“The point is, in investing, price has to matter.”
That’s what Oaktree’s investment chief, Howard Marks, wrote in a recent memo to his clients where he was talking down the perception of value embedded in the price of gold. It’s a very simple market practitioner’s point, but it’s worth highlighting; especially as we traverse year-end storytelling as to why everything that’s going up in price is still “cheap.”
The price of the US stock market was cheaper 4 trading days ago than it was at last night’s closing price of 1254. That’s because the SP500 has been up for 4 consecutive days, taking it to a new YTD high. But does that make the price of the US stock market cheap?
Well, it’s definitely not cheaper than the SP500’s March 2009 closing low of 676. An arithmetically proficient 8th grader could tell you that 1254 is +85.5% more expensive. In fact, if I give him the right button to press while he is sitting on my lap at my desk, my 3-year-old son could get you a PE ratio and 200-day Moving Monkey average on that too.
Wall Street’s favorite way to justify higher-prices is to talk about “valuation.” Again, the opacity of the lingo is what it is, but it’s less convincing to hear a fast monkey talk about valuation today than it was, say, before the internet. Calculating “valuation” on the sell side’s consensus estimates is a trivial exercise that requires a connection, not an education.
Storytelling about “valuation”, however, requires academic degrees spanning law and social science. At the end of the day, the stories don’t change the historical reality that stocks, bonds, and commodities trade all over the place on “valuation” but, most importantly, on last price.
In the last 6 months, let’s look at what some prices have done at the same time as the storytellers talk about “the deflation”:
Now before I accuse myself of cherry-picking that all-time high price of copper of $4.27/lb this morning and what it may mean to people who make and/or sell things that include the price of copper, let me tone down my argument and look at the price of oil. Its price is up less.
The price of gasoline is hitting higher-highs this morning after a +25% move in the price of WTI crude oil since July, and the Chinese are being forced to raise consumer gas prices this morning for the 3rd time in 2010. Price fixing aside, I suppose this is Ben Bernanke’s Merry Christmas card to the world’s lower and middle class.
Inflation is a policy and Price Matters.
Ask the Bank of England. Finally it reflected some form of reality in their policy statement this morning as they opined on inflation. The minutes in the BOE’s statement read that “most of those members considered that the accumulation of news over recent months had probably shifted the balance of risks to inflation in the medium term upwards.”
Now, to be clear, don’t expect Bernanke to do what the BOE just did. If Ben Bernanke didn’t see inflation hammering America’s middle class with $150/oil in 2008, don’t expect him to see it (or Chinese or Brazilian inflation) ramping to the upside like the prices on your screen are this morning. The Heli-Ben doesn’t do global macro.
The Ber-nank’s storytelling and views about last price don’t trump what’s happening to market prices. Inflation has been hurting emerging market prices (stocks, bonds, and currencies) since November, and we don’t see what will change that direction of market prices in the new year. Inflation is a matter of prices. It’s the one thing that’s killed modern societies (and their markets) for hundreds of years.
As always, Price Matters to every long and short position we hold in the Hedgeye Portfolio. Being short the SP500 (SPY) for the last 3 weeks has been as wrong (-3.84% against me) as being long Corn (CORN), Germany (EWG), and China National Offshore (CEO) has been right.
In terms of Asset Allocation, my best “idea” going into 2011 is being long of Cash. The price of American cash (US Dollar Index) is one of the few price charts in global macro that isn’t trading at its cycle highs yet. Heck, maybe someone can tell me a story that it’s “cheap.” US Congress’ credibility on fiscal responsibility definitely trades at a discount!
And, yes, I get that in a world where you can’t buy bonds (because they are going straight down in the face of Global Inflation Accelerating) that Bernanke is daring me to chase the “yield” of the US stock market’s last price. But I also get that investing in a globally interconnected marketplace has less and less to do with the US stock market’s price than it did before 2008.
My immediate term TRADE lines of support and resistance for the SP500 are now 1242 and 1256, respectively. We’re still long the US Dollar (UUP) and short the Euro (FXE) in the Hedgeye Portfolio and the Cash position in the Hedgeye Asset Allocation Model is currently 67%.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on December 21, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“One can find so many pains when the rain is falling.”
Timing is everything in life. As it relates to my current trip to Southern California, my timing couldn’t have been worse. I took a few hours away from the screens yesterday to finish up my Christmas shopping and a number of local business people informed me that this was one of the rainiest weeks Los Angeles had seen in, well, a really long time.
Today Keith is off to his hometown of Thunder Bay, Ontario with his wife and little ones, Jack (already a heck of an ice skater at only three years old) and Callie. Tomorrow I’ll head to my hometown, the small Alberta prairie outpost of Bassano, Alberta (total population of 1,200 and 75 some dogs). I think both of us, like many of you I’m sure, will take the next week to relax and begin planning for 2011. Much to the Steinbeck quote above, as I contemplate the future on this dark wet California morning, I do see a few pains.
While Steinbeck is most known for his literary career which culminated in the Nobel Prize for literature in 1962, he also knew a thing or two about state and local finances in California. In fact, his father was the long serving Treasurer of Monterey County.
California has become the poster child for one of the key potential pain points heading into 2011, that of municipal debt and deficits. We recently shorted municipal bonds in our Virtual Portfolio via the etf, MUB. While clearly not all municipal bonds are created equally, the general short case for the municipal bond market is as follows:
1. Rates are going higher – We’ve obviously already seen this over the last 30-days, but as the Fed is unable to keep the long end of the curve down, bonds will continue to suffer, especially as inflation expectations accelerate. Rates, obviously, have much more room to the upside from these historically low levels.
2. Housing prices have more downside – We are bearish on housing prices to the tune that we think home prices have 15 – 30% more downside nationally. Since appraisals for tax purposes operate on a 2 – 3 year lag to market prices, municipalities will begin collecting taxes based on dramatically declining home prices, which should hurt their tax receipts. Real estate taxes are the single largest revenue source for local governments. In the Chart of the Day, we show the Case-Shiller index versus property tax receipts.
3. State deficits set to expand – Currently, state level revenue is 12% below pre-recession levels, which is substantially worse than the revenue recovery in the past three recessions going back to the 1980 – 81 recession. This pain is likely to intensify, with States facing a $140 billion budget gap in fiscal 2011, according to the Center of Budget and Policy Priorities.
This is obviously the cliff notes version of our body of work on the municipal market, so if are a subscriber or prospective subscriber and would like more information, or to set up a call to discuss this topic with us, please email our Head of Sales Jen Ken at firstname.lastname@example.org.
While Steinbeck has become one of America’s most lauded authors, he was also, while alive, one of its most controversial. He had left leaning politics and was long suspected to have ties to the Communist Party. In fact, perhaps his greatest work, The Grapes of Wrath, which is considered by almost all as one of the top ten English language novels of the last century, was originally harshly critiqued because it was deemed to be too pro-worker and overly critical of capitalism.
In addition to his full-time career of writing, Steinbeck was also a very active traveler. In 1947, he travelled to the Soviet Union with noted photographer Robert Capa. They were two of the first Westerners to visit the Soviet Union after the Communist Revolution. The output of this trip was A Russian Journal, which describe the harsh living conditions in the Soviet Union.
Since Steinbeck’s visit almost 60-years ago, much has changed in the former Soviet Union. While the transition to a fully functioning democracy in the vein of the West is still a work in progress, the introduction of capitalistic ways has certainly benefitted Russia, particularly as it relates to its vast natural resources. Due to modern reinvestment and the opening of her oil fields, since 1999 Russian oil production has increased 62%, or 3.5MM barrels per day, while total global oil production has only increased 10.5%, or 7.6MM barrels per day. The Russians are taking market share.
Despite the pain we see in municipal debt markets headed into 2011, we do have some great long ideas. As it relates to the Russian oil theme above, one of our favorite long ideas is Lukoil (LUKOY). According to our Energy Sector Head Lou Gagliardi:
“Although labeled a National Oil Company (NOC), Lukoil is 100% publicly owned. But, geopolitical risk, the Russian economy, a weak global economy and energy demand, and an onerous export tax duty have all weighted heavily on Lukoil’s share price in 2010 widening its market price discount to its discounted cash flow valuation further to 50%.
Historically NOCs trade at a discount to cash flow valuations and Lukoil’s historical discount has been in the 30% range. We believe its market discount will narrow reverting to the mean in 2011 driven by several catalysts. Lukoil’s high oil production weighting of 87% levers its share price to higher crude prices; its long-lived reserves, its expanding production profile internationally, and its growing crude oil production profile of ~2% per annum will contribute to significant earnings growth in 2011.
Lukoil’s balance sheet is strong with a debt to capital ratio of ~16% and a net of cash ratio at ~12%, as the Company is living within its capital spending. At $85.00 crude oil in 2011, we expect Lukoil to easily beat consensus with a ~25% E.P.S increase from 2010 to $14.75/ADR. For 2011, NCF at $85/bbl is targeted at $8.4 billion, or $10.12/ADR. At $89.00/bbl, earnings would jump 35% from prior year to nearly $16.00/ADR, adding roughly another $1 B in NCF.”
To put it simply: Lukoil is cheap, growing, has deep reserves, and a pristine balance sheet.
While the outlook does seem a little cloudy and rainy, there are plenty of Lukoil type opportunities out on the horizon. Moreover, as another well know American literary figure Dolly Parton once sang:
“The way I see it, if you want the rainbow, you gotta put up with the rain.”
Enjoy the holidays with your families and stay out of the rain,
Daryl G. Jones
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Conclusion: Darden continues to deliver from an earnings perspective and management is not raising any red flags. With respect to Red Lobster, there are structural issues that need to be addressed.
Darden’s earnings call brought few surprises to the fore this morning with management reaffirming their long-term EPS guidance within their 10-15% growth range. This is based on a long-term same restaurant sales growth target of 2-4%. Currently, for FY11, the company is trending at or above the higher end of the longer term EPS range (guided to +14-17% growth) and at the lower end of the same restaurant sales range (guided to approximately +2% growth, down from its prior +2-3% guided range). While this dynamic is unsustainable, it puts a premium on sustained management of cost efficiencies and continued strong performance of new units.
Looking at same-store sales trends, there is reason to be concerned by the decline in the GAP-TO-KNAPP which has narrowed significantly for Darden over the past couple of years. Looking at The Olive Garden, on a fiscal year basis, the Gap to Knapp has come down meaningfully from levels sustained throughout much of FY08, FY09, and most of FY10. The second chart below shows the Gap to Knapp for Red Lobster and it is clear to see why many investors view this as DRI’s “everlasting turnaround”. The brand has been struggling for some time, relative to the performance of Olive Garden, and now LongHorn.
President and Chief Operating Officer, Andrew Madsen, emphasized Darden’s wariness of “utilizing deep discounts to combat difficult industry conditions”. It seems to me that the Great Recession may have changed the playing field in such a way that Red Lobster, in its current form, is suffering from structural problems as it relates to today’s Red Lobster customer.
Management talked around this issue during this morning’s call, singling out “price specificity” in its marketing message as being a key driver of traffic at Red Lobster but it is clearly lower prices, a.k.a. discounting, that is driving traffic at the concept.
There was a promotional timing mismatch with Red Lobster’s Endless Shrimp promotion (began two weeks later and was one week shorter than the Endless Shrimp promotion in FY2010), which was altered to “help address the very difficult business conditions”. It is fair to say that the promotion mismatch was a negative year-over-year for Red Lobster. However, at the same time, explicitly stated in management’s explanation of this mismatch and general commentary today is the view that business conditions, year-over-year, are much improved from their “difficult” level of FY2010. It seems that the Red Lobster customer has been rendered an “impaired asset” by the Great Recession and the price elasticity of demand is high relative to other casual dining customers as a result.
In contrast to Red Lobster, The Olive Garden’s environment has improved year-over-year relative to necessary value-driven marketing (only ran 10 weeks of value-oriented, price-point advertising this year versus 18 weeks last year). This was outlined in management’s comments surrounding their wariness of discounting and the same was true for LongHorn as it was for Olive Garden. All in all, I think that the bifurcation between these two brands and Red Lobster, in this regard, underlines the need for management to address the glaring issues with Red Lobster gaining traction with its customer base.
Margin performance in 2QFY11 was strong, thanks to an improvement in food and beverage expense that was attributable to lower food costs offset by negative mix changes related to the company’s promotional offerings strategy. Labor expense declined by 120 basis points thanks to improved productivity and lower turnover, partially offset by higher benefit expense. Management said more than once that with comps turning positive, they expect to see more leverage across the P&L, particularly on the labor cost line.
In terms of outlook, management expressed comfort with their earnings target for the full fiscal year 2011 in spite of same restaurant sales being at the lower end of their embedded range of 2-4%. It is important to note that even with DRI lowering its blended comp guidance to +2%, they might not have lowered the bar enough. A +2% comp for the full year implies a significant uptick in two-year average trends from current levels. Even if I assume a significant acceleration in trends at Red Lobster, combined with continued steady improvements at Olive Garden and LongHorn, I have a hard time getting to +2% for the year. Management said the improved trends should be driven largely by:
We will have to see how the industry overall fares, but according to Malcolm’s Knapp’s most recently reported November numbers, trends slowed slightly on both a one-year and two-year average basis. And, although comp trends were positive in November at each of DRI’s three largest concepts, two-year average trends slowed across the board from October levels.
Leverage over the labor line was highlighted as a bright spot for last quarter but it is clear that commodity costs will be a determining factor in DRI’s earnings performance for the remainder of FY11. Management forecasts commodity costs to be 1-1.5% higher in 2HFY11 on a year-over-year basis. Specifically, the company guided to flat food and beverage costs as a percentage of sales for the full year. Given that these costs were about 80 bps favorable in 1QFY11 and 10 bps favorable in 2QFY11, the food and beverage expense line will become a headwind for the company on a YOY basis in 2HFY11. In terms of visibility, most of their commodity costs are locked with the exception of beef which is only 25% covered and constitutes 14% of DRI’s food cost basket. Management expressed their intent to extend coverage after the holidays.
CCL BEATS REVISED GUIDANCE ON STRONGER NET YIELDS AND CURRENCY. FY2011 GUIDANCE IN LINE WITH CONSENSUS
"Booking trends have continued to improve for both our North American and European brands, particularly for our peak summer season. We are optimistic these positive trends are an indicator of a strong wave season, our heaviest booking period which begins in early January. Given the recent cold weather and snow, particularly in the Northern U.S. and Europe, there is no better time to book a cruise vacation."
- Micky Arison, Carnival Corporation & plc Chairman and CEO
HIGHLIGHTS FROM THE RELEASE
CONF CALL NOTES
TODAY’S S&P 500 SET-UP - December 21, 2010
As we look at today’s set up for the S&P 500, the range is 11 points or -0.65% downside to 1239 and 0.23% upside to 1250. Equity futures remain range bound in what is expected to be a positive start to trading as the pre-Christmas rally finds further strength. A reduction in tension on the Korean peninsula and supportive comments for the Euro from the Chinese Vice-Premier Wang Qishan looks to be the main catalyst behind today's positive tone. With little in the way of macro headlines expected this session, activity is expected to remain light.
CREDIT/ECONOMIC MARKET LOOK:
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