of obstacles for yields to continue to push higher will have many wondering how far this new push higher can go,” said Rodrigo Catril, a Sydney-based strategist at National Australia Bank Ltd.

Short sellers were already positioned for more pain in the Treasury market. Speculative net short positions on 10-year notes climbed to a record, the most recent Commodity Futures Trading Commission data showed. An update to those figures comes Friday.

“In hindsight, we wish we were even shorter on U.S. rates,” said Raymond Lee, a fund manager at Kapstream Capital Pty in Sydney.

“That gradual withdrawal of liquidity is causing yields to rise,” Bob Baur, chief global economist at Principal Global Investors, said in an interview with Bloomberg Television in Tokyo Thursday. “We look for 10-year Treasury yields to hit 3.5 percent at some point — later this year, early next year — and I think that’s going to be a real problem for stock markets.”

The famous speculator of the early 20th century, Bernard Baruch, used to say “Something that everyone knows isn’t worth anything.”

The “Bond Bear” narrative was predicated on a false trend. It wasn’t a sustainable move. Our leveraged balance sheets combined with a decelerating China and a responsive Fed ensured it. Crowding in both positioning and narrative combined with a textbook technical breakout in late October made for a perfect buying opportunity — something we pitched in our November MIR at the time.

Not only was the move in bonds not much of a “Game Changer…” but it was also clearly a local extreme on the swing of the pendulum. The narrative was on the front pages of ALL the financial newspapers and shared by nearly ALL the talking heads on CNBC.

And how quickly that narrative pendulum has swung back. It’s now accepted wisdom that yields won’t and can’t rise. The global economy is simply too weak and the Fed too dovish… Subsequently, investors have been stampeding in droves into bonds since the beginning of the year. More on this in a minute. 

Something that everyone knows isn’t worth anything…

 Equity markets too, have seen a full swing of the pendulum over the last six months. Back at the end of December when we put out a number of reports explaining why it was an excellent time to buy, the dominant belief was that a vicious bear market had started and a recession was around the corner.

I mean, the Yield Curve had inverted!!!! Everybody was fretting about the yield curve and a recent drop in retail sales…

Five months and a vertical runup in stocks later and there’s hardly a whisper of either. Now, the talk is of a Fed Put, a low growth low inflation Goldilocks economy, and a Melt-Up in equities.

One more time: Something that everyone knows isn’t worth anything…

Viewing markets — also history, politics, culture, and on and on — through the lens of a swinging pendulum is a useful heuristic. Look for local extremes and compare it to alternative possible outcomes, ones that aren’t being discounted by the market. Then wait for a break in the technicals and you have yourself a trade.

Doing this, you’ll find that the market, especially when at pendular extremes, is more often than not suffering from acute myopia. It tends to overly discount what’s happening now while not accounting for a future that could look any different than today.

Stanley Druckenmiller (aka The GOAT) put it like this:

[My] job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.

Too many investors look at the present; the present is already in the price. You’ve got to think out of the box and visualize 18 to 24 months from now what the world is going to be and what (level) securities might trade at… what a company has been earning doesn’t mean anything, what you’ve got to look at is what people think a company’s going to earn and if you can see something in 2 years that’s going to be entirely different than the conventional wisdom, that’s how you make money.

Disney, Memetics, and Markets


Here’s a clip from a MO Collective trade alert I wrote back in May of last year on Disney (DIS).


Today we’re putting on a large position in Disney (DIS). This is a trade I’ve been thinking about for a while. The chart is what first caught my eye. Here it is on a monthly basis, below.

That’s a beautiful looking 3-year coiling wedge. Long technical setups like these are some of my favorites to play as they usually precede explosive trends. They also offer us great inflection points with clear go/no-go price points in which to enter and place stops.

In addition to the great looking tape, Disney also has a very attractive developing fundamental story. The stock is trading at just 13x next year’s earnings and the company has been aggressively buying back shares. And after 3-years of little to no revenue growth, top-line numbers have begun accelerating higher again.

Disney is a classic case of the market latching onto a stale narrative and failing to see the changing fundamentals. The stale narrative in this case is the focus on a declining subscriber base in Disney’s media business (think ABC/ESPN), which the market is now valuing at just 2x EBITDA — which is kinda crazy…

This stale narrative was pervasive and common accepted knowledge amongst the financial media and Wall St. analysts.

Despite a clear positive inflection in the fundamentals — both income and revenues pivoted higher in the middle of last year — along with extremely positive catalysts in the company’s DTC SVOD plans, this narrative persisted and Disney’s stock price continued to languish.

That is of course until last week when the stock finally gapped up and out of its 4-year trading range. This move has been accompanied by a complete and total shift in the popular narrative from “Disney as an out of touch legacy media business with a gangrenous ESPN division” to “Disney is a Netflix killer and the new hot growth stock”.

The only notable cause of this shift was Disney’s Investor’s Day the day prior to the breakout (here’s the link to the presentation and slidedeck). But hardly anything new was announced at the event other than frivolous details. Pretty much all of it was a rehash of what the company’s been communicating for the last 18-months and yet here we are, not only has the narrative changed but so has the trend in price.

What’s going on?!? Why do markets do this time and time again where they ignore the obvious shifting landscape and instead willingly latch onto bygone narratives that no longer reflect reality?

Let’s discuss…

In our December 2017 MIR I included the following section from Yuval Harari’s book, Sapiens (emphasis mine):

Sapiens rule the world, because we are the only animal that can cooperate flexibly in large numbers. We can create mass cooperation networks, in which thousands and millions of complete strangers work together towards common goals. One-on-one, even ten-on-ten, we humans are embarrassingly similar to chimpanzees. Any attempt to understand our unique role in the world by studying our brains, our bodies, or our family relations, is doomed to failure. The real difference between us and chimpanzees is the mysterious glue that enables millions of humans to cooperate effectively.

This mysterious glue is made of stories, not genes. We cooperate effectively with strangers because we believe in things like gods, nations, money and human rights. Yet none of these things exists outside the stories that people invent and tell one another. There are no gods in the universe, no nations, no money and no human rights—except in the common imagination of human beings. You can never convince a chimpanzee to give you a banana by promising him that after he dies, he will get limitless bananas in chimpanzee Heaven. Only Sapiens can believe such stories. This is why we rule the world, and chimpanzees are locked up in zoos and research laboratories.

We are genetically programmed to buy into the popular narratives that are shared by the crowd.

The German Physicist Max Planck quipped that “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it”. This is where the saying “science advances one funeral at a time” comes from.

I think a similar dynamic plays out in major trend changes and popular market narrative shifts. And no, I’m not implying that new trends are caused by investors dying off. Rather, it’s that narratives eventually exhaust themselves by driving every seller who is going to sell, to sell, or vice-versa for buyers in a bullish narrative.

Price and narratives work in a reflexive relationship where both drive each other in a continuous and cyclical boom/bust process throughout multi-fractal timescales. The diagram below shows what this process looks like.

Since the two are self-reinforcing and all market participants suffer from cognitive shortcomings such as anchoring and confirmation bias, the availability heuristic, and so forth. It’s only natural that narrative and price trends would continue on well in advance of their past-due date — Tesla being an obvious current example of this.

There’s a research paper titled “Memetics Does Provide a Useful Way of Understanding Cultural Evolution” (h/t Jim O’Shaughnessy) which dives deeper into how narratives (aka, memes) spread. It’s a super interesting paper and I suggest you read it in full (here’s the link).

The paper discusses the origins of the term ‘memetics’. A word coined by Dawkins in his landmark book The Selfish Gene. Dawkins argued that “Darwinism is too big a theory to be confined to the narrow context of the gene.” He believed in Universal Darwinism as a general principle where whenever information, in any form, is “copied with variation and selection, then you must get evolution.”

The paper goes on to posit that memes, a word that stems from the Greek root mimēma which means “that which is imitated”, and can be thought of as the cultural transmission of packets of information, are not only the evolutionary force behind human culture (i.e., language, art, music etc…) but might have been a fundamental driving force behind human physical evolution, as well.

Essentially, what this means, is that we humans physically evolved to be optimized for imitating one another and transmitting memes. The paper notes that in line with this “prediction is that the parts of the human brain that maximally increased in size should also be those involved in imitation, and this has been confirmed by brain scanning studies (Iacoboni et al 1999).

Here’s a section from the paper which lays out exactly what all this might signify (emphasis by me).

A common objection to memetics is that it undermines human autonomy and the creative power of consciousness, and treats the human self as a complex of memes without free will. These ideas follow naturally from the universal Darwinism on which memetics is based. That is, the idea that all design in the universe comes about through the evolutionary algorithm and is driven by replicator power. This means that human creativity emerges from the human capacity to store, vary and select memes, rather than from some special creative spark, or power of consciousness (Blackmore 2007). The human self may also be a construct of memetic competition, surviving because it protects and propagates memes, including the many memes that make up a person (Dennett 1995). In this view the self is not a continuously existing entity with consciousness and free will but is a persistent illusion. This memetic view of human beings as the evolved creation of two replicators may be unsettling but it has the advantage of uniting biological and human creativity into one, and providing new ways of understanding human nature, self and consciousness.

This is kind of heady stuff and I’m not sure I fully believe in it but the concept is an interesting one and certainly has descriptive power for how we act in the aggregate.

Moving back to how we can think about this on a more practical note. Jim O’Shaughnessy I thought did a good job of summing up the intersection of memetics and markets in a recent tweet. He said “In non-academic speak: Many times, markets move from heterogeneous to homogeneous caused by consistent information cascades that compel people to copy other’s behavior. For example, after writing a scathing paper on the prospect of internet stocks, I founded an internet Co.”

Essentially, few things are more compelling than a popular narrative. It’s tough, if not outright impossible to completely remove ourselves from the ‘Herd’. We’re all a part of this Grand Collective Intelligence and are literally wired at the genetic level to be so.

This is why popular market narratives can persist — and often do — well past the point of no longer describing reality. Memes have a momentum all their own. And it often takes repeated bludgeoning from reality for them to die off and be replaced with a new one.

As participants in this game who are all equally susceptible to the same pull and sway of memes, all we can do is remind ourselves of our cognitive foibles, try to stand back and observe the observer, and continuously stress-test our opinions against the data and the market.

Studying the trading greats, you find that nearly all of them had an uncanny ability to get outside themselves and more objectively view their thinking. George Soros put it like this.

I am outside. I am a thinking participant and thinking means putting yourself outside the subject you think about. Perhaps it comes easier to me than to many others because I have a very abstract mind and I actually enjoy looking at things, including myself, from the Outside.

And in order to help combat the pull of popular market memes, he would begin his research from the starting point that the market was wrong. Soros said:

The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong. Even if my assumption is occasionally wrong, I use it as a working hypothesis.

So that’s that.

For those of you wishing to dig more into memetics after reading the above paper, I’d recommend picking up The Diffusion of Innovation by Everett Rogers. It’s essentially a textbook on how ideas spread and there’s an extremely useful concept in it called The Adoption Curve (here’s a short Youtube video overview) with obvious applications to markets (I plan to write more on this soon).

Lastly, if you’d like to dig more into Disney and the new direction the company is headed in, then check out Ben Thompson’s latest Stratechery write-up (link here) and, of course, Matthew Ball’s recent work (link here).

Minsky and the Levy/Kalecki Profit Equation


I want to talk Minsky and the Levy/Kalecki Profit Equation

This may sound a bit heady, but don’t worry. We’re going to break it all down Barney style and then walk you through how you can use the frameworks for understanding the current environment in order to better assess the probabilities of potential outcomes (ie, gauge the general conditions).

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.  ~ Jesse Livermore

Let’s kick things off with the Levy/Kalecki Profit Equation.

The Profit Equation is just a macroeconomic accounting identity for how the global economy actually operates. Specifically, it answers the question as to where “Profits” come from and thus, growth.

If you’ve ever heard of The Jerome Levy Forecasting Center where a number of talented economists work. Well, that’s the same Levy. The center performs analysis using the Profits Equation framework developed by Jerome Levy in 1908 (side note: Kalecki was a renowned economist who developed the same framework as Levy years later and received credit initially for it because Levy was a relatively unknown name).

Now, you can read the full white paper on the equation here, which I highly suggest you do so. We’re just going to cover the gist of it today, because it’s relevant to potential macro risks and constraints we’ll be facing in the coming year(s).

The actual accounting identity looks like this:

Profits before tax = + Investment – Nonbusiness saving + Dividends + Corporate profits taxes

This accounting identity, which like any identity holds true under any circumstance, is just saying that corporate profits are the direct result of net investment minus nonbusiness (Households + Government + rest of world) saving before dividends and corporate taxes are paid out.

Confused? Don’t worry. I’ll break it down even more.

We all know where profits come from at the individual level, right? A company earns more in revenue than its costs and the excess is profit.

Well, if you pull back and look at the global economy as a whole, it’s a closed system. Its closed in the sense that profits aren’t magically appearing from anywhere outside of the global economy. But profits obviously aren’t a zero sum game. If one company earns profits it doesn’t necessarily mean that another company somewhere has to be operating at a loss. There wouldn’t be any growth if that was the case. So, where do profits come from then?

The answer is in net investment, which is a positive sum game. If we divide the economy into our four aggregate entities (1) US Corporations (2) Households (3) All levels of US Government and (4) the Rest of the World (RoW) and look at them as a whole, there needs to be net positive investment as a whole for their to be profits.

This means that an economy’s ability to produce profits comes down to the net expansion of the aggregate balance sheet in the macro accounting identity. For instance, if the US Government is running a budget surplus (shrinking its balance sheet), like it did in the late 90’s. Then either the Household, Corporate, or the RoW needs to take up the slack and expand their balance sheets to make up for the fall in demand. Or else demand will fall and profits will contract.

In the late 90’s, US Corporates made up for the government’s demand deficit by expanding their balance sheet. In the 2000s it was Households and the RoW (led by China) who borrowed money and invested — US Households in homes and China in building entire cities.

Understanding that profits are essentially the residual of the net balance sheet expansion/contraction of the entire global economy is helpful because (1) we can look at the trends in the balance sheets of our four macro aggregates to see if net demand (profit) is being created and (2) we know that their are natural limits to how much balance sheets can expand and therefore whether the global economy may be headed for a contraction in profits.

This is essentially a more nuanced framework for understanding how the debt cycle (as put forth by Bridgewater) works. Profits are essentially the result of expanding balance sheets (increases in debt). The more balance sheets expand the lower interest rates need to drop in order to decrease debt servicing costs and keep the cost of capital down for marginally profitable firms — essentially keep the economy from going into free fall.

Enough with the theory… How does this apply to the present day?

Well, think about what’s been the source of profits in the US economy the last couple of years.

The Household sector has been deleveraging since the Great Financial Crisis (GFC). They’ve been contracting their balance sheets and thus have been a negative source of profits/demand in the economy. The demand then has come from both the Federal Government and the Private Sector, both of which have been rapidly expanding their debt.

The RoW, primarily the Eurozone and China being the two economies large enough to matter, have been either a wash or net drag on global demand over the last few years.

China has pretty much maxed out its balance sheet limits where it now takes extraordinary injections of credit from the government to produce a relatively modest and short-lived economic impulse — the whole “pushing on a string” thing. And European consumers and corporates are fairly weighed down by debt and haven’t been helped much at all by their governments, who unlike the US decided to go with German imposed austerity following the GFC (though this may be starting to change, which we’ll discuss soon).

And this brings us to a growing concern of mine. Where is net demand going to come from in the future?

The fiscal impulse from the US tax cuts and increased budget deficit is starting to wear off. And on the corporate side, with corporate debt to GDP at all-time highs, how much more credit driven demand can we expect?

Things actually look worse when you disaggregate the corporate data. Taking a look under the hood we find that debt is actually much higher and there are a number of “zombie” firms that aren’t profitable even in such a low cost financing environment which means its going to take just a small tightening of financial conditions to cause these firms to go belly up, potentially kick starting a chain reaction of defaults.

Check out the following notes from Financial & Insurance Firm, Euler Hermes (emphasis by me):

  • Between 2009 and Q3 18 the US total debt has declined from a peak representing 350% of GDP in Q1 09 to 311.5% in Q3 18. While the US as a whole has been deleveraging, the business sector (corporate and non-corporate) has re-leveraged, standing at 72.6% of GDP or USD 15tn today. This represents a 2pp deviation to trend. Past recessions in the US have coincided with positive deviations ranging from 2-8pp of GDP.
  • According to our calculations, the true level of non financial corporate debt in the US may be 30% or USD 3.9tn higher than officially reported, primarily because of leveraged loans bought by non-banks. We estimate that the debt-to-EBITDA ratio would thus be close to 4.6 instead of 3.9. As a consequence, the BAA-Treasuries’ spread (to AAA) should be about 120bps higher than currently observed (~ 230bps today) if hidden debt were factored in.
  • The Trump Administration’s fiscal stimulus has boosted demand in the US over the past couple of years. According to our model, a correction of this excess demand, back to potential output growth, could trigger an increase of the corporate delinquency rate from 1% in Q3 18 to 2.32% (highest level since Q2 11). This adjustment could follow strong disagreement about fiscal policy as we enter 2019-20 budget discussions. Corporate spreads will thus continue to hover around 230-250bps as seen today, still underestimating hidden debt, but aware of looming risks in the corporate sector. In a stress scenario (likelihood to switch estimated at 35%), which could correspond to a series of defaults for instance, the delinquency rate would jump to 3% and credit spreads would very quickly increase by 70bps higher than today.
  • The bottom line is that be it from scoping (hidden debt) or for cyclical reasons, we believe that corporate spreads are underestimated today, and that unfortunate events (rapid downturn, market defaults) could end up pushing up spread by 70-190bps, by sheer realization by market actors of intrinsic risks in that segment.

The Bank for International Settlements (BIS) put out a research paper last Fall, titled “The rise of zombie firms: causes and consequences”, where they discuss the pervasive rot in the developed market corporate sector, especially here in the US.

Here’s a few of the notable highlights from the paper.

  • 12% of all companies globally are now “zombie firms,” meaning that they can barely pay the interest on their debts. The number is 16% in the US, which is an eight-fold increase since the 90s.
  • These zombie firms have been kept alive by low interest rates along with investor demand for “leveraged loans”.
  • The leveraged loan market is now in the trillions (the exact number is unknown) and consists of low-quality corporate debt that’s at risk of being downgraded — which would cause forced liquidation — should interest rates rise too much.

It seems we’re on a clear course of transition from what Minsky would call the “speculative financing” stage to the “Ponzi Financing” stage of the financial cycle.

For those of you not familiar with Hyman Minsky, here’s a brief summary of one of his more popular theories, which applies to our discussion today.

Minsky came up with the “financial-instability hypothesis” which stated that long stretches of prosperity sow the seeds for an eventual crisis. Economic stability breeds instability.

Minsky understood that recency bias drives myopia in the human decision making process. Economic actors end up extrapolating low volatility into the future which leads to more risk taking in the present through the use of leverage (credit).

The theory was established by defining what investment is, and its role in an economy. Which, put simply, investment is the exchange of money today for money in the future. That money (investment) can come from one of two sources: the economic actors’ (consumer, company, government) own cash flows, or from the cash flows of others (lenders). And it’s the balance between these two sources of investment that comprises the stability of the financial system.

According to Minsky, the financial cycle typically follows three stages of financing; these are:

  1. Hedge financing
  2. Speculative financing
  3. Ponzi financing

Hedge financing is the most stable of the three. It’s when the economic actor relies on its own stable cash flows to repay any borrowings. It’s when the actor’s earnings far outweigh its limited borrowings.

Speculative financing is when the actor uses its own cash flow to pay the interest on its debt, but must assume more debt to repay the principal; thus rolling its debt over. This stage of financing is less stable than hedge financing.

And lastly, there’s Ponzi financing, which is the most unstable of the three stages of financing. Ponzi financing is where the actor’s cash flows do not cover either the principal or interest payments on its debts. The actor is completely reliant on the appreciation of the underlying asset in the hopes that it’ll be enough to cover its liabilities.

Minsky argued that financial cycles naturally progress from each stage of financing to the latter; driven by human greed and carelessness. When economies enter the Ponzi stage, they become increasingly unstable and eventually experience a “Minsky Moment” which is a sudden collapse in asset values, leaving both lenders and borrowers exposed. This is the deleveraging phase of the debt cycle as put forth by Bridgewater.

So we have a diminishing US fiscal impulse, a nearly tapped out corporate sector riddled with zombie firms in an economy transitioning from speculative to ponzi finance, all which sits atop a leveraged loan market that measures in the trillions. Great…

The Game Masters (Policy Makers) are well aware of this threat. Former Fed chair Janet Yellen remarked in an interview with the FT last Fall that “I am worried about the systemic risks associated with these loans. There has been a huge deterioration in standards; covenants have been loosened in leveraged lending… There are a lot of holds. We should not feel the financial stability glass is full.”

I believe it was the market’s concern (rightfully so) that drove the large selloff at the end of last year. With the Fed acting as if they were on rate hiking autopilot, a painful recession and zombie killing field was all but assured if they had not changed course. But, they did, and here we are. The game is still going and may very likely go on for a while longer.

This is all rather big picture stuff. It may or may not be actionable in the near future. But it’s certainly something we need to be aware of because it will eventually matter and be actionable.

I’m still bullish the market but I do think the longer-term risk/reward is less positively skewed than it was just a few months ago.

There’s some deteriorating data that’s linked to the leveraged loan market as well as our zombie firms that will eventually cause a domino effect of economic pain should the data not reverse following the Fed’s easier stance. The two charts below are evidence front and center for this. We have the Fed Senior Lending Officer (SLO) survey showing banks are increasing the spreads on loan rates to large and medium firms (a reading above zero means lending conditions are tightening).

And the BAA/AA corporate bond spread has failed to reverse with our other indicators of financial/liquidity conditions. This tells me the market is finally starting to sniff out the brewing trouble we just discussed.

Thanks for reading! I’ll have additional updates as the data unfolds.