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Europe’s Shaky Compass

Hedgeye Portfolio: Short EUR-USD via (FXE); Short Italy (EWI)


Conclusion: as the interconnected risk trade in Europe heightens alongside the US Fed’s Quantitative Guessing (QG) decision to pump more dollars into the system, we’re taking the explicit tact to short the EUR versus the USD.  Today’s announcement from the ECB and Bank of England to hold benchmark interest rates at their current levels of 1.00% and 0.50% with no comment to explicitly issue their own QE2 packages, while the region pushes through austerity measures, leaves many questions unanswered, including just how these central banks and global governing bodies may need to act in the very near term given the explosion in risk premiums for Europe’s fiscally imbalanced countries, particularly Greece, Ireland, Portugal, Spain and Italy. As we stated in our Q2 2010 quarterly theme of Sovereign Debt Dichotomy, history shows that kicking the can of debt down the road doesn’t end well. In the case of the Eurozone, countries like Ireland are bearing the brunt of the European Monetary Union’s (EMU) constraints, namely the inability to influence monetary policy to lessen debt obligations and market volatility.


Below we highlight the rising risk trade in Europe and the fundamentals behind our bearish view on Italy:


Trading Europe’s Risk Inflection:


From the recent movement in our Hedgeye Portfolio and our research over the past 10 days, we’ve noted heightening risk for paper across Europe, but particularly for Europe’s fiscally bloated member states. This marked inflection, which we’re measuring via government bond yields and sovereign CDS spreads, has emerged after the month of September and most of October saw risk compress. As the charts below of the 10 YR government bond yields and 5YR CDS spreads demonstrate, risk is blowing out to year-to-date highs (excluding Greece), and therefore we’ve oriented ourselves accordingly!


Europe’s Shaky Compass - mh1


Europe’s Shaky Compass - mh2


Below are some of the major macro moves in our Hedgeye Portfolio over the last few days:



9:57am Covered UUP (US Dollar Index Fund) @22.23



3:26pm Sold USO (US Oil Fund) @ $36.67

3:36pm Shorted FXE (EuroTrust Fund) @ $140.55



10:28am Shorted FXE (EuroTrust Fund) @ $142.10

10:16am Shorted EWI (Italy Index Fund) @ $18.34 (*initially shorted on 9/24/10 @ $16.65)


Explicitly we’re playing Europe’s currency risk on the short side versus a bullish view on the USD from a short-term, mean reversion perspective. We think the USD should gain on the back of a Republican victory of the House and next week’s G20 meeting in Seoul (Nov. 11-12) in which global players will put additional pressure on the US to quell further USD debauchment.  [As a side note, ECB President Trichet said in a press conference today that he is confident the US is not promoting a weak dollar.]


Our quantitative models suggest the EUR-USD is overbought from an immediate term TRADE duration at $1.42, with TRADE support at $1.39. Our intermediate term TREND line of support is at $1.33.


Europe’s Shaky Compass - mh3


Returning to the sovereign debt outlook, Ireland is one country that stands out in the charts above.  The country is currently the region’s debt poster child, with 2010 debt and deficit levels estimated at 10% and 32% of GDP, respectively. Certainly Ireland has “earned” its reputation after pigging out on low interest rates for nearly a decade, resulting in a severe domestic housing bubble and financial crisis, the latter of which is contributing heavily to its 2010 deficit.  While Irish economic ministers have tried to calm investor fears by stating that the country has €20 Billion in cash to fund its debts into April of next year, as the government plans to push through spending cuts and tax hikes worth €6 Billion next year, the market is telling a different story--one of desperation.


We’re of the opinion that Ireland, like Greece, presents risks that could snowball beyond their individual borders.  We have not actively taken a position in Greece or Ireland, due to this volatility, however it’s interesting to note that Greece’s bond yields and CDS spreads exploded exponentially over just a few days, which ultimately led Eurozone finance ministers to issue a €110 Billion bailout package for Greece on May 2nd and days later, along with the IMF and World Bank, a €750 Billion package to rescue troubled European nations. 


Could Ireland be the next Greece?  Certainly the data is pointing in that direction.




Italy’s Headwinds


We shorted Italy again today via the etf EWI in the Hedgeye Portfolio, and while our short position is working against us, the fundamentals continue to suggest further economic downside over the intermediate to longer term. We’ve identified three main headwinds:

  1. Exorbitant debt levels and the magnitude of near-term maturities
  2. Berlusconi’s divided government
  3. Aging population

Debt Doldrums


With a debt ratio at 115.2% as of fiscal year 2009, Italy’s debt is of particular concern to us, while its deficit as a percentage of GDP is less worrisome at -5.3%, yet nevertheless above the -3% target rate set by the EMU.


Europe’s Shaky Compass - mh4


Below we’ve compared the country’s government debt obligations over the next three years. What’s interesting to note is that Italy has a massive obligation over the period, especially next year at €266.6 Billion alone, and its obligations rival those of Germany and France, countries with far larger economies. (Germany’s GDP is ~ 1.6x Italy’s).


Europe’s Shaky Compass - mh5


If we look at debt maturing over the period as a percent of projected GDP, we find that the PIIGS have a significantly larger share to pay off than their fiscally prudent brothers, especially Germany. While this isn’t a huge surprise, it reinforces the point that countries that want to issue or refinance debt will have to do so in a period of higher costs of capital as yields rise (in some cases to record highs!), which should increase and/or accelerate sovereign default risk. 


Europe’s Shaky Compass - mh6


Berlusconi’s Divide


With regard to Italy we question the country’s ability to materially cut its bloated balance sheet, particularly given the increasingly contentious political backdrop. Remember that back in July PM Silvio Berlusconi expelled his speaker of the Parliament, Gianfranco Fini, and other dissents from his People of the Liberty party, which left his party with a majority coalition.


However, Fini has been increasingly critical of Berlusconi, and rightfully so for Berlusconi continues to make scandalous headlines. The latest scandal concerns his involvement in the release of a teenage belly dancer accused of theft in May.


We view the uncertainty in the government as bearish on the margin.  We’ll have our eye on Fini who has found support in both Houses of Parliament and could play an integral role over the next weeks in bringing down Berlusconi’s government.


Aging Population


We’ll let the chart below do the talking, but Italy’s aging population must be considered in making an investment position, for it will be a further drag on the social state. The data suggests that in 2015, 21.9% of Italy’s population will be >65, the highest of the Eurozone countries. Moving out to 2020, Italy’s percentage moves to 23.2%, the highest rate of any member country, with Finland and Germany trailing at 22.8% and 22.6% respectively.


Europe’s Shaky Compass - mh7


Stay tuned as the Macro Team digests the daily interconnected risk.


Matthew Hedrick

Bernanke's Brush Fires

This note was originally published at 8am this morning, November 04, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

"It does not require a majority to prevail, but rather an irate, tireless minority keen to set brush fires in people's minds."
-Samuel Adams


While I don’t expect any professional politician in Washington or the manic media that gets paid advertising dollars for stock market cheerleading to call this out for what it is until this stock market is a lot lower, I will. The US Federal Reserve is officially and unequivocally politicized.


Yes, Ben Bernanke himself has admitted that Quantitative Guessing (QG) is “unconventional.” But now he is so politicized that he is compelled to write an Op-Ed for the Washington Post on “What The Fed Did And Why: Supporting The Recovery And Sustaining Price Stability.” The Chinese, Hedgeye, and anyone with real-time market quotes, are sitting here staring at their screens this morning with shock and awe.


The US Dollar is making new lows this morning (down -15% since June!). The modern day Roman Empire’s credibility is burning at the global stake.


Notwithstanding unprecedented timing of the Op-ed (on the day of the Fed’s decision – do you think anyone leaked its contents?), or the fact that the words “US DOLLAR” were not mentioned ONCE in his allegedly objective and politically unbiased analysis, allow me to break down Bernanke’s view for you versus reality:


1.  STORYTELLING PREFACE: “Two years have passed since the worst financial crisis since the 1930s…”


KM: That’s always the 1st sentence of the fear-mongering message campaign that will lead you to believe no one notices Wall Street’s 2010 bonus pool.


2.  OUTCOME: “These steps helped end the economic free fall and set the stage for a resumption of economic growth in mid-2009…”


KM: Of course, the professional politicians saved us from the crisis they helped create and now we should pay homage to the banks, never earning a rate of return on our hard earned savings again. Fiscal sobriety and conservatism be damned. Get out there and chase some yield folks.


3.  MANDATE: “Notwithstanding the progress that has been made…” (we saved you)… “the Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation…”


KM: Right, you saved us from the evil-doers and completely screwed up the employment picture by fear-mongering employers to stop hiring. Ok. And now we’re seeing the credibility of the US Dollar collapse and, as a result, global commodity prices hit new YTD highs, DAILY. The CRB Commodities index is up +16.4% since Bernanke’s decision to Burn the Buck on August 27th in Jackson Hole.


4.  INFLATION: “Although inflation is generally good, inflation that is too low… can morph into deflation…”


KM: Right, right. China, India, and Australia have raised interest rates in the last few weeks specifically because they (like anyone with real-time quotes) see the inflation implied in expectations. The US Treasury Inflation Protection (TIP) auction yielded -0.55% (lowest EVER) in October (implying outright fear of inflation), but Bernanke keeps Burning the Brush Fire of Fear-Mongering about a great depression that no one in finance has remotely experienced.


5.  ECONOMIC STAGNATION: “falling prices and wages, which can contributed to long periods of economic stagnation.”


KM: How about JOBLESS STAGFLATION (sorry PIMCO, we called it first) = US Government sponsored fear-mongering towards employers + inflation. In the 1970s, Jimmy Carter and the Fed’s panderer, Arthur Burns, didn’t get it. This time around, I don’t expect Obama and Bernanke to either. It’s Keynesian theory versus real-time market realities. The problem here isn’t US Consumer reaction to government policy. It’s government policy itself.


6.  QE2: “so far looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action… lower mortgages will make housing more affordable … and higher stock prices will boost consumer wealth …”


KM: This is the central narrative fallacy of the Bernanke Brush Fire that really lights up the anxieties of anyone observing growth and inflation data on a globally interconnected basis. Re-read what he’s implying here and your jaw should drop:


A)     US Dollar Debauchery – Let’s ignore that chart.

B)     Inflation – I’m willfully blind to that chart too and/or whatever any other major country is currently saying on the matter.

C)     Stock Market – I fundamentally believe that manipulating its price via investor expectation is what drives this economy.

D)     Mortgages – I’m not going to mention that 30-year yields have gone straight UP +65% (from 3.55% to 4.09%) since I moved to QE2 in August.


7.  CONFIDENCE: “we are confident that we have the tools to unwind these policies at the appropriate time…”


KM: What a joke. While virtually every central banker in the world (ex the Fiat Fools in Japan and the EU) have hiked interest rates multiple times since the mid-2009 recovery that Bernanke pats himself on the back for, I can assure you that if he couldn’t raise rates with 6% US GDP growth, he’ll likely never be able to “unwind these policies” at any time. Sadly, the global markets may very well do that for him. And that will be it for this QG experiment going bad.


Don’t take my word for it on all of this. I’m just a man who is selling everything and going to cash. Get some real quotes and study the history of countries who attempted to debauch the currency of their citizenry. Then read some Asian newspapers - or something other than the Washington Post.


Overnight, China’s central bank adviser, Xia Bin, said the Fed’s Quantitative Guessing “amounts to uncontrolled money printing.” Even Japan’s bureaucrat PM, Naoto Kan, said this was “the US pursuing weak-dollar policy.” At least those Op-Eds were short and to the point. They also sound just about right.


My immediate term support and resistance levels for the SP500 are now 1186 and 1201, respectively. My SP500 short position (SPY) is -0.96% against me in the Hedgeye Portfolio, and I intend on shorting the market again today on strength. Being early on the short side here is also called being wrong. I get that. I was early in October/November of 2007 too. Remember, market tops are processes, not points.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Bernanke's Brush Fires - bern

Natural Gas Inventory Climbs Higher

Conclusion:   Consistent with our thesis of oversupply of natural gas, inventory in the U.S. continues to build.  We tactically covered our short natural gas position on November 1st, but continue to have bearish view on Natty.


Consistent with our thesis, as articulated by Energy Sector Head Lou Gagliardi, natural gas inventory in the United States continues to build due to a mismatch of supply and demand.  According the Energy Information Administration, natural gas inventories grew by 67 billion cubic feet for the week ended October 29th. This was slightly more than analyst expectations, which looked for a build of between 61 and 65 billion cubic feet.


As we’ve highlighted in the chart below, supplies in the United States are now about 10% higher than their 10-year average and up about 1% year-over-year. Interestingly, according to the EIA, inventory in the producing regions, which includes Alabama, Arkansas, Kansas, Louisiana, Mississippi, New Mexico, Oklahoma, and Texas, was up 2.4% and is now 20% above the 5-year average. This data point clearly underscores our view that producers are overproducing.


Furthermore, the EIA provided the following comment today as it related to supply and demand balance:


Though supply still exceeded demand during the Thursday-to-Wednesday report week (October 28-Nov 3) as reported by BENTEK, the supply/demand balance continued to tighten as demand rose while supply stayed flat. Total supply rose less than one half of one percent during the report week, as production and liquefied natural gas (LNG) sendout rose slightly. Overall, Canadian pipeline imports fell by an estimated 2 percent, but declines in imports to the West and Midwest were partially offset by a 17-percent increase in imports to the Northeast. Total consumption rose 7 percent, bolstered by a 30-percent increase in residential and commercial consumption, and partially offset by a 9-percent decline in consumption of natural gas for electric power generation. Compared to last year, total consumption is 2 percent higher and total supply is 6 percent higher.”


The two key takeaways from this statement for us are that electrical consumption is down 9%, which likely indicates soft economic activity, and the continued imbalance of consumption growth (2%) and supply growth (6%).


Additionally, the outlook for production in the United States continues to suggest further growth based on rig count acceleration.  Currently, there are 1,672 rigs working in the United States, which is 600 more year-over-year.   While there is more rig activity chasing liquids (oil), according to Baker Hughes almost 58% of the operating rigs focus on natural gas and almost 57% of those rigs are horizontal. 


More rigs and more horizontal drilling means more supply.  It is that simple.


Daryl G. Jones

Managing Director


Natural Gas Inventory Climbs Higher - nat gas inventory chart

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Bear/Bull Battle: SP500 Levels, Refreshed



Being short the SP500 today would make me wrong. I get it. I’m not going to point fingers or make excuses. The screen tells the score. Ben Bernanke has beaten me today.


I’m not always sure how it feels on the days preceding crashes, but today definitely feels as different as a few days did in late 2007. Not only from a price, volume, and volatility perspective, but in that dangerous place that we market practitioners call our gut. Any move beyond the 1215 line in the SP500 equates to a 3.3 standard deviation move on my key immediate term TRADE duration. These happen very infrequently. Someone might be blowing up.


I’ll leave getting today wrong for those who want to be focused on yesterday’s mistakes. Right here and right now our immediate term risk management task is to manage toward the risk that will be in this market tomorrow. In the chart below, we have outlined the immediate term TRADE risk to the downside at -3.5% (1173). Could it all happen in a day? For sure. I wouldn’t call it more than a 1.7 standard deviation move, which is normal – put it that way.


I’ve moved to 70% Cash in the Hedgeye Asset Allocation Model. However painful, tops are processes, not points.



Keith R. McCullough
Chief Executive Officer


Bear/Bull Battle: SP500 Levels, Refreshed - 1


Today’s October sales results can best be characterized by the term, “disconnect”.  A disconnect between the reality of a slower topline and a day in which almost every publicly traded retail stock is moving higher regardless of the quality of its monthly report.  Miss on the topline, stock is up.  Beat on the topline, stock is up.  Pre-announce to the upside, stock is up.  Pre-announce inline, stock is up. 


The bottom line is that October was the weakest month of the quarter and yes, weather was partly to blame.  Sales momentum did slow in the month, only to recover a bit towards the end as more seasonal weather patterns emerged.  Promotional activity was also up on the margin, largely the result of retailers such as GPS looking to prevent an inventory overhang as the most critical selling season of the year approaches. 


Is there anything major to glean from October?   Probably not.  The consumer remains in a holding a pattern, only to emerge around key events.  Despite retailers efforts to jumpstart holiday shopping at the same time Halloween costumes hit the clearance rack, we believe we have a long way to go before any definitive judgment can be made regarding Holiday 2010. Despite the waiting game also known as “holiday anticipation”, there  are a handful of callouts that are worth noting from today’s releases:


  • Same store sales day inches closer to obsolescence with ANF’s announcement that it will cease to report monthly results beginning in fiscal ’11.  That leaves just three more months to trade the lights out on all the speculation, whispers, and channel checks one could possible consume.  The truth is, apparel retail is managed around seasons, not months.  Within the next 1-2 years, it’s likely we’ll see many of the remaining monthly reporters calling it quits as well.  For reference, monthly sales reports are a legacy item, unregulated, not mandated, and unaudited.
  • From ANF’s recorded call, “Sales for the quarter are approximately in line with expectations at the beginning of the quarter.”  Aren’t sales either in-line or not in-line?  Ambiguity.
  • ROST noted that as cooler weather trends materialized, customer traffic increased.  Dresses were once again called out as a leading category, as well has home.  Pack-away levels were also notable, with an increase of 500bps year over year.
  • JCP noted that early sales of the Liz Claiborne exclusive remain strong and ahead of management’s plan. Men’s apparel and shoes were the best performing product categories for the month.   Cold-weather sensitive categories including sweaters, outerwear, and fleece were weak.  Overall, management once again noted AUR pressure as a result of heightened promotional activity.
  • JWN reported that California trends still remain below the company average but that the spread between CA and overall results continues to narrow.  Jewelry, dresses, and women’s shoes were leading categories in the month.
  • Despite pressure on margins driven by increased clearance activity, GPS guided EPS above the Street for 3Q to $0.47-$0.48 (Street $0.44).  Interestingly, the tail end of the quarter and the first week of 4Q have included 40% off promotions at core Gap.  Recall it has been quite some time since a “40% off any item in the store” promotion has been used.  If you haven’t already checked out this coming Friday’s promo, it’s worth taking a look at: http://www.facebook.com/event.php?eid=159056334132258
  • Costco highlighted that food inflation picked up in October, driven primarily by milk, butter, cheese, and deli meats.  Overall inflation for all food and sundries was 1.5%, a measurable increase from prior months.
  • ARO reported that its AUR’s decreased by mid single digits as a result of increased promotional activity as well as a negative mix shift towards lighter weight merchandise. 
  • AEO reported that its average prices on apparel were actually up year over year.  However, the mix impact of higher sales of accessories and Aerie negatively impacted overall AUR.
  • Add Gymboree to the list of retailers noting that a heightened promotional environment had a negative impact on margins.
  • Despite what was believed to be one of the strongest Halloweens in years, only Hot Topic called out the holiday’s impact on the month. Unfortunately, Halloween proved to be disappointing for HOTT.  Historically, the retailer was a merchandising leader for Halloween.  However, decisions to dramatically cut back on punk pants, corsets, and fish nets had a meaningfully negative impact on monthly results.

Eric Levine



Initial Claims Rise 23k, Offsetting Last Week's 21k Improvement

The headline initial claims number rose 20k last week to 457k (23k net of revisions). Rolling claims came in at 456k, an increase of 2k over the previous week. This wiped out last week’s improvement, and claims still remain in the same band they’ve occupied for the year. We're still a solid 50-75k above where we would need to be in order to see unemployment fall.


QE2 Not Showing Any Signs of Taking Down Claims So Far

Interestingly, in the last round of Quantitative Easing (QE1), we saw almost all of the decline in mortgage rates occur between the time when the program was announced in late 2008 and when the buying commenced in early 2009. We think this time is similar in that mortgage rates have already come in substantially, to all time lows. What's interesting to observe is that mortgage rates have been exceedingly low now for a few months, but we've seen no real improvement in jobless claims. Maybe this is too short a window against which to measure success, but it is interesting to note that so far there appears to have been no transmission of QE2 into lower claims. We would not expect to see long rates drop much further from here, consistent with QE1.






In the table below, we chart US equity correlations with Initial Claims, the Dollar Index, and US 10Y Treasury yields on a weekly basis going back 3 months, 1 year, and 3 years.




Joshua Steiner, CFA


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