We do things differently here, not just for the sake of being different but because we are driven to gain insights into market opportunities and risks that most investors miss. For this reason, we sound different to most other financial market research firms.
We know you must analyze data and behave differently if you want to earn superior, risk-adjusted returns. You cannot make decisions in the same fashion as everyone else and expect your investment performance to deviate from the average.
Because of our unique approach, you may initially find yourself confused or unclear and what exactly we are trying to convey to you.
Below we’ve provided an overview of the some of the most common words and phrases we use that are unique to us and the way we evaluate markets.
When we refer to the “Old Institution,” we are referring collectively to the majority of global financial (and financial-adjacent) institutions that still evaluate and discuss economies and financial markets in an outdated, dogmatic manner.
“Old Institution” includes but is not limited to: Wall Street firms, every central bank on Earth, organizations like the International Monetary Fund (IMF), foreign banks, traditional media, think tanks like the Organization for Economic Cooperation and Development (OECD), and anyone else exhibiting the characteristics outlined below.
These organizations’ motives (including self-interest and profit incentive) vary widely, but the way they evaluate and communicate about economies and markets very much overlaps:
They focus on either lagging data that is often significantly revised or on forecasts of what will happen six to twelve months away. These rearview mirror and forecast-oriented approaches mean they are always months late and a dollar (euro, yen, pound, loonie, real, etc.) short to shifts in Fundamental Gravities, as well as to bull-bear regime shifts in financial markets.
In contrast, we focus on better understanding what’s happening right now. This “Focus on Now” approach allows us to filter out the noise of backward-looking narratives and forecasts that are sure to be proven wrong. Our “Now” philosophy reduces the likelihood of missing even the slightest economic or financial market development, and it routinely positions us to be among the first to detect an economic or financial market regime shift.
They focus almost exclusively on the “levels” of this lagging and often heavily revised data, rather than on what really matters, which is the slope (rate of change) of the data. This “levels” preoccupation means they don’t see shifts in Fundamental Gravities until months after the fact.
By the time the data has deteriorated (or accelerated) to “levels” that send them a clear signal, asset classes have already responded to the new economic conditions. In short, by the time the Old Institution acknowledges the changed environment, the low-risk, high-reward trades are as dead as disco.
In contrast, we focus our attention on the slope, or the rate of change (ROC), across both economic and financial market data. As our CEO, Landon Whaley, likes to say, “What matters most in macro occurs at the margin.” The ROC gets you paid, while the “levels” get you left behind.
They depend on narrative rather than data. No matter what occurs across global economies or financial markets, these folks scramble to find the narrative that fits it best. This particular peccadillo isn’t just the domain of the media—every party included in our definition of the “Old Institution” is guilty of this one.
For example, in November 2018, Mario Draghi, who was president of the ECB at the time, gave a speech in which he blamed everything from the weather to sickness for what he called a “soft patch” in the eurozone economy. His speech was delivered after nearly a year of slowing economic data across both core and periphery economies, with Germany, the largest eurozone economy, just one quarter away from a technical recession, and stock market crashes in multiple countries.
Rather than acknowledge the litany of data signaling much more than a “soft patch,” the head central banker clung to a narrative driven by inclement weather and disease.
In contrast, we depend steadfastly on data. We focus exclusively on the data and nothing but the data, rather than the narrative du jour being spun about it. Data doesn’t lie, but narratives do.
The Old Institution (and most investors) are prisoners of the moment and simply extrapolate the most recent events or trends across economies and global markets forever into the future.
For example, in July 2018, all three primary gauges of U.S. inflation (consumer, core and producer prices) had been accelerating for six to 24 months, depending on the gauge. Based on this most recent trend, the Old Institution and its followers were calling for inflation to ramp even higher for the remainder of 2018 and well into 2019. They simply looked at what inflation had been doing and extrapolated that trend forward.
In contrast, we take a Bayesian approach to evaluating markets, updating our view of each economy and asset class as each piece of data rolls in. We will never be perma-bullish or perma-bearish. We aren’t trying to drive trading activity, get clicks or attract advertisers. We are trying to get the big macro calls correct so you can position yourself accordingly, before the Old Institution and its devout followers figure out what’s happening.
In “The Playbook” from the July 16 edition of Gravitational Edge, we said, “Despite everyone’s belief that inflation is pulling a Superman and going up, up, and away, we believe inflation—along with growth—will begin to slow towards the end of 2018 and heading into 2019.”
Rather than use the highly scientific technique of straight-line extrapolation, we had evaluated U.S. inflation using our models, which take into account factors like “base effects” and the non-periodicity of economic cycles. We realized that inflation was likely to peak within two months and alerted our subscribers accordingly. All three gauges of U.S. inflation peaked in July and remained in a downtrend for the remainder of 2018.
This data-dependent, Bayesian approach of focusing on Now and on the slope of economic and financial market data is how we are able to consistently position ourselves before markets move.
In early 2018, we were one of the first firms to flag slowing economic growth in places like China, Germany, Brazil and South Korea and to discuss the impact this Fundamental Gravity shift would have on the equity markets in those economies. Our CEO, Landon Whaley, made these calls publicly before equities crashed in China, Germany, Brazil and South Korea and months before these developments were headline news.
This approach is also how we anticipated and positioned correctly for the U.S. market carnage of Q4 2018. We alerted our research clients the week of September 24 and were positioned correctly heading into October’s “sea of red”.
If you want to be a consistently successful investor, you must forget what you’ve always been told by the “Old Institution” and embrace a new way of analyzing economic and financial market data.
One of our three Core Principles is that we channel our inner Eckhart Tolle and focus on better understanding what’s happening right now.
In contrast, most investors spend their time focused on what’s already happened and on economic data that is months old, or focused on forecasts three months in the future, or further.
Using old data to make decisions today is as risky to your portfolio as driving while only looking in the rear-view mirror.
As for forecasts, let’s take our cue from meteorology. With all the technology available, weather can’t be accurately predicted beyond 72 hours, and some would say getting it right today is a stretch. If this is true, why would we think that anyone can accurately predict something as complex as the global economy three months into the future? The simple answer is that they can’t.
We certainly keep an eye on what’s already occurred, and pay sharp attention to potential future developments. However, our experience tells us that by understanding what’s happening right now, we can gain insights most investors miss.
In order to be a successful investor, it is imperative to remain data dependent. Being data dependent means that data alone drives your decisions, not the narratives that people spin about the data. The second of our three Core Principles is that our research focuses on what’s happening at the margin of economic and financial market data. In contrast, most investors rely on media headlines or the top line economic data point to inform their decisions. The trend, or the slope, of the data is what matters most, not a single data point. When we evaluate economic data, we focus exclusively on the slope of the annual growth rate of that data series. This is an important distinction because most economic data is not analyzed in these “year-over-year” terms. Focusing on the slope of the annual growth rate allows us to decipher the signal, rather than being bombarded with the noise inherent in the monthly or quarterly growth rates.
Our third Core Principle dictates that we focus on understanding not just the slope of economic and financial market data, but also the extremes. In contrast, most investors focus on averages. With economic data, they focus on how the data performed versus the “consensus expectation,” which is the average opinion of a group of economists. When it comes to financial markets, they focus on average returns and moving averages to help guide their decisions. We say that averages don’t provide any significant guidance. Instead, we monitor the trend of economic and financial market data to alert us to extreme measures of fundamental, quantitative and behavioral factors. We study the extremes in markets for the same reason biologists study disease to better understand the healthy body, or meteorologists study hurricanes to better understand everyday, local weather. When analyzing economies and markets, it’s understanding the abnormal and irregular—the extremes—that provides the greatest insight into risks and opportunities.
When we refer to investors’ “humanness,” we mean all their biases and their predilection to let emotions rule over sound judgment.
Human beings are innately flawed decision makers, especially when it comes to making financial decisions. We are hardwired to do exactly the wrong thing at exactly the wrong time.
This is why understanding the behavioral aspects of financial markets is just as important as the fundamental and quantitative. Remember, markets are driven by human beings making human errors, which is what gives rise to risks and opportunities.
Nowhere is investors’ humanness more on display than when they attempt to evaluate the quantitative aspects of financial markets.
We instinctively obsess over the smooth and symmetric, which is why we look for patterns and symmetry everywhere. This subconscious obsession forces us to impose patterns where none exist, and to deny patterns if they don’t conform to our perspective.
Our DNA is why “technical analysis” is fool’s gold. Investors identify various chart pattern formations or “support” and “resistance” levels simply by eyeballing a chart. Most people don’t understand that chance alone creates false patterns and cycles that appear to be predictive, when in fact they are not. They also evaluate markets using traditional quantitative methods built on the belief that markets are linear and rational. But in reality, financial markets are a nonlinear, turbulent system produced by the interaction of human beings—in short, chaotic. This makes traditional methods ineffective and misleading.
Understanding the “humanness” of investors allows us to gauge perceptions, reactions and decisions across time, gaining valuable insight into others’ behaviors.
Our insight is distilled from our proprietary Gravitational Framework, which helps us better understand the three most critical forces, or gravities, that impact asset prices: Fundamental, Quantitative and Behavioral.
There are two chief variables that impact the direction of asset prices: one is economic conditions, and the other is how central banks respond to those conditions. Together, they drive what we call an economy’s Fundamental Gravity. We anchor every market bias we carry to its Fundamental Gravity because it impacts the risk and return of asset classes in a very specific way.
What’s in a Name?
We label each of the four possible Fundamental Gravity environments that an economy can experience based on the seasons for two primary reasons.
First, we are one of the few firms in the world harnessing the power of Chaos Theory to understand how economies and financial markets truly work.
The Old Institution believes markets and economies are linear and rationale, which is why they utilize tools designed to analyze these types of systems. This is the primary reason their forecasts are garbage and why they miss every major macro move until after its nearly over.
In sharp contrast, we know markets and economies are nonlinear, and to steal a word from science “chaotic.” This chaotic reality means they share many traits with other chaotic systems like weather and climate. Naming our Fundamental Gravities after the seasons will help drive home, and act as a constant reminder, that the way we analyze economic and financial market data is far more effective than most market participants.
Second, the mental imagery the seasonal label induces is a near perfect match to the financial market characteristics of each Fundamental Gravity environment. For example, if we write the “Winter Fundamental Gravity in South Korea,” you quickly understand the type of environment we are discussing, far more effectively than if we say, “The Fundamental Gravity #4 environment in South Korea.”
Not only does each FG have a unique playbook for how to trade markets, but each environment also has its own portfolio management implications.
Spring Fundamental Gravity
In this FG environment, economic conditions and central bank policy favor equities and bonds that behave like equities. This FG is by far the most bullish of all Fundamental Gravity environments, and as a rising tide lifts all boats, there isn’t an equity sector that won’t generate positive performance. That said, to generate the most alpha, you’ll want to focus your long equity exposure in the growthy sectors like tech, consumer discretionary and industrials. Focus your bond exposure on convertibles and high yield bonds. You want to avoid equities with bond-esque tendencies like utilities, REITs and consumer staples. On the fixed income side, treat all durations of U.S. Treasuries like the plague. From a portfolio management perspective, this is an environment to go all in and push your chips to the middle of the table. Maximize your gross exposure and minimize cash but avoid shorting anything unless you’ve got a crystal-clear downside catalyst.
Summer Fundamental Gravity
In this FG environment, economic conditions and central bank policy continue to favor equities and bonds that behave like equities. The twist in this FG environment is that inflation is now in play. To generate alpha during the Summer, continue to focus your equity exposure in tech, consumer discretionary and industrials, but now add energy stocks to your buy list. On the bond side of things, stick with convertibles and high yields bonds, but now TIPS exposure is warranted as well. The Summer environment is also the most conducive for commodity investing. The most bullish commodities are crude oil, copper, gold but even a broad-based commodities index performs well. You want to continue to avoid all manner of U.S. Treasuries, as well as the bond-like equity sectors: utilities, REITs and consumer staples. From a portfolio management perspective, this remains an environment to maximize your gross exposure, minimize cash but to avoid shorting anything unless you’ve got a crystal-clear downside catalyst.
Fall Fundamental Gravity
In this FG environment, economic conditions and central bank policy favor certain sectors of the equity market, and it favors long-dated Treasuries. As compared to Spring and Summer, when just about every sector and industry is likely to post positive performance, the Fall is a much more nuanced environment to trade. To generate alpha during the Fall, you’ve got to flip the script and focus on the areas of the equity and bond markets we loathe during Spring and Summer. In equities, you want to focus on utilities and REITs. Tech stocks are still a good choice as are energy stocks because this is the other FG environment with an inflationary impulse. From a fixed income perspective, stay singularly focused on long-dated Treasuries, avoiding all durations less than 30-years. From a commodity perspective, the Fall is the only other time when long exposure is condoned and what worked during the Summer continues to work here: crude oil, copper, gold or just a broad-based commodities index. Fall is also the FG season where we dust off our short book and go huntin’ for wabbit. That said, this environment is not uber-bearish like Winter, so you want to be discerning about your short exposure by sticking to financials and basic material stocks. Completely avoid (long or short) any equity sector or bond market not mentioned here because their risk-return characteristics are not consistent from one Fall FG environment to the next. From a portfolio management perspective, the Fall is where you dial back your exposure levels. Rather than maxing your gross exposure, be much more prudent with your risk capital and keep a healthy pile of cash. This is also one of only two FG environments where its advisable to be actively shorting the most bearish areas of the equity market.
Winter Fundamental Gravity
In this FG environment, economic conditions and central bank policy favor only the U.S. dollar and all durations of Treasuries. If the Spring Fundamental Gravity is the most bullish environment for risk assets, then the Winter is the polar opposite. There only three equity sectors for your consideration on the long side: utilities, REITs, and consumer staples. But a word of caution, make sure the Quantitative Gravity for these markets is confirming a bullish environment before risking capital. Not all Winter FGs are created equal and these equity sectors may or may not trade bullishly. In the fixed income space, avoid all bonds not named “Treasuries.” Winter is fertile ground for short sellers and its where all the alpha is generated in this environment. In equities, focus on being opportunistically short energy stocks, financials, industrials, tech stocks, and small caps. From a commodity perspective, the playbook is straight forward: long gold and short everything else, especially crude oil, copper and any other industrial commodity you can get a borrow on. From a portfolio management perspective, Winter is the time to batten down the hatches. Minimize your gross exposure, raise your cash pile as high as you can get it and build a damn igloo out of it if you can. Minimize your long exposure to anything outside of the local currency or government debt. While you’re minimizing risk on the long side of your portfolio, Winter is the time to press as much short exposure as you can stomach when the market timing component of your process gives you the green light.
Keep in mind; these Gravity guidelines don’t just apply to U.S. markets you can use these playbooks when you’re trading in Australia, Singapore, Italy, anywhere! The only modifications needed are to swap out the U.S. dollar in favor of the local currency, and any discussion of U.S. Treasuries applies equally to the sovereign debt of the county where you are trading.
SOCIAL: The first dimension of market structure is the energy, or trend of the market. For this analysis we use SOCIAL to determine the current state of the market. Remember, 75% of price movement occurs only 10% of the time; the rest is just noise. Markets move from one state of rest to another, and then those rest periods are disrupted by investors who believe the market in question is priced either too high or too low. SOCIAL helps us identify when the market is in one of four states: party (bullish), hangover (bearish), taking a breather from the current trend, or completely asleep.
MOMO: The second dimension of market structure we monitor is the force, or momentum of the market. For this analysis we use MOMO, which gives a clear measure of the force behind the current state of the market, which is identified using SOCIAL. More importantly, MOMO tells us how that force is shifting over time.
BAROMETRIC: The third dimension of market structure is the rate of force, or the buying (selling) pressure associated with the current momentum of the market. For this analysis we use BAROMETRIC, which gives us immensely more information about investors’ degree of conviction than a simple measure of volume alone.
TOPO: Finally, the fourth dimension of market structure is the volatility of the market. For this analysis we use TOPO, our proprietary measure of a market’s irregularity. Volatility is an often-overlooked aspect of markets until a sell-off occurs. However, volatility is a primary factor of the underlying market structure and a critical driver of price.
ALPINE AND ABYSS LINES
Our proprietary ALPINE and ABYSS lines are not “support” and “resistance.” Rather, they are the most critical prices above and below the most recent closing price.
We calculate these critical prices based on Chaos Theory and the underlying market structure, which is not visible on a price chart.
When the market’s price interacts with the ALPINE or ABYSS line, the outcome gives you critical insight into the most likely direction of the market being analyzed.
The ALPINE or ABYSS lines provide a great deal of information beyond the standard “support” and “resistance” levels, regardless of whether the market is rejected by the ALPINE or ABYSS line or is able to breakout above (or breakdown below) it.
We’ve named the market timing part of our investment process “The Mongoose” because the market behaves like a cobra, and in order to consistently be successful, we must trade like its opposition: a mongoose. The mongoose provokes the cobra to attack, then rapidly dodges and follows up with another distracting motion. It tirelessly darts and nips, completely focused on its opponent. Finally, precisely when the cobra is fully extended and about to strike, the mongoose clinches the attack with a deadly bite. We let the market make its repeated strikes, moving from price to price. When it’s at last over-extended and at a point of exhaustion (to the upside or the downside) like the cobra, we position ourselves opportunistically for the market to reverse course, thus clinching the attack, like the mongoose.
The MAX FAV measures the maximum profit (favorable) that could have been extracted from a given Focus Market trade from the time it’s added to the list until the day it's removed. In short, once we made the Focus Market call, how far in our favor did the trade move?
The MAX ADV measures the maximum loss (adverse) that would have been weathered in a Focus Market if the investor had been in the trade from its added to the Focus Market list until the day it's removed. In short, once we made the Focus Market call, how far against us did the trade move?
The R-2-R is the reward-to-risk statistics for a given Focus Market trade.
Our sole objective is to help you side-step dangers that no one else sees coming and help you position for opportunities that most investors miss.
While this objective is philosophical enough to make Plato proud, it’s also quantifiable by answering just two questions: 1. During the time we recommended a Focus Market, did it generate a positive cumulative return? 2. During the time a Focus Market was active, did the market’s largest move in our favor far outweigh the largest move against us?
If your head is swimming a bit here, no worries, this is a differentiated way of evaluating and being accountable to market calls. Since you haven’t heard this type of analysis from the Old Institution, let’s run through a case study.
Case Study: South Korea On May 28, 2018, we initiated our “The Other Korea” macro theme with South Korean equities as a bearish Focus Market via the iShares MSCI South Korea ETF (EWY). On that day we said, “All three Gravities [Fundamental, Quantitative, Behavioral] are aligned and decidedly bearish, which means it’s time to put on a short trade and go huntin’ for wabbit.”
We carried that Focus Market trade until we closed the macro theme on January 7, 2019 stating, “At this point in the game, the downside in South Korean equities is extremely limited, making it a no-go for further short selling. South Korean data continues to deteriorate, but we are de-activating this theme because there are better risk-adjusted opportunities elsewhere for our capital.” After we closed that macro theme, we put on the big boy pants of accountability and asked ourselves those two critical questions to determine if we upheld our objective.
Did the Focus Market trade generate a positive cumulative return over the time frame we recommended it? From the close on May 29, 2018 (May 28 was a U.S. holiday) through January 7, shorting EWY generated a +17.9% return.
During the time this market was on our Focus Market list, did the market’s largest move in our favor outweigh the largest move against us?
Over the time of our recommendation, the most adverse move we experienced was -2.6% when EWY rallied to a peak of $73.55 on June 7, 2018, one week after we activated the market call. The maximum favorable return was +22.5% when EWY fell to a low of $55.58 four months later, on October 29.
When we compare the most favorable move to the most adverse, we get a reward-to-risk heavily skewed in our favor at 7.8-to-1.
FOCUS MARKET OPPORTUNITY SET
The Focus Market Opportunity Set is the entry-to-close cumulative performance of our calls.
For instance, we carried a bearish bias for Oil Service Companies (OIH) from August 27, 2018, to February 4, 2019. During this time, OIH declined -29.7% (in our favor), and so this +29.7% cumulative return is included in the performance statistics on page 5 each week.
We sum all of the cumulative returns (gains and losses) of all closed Focus Market calls over the trailing 12 months.
These statistics give you an idea of the complete opportunity set we provided to investors (across all four asset classes) to help drive their investing decisions.
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