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How To Profit From The Asian Middle Class Explosion

How To Profit From The Asian Middle Class Explosion

Today I want to talk about one of the most important macro themes we’re currently tracking. And then discuss some of the amazing asymmetric trade opportunities which dovetail off this secular story. But, first, this.

Mauboussin wrote the following about S-curves in his book More Than You Know (emphasis mine).

There is substantial evidence that industry sales and earnings trace an S-curve after a discontinuity or technological change. Growth starts slowly, then increases at an increasing pace, and finally flattens out. This diagram is useful for thinking about shifting expectations. Investors (indeed humans in general) often think linearly. So at point A, investors do not fully anticipate the growth and economic returns from an industry, and they extrapolate the growth and economic returns from an industry, and they extrapolate relatively low growth. Expectations for future financial performance are too low. Following a period of sustained growth (point B), investors naively extrapolate the recent growth into the indefinite future.  Expectations are too high. Finally, at point C, investors reign in expectations and adjust stock prices to reflect a more realistic outlook.

Humans are bad at many things. Thinking in non-linear terms is one of them.

Things like exponential growth and the incredible power of long-term compounding are tough for us to wrap our little monkey brains around.

This is one of the many reasons why we’re naturally bad investors.

The ability to think in exponential terms and understand how to harness the power of compounding are a few of the traits that make the greats, well… great.

Lucky for us, we can all learn to think in these terms and utilize these frameworks with enough practice.

Adding the S-curve model to one’s tool-kit, certainly helps.

The power of the S-curve isn’t limited to only industries and products. It’s also relevant to countries and whole economies, as well.

If you study the history of how economies grow along their maturation cycle. How they move from frontier to emerging, and finally to developed economy status. You find that the growth is not linear but follows an S-curve pattern similar to the chart above.

This is something we wrote about in our October Market Intelligence Report (MIR) which we titled The Curve of Destiny (cheesy, I know). Here’s a section from that report.

Tracking the progression of what we call the “wealth S-curve” is an important part of the current framework we’re using to gauge and assess the developing state of global macro affairs.

We think its impact over the next two decades is going to be, well, exponential. So, a lot larger than what anybody is figuring right now.

Here’s a brief summary of what we see coming:

  • When a country’s gdp-per-capita crosses the “tipping point” on the wealth S-curve (this is in the range of $2,300-3,300 USD). Not only do the consumption habits of its citizens drastically change. Transitioning from simple low input goods to higher value/input goods. But the aggregate amount of what they consume begins to increase exponentially.
  • Between 1970 to 2000, the average number of people in the world hitting th S-curve simultaneously was fairly stable at around 700M.
  • In the early 2000s this began to change. More people around the world began passing the S-curve tipping point. This was initially led by China, but is now also being driven by India and other Asian countries. According to current calculations, we’re about to see approximately 4 billion people around the world go through the knee of the curve at the same time.

This is going to be one of the largest driving forces of markets throughout the globe over the coming decade(s). And its impact is starting now…

Just read a few of the following excerpts from a recent paper put out by the Brookings Institute titled The Unprecedented Expansion of the Global Middle Class (emphasis mine):

…in two to three years there might be a tipping point where the majority of the world’s population, for the first time ever, will live in middle-class or rich households.

The rate of increase of the middle class, in absolute numbers, is approaching its all-time peak.

An overwhelming majority of new entrants into the middle class—by my calculations 88 percent of the next billion—will live in Asia.

The implications are stark. By 2022, the middle class could be consuming about $10 trillion more than in 2016; $8 trillion of this incremental spending will be in Asia.

By 2030, global middle-class consumption could be $29 trillion more than in 2015. Only $1 trillion of that will come from more spending in advanced economies. Today’s lower middle-income countries, including India, Indonesia, and Vietnam, will have middle-class markets that are $15 trillion bigger than today.

We are witnessing the most rapid expansion of the middle class, at a global level, that the world has ever seen. The vast majority— almost 90 percent—of the next billion entrants into the global middle class will be in Asia: 380 million Indians, 350 million Chinese, and 210 million other Asians.

Over the coming decade, the middle class in Asia is going to grow by 153%.

While the developed world continues to experience subdued growth amongst a secular malaise marked by low productivity. In Asia, productivity growth is booming…

In 12-years time, four of the world’s top 10 economies will be in Asia.

The majority of this growth is going to come from the two behemoths of Asia, China and India.

China crossed the wealth S-curve tipping point back in the early 2000s and is about half-way through the ‘knee of the curve’. This is what drove much of the early 2000’s commodity and emerging market boom.

And now, India on a gdp-per-capita basis, is right where China was in the early 2000s. It’s crossing the tipping point…

Knowing this, we have to ask ourselves: “if we could travel back in time, to the early 2000s, and buy some Tencent, a little CTrip, maybe some Baidu, wouldn’t we?”

I know, stupid question, of course we would.

And no we haven’t invented a time machine. But… lucky for us we don’t need one.

Because, India is giving us nearly the exact same opportunity. We know that exponential growth is coming to one of the largest countries by population in the world. This country is surrounded by other countries whom also have either crossed the tipping point, or are about to. And these countries trade and do business with one another. Do you see the potential for a massive flywheel of economic growth here?!

Take a look at the following charts via commodity fund, Goehring & Rozencwajg.

In the 1960s, South Korea was one of the poorest countries in the world. Now it’s the 12th largest, on a GDP basis.

South Korea crossed its tipping point in the early 1980s. It then experienced rapid growth over the following two decades. China is where South Korea was along the wealth S-curve in the very early 90s. India matches South Korea at the start of the 80s. Both are following a similar pattern. And both have populations that are many multiples the size of Korea’s.

Are you starting to get a sense for how big this opportunity is?

Now, is the market pricing any of this in?

Of course it isn’t.

The market thinks in linear terms, remember… it extrapolates the recent past and projects it far into the future. The kind of exponential growth we’re talking about is nearly impossible for the average market participant to imagine.

The market’s limitations though, is our advantage. Because we’re aware of this powerful developing macro trend, we get the ability to essentially travel back in time and pick the Indian equivalents of the Tencents, the Baidus, and Ctrips.

I’ve been digging into this market and have found a handful of “coffee can” stocks.

These are the kinds of companies that have a trifecta of secular growth winds at their backs. They’re in fast growing industries, in expanding markets, and in secular high growth countries. The runway for these companies is so long that you just want to buy the stock and stuff it away into a coffee can and forget about it for next 10-years.

We’re going to be covering these stocks and the secular rise of Asia in February’s Macro Intelligence Report (MIR). I’m excited to share what I’ve found with you. I think some of these names have 10x+ potential over the next five years. And that’s not an exaggeration.

If you’re interested in riding the Asian S-Curve with us, subscribe to the MIR by clicking the link below and scrolling to the bottom of the page:

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

Like I said, the Asian S-Curve could be the defining investment theme of our careers. Don’t miss your chance to take advantage.

Click Here To Learn More About The MIR!

 

 

The Confounding US Dollar

The Confounding US Dollar

Markets work to surprise the majority of people, the majority of the time. This is because the average of everybody’s expectations is already embedded in price.

Nowhere is this more true, than in the currency markets. Consensus is the ultimate killer of currency trends. The chart above is a perfect example of this, where The Economist magazine cover marked the top of the US dollar bull market at the end of 2016.

The dollar has since fallen 15%. A move that hardly anybody was expecting.

This is why, when analyzing currencies, we need to adopt Percival’s rule of thumb and know “that expectations will be confounded.”

We often refer to the US dollar as the lynchpin of global markets. This is because global trade is done in dollars, commodities are priced in dollars, and the greenback is the world’s reserve currency and largest source of global funding… The path of the dollar affects nearly every other asset in some way, shape, or form. And if you can get a good handle on the dollar then you’ll have a good grasp on where commodities, emerging markets, and global liquidity are headed.

To start, here are the primary models I use to think about currencies in order to understand the driving narrative (currency markets are narrative driven) and supporting fundamentals.

  • The Core-Periphery model: This model was used extensively by George Soros in his currency operations back in the day and discussed at length by economist Javier Gonzalez in his book How To Make Money With Global Macro. In this model, the US is the core and emerging economies are the periphery with other developed markets sitting in the middle. Long-term capital flows tend to cycle back and forth between concentration in the core, to strong flows to the periphery. The primary fundamentals of this model are relative growth numbers between the regions (ie, relative GDP growth and relative equity and bond market returns). When global growth is strong and broad based, risk is perceived as low, so capital flows out from the core to the periphery. The opposite holds true for when risks are perceived as being high. Put simply, capital flows to where it’s believed it’ll be treated best (ie, earn the highest stable total return relative to perceived risk). The US, along with other DMs, receives a premium over the periphery.
  • Sentiment/Positioning: Like we discussed above, we want to operate off the rule of thumb that “expectations will be confounded”. So we always want to know what the popular sentiment is and how the market is positioned. To do this, we can look at anecdotal evidence such as magazine covers, news articles, and fintwit talk to get a feel for what narratives/belief are popular. And for positioning, we can look at the COT data and sentiment/positioning surveys like the BofA Fund Manager survey to see how investors are positioned.
  • Trend and Total Return: Once a currency gets going it has a tendency to persist for long periods of time. This is because currency flows are largely speculative, meaning they chase market returns around the world. And when capital flows into a country where the equity/bond market is outperforming on a relative basis, these flows then strengthen the underlying currency. Now you have an outperforming equity/bond market + a strengthening local currency (lowering local inflation and boosting real returns). This ups the total return for foreign investors, thus attracting more flows and creating a positive feedback loop. So when analyzing currencies we always need to look at relative market performance, because currency pairs tend to track relative stock/bond market performance over time.

To begin our analysis of the dollar, let’s take a look at relative GDP growth between the US (the core) and the rest of the world (periphery). Relative gdp growth is important because growth affects everything from investor behavior, inflation and interest rate expectations, and perceptions of risk.

The chart below clearly shows the relationship between US GDP growth relative to the rest-of-the-world (ROW) and the subsequent trend direction in the dollar.

When growth in the core outpaces growth in the periphery (as it did from 09’-16’), capital concentrates in the core and drives the US dollar higher. When growth in the periphery outpaces the core, capital flows outwards leading to a lower dollar.

It’s important to note that it’s the trend in this relative growth that matters. Growth in the core (US) is almost always lower than that of high growth emerging markets. But US growth gets a premium over EMs. Which is why it’s the trend in relative growth and not the absolute levels that are important.

In mid 2016, beaten down equities in the ROW began outperforming the US. While at the same time, US relative GDP growth turned lower, and both sentiment and positioning reached extreme long consensus in the dollar. This led to the top in the dollar bull market.

Currently, we find ourselves with conditions that are the opposite of those that created the dollar bull market.

Instead of narrow and tepid growth, we have a global economy that’s firing on all cylinders and seeing complete synchronized growth across the board (chart via DoubleLine).

To adhere to Occam’s razor then, it’s fair to assume that the dollar is falling because we’re in the goldilocks period of the market cycle where growth is strong and risk is perceived to be low. This is leading to capital flowing out from the core and to the periphery.

The budding narrative is as follows: The horizon looks clear and foreign markets offer better relative value to expensive US stocks and bonds.

In addition, there’s a lot of capital concentration which accumulated in the core over the last 7-years. This capital is likely to be converted out of dollars and into other currencies over the coming year(s). This will put further downward pressure on the dollar and risk creating a bearish feedback loop.

For example, the dollar currently makes up an unnecessarily large percentage (64%) of global foreign reserves, as shown on the chart below via Morgan Stanley.

Hedge fund manager, Ray Dalio, recently noted (emphasis mine):

The dollar’s role as the dominant world currency are anachronisms and large relative to what one would want to hold to be balanced, so rebalancings should be expected over time, especially when U.S. dollar bonds look unattractive and trade tensions with dollar creditors intensify.

Morgan Stanley commented on the vulnerability of the dollar in a note, saying (emphasis mine):

Our key point here is that foreign holdings of USD-denominated debt have increased, while foreign holdings of European debt instruments have declined. A similar dynamic has taken place for equities, where foreign ownership of US equities has more than doubled, which contrasts with trends in the foreign ownership of European equities. An important implication is that, should US assets lose their relative attractiveness (e.g., widening credit spreads, declining equities), then there could be a substantial amount of foreign-held USD-denominated assets for sale.

With the US deficit set to widen because of the recent tax cuts and expected increases in fiscal spending (coming infrastructure plan), we’re set to see a rise in the supply of USD assets at a time when investors are moving their capital out of dollars and into other markets.

That’s not the kind of backdrop that’s supportive of a stronger dollar.

On top of this, no matter which means of valuation you use, the dollar is overvalued, especially against emerging market currencies.

When looking at the dollar, we have to include the euro. The EURUSD pair makes up well over half of the trade-weighted dollar basket, so it has a large influence on where DXY goes.

You can see on the chart below that the euro has completely retraced the breakdown from its previous multi-year trading range. If price holds this month, it would mean that this was a major multi-year bear trap.

Sentiment and positioning in the euro and European assets have ticked up, as shown in the chart below via the BofA FMS.

Spec COT positioning is stretched and is now a headwind over the near-term.

The real yield differential between the US and Europe hasn’t supported the move up in the euro. But the market is driving the EURUSD pair higher on the expectations that European rates have more room to move up from current levels, than US rates do.  

In fact, the dollar is currently a top-4 yielder out of the G10 (chart below via DB).

While yield differentials are important, currencies can move against logical yield relationships for long periods of time. And it’s the expectations over future yield differentials that tend to matter more than the current spreads.

The most important chart for the dollar in my opinion is this one. The S&P versus emerging markets. Even with US stocks going on an endless tear, EMs are performing even better.

If EM outperformance continues, it’s going to attract more capital flows which will help to drive the dollar lower.

A falling dollar creates a number of positive tailwinds for EMs besides raising foreign investor’s total returns.

It leads to higher commodity prices, which benefits commodity producing countries. And it leads to lower funding costs (many EM corporates and countries borrow in USD, so a lower dollar equates to lower debt costs).

With liquidity as loose as it is today, there’s little on the near-term horizon that could significantly reverse these dollar bearish flows outside of a major shock that raises investor’s perceptions of risk. Sentiment and positioning is now bearish the dollar but far from extreme levels that tend to mark significant reversal points.

I don’t expect the dollar to continue falling straight down. Many DM-USD pairs appear to be stretched over the short term and are nearing significant resistance levels. So we’re likely to see a pullback soon. But as traders we have to respect the tape and acknowledge the possibility that the dollar bull market which started in 11’ is now over.

If this is the case, it will have big implications for markets moving forward.

If you want to stay up to date with our latest US dollar coverage then check out our Macro Intelligence Report (MIR) here.

 

 

Barclays

Hated Euro Banks Are The New Turnaround Story

European financials have been one of the most hated areas of the market for years. Investors have been jumping ship and moving capital to a more productive place. It’s just too hard for these banks to make money with interest rates so low.

But the bear thesis dies once interest rates reverse trend. With higher interest rates, banks can lend again for a fat profit. If interest rates in the Eurozone reverse course, we could see a major rally in these beaten down banks.

Right now, there’s a huge disparity between where European interest rates are trading and the improving economic backdrop in the Eurozone.

The German 10yr is currently trading for a measly 50bps. This is over 200bps lower than comparable US rates. While at the sametime, it can be argued that the economy in Europe is just as good, if not better than the US.

The eurozone PMI recently came in at 60.6. This marks the strongest pace of economic expansion since the series began in 1997. And country specific PMI’s printed at all-time highs for Austria, Germany, Ireland, and the Netherlands.

The charts for Barclays (BCS), Credit Suisse (CS), Banco Santander (SAN), and Deutsche (BCS shown on the chart below) all look very constructive.

Barclays reminds me of where Deutsche was in 2016. It was the most hated of the big banks. It was being investigated for a number of misdealings, it’s capital cushion was low, and it had a bunch of bad loans on its book. Everybody was predicting its collapse…

I remember tweeting in September of 16’ that I thought all the bad stuff was already priced into DB and the stock was now a great contrarian long. A number of people replied to let me know how ignorant and wrong I was… The stock put in its bottom that week and is now up 60%.

That’s where Barclays is now. It’s got a whole range of issues. It’s CEO, Jes Staley, is under investigation by UK and US regulators for attempting to unmask a whistleblower. And the bank faces potential heavy fines for possibly illegal fundraising for Qatar and mis-selling mortgage securities in the lead up to the GFC.

It recently completed a costly multi-year restructuring where it’s sold off a number of its operations, including its business in Africa, in order to refocus on its two core markets in the US and UK.

Because of all this, the bank has been one of the worst performers amongst its peers over the last few years. And in addition, it hasn’t helped that Barclays is a UK based bank and UK stocks are, and have been for a while, the most hated assets on the street. Just look at these two charts below from the BofA’s latest Fund Manager Survey.

“The UK remains the consensus short amongst fund managers.”

So we have one of the most hated banks in one of the most hated markets (the UK). Is perhaps all the negative sentiment priced in already?

I think so.

Here’s the deal, BCS is trading well below its peers on valuation metrics. Selling for just over half of tangible book, it’s cheap.

And what’s great is that there are a number of positive catalysts on the horizon that can flip this negative narrative around and send the stock soaring.

  1. The company is finally done with its costly restructuring. And next quarter will be the first quarter in years that the company’s numbers haven’t been weighed down by these costs.
  2. Management hinted last quarter that they may raise the dividend next quarter after cutting it more than two years ago.
  3. Even though the bank is headquartered in the UK, a large portion of its operations are in the US. Barclays bought Lehman following the GFC and now runs its investment banking operations. This sets up the bank to be one of the main beneficiaries of the recent tax cuts. It also means the bank will benefit from rising interest rates in the US as well as the UK.

Apparently, Tiger Global, the successful macro hedge fund run by Chase Coleman, also agrees with this thesis. The fund recently made BCS one of its largest positions and now owns roughly 2.5% of the stocks float.

Purchasing some BCS here seems like an incredibly attractive way to play the European recovery narrative.

If you want to stay up to date with our latest European financial research and the specific stocks we’re looking at, then check out our Macro Intelligence Report (MIR) here.

 

 

Japanese Equities Awaken

At Macro Ops we like trades where a confluence of positive tailwinds intersect with a thematic that has a long runway. Opportunities where attractive valuations spawned by negative to neutral sentiment combined with improving fundamentals and accelerating momentum are what we look for.

One of our current holdings checks all these boxes. I’m talking about Japanese equities. A theme we’re playing using futures on the Nikkei (DXJ is the ETF alternative).

The Nikkei has had a good run since it first popped up on our radar back in September.

But this move is only getting started. Here’s why it’s time to be long Japan.

On a valuation basis, Japan is one of the cheapest developed markets. Trading at a forward PE of 15x it’s well below the global PE average of 17X and the US’s lofty forward PE ratio of 18.6X,

While the US and European markets have been getting all of the attention. The Nikkei has quietly made new multi-decade highs.

And after underperforming relative to the rest of the world (ROW) for decades, the Japanese market has been rising faster than global stocks as a whole since 2013.

Relative momentum is an important factor. It makes plainly visible the large trends created from global capital flows. These trends, once started, have a tendency to persist for years.

Behind this improving tape is one of the best looking fundamental backdrops of any advanced economy.

Japan had the fastest increase in earnings growth of all the major stock markets in 17’. Net profits for Topix companies increased 35% Y/Y in the first half of fiscal year 18’.

And the market continues to be overly pessimistic on earnings estimates. This is resulting in forecasts having to be continuously revised higher.

It’s steady positive surprises like these that drive bull markets (the market climbing the proverbial wall of worry). Here’s the same chart along with FTSE Japan on a Y/Y basis, showing earnings surprises (both positive and negative) leading stock returns.

We expect this positive fundamental momentum to accelerate in the year ahead.

After years of stagnation, Japan is finally seeing its nominal GDP make new highs (chart via Morgan Stanley).

Its Leading Composite index (LCI), a composite of 12 indices measuring the country’s economic and financial health, has been strongly trending higher since 2015. This signals robust economic momentum that should continue into the foreseeable future.

We can see this improving economic momentum across the board. The Tankan business conditions survey recently saw its most positive results in over 20+ years.

Employers are on a hiring binge.

The labor market is the strongest it has been in 23 years.

In addition to this great trifecta of low valuations, negative to neutral sentiment, and improving fundamental backdrop, there are a number of catalysts that are set to drive this trend onwards and upwards.

In December, the Japanese ruling coalition approved a draft for a significant tax package (surprisingly, it’s received little attention in the press).

The aim of this tax proposal is to incentivize corporates to raise wages and increase capex spending.

If passed, it would lower the effective corporate tax rate to as low as 20%, down from 30% where it currently sits. The law would allow large corporates to reduce their effective corporate tax rates to 25% if they raise wages by more than 3% as well as expand investment.

The 25% rate could be reduced further, to the minimum 20%, if companies invest into new technologies that are related to the Internet of Things (IoT).

If this proposal gets passed into law (we think it will be, albeit with some minor changes), it will take effect this fiscal year and run for three years.

This would be huge… Japanese public companies have a lot of cash (estimates put it at close to 120tn yen) sitting on their balance sheets. That’s a lot of cash that could potentially be put to work in the real economy.

There’s also a number of positive macro tailwinds, such as a likely fiscal/infrastructure boost in spending as Japan prepares for the coming 2020 Tokyo Summer Olympics. Not to mention, accelerating economic/business ties between Japan and mainland China. China is seeing rising labor costs and so is turning to Japan for robots, amongst many other high-value items.

If you don’t own any Japanese stocks, you might want to rethink that.

In a follow on piece, I’ll talk about a few Japanese stocks we’re tracking which have large upside potential.

PS — If you’d like more of this type of research, then check out the Macro Intelligence Report (MIR) here.

The Commodity Boom of 2018

The Commodity Boom of 2018

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

2018 will be the year the commodity bull gets running…

When a man makes his play in a commodity market he must not permit himself set opinions. He must have an open mind and flexibility. It is not wise to disregard the message of the tape, no matter what your opinion of crop conditions or of the probable demand may be. ~ Jesse Livermore

The stock market has far more short-term countertrends. After the market has gone up, it always wants to come down. The commodity markets are driven by supply and demand for physical goods; if there is a true shortage, prices will tend to keep trending higher. ~ Bruce Kovner

In late August we turned outright bullish on crude oil and energy related stocks. At the time this was a deeply unpopular opinion. No sooner than when we published did we start receiving emails giving us a list of reasons why we were wrong. I love this type of response when I take a real contrarian viewpoint. The more derided and unpopular our market stance, the more profitable the trade usually ends up being.

At the time, WTI crude was trading around $46bbl. And most market players were calling for a return to the $30s. Instead, crude went on a run rising over 30% to +$60bbl where it is today.

The energy stocks we’ve recommended over the last four months have done well.

  • WTI is up over 100%
  • RIG is up 36%
  • CRR is up 70%
  • ESV is up near 50%
  • COG is up 14%

Despite this run up in oil and energy stocks, we’re still hearing primarily bearish takes on the sector with traders looking to call a top after every rise.

Typically after a 30% rise over a short few months, a bullish narrative becomes popularized and widely adopted. But we have yet to see that. This is all the better because the greatest bull runs climb a mountain of disbelief. And that is what we’re seeing here.

This negative sentiment just bolsters the bull case. We think 2018 will be the year of the commodity bull. We expect WTI crude oil to climb over 20% higher and finish the year above $75bbl. This will drive energy stocks (our basket included) up by multiples, and the energy sector will finish the year as one of the best performing sectors.

The evidence is increasingly pointing to this potentially being a secular bottom in commodities and energy stocks in particular.

We have commodity valuations relative to stocks at 100 year lows.

Commodity pricing relative to stocks tends to follow a full 15.5 year cycle. We’re at the trough of the current cycle — a point that has marked the start of the last three commodity bull markets.

And energy’s relative total returns to stocks is classically a late cycle performer, as we’ve noted at length in our September report on where we are in the Investment Clock cycle.

We are at a long-term inflection point for commodities.

Global growth continues to surprise to the upside, which we expect to continue in 2018. And inflationary pressures are starting to build which will become apparent next year (note: we don’t expect “bad” as in high rampant inflation, but we expect stronger, around 2% inflation to persist towards the second half of the year). And beaten down commodity/value stocks do well in this environment.

Throw in the potential for a new infrastructure spending bill here in the US, as well as increasing expansionary policies in other parts of the world (ie, India), along with the wealth S-curve, and we have the makings for a large secular bull market in commodities that’s ready to get started.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Macro Ops 2017 Portfolio Review: Pain + Reflection = Progress

Macro Ops Portfolio

Return Metrics *Through December 8th 2017
YTD: 22.19%
12-Month Return: 20.57%
Inception (Jan 1st, 2016): 40.88%
Annual Vol: 7.85%
Sharpe Ratio: 2.29
Max DD: 3.97%

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.

It’s 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 transparent… to bare our warts and all (this year I feel like a leper). At the end of the day, like you, we just want to become better traders. Being fully transparent helps us do that.

For those of you who aren’t familiar with our approach to markets, let me give you a quick rundown of how we do things.

The Macro Ops Portfolio consists of two broad strategies — big bet macro and volatility carry. The goal is for these two strategies to balance each other’s return streams like a barbell.

This is important because all strategies perform well or poorly in different market regimes. And since distinct market regimes can last years, it helps to utilize multiple strategies that perform well in opposing environments. This smooths your equity curve, making your returns more stable. And there’s a psychological benefit as well, in that it keeps you from pressing a strategy ill-fit for the environment because you’re hungry for returns.

Big bet macro trading focuses on placing asymmetric bets on large market mispricings caused by a misinterpretation of the fundamentals, technicals, and/or sentiment.

This strategy is structured to have a low win rate with high return potential. The aim is to capitalize on the inherent 90/10 return distribution of markets by maximizing Pareto’s Law and letting positive compounding do its work.

The returns on this trading strategy are naturally bunchy; meaning they tend to experience long periods of flat returns followed by a large jump in NAV over a short period of time.

Volatility carry thrives in the opposing regime, one of low volatility and smooth price movements. Its primary aim is to generate positive carry by harvesting the volatility premium. We increase and reduce its leverage in accordance with our macro framework.

It’s a more efficient and lucrative means of collecting risk premium from the market versus sitting in a passive diversified portfolio.

This philosophy of opposing strategies has served us well as proven by our investment results since we started Macro Ops two years ago. We’ve managed to produce slightly over 40% in gains while only taking a max drawdown of 4%.

Now onto a critical assessment of our 2017 performance…

Our Biggest F*ck Up

Our biggest f*ck up this year was not immediately cashing out of our business, liquidating all our boring equity, commodity, and FX trades and then using that cash to buy as much crypto coins we could safely leverage up to our eyeballs for purchase.

This would have been the smart and responsible thing to do. Had we done it we’d have similar returns to all the visionary crypto twitter bros… the Buffetts of the digital age… who had the insight early on to see that bitcoin is worth at least the total market cap of the world or more or whatever… because the amazing thing that these investors discovered is that assets with no intrinsic value (ie, no cash flows or real utility) are the most valuable things of all. Because everybody says so and so it is…

The big takeaway from this experience is to always buy and HODL… always.

To be honest, we’re still peeling back this gem of investing wisdom, trying to unlock its eternal truth. What does it mean and where did it come from? We don’t know but we’ll continue to study it diligently in the hopes that we too can someday properly HODL in markets.

Moving on, this was a shit year for me personally. Relative to the opportunity set, it’s been one of the toughest years for me in some time. The following are the complete stats for the macro trades:

Macro Trades

Return Metrics *Through December 8th 2017
YTD: 6.80%
12-Month Return: 4.01%
Inception (Jan. 2016): 23.52%
Annual Vol: 11.26%
Sharpe Ratio: 1.02
Max DD: -9.50%

The mediocre 2017 performance is largely due to the fact that we’ve been in a market regime that doesn’t lend itself to macro trading.

The market had a sharpe ratio of over 5 this year. That’s insane…. The strategy for Hindsight Capital this year would have been to buy everything on January 1st, leverage up, and then go on vacation.

This type of macro environment is a killer for active managers and it’s why big name macro funds have been dropping like flies.

(Image via @sentimenttrader)

Paul Tudor Jones shuttered his flagship macro fund this year, as did Hugh Hendry. Brevan Howard’s AUM shrunk to a fraction of what it once was. John Burbank surrendered and killed off his macro fund only to start another fund trading crypto and digital kittens (I assume). Tiger cubs have been getting gored left and right with the latest being John Griffing announcing that he’s quitting the game.

Even the GOAT, Stanley Druckenmiller, recently said on CNBC that he’s had the worst year of his career and has come close to having his first down year in over 30+ years of trading.

This again, is why we diversify strategies. Over the last two years the market has awarded passive holders of risk. Stock pickers and traders have had a rough go.

But to be honest, this is an excuse and excuses don’t pay the bills nor allow for valuable lessons learned.

Despite it having been a tough environment for macro trading I’m more disappointed in my execution and I could have and should have done much better this year.

What’s tough to stomach is is that we nailed most of the major themes throughout the year. Here’s a breakdown of the calls we put out in our monthly reports (MIR).

  • January: We wrote, “the US market will likely go on a tear higher from here… European and Japanese stocks should also perform well.” We were leaning bullish the dollar but remained open to its direction and noted that should the “dollar turn, we’ll buy up emerging markets and commodities, hand over fist.”
  • February: We noted that we hadn’t yet “seen the level of frothiness or excitement that’s indicative of a market top” and that at “Macro Ops we’ll continue to play the US market to the long side until we see the bond/stock spread go over 1.
  • April: We talked about how we thought pessimism was overblown in Europe and the markets should rebound. We predicted a Macron win and believed that the European stock market would embark on a Soros style false trend and outperform.
  • May: Our MIR titled “A Three Legged Bull” we wrote “During the last few years of the 90’s tech boom, sentiment clearly reached euphoric levels. This market is missing that component… This is why we refer to this market as a three-legged bull. It has until very recently, lacked the fourth leg of the bull which is extreme optimism. While we’re seeing small pockets of excessiveness in some parts of the market, it’s still a ways from the heady euphoria that typically marks the end of the 5th stage. This is one of many reasons we believe there’s still plenty of room for stocks to run. With only three legs this bull has walked more slowly than past cycles, and because of its missing leg, it’s also likely to endure longer.”
  • July: We pitched Chinese equities noting that “(a.) China is starting to benefit from a weaker yuan which can been seen through a rise in exports. (b.) A strengthening global economy is leading to increasing demand for Chinese goods. (c.) China’s all-important Congress is coming up in November. This makes it likely they’ll ease off this recent period of tightening to juice the economy.”
  • August: We criticized market perma bears who had for years been citing the high valuation multiples without understanding the context behind them. Writing:

 

  • September: We wrote about the turning of the ‘Investment Clock’. And how we should begin to see growth and inflation pick up over the coming quarters. And how this should drive the outperformance of energy and value stocks in the months ahead.
  • November: We talked bitcoin and discussed about how it’s purely a speculative vehicle at this point. But we noted that it was likely to head much higher because global liquidity is flush, it’s an illiquid asset and there’s still probably lots of untapped global demand for it (ie, Greater Fools).

We were right on most of the big trends throughout the year.

We started the year bullish and remained bullish throughout (though I’ll admit, at times, I became too cautious and held more cash when I should have pushed harder. I should have just focused on my liquidity indicators which were saying BUY and not on the vertical persistence (overbought) nature of the trend).

We called the rebound in Europe and China while also hitting the bottom in the energy sector.

And in addition to the macro, we researched and pitched a number of stocks that went on to kill it, but we either never got a position on or were sized too small relative to the opportunity.

Here’s some of the names we covered but didn’t fully exploit.

AAAP we covered in our April MIR when it was trading for $38. It went on to rise over 110% and now trades for $82 — we never got a position on.

In that same report we pitched FCAU when it was trading at just over $10. It’s now up over 80% at $18+. There was GAIA in March, now up 60% —  sized too small. In August we pitched IBKR which went on a tear of 65% — sized too small and too slow on the trigger. In November I wrote about PANL which quickly ran up 257% — no position.

Considering how much we got right on our macro calls and micro picks, this should’ve been a great year for the macro trades. But again the poor performance all comes down to execution error on my part. We didn’t fully take advantage of the opportunity set we uncovered from our research.

I mean, it’s always going to be the case that you’re sized too small in your winners and too large in your losers. That’s just a reality of trading. But, after studying all the macro trades for this year it’s clear that execution could have been much much tighter.

My sloppy execution dragged on our returns in the second half of the year. Where in the first half, which we talked about in our mid-year review, was decent. The macro trades were up 10.5% and beating the market. My takeaway then on where I performed poorly was “Failing to execute and size up on solid macro themes.”

This has been a creeping issue in my trading this year and I need to work to develop the systems necessary to dial in my execution so we produce the results that we deserve from our research.

Our second half performance was also hit by a stupid large long put option position against TSLA (2% of capital). I broke one of my rules, which is to never bet against the one-percenters like Elon Musk because even if they can’t pull off their high wire act they can still inspire a rabid investor fan base.

We still have plenty of time on these options and I think there’s a good chance the trade will finish in the money. But it wasn’t worth the capital drag. Not to mention, worth breaking my rules for.

The brightside going into 2018 is that the signs are pointing to a coming regime change in markets and a return of volatility. Sentiment and positioning are stretched and credit spreads can’t get much tighter. Meanwhile, inflation is set to trend higher which is going to drive yields up next year. We’re not predicting the end of the bull market in 18’ but we do have high conviction that this period of low-vol melt up is coming to an end.

So my money is on our macro trades having a much better year in 18’.

Vol Trades

Return Metrics *Through December 8th 2017
YTD: 37.82%
12-Month Return: 37.82%
Inception (Jan. 2016): 58.40%
Annual Vol: 8.49%
Sharpe Ratio: 2.83
Max DD: -4.46%

Tyler here.

Vol carry has been the easiest trade of 2017 — which is quite comical considering this time last year every single analyst on Wall Street thought Trump’s first year in office would create extremely high volatility.

Literally the exact opposite happened.

Take a look UVXY, the ultra short vol ETF. I think it wins the prize for best mega-trend of the year. (Outside of crypto!)

Our volatility strategy nailed most of this trend, while also managing to stay out of the market during the large spike in August.

One thing that separates our vol trading from the pack is that we just don’t sit blindly shorting these products into oblivion. We carefully assess the macro environment and then tweak position sizing and even go long volatility depending on the macro read.

All 4 of our short vol trades were winners. And we actually still won on 60% of the long vol trades. So all in all a great year. The macro reads helped the vol trading tremendously.

But performance wasn’t perfect and there’s still room for improvement which is why I want to dissect some trades for nuggets of info that we can take with us in the years ahead.

Short Vol

The first three vol cycles I sold played out in a conventional manner. The overpriced futures slowly rolled down the curve as SPX floated higher. Buyers of volatility paid sellers of volatility for hedging a risk event that never happened.

The highlight of our performance came after Trump struck a last minute deal with the Dems to move the debt ceiling deadline further out in time.

I figured short-term vol would get crushed with the only macro catalyst kicked down the road. I upped leverage and aggressively sold volatility at the beginning of September. That call ended up paying off and was the largest winner of the year.

After a very profitable October cycle, I couldn’t bring myself to sell futures for the next cycle at extremely low prices. I also thought that debt ceiling fears were going to creep back in towards the end of the year and send the price of fear higher.

That never panned out. The debt ceiling was ignored and instead investors continued buying the market on hopes of tax reform.

I should have kept with the program and continued to ride the trend. All of our macro liquidity indicators were in bullish territory and the data said to keep selling vol. I overrode those signals and succumbed to the bear narrative that vol was “due to blow up.”

Lesson: stick to the process and ignore the noise of the Twiterrati.

All in all I’m satisfied with our performance on the short side this year. We hit this trend hard in the right spots and fully exploited this low vol market regime.

Long Vol

There were 5 times in 2017 where I took a stab at going long VIX

  • Pre-French elections
  • The August N. Korea scare
  • The pre-debt ceiling deadline
  • November super lows
  • End of year debt ceiling rehash

I won on the first three, got cocky, and then went on to give back those profits on the last two long vol trades of the year.

As traders we have to constantly battle emotional pulls towards fear AND greed. Experience helps to control things, but maintaining proper balance is always a challenge. I could of better managed my emotional highs during the late fall of this year.

Position sizing was the other thing that killed me here. I played smaller in the beginning of the year and bigger at the end of the year. If your small on your wins and large on your losses it doesn’t matter how good of a hit rate you have. Your P&L won’t look good. I want to focus on using more consistent position sizing next year.

To sum up, I think I can walk away from 2017 content with the performance. I’m not ecstatic — things could of been better going into the end of the year. But overall the process here is working.

Conclusion

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 two years ago with the aim of building a trading service/site that we always wanted but that didn’t exist.

We plan to continue busting our asses improving and evolving our service so that it stands head and shoulders above the other sites out there; we want to be the best when it comes to education, trade theory, analysis tools, trading returns, and quality of its 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, who, like us, are singlemindedly focused on becoming the absolute best; who think differently than the average market participant and strive for a deeper understanding of how this game works.

The MO community is still small, but I think we’ve been successful in our hunt for quality.

If you want to join us on our journey, definitely check out the Macro Ops Collective.

Our Operator Collective has shared in the success you’ve read about above by receiving our research and trade alerts. They see exactly what we’re doing in portfolio, REAL-TIME.

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

There’s a 60-day money-back guarantee too. Like I said, we’re always upfront with our community. That’s why we give you the opportunity to try the Collective for two whole months before you commit. If at any time you feel it’s not a good fit, we’ll refund your money right away.

We’re only keeping the doors to the Collective open till December 31st at midnight EST. After that, enrollment will shut down. Please take advantage before then.

Click Here To Learn More About The Macro Ops Collective!

 

 

The Oil Market’s Massive Repricing

The Oil Market’s Massive Repricing

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Seeking out asymmetric trades today is a bit tougher than normal because of where we are in the cycle. We’re in the latter stages and valuations are high (very high) so upside is somewhat limited on the whole and completely dependent on sentiment.

But it’s not late enough in the cycle where it makes sense to start pressing shorts — the trend is still up and could persist for another couple of years.

The large vampire squid (aka, Goldman Sachs) noted recently that the “average valuation percentile across equity, bonds and credit in the U.S. is 90 percent, an all-time high.

A good approach in environments such as these is to stick with the large trends that are running, but to start toeing the water in the few discarded and unloved assets that have upside asymmetry and a relative margin of safety.

For our team at Macro Ops, the asset that fits the bill is oil.

Back in August we wrote about why we thought the puzzle pieces were coming together for a bullish oil rebound — a veritable “Marcus Trifecta” of macro, sentiment, and technicals signaling major upside asymmetry.

We made the argument that the market was overestimating oil’s future supply growth while understating demand. Furthermore, we remarked how the market was headed for a supply constrained environment due to a record level of cuts in CAPEX (ie, reduction in the investment into future supply) to the global oil market over the past few years.

Lastly, we wrote how the bullish case for oil was made even more delectable by the trend rates in GDP growth and inflation. The “Investment Clock” framework has us entering the “Overheat” phase of the business cycle. In this phase, commodities and oil and gas stocks in particular historically perform very well. The chart below shows energy’s relative total return outperformance in the final year(s) of a bull market.

This was, and remains, a very contrarian call. And that’s all for the better.

Since our August report, WTI crude has climbed from $49/bbl to a high of $59/bbl last week. The basket of three oil and gas stocks that we recommended is up over 12%; roughly double the S&P’s return over the same time.

So we’re off to a decent start.

But as we’ve continued to dig into the energy story we’ve become more convinced that there’s incredible asymmetry building in the space. Today we’re going to reiterate our bullish call for oil and gas equity outperformance going into 2018 and update the evidence on why it’s nearing time strike it rich.

There Will Be… Bull? — The Coming Oil Bull Market

One of the more difficult, yet important, jobs of a trader is tease out what’s likely to happen versus what’s already priced in. It’s at this intersection of the unfolding path of reality and embedded expectations where trades are born and die.

But getting inside the head of every other market participant and weighing their thinking against the price of the market is tough going for obvious reasons.

A workaround we use is paying attention to the popular stories that market participants are telling. And more importantly, how these stories evolve and react to new information, and then how these reactions get reflected in prices.

Narratives are the human way of trying to make sense of a chaotic, complex, system. The stories we tell ourselves are often wrong, incomplete, and sometimes crazy. But nonetheless our ability to believe in them has been so powerfully ingrained in us because it’s helped us thrive as a species.

Author of the book Sapiens, Yuval Harari, notes the following:

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. That’s why it’s so damn hard to be a contrarian… it’s literally against our biological programming to go against the herd.

Similar to how species react, adapt, and evolve slowly in response to environmental stresses, so too do the popular narratives adjust slowly over time as new information enters the picture that challenges their validity.

This is why popular market narratives always lag the market. And once the market finally acknowledges the faults in the prior narrative, we see violent surges and reversals in price.

We want to identify the popular story that’s embedded in prices and look for instances where new information signals a diverging outcome. The more divergent, the more lucrative the trade.

We want to be ahead of this narrative adoption. If we can lead the story then we can make money.

Going back to the oil markets:

The popular story over the last three years of the oil bear market rested on two things (1) that the world is awash in oil thanks to the introduction of fracking and (2) the adoption of electric vehicles was going to soon kill the internal combustion engine, thus clipping off a big source of demand for oil.


But the data doesn’t support this narrative.

Like most popular stories, this one was born in some truth.

But that truth, or rather its supporting facts, have evolved. And the popular narrative of the oil market has not yet fully awoken to the new reality.

Once it does we’re likely to see $80, even $100/bbl oil in the coming year.

Here’s why.

The consensus in oil is predicated on the belief that fracking and the introduction of shale oil has led to a new paradigm of sustainable drilling productivity growth, making the US a major swing producer in the global market.

But recent data isn’t backing this up.

Supply forecasts have been predicated on the belief that improvements in fracking technology will continue to increase well productivity at the growth rates we’ve seen over the last few years. The expectations are that this rate will compound, bringing ever more supply growth online.

The problem is that these forecasters have mistaken the source of that “well productivity growth”.

For example, output in the Bakken shale (one of the most productive shale regions in the US) more than tripled from 2012 to 2015. Recent research done by MIT suggests this rise in well productivity was not actually due to improved fracking technology and efficiency gains… but rather because shale companies abandoned their less productive fields following the market slump and instead pumped from their prime acreage.

In addition, the E&Ps have been tapping their drilled but uncompleted (DUCs) wells.

The combination of only pulling from Tier 1 fields, along with draining pre-drilled wells, led to forecasters greatly overestimating future supply growth by misattributing the excess supply to technology driven productivity gains.

So while forecasters have been modeling out continuous well productivity growth of roughly 10%, the real number is likely closer to 6% or less. And while that difference may not seem like a lot, when you think about the compounding effect that 40% less growth has over time… it’s huge.

This has led to forecasters continuously overestimating US production over the last year.

Commodity Hedge Fund, Goehring & Rozencwajg Associates (GRA), wrote the following  in their latest quarterly letter (emphasis mine):

Most oil analysts at the start of 2017 believed US crude production would grow by approximately one million barrels per day between January 1st and December 31st. That level of growth would imply full-year 2017 oil production of 9.3 million barrels per day or 450,000 b/d above 2016 levels… Many analysts felt these estimates would ultimately be revised higher.

Even with substantial OPEC production cuts, the energy analytic community has vigorously argued that because of strong US shale oil growth, global oil markets would remain in long-term structural surplus…

However, data has now emerged suggesting that US crude production growth is rapidly slowing…

Between September 2016 and February 2017, US crude production grew by 100,000 barrels per day per month, but since then US production has ground to a near standstill. Between February and July, US production has only grown by 33,000 barrels per day per month – a slowdown of 67%. Moreover, preliminary weekly data for August and September (adjusted for the impact of Hurricanes Harvey and Irma) suggest that production growth has slowed even more.

The slowdown in US onshore production growth is even more puzzling given the huge increase in drilling that took place over that time. The Baker Hughes oil rig count is up 130% since bottoming in May of last year. In spite of a surging rig-count, onshore production growth is now showing signs of significant deceleration.

Although it is still early in the production history of the shales, it now appears the growth in US shale production may not be nearly as robust as originally expected. If our observations and analysis are correct, then the oil market will be even more under-supplied that we expected in the 4th Q of the year and incredibly undersupplied into 2018. The ramifications are going to be huge.

The deceleration in production growth has led to a large comparative drawdown in inventories.

GRA notes that “inventories have now drawn down to critical points where further inventory reductions will result in severe upward price pressure” and, “If our inventory extrapolation is correct and inventories reach these levels (and they should — our modeling has been correct over the past nine months), then prices have historically surpassed $100 per barrel.

Signs of a tightening supplies are beginning to show in the futures market where the spot price has recently pushed above long dated futures for the first time in years.

Despite this new data indicating a market moving closer to a supply deficit, the market continues to operate under the old narrative and faulty assumptions.

The irony is that these faulty assumptions (wrongly extrapolating shale productivity growth into the future) has driven OPEC to extend their output cuts — where compliance has been strong — for another year.

On top of this, oil companies are beginning to focus more on cash flows and less on production which means even less CAPEX (investing into future production). And this is all following the largest reductions to CAPEX in the history of the oil and gas market over the time for which we have data.  

This is setting the market up for a massive repricing sometime in the coming year(s). None of this is priced in.

Despite crude’s recent rally, the most bullish piece put out by the Street has come from Goldman Sachs which went out on a caveat filled limb saying they expected WTI to finish the year at a whopping $57.50 (it’s trading at $56 right now).

Oil trader and fund manager Pierre Andurand of Andurand Capital (who’s fund has returned over 560% since 2008) noted the following in his recent investment pitch in Sohn, London (summary via marketfolly):

Oil prices will go much higher than consensus. In the last 18 months there has been a lot of negative hype about oil prices. The two most discussed factors have been US shale production and electric vehicles. US shale has been called the internet of oil.

Demand for oil has rarely been as strong as it is today. Demand is as high as it was 10 years ago when there was a lot of talk about the super cycle and demand growth. New oil discoveries are at all-time lows.

Supply will peak before demand at current oil prices. Oil demand will peak sometime between 2027 and 2035, much later than the consensus view. The supply of electric vehicles will be constrained by a shortage of batteries.

Supply will peak in 2020. Oil discoveries peaked in the 1960s. They stabilised in the 1990s making a lower peak with US shale discoveries in the early 2000s but they have been declining since then. We are finding 10x less oil than we were 20 years ago. Global reserves are going down fast. We have a 100bn barrels (or 10% less) of reserves than we had 10 years ago when everyone was worried about peak oil. The largest declines have been in ex-US small oil fields. The rate of decline will quicken and supply will be less than expected.

Nobody wants to invest in oil projects that take 6 years to come to market and 20 years to make a profit. Against expectations, US production is flat this year. Productivity per well will go down. We could need $100 a barrel oil to mitigate the fall in supply.

If OPEC goes back to full production, there would still be a deficit of half a million barrels per day. Inventories are low.

OPEC is unlikely to go back to full production leaving a deficit of 1m barrels per day. In this scenario oil could easily reach $80 per barrel.

While the “Death of the Combustion Engine” narrative sounds compelling, the data again doesn’t support it.

Even under the most bullish adoption estimates, EV’s impact is expected to be limited in the coming decade. Bridgewater notes that “in even the most bullish scenarios, only 0.2-0.3 mb/d of oil are expected to be displaced over the next five years.” (charts below via BW)

That’s a drop in the bucket.

While EV’s will undoubtedly change the energy landscape in the distant future, it’s not going to have a material impact within the next decade, which is the timeframe we’re investing in.  

In any case, EV’s impact pales into comparison to the growth in the global car stock that we’ll see over the next decade. Charts below again via BW.

This goes back to the powerful impact of Asia, which led by India, is hitting the wealth S-curve that we talked about in the October MIR.

We’re going to see the global middle-class balloon to over 4 billion people in the coming years. This means EXPONENTIAL growth in commodity consumption… and a lot more gas guzzling cars on the road.

Which brings us to our current cycle.

We are hitting that sweet spot in the global business cycle where the world economic engine is firing on all cylinders.

The OECD Growth Indicator below shows all 35 OECD countries are in growth and/or accelerating expansion mode for the first time since 2007.

And this has led to GDP forecasts being continuously revised upward.

The demand forecast for oil is also being continuously revised higher.

It’s frequent data surprises like these that eventually force new narrative adoption and drive new trends.

Under this backdrop of greater than expected rising demand and significantly lower than expected supplies, we have oil and gas equities priced near secular lows, and completely out of favor with the market.

Do you think there may be some asymmetry here?

Now of course, there’s potential downsides that may delay our bullish oil thesis.

The big unknown is China. With President Xi having consolidated power there’s now talk he’s going to make some moves to deleverage the economy. And there’s evidence in the data of this effort (look at the recent selloff in metals).

It’s unclear how aggressive the communist party will be in cleaning up China’s balance sheet. Since the CCP’s number one priority is maintaining social order, it’s unlikely they’ll move too swiftly and risk blowing up the system.

But China remains a black box. All we can do is look at the data available and adjust fire as we go.

Besides, there are numerous potential geopolitical shocks that could light a fire under our bull case.

There’s potential war brewing between Saudi Arabia and Iran using Lebanon and Hezbollah as proxies. Not to mention the new Saudi crown prince seriously shaking things up at home. Then there’s North Korea always on the brink of war and Venezuela which is quickly becoming a failed state. And the list goes on…

Arguably none of this is priced into the market at the moment.

But there are signs that the popular story is changing… albeit slowly.

This change is being led by the rise in price (as always). And we can bet that sometime next year, a reflexive loop will form where the rise in prices spurs adoption of our bullish oil thesis which further drives prices.

John Percival’s quip, “Listen to what the market is saying about others, not what others are saying about the market” perfectly applies here.

Summary

  • The popular narrative surrounding oil over the last 3 years has been:
    • 1) Supply is rapidly growing due to fracking driven productivity growth
    • 2) Electric vehicles are taking away a huge source of demand
  • But the latest data doesn’t support this narrative…
  • Forecasters have been misattributing increased oil supply to productivity gains when it was really from tapping Tier 1 fields and DUCs.
  • Drillers have cut production and CAPEX and are now experiencing large drawdowns in inventories.
  • The most bullish scenario for electric vehicles displaces only a miniscule amount of oil demand over the next decade. Oil demand is actually set to rapidly grow as Asia hits the wealth S-curve
  • The market is slowly waking up to this reality and there will be a massive repricing once it does.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

For more on the oil bull market, watch the video below! 

 

The Coming Bull Market In Oil

The Coming Bull Market In Oil

To be a smart contrarian you need to have the confidence to dive into unloved areas of the market and sort through the rummage in search of asymmetric opportunities.

Our team at Macro Ops has been digging deep and has finally “struck oil” in the energy market.  

The popular narrative driving oil’s bear market over the last 3 years has consisted of two core ideas:

  1. Fracking has caused the supply of oil to explode.
  2. The adoption of electric vehicles is killing a huge source of oil demand.  

Combine increased supply with decreased demand and of course you’re going to get a drop in prices.

Though this remains the popular narrative, the latest underlying data is telling a different story. And as always investors are slow to react, creating an opportunity for us.

First off, the market is overstating oil’s supply growth.

OPEC’s recent decision to extend their current output agreement means production will hold steady into the end of 2018.

And production outside OPEC, Russia, and the US and Canada has been shrinking. Over the last year aggregate production as fallen by 0.3 mb/d. It’s expected this number will fall by another 0.1 mb/d in 2018 as well.

This puts pressure on US frackers to pick up the slack. For them to fill the gap they’ll need to grow their output by 20% in 2018.

But what we’re finding is that shale productivity growth is slowing at an alarming rate. This is because frackers have already pulled the easy oil from their tier 1 properties they’re now having to move on to less productive fields.

In addition, oil companies in the US and the rest of the world have significantly cut their CAPEX over the last 3 years.

Global oil and gas investment, as a percentage of GDP, has collapsed from a cycle high of 0.9% in 2014 to just 0.4% today.

That means CAPEX into future capacity is now less than half of what it was just a few years ago. This makes it one of the largest capex reductions in the global oil and gas space, in history.

At the same time, global oil demand is increasing.

And this will only accelerate as we progress further into the “Overheat” phase of the business cycle where commodity prices shoot higher.

You can see how well energy performs in the final years of a bull market in the chart below:

The result of this mismatch in supply and demand has caused inventories to fall drastically.

So what we have here is a market that believes there’s an ever-growing supply of oil faced with shrinking demand, when in reality, the opposite is true. Demand is growing and supply is shrinking which will cause prices rise.

As traders we’re rarely given scenarios where the market is so wrongly positioned. This is one of them.

The argument we’ve made here is just scratching the surface of our full oil thesis. In this month’s Macro Intelligence Report (MIR), we layout the evidence we’ve gathered that shows just how off the market is.

We’ll also show you exactly how we plan to play this oil reversal. We’ve got a basket of oil stocks that are primed to take off along with an options play on the commodity itself.    

And we’re not just covering oil either… we also have some key information about the financial and industrial sectors of the market that you’ll want to hear.

If you’re interested in riding these macro trends with us, then subscribe to the MIR by clicking the link below and scrolling to the bottom of the page:

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There’s no risk to check it out. There’s a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to profit from it, then just shoot us an email and we’ll return your money right away.

Like I said, blatant contrarian opportunities like this are rare. Don’t miss your chance to take advantage.

Click Here To Learn More About The MIR!

For more on the oil bull market, watch the video below! 

 

Using Gold To See Where The Dollar Will Move Next

Using Gold To See Where The Dollar Will Move Next

I’ve written a lot about how the US dollar is the fulcrum of the global financial system.

Commodities are priced in dollars. Global trade is done in dollars. And the majority of international funding is in USD.

The dollar is important. Dollar trends impact markets and assets around the world in various ways. Hence why the dollar is the fulcrum.

But if the dollar is the fulcrum then gold is the foundation on which that fulcrum sits.

I should make clear, I’m no gold bug and have no special affinity for the yellow metal.

But when it comes to analyzing assets and markets we run into a measurement problem. That measurement problem is due to the fact that things that are priced in US dollars, or any currency, fluctuate according to the price of the currency in addition to the good’s underlying supply and demand fundamentals (ie, the price of oil is impacted by the relative price of a US dollar).

And the price of dollars can fluctuate a lot.

You can see how this makes things difficult. When you analyze goods priced in USD you have to also assess the US dollar as well.

Gold is a useful tool helping with this measurement issue.

Perhaps due to gold’s long history as a store of value it has a special place in the market’s psyche. Since gold is priced in USD but has little intrinsic value (ie, little productive use and no cash flows) it acts as a good barometer to gauge the changing relative value of $1 USD of account or the price of 1 unit of USD liquidity (USD assets).

When international demand for USD liquidity exceeds supply, gold tends to perform poorly. And vice-versa when USD liquidity exceeds global demand for that USD liquidity.

Make sense?

Because of this, when I’m trying to discern the probabilities of where the dollar is headed next, I always start with gold. Even though gold is priced in dollars, it often leads at major turning points because the fundamentals are similar for both assets but for whatever reason those fundamentals often show themselves in gold first.

Of course, this isn’t always the case (there’s no such thing as a perfect indicator). But even in the cases when it doesn’t lead it still serves as a good confirming or disconfirming signal for the dollar.

Below are some charts. They’re a little messy but I think they get my point across and show how useful gold can be as a leading and/or confirming signal for the dollar and hence the dollar priced commodities.

This chart shows gold inverted (black bars) and the US dollar (red line) on a monthly basis.

Notice how gold failed to confirm the dollar’s bear move from 94’-96’ when the dollar sold off but gold traded sideways in a range. This is a disconfirming signal for the dollar which suggested the move was a corrective one and not the start of a new trend.

But then in 96’ both the dollar and gold (inverted) began trending upwards together. This signalled that this was the start of a new trend. The macro fundamentals also supported the case. The world was hungry for US dollar liquidity (assets) and demand outstripped supply which was bearish for gold but bullish for the dollar.

Then go to 01’ where  inverted gold peaked and began making lower lows and lower highs. While at the sametime the dollar made one more new high. Gold gave a leading signal that the bull market in the dollar was over.

Now check out this chart.

Here’s the current dollar bull market (red line) on the weekly. The dollar made lower new highs and coiled into a tight range from 13’-14’. At the same time, inverted gold trended higher, not confirming the lower move in the dollar which suggested building pressure in USD demand.

And then again from 16’ to 17’ inverted gold moved lower while the dollar made a new cycle high that gold did not confirm. This gave a sell signal on the dollar and USD shortly turned over thereafter.

Of course, there’s instances where the indicator gives false signals and using it is as much an art as it is a science. It alone shouldn’t be used as a reason to go long or short the dollar but rather as a key input into one’s macro decision making process.

Now let’s quickly look at where gold and hence the dollar may be headed in the near future. Many of the charts are suggesting a coming explosive move in one direction or another.

Below is gold on the monthly timeframe showing a coiling pattern. This type of price action typically precedes large moves.

And I’ve been pointing out over the last month how numerous dollar pairs are at large critical junctures and a coming significant move is likely.

Below are AUDUSD, GBPUSD, and EURUSD on a monthly basis.

Now let’s take a closer look at gold and see if it’s telling us anything.

In this chart, gold (inverted) and marked by the black line failed to confirm the dollars most recent new pivot low. But the disparity isn’t that great so this doesn’t give us much confidence.

Another thing I like to do is to look at the momentum structure of gold to see if momentum is building in one direction or another.

The chart below shows gold (black line) and gold’s momentum relative to its 3-year mean. It signalled the end of the bull market in gold well beforehand. But right now, it’s not tipping the scales in one direction or another. It’s slightly positive to neutral.

So unfortunately it’s tough to get a good read at the moment. My bias is that US stocks are about to start outperforming the rest of the world soon. And this is going to help reverse capital flows which will put a bid back under the dollar and start a new leg higher in the greenback.

There are other macro dynamics such as changing international trade rules, raising of the debt ceiling, and US tax and monetary policy which are supportive of this hypothesis.

And I believe that gold is setting up to signal one way or another soon so I’ll be keeping a close eye on it.

In a future piece I’ll lay out a fundamental macro model I use that shows one way of looking at the big picture USD liquidity supply and demand picture. This is a useful tool for seeing where the attractors are for gold on a cyclic level.

PS — If you’d like more of this type of research, then check out the Macro Intelligence Report (MIR) here.

 

 

A Bullish Big Picture With Growing Near-Term Headwinds

A Bullish Big Picture With Growing Near-Term Headwinds

There’s some growing signs of weakness in this market. Breadth is slipping, credit doesn’t look too great, there’s more new lows versus new highs being made… that kind of stuff. I’m still not getting any major sell signals, except from my high-yield indicator. It flashed a signal today.

But there’s word the recent weakness in junk may be due to concerns over how deductions for debt and interest payments will be treated in the Republican tax reform plan. I don’t know. Either way, I’m not seeing any major red flags outside of junk bonds just yet.

I’m in “wait and see” mode, just “sitting on my hands” as Livermore would say. I’ve trimmed my book some but mostly because I want to free up capital for other trades that are lining up.

One of these trades is long dollar. I won’t expend much digital ink laying out my long dollar case, I’ve already done that plenty.

The skinny is that the market is underpricing the impact of tax reform, changing trade policies, and the coming normalization of the Treasuries balance sheet. These are bullish drivers for the dollar. I think the market will wake up to this in the coming months.

I’m already long the dollar through the yen pair. But I’m looking to also get long against the aussie and pound as well.

The technicals for the trades are setting up nicely. Take a look at this monthly chart of AUDUSD. Price has broken below a 15-year trendline and recently had a failed breakout to the upside.

Here’s the same chart on a weekly basis. You can see the bull trap failed breakout and now price is near the critical support line of its consolidation zone. The aussie is also plagued from a slowing China and a leveraged domestic housing market. A break below here would spell trouble for the pair.

Similarly, the pound has broken below a major 20+ year trading range shown on the monthly chart below.

It has retraced back up to its previous long-term support level which is now serving as resistance. Price is currently trading at a critical support level where if broken would likely indicate lower prices ahead. GBP has a number of political and economic headwinds, many of which could serve as a catalyst/driver for lower prices against the dollar.

Here’s a quick ‘Marcus Trifecta’ look at the technicals, sentiment, and macro of the market.

Sentiment: A little frothy

Market sentiment has notably shifted to very optimistic over the last six months. And nearly all of the sentiment and positioning indicators we track are showing that.

BofA’s Bull & Bear Indicator is nearing extreme bullish territory. The components of this indicator can be seen in the chart on the right.

And their latest fund manager survey showed that hedgies are becoming quite optimistic on equities and much less risk averse.

The chart below shows there’s a record number of survey participants taking on higher than average risk.

A record number also said stocks are overvalued, yet their cash levels are falling, meaning they’re upping their risk exposure. BofA is calling this a sign of “irrational exuberance”. I’m not sure we’re at that stage yet, but we’re be getting close — as I write this a Da Vinci painting of some dude or a chick that looks like dude just sold for roughly $500M. Yikes…

The latest positioning data has banks and the eurozone topping out as the assets that investors are the most long relative to the survey’s history.

I wonder how much this data is skewed though since banks and European stocks have been investor kryptonite over the last 8 years. Maybe overall positioning here isn’t indicative of extreme bullishness and therefore it’s less reliable as a contrarian signal? I don’t know, just something to think about.

Tech on the other hand remains a one way street. Investors have been throwing money at the big tech stocks, where being long FAANGs has become the “no-brainer” trade in the market. Weekly inflows into the sector recently hit their highest levels on record. And now with the FANG futures coming out things are really starting to get ridiculous.

Technicals: Path of least resistance is still up

SPX continues to trend higher in its ascending channel. The short-term trend is overextended but that alone is not cause for concern (chart below is a weekly).

Small-caps are close to having a failed breakout of their broadening top pattern. The weekly chart below shows price just trying to hold above the top support level of the pattern. Something to keep an eye on.

Many financials are retesting their recent breakouts.

The weekly chart of JPM below is a good bellweather to watch for this sector. This trade is largely moving off of long-term rates, so if the yield on the 10yr continues higher then we should expect to see financials trend up as well.

Macro: Strong but keep an eye on China

Growth is picking up in most countries around the world. Numerous ‘Big Picture’ macro indicators we track are signalling further economic strength in the months ahead, such as the BofA GLOBALcycle chart below showing a hockey stick move higher.

As growth picks up and the global credit cycle progresses, a number of inflationary pressures are building such as growing wage pressures and higher input costs from rising commodity prices. Expect these pressures to continue to build as more output gaps tighten in the coming months.

One of the major threats to the global economic recovery is China.

China’s credit cycle is long in the tooth and now that Xi has consolidated power he has the freedom to make the moves to begin deleveraging the economy. How this plays out will have consequences for the rest of the world. And things won’t be helped by the beginning of a liquidity suck driven by a tightening Fed and a US Treasury normalizing its cash balance; both of which will pull the dollar higher.

I like to keep a close eye on China’s property market since it tends to act as good indication of which direction leverage/credit are moving in the country. And floor space sold in Tier 1 cities has recently fallen through the… It’s something to keep an eye on.

No cause for alarm yet. The broader cyclic indicators we track for China remain supportive in the near-term.

Conclusion: Big Picture remains bullish but near term there’s growing headwinds

  • Sentiment is reaching frothy levels and will likely act as a market headwind in the coming weeks. Tech, especially long FAANG stocks, is a crowded trade and there’s a good chance for a large shakeout soon.
  • Technicals: The trend is still clearly up. It’s overextended in the near-term but that’s not cause by itself for a sell-off. There are signs of growing technical weakness but no major sell-signals yet. It seems the market is waiting for news on tax reform (which I think is going to pass). I wouldn’t be surprised to see stocks rally on positive tax reform news only to sell off shortly after. But who knows, we’ll continue to read the tape and see.
  • The macro is strong and all signs point to higher growth ahead. This growth will bring inflationary pressures over the coming months which is going to push rates higher and change the tune for central banks. A tightening Fed and moves by the Treasury following a raised debt ceiling at the end of the year will start the process for global liquidity to begin to slowly get sucked from the system. This trend will also be exacerbated by more companies raising there CAPEX spend which will pull the buyback bid from markets. On top of this we need to keep a close eye on China where the property market is cooling but the main indicators remain supportive.

If you want more market analysis like this, be sure to the check out our Macro Intelligence Report (MIR) here.