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America's Armpits

This note was originally published at 8am on January 03, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I know it's hard when you're up to your armpits in alligators to remember you came here to drain the swamp.”

-Ronald Reagan


Welcome back to a New Year. It’s Game Time.


While my New Year’s resolution is to remain as far away from professional politicians and academic charlatans as I possibly can, until this game changes I’ll have to remain focused on attempting to understand what Big Government Intervention can do to our markets.


President Obama seems keen on understanding more about what Ronald Reagan thought about the economy. Or at least that’s what the White House says he was reading about this past week. Lou Cannon’s President Reagan: The Role of a Lifetime is officially out of stock on Amazon due to a surge in speculative Democrat buying.


Ironically enough, I read The Reagan I Knew by Bill Buckley a few weeks ago. Don’t worry, I’m neither Republican or Democrat. I’m just a Canadian-American looking for historical perspectives, accepting that they are often decorated with hyperbole.


What will be most interesting to me with this new Obama/Reagonomics Revolution thing is whether or not the President justifies a bloated US budget deficit by reminding the Republicans that “Ronnie used one.” After all, as Danilo Petranovich reminds us in the Introduction of Buckley’s book, “Reagan, of course, had promised to cut the size of government, and yet the budget deficit nearly doubled during his tenure.”


American storytelling and political hypocrisies aside, the non-fiction version of the fiscal New Year is that America is up to its armpits in deficits and debts. It’s time we “drain the swamp”, and I think we can all save and make money while we do it.


In term of percentage allocations, here’s how I have the Hedgeye Asset Allocation Model positioned for what we’ll be introducing as a Q1 Macro Theme in the coming weeks – American Sacrifice (fiscal reform): 

  1. US Cash = 61% (long US Dollar, UUP)
  2. International FX = 18% (long Chinese Yuan, CYB)
  3. International Equities = 9% (long Germany, EWG)
  4. Commodities = 6% (long Oil, OIL; long Sugar, SGG)
  5. US Equities = 3% (long Healthcare, XLV)
  6. Fixed Income = 3% (long Treasury Inflation Protection, TIP) 

For those of you who follow my day-to-day risk management moves closely, you’ll recognize that I dropped my Cash position from 70% to 61% last week and re-allocated that Cash to Commodities and US Equities. This doesn’t mean I’m bullish on US Equities up here. It means I’m bullish on the Energy and Healthcare sectors at these prices.


There are obviously plenty of negative mean-reversion risks associated with buying anything US Equities after an +86% rally from the March 2009 lows. If you dare to chase equity oriented yields up here, we think you need to protect against 3 critical risk factors that are going to be perpetuated by Big Government Intervention

  1. Congress
  2. Fed Policy
  3. Inflation 

If we’re going to attempt to find the political spine to “drain the swamp”, these 3 factors will remain omnipresent. Congress will be getting paid to push their own book. Fed Policy rhetoric will trade like a NYC hedge fund. And yes, Inflation, will remain a policy.


Energy (XLE) and Healthcare (XLV) companies have leverage to inflation. Higher selling prices, in theory, help these companies expand margins. While the SP500 is running close to peak margins, these two sectors aren’t. There’s some mean-reversion opportunity there in equity prices for these sectors as a result.


In Energy, I’m not long the sector – I’m long the stocks. We remain bullish on China National Offshore (CEO), Suncor (SU) and Lukoil (LUKOY). In the immediate-term, the Energy sector ETF (XLE) is overbought with immediate-term TRADE support down at $66.29. In Healthcare, immediate-term TRADE lines of support and resistance for the XLV are $31.03 and $31.91, respectively.


From an asset allocation perspective (and I mean your money, not some theoretical Big Broker’s high net fee, commission, and compensation model), being bearish on Congress and bullish on its inflation policy is fairly straightforward to express. If I had to be in one or the other, I’d be in US Equities over US Treasury Bonds here. Fortunately, I don’t have to be in either.


What I am most bullish on is the hard earned Cash that my family and firm has earned over the course of the last 3 years. No, we weren’t the super duper top US Equity performer of the Year in 2010 (although I did win the Forbes stock picking contest!)… but we made money for the 3rd consecutive year, and there’s nothing that smells like America’s Armpits about that.


My immediate term support and resistance lines in the SP500 are now 1249 and 1263, respectively.


Best of luck out there this year,



Keith R. McCullough
Chief Executive Officer


America's Armpits - 1

Tales of the Global Inflation Tape Part II: China, Brazil and India

Conclusion: Inflation continues to percolate within these economies and we expect additional monetary policy tightening in each country over the intermediate term. Furthermore, we expect inflation to continue to remain a headwind for many countries globally and for that to lead to slowing economic growth globally (via policy tightening).


Chairman Bernanke’s experiment with Quantitative Guessing continues to have unintended consequences for the global economy, due to the impact of the equation highlighted below:


QG = inflation [globally] = monetary policy tightening [globally] = slower growth [globally]


A brief review of global economic data points highlights three very key countries’ struggles with inflation (China, India and Brazil). While the divergence between each country’s response reminds us that both inflation and monetary policy are local, analyzing them collectively allows us to derive the equation laid out above.


Let us briefly visit each country’s headlines and data points from today’s global macro run for a quick update on the global inflation front. Not surprisingly, not much has changed from a grading perspective since we originally published this piece on November 24th:


Country: China; Policy Stance: Proactive


On a relative basis, China has been particularly proactive in their fight with inflation of late, hiking interest rates twice in the last 2.5 months, raising bank’s reserve requirements, and announcing potential price controls and supply rationing in its food market. Since we last published this note, China has continued to proactively fight speculation and today’s PMI report shows early signs of success.


Manufacturing PMI (a proxy for demand) slowed in December to 53.9 vs. 55.2 prior with the Input Prices component backing off a 29-month high, coming in at 66.7 vs. 73.5 in November. Dampening some of the positive headway made in today’s report was an acceleration in Non-Manufacturing PMI to 56.5 vs. 53.2 prior, which suggests Chinese monetary policy has more tightening to do before growth has slowed enough to rein in both inflation and inflation expectations.


Tales of the Global Inflation Tape Part II: China, Brazil and India - 1


We continue to have conviction that growth is slowing and inflation will remain a headwind in China over the intermediate term, necessitating more tightening measures which are likely to have an incremental drag on Chinese (and therefore global) GDP growth. Chinese Central Bank Governor Zhou Xiaochuan agrees, pledging Friday to shift Chinese monetary policy to a “prudent” stance in order to tackle inflation in the New Year.


Country: Brazil; Policy Stance: Reactive


When we last published this report, Brazil’s monetary policy graded out less than favorably due to its relatively late reaction (compared to China) in fighting inflation. It appears Brazil is finally ready to shift the fight into high gear in January, after raising reserve requirements early last month. Analysis of Brazilian interest rate swaps suggests traders are betting incoming Central Bank President Alexandre Tombini will hike the benchmark Selic rate +50bps to 11.25% in his fist meeting as chief on January 18-19.


New President Dilma Rousseff, who only recently brought about widespread concern in the Brazilian bond market because of the perception that she would fail to contain inflation, is joining in on the fight, pledging to cut government spending by $15B – a sum that exceeded investor expectations. Over the weekend, she also pledged to tackle the “plague” of inflation:


“To ensure the continuation of the current economic growth cycle we need to ensure stability, especially price stability… We won’t allow under any hypothesis that this plague returns to eat away our economic tissue and hurt the poorest families.”


The hope is that she’s willing to back her rhetoric with prudent policy action, and to some extent, she’s shown signs of this of late. On the flip side, however, we see that the Brazilian Congress just approved an increase in the minimum salary – a metric that determines both the nation’s minimum wage and transfer payments. For reference, the last adjustment to the Bolsa Familia program was a +10% increase in 2009.


Given that a broad-based wage hike would augment already-robust Brazilian consumer demand, we would expect to see more monetary policy tightening and offsetting fiscal restraint elsewhere in the government’s budget over the intermediate term.


Elsewhere on the demand front, we see Brazil’s Manufacturing PMI came in at 52.4 for December, a +2.5 increase over November’s 49.9 reading. Brazil is in a setup very similar to China: while we have conviction that growth will continue to slow throughout 1H11, it is robust enough to continue providing demand-side inflationary pressures.


Tales of the Global Inflation Tape Part II: China, Brazil and India - 2


Brazil’s CPI (as measured by the unofficial FGV IGP-M Index) accelerated in December to +11.32% YoY driven by higher food prices that are now consuming one-third of poor Brazilian’s incomes. By comparison, the Benchmark ICPA Index accelerated to a 21-month high in November, coming in at +5.63% YoY.


Tales of the Global Inflation Tape Part II: China, Brazil and India - 3


Country: India; Policy Stance: Inactive; Hurtful


India continues to lag in its bout with taming inflation, opting instead for the “wait and see” approach with regard to implementing another round(s) of tightening. Having shifted from his hawkish stance (six rate hikes in 2010) to a more relaxed position, Reserve Bank of India Governor Duvvuri Subarrao has held true to his November promise that additional rate hikes are not in India’s near-term future.


That would be fine if India had inflation under control; unfortunately, the latest WPI reading of +7.5% YoY suggests India is far from achieving its target of +4-4.5% YoY inflation. It is, however, a marginal improvement nonetheless, though expecting an additional +300bps drop from here absent any further tightening would be reckless at best. Moreover, food inflation continues to plague the 828 million Indians who live on less than $2 per day at PPP, accelerating to +14.44% YoY in the second week of December.


Tales of the Global Inflation Tape Part II: China, Brazil and India - 4


Compounding this blatant lack of vigilance is the RBI’s decision to add fuel to the fire by buying back government bonds from Indian lenders with the intention of increasing liquidity in a cash-strapped banking system that has been struggling to meet demand for loans. In December, the RBI pumped nearly 414B rupees ($9.3B) into India’s financial system via sovereign bond purchases (a.k.a. Quantitative Easing).


Fueling speculation when inflation is running at nearly twice the target rate is not our idea of prudent monetary policy. We expect further tightening ahead, but only after inflation becomes the problem it was in 1H10. For this reason, we continue to remain bearish on Indian equities over the intermediate-term TREND. We are, however, bullish on many commodities (corn, sugar, oil, etc.) as countries like China and India look to accelerate food and energy imports to ease any supply shortages that are perpetuating rising prices in their economies.


Darius Dale


Retail: The Expectations Fairy


Let’s synch expectations for earnings revisions, earnings growth, with valuation and stock performance. Not a pretty story. We still think margins are off in apparel retail by 300bp next year.


In the land of retail, there’s usually 2 main factors that that drive stock performance (outside of M&A). 1) Earnings Expectations, and 2) the Delta between Expectations and Economic Reality.


Today, we are looking at 16x forward earnings expectations, and a 16x multiple that the market is placing on those expectations becoming reality.


What’s interesting is that in looking at revisions, multiples, earnings growth, and absolute stock price change…the past three years has been so typical of retail. Peak multiples on peak earnings, and trough multiples on trough earnings (with the sell-side earnings revisions lagging stocks by about 3-5 months).


Today’s bull could argue that we’ve taken this ‘peak on peak’ exercise up and above 20x/20% in years past. Math is math and I won’t dispute it. But what we would argue is that if we look at history going back a decade, there’s never been period where it’s been sustainable for anything more than six months. Also, the cost pressures at retail to drive margins lower were nonexistent during such times. In fact, we think that retail will be down around 300bp next year.  There is absolutely no way that the charts below recognize this as anything in the ballpark of being a possibility.


Retail: The Expectations Fairy - EarnRev PE 12 29 10


Retail: The Expectations Fairy - EarnRev 12 29 10



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R3: BBY, CROX, Luxury Watches, and E-commerce Spending


January 3, 2011




  • Keep an eye on Best Buy’s efforts to drive sales and brand loyalty via a substantial step-up in the company’s editorial efforts.  The launch of the company’s multichannel network containing everything from how-to videos to primers on new technology is called “Best Buy On” and includes both an online and in-store component.  In addition to content aimed at helping consumers become more educated on consumer electronics, the closed distribution network will also look to serve ads from brands including Swiffer, Tide, Duracell, and Braun.
  • According to comScore, e-commerce spending from November 1- December 26th increased by 13%, largely in-line with original expectations for a robust increase in online holiday spending.  Interestingly, the final push into the holiday (Dec 20-26) actually accelerated, with sales increasing by 17% for the week.  We’re still waiting to see what the post-Xmas trend looks like, especially I light of major weather events that were sure have tempered some clearance shopping.
  • In an effort to generate a little buzz, a North Carolina-based jewelry store Perry’s Emporium offered customers a full refund on holiday purchases if it snowed more than 3-inches during December – Ashville, NC ended up getting 6! For the expense of a $10,000 insurance policy, not only will Perry’s refunds be covered in full, but the publicity will also be hard to beat for the price.



Holiday Winners and Losers in Retail - The key question after holiday 2010 is which retailers gained in the bruising battle for market share and which ones lagged. And the fight is only going to get more intense in 2011.
“The pie is not growing. It shrank, and now it’s just regaining its original shape, recovering to 2007 levels,” said Arnold Aronson, managing director of retail strategies at Kurt Salmon Associates. “Luxury is leading the way, department stores are stabilizing and improving, the specialty area is where you see some trade-offs and discounting as a whole is seeing some improvement. It’s still a zero-sum game, and any increase is going to be a hard-fought battle. The winners in 2011 will be those that are multichannel, aggressive globally and focus on merchandise innovation.” 
They also are likely to be the stores that scored big this holiday. December sales numbers, to be reported by many major retailers on Thursday, should bear this out, though last week’s blizzard severely impacted business for two days. <WWD>

Hedgeye Retail’s Take:  Winners include e-commerce above just about all others – while the “zero sum game” landscape remains unchanged for retailers in 2011.


Retail Stocks end year with 23.5 Percent Gain - Aided by stores’ recovering sales and ongoing operational discipline, as well as a flurry of merger and acquisition interest at the end of the year, retail stocks posted a 23.5 percent gain in 2010 and moved within points of their historic highs at year’s end. Even after a 0.8 percent decline in the final week of the year, the S&P Retail Index ended 2010 at 507.79 versus its 411.12 finish in 2009. Its 52-week high through 2010 was the 514.64 reached on Dec. 7, and its 512.35 close on Dec. 21 was its best daily finish since July 20, 2007. With their 47.2 percent gain in 2009, retail issues essentially recovered the ground they had lost since the end of 2007, which concluded with the index at 409.94. The strong gains last year brought them close to their high-water marks of early 2007, before growing problems in the housing market and rising gas prices pressured them downward. Since its June 2002 recalibration, the retail index’s highest point was the 538.50 reached on Feb. 20, 2007. However, retail stocks sold off 31.9 percent in 2008 as the financial crisis spread and touched off the worst recession since the Great Depression. <WWD>

Hedgeye Retail’s Take: While expectation for M&A activity remains elevated in the 1H of 2011, the benefit of multiple tailwinds in 2010 are set to give way to several headwinds that are unlikely to result in similar gains come 2011.


Triple Five Hopes to Create New Xanadu Meadowlands - Major surgery is in store for Xanadu Meadowlands. And a big first step in overhauling the beleaguered, massive mixed-use complex happens today, when top officials from Triple Five, the developer of Mall of America, meet on-site for the first time with Xanadu creditors. Late last year, Triple Five and the creditors signed an agreement whereby Triple Five takes over and redevelops the stalled project, which is located in northern New Jersey on Route 3 in East Rutherford. Everything is on the table, from changing the project’s name to overhauling the exterior and reworking the retail space and tenant roster, according to Triple Five. For those driving along Route 3, the incomplete Xanadu is an eyesore. It’s also been a drain on the New Jersey economy. “This project needs help. It needs to be redesigned for productivity,” Maureen Bausch, executive vice president of business development for Triple Five, told WWD. “Now we are taking it to the next level, fine-tuning the plan design and the name, and so on. We are getting to work to see how to make it a reality.” Some design options will be reviewed today. “Some [retail] spaces are very, very deep. Retailers would prefer more store frontage. They don’t want the consumer to walk very far. They want guests to be able to get to a lot of stores and attractions with the shortest amount of work,” Bausch said. <WWD>

Hedgeye Retail’s Take: Perhaps viewed as a new square footage growth opportunity by retailers, with many questions left to be answered and a ‘goal’ of having the development open by 2014 interested retailers should have plenty room for negotiating.


Interview with Hublot’s CEO – Biver, 61, joined Hublot in 2004 and launched the Big Bang collection, which is promoted by celebrity faces such as skier Bode Miller, track star Usain Bolt and actor Jet Li. In 2007, Biver opened Hublot’s first store in Paris, and the brand now operates 26 units worldwide. One of Biver’s major goals was to penetrate the U.S. market, which he feels is underserved by the luxury watch industry. Hublot has stores in Bal Harbour and Boca Raton in Florida, a boutique in St. Thomas in the U.S. Virgin Islands and plans to open shops next year in New York and Beverly Hills. In Response to viewing the U.S. as an emerging market for watches: “It’s an emerging market for watches.…Compared to markets in Singapore, Switzerland, France, Germany, we are quite emerging.…In Asia they use the watch to communicate personality. They tell you who you are. Are you elegant? Are you discreet? Are you low-profile? Are you powerful? Are you arrogant? All these things can be communicated through the watch…and the Asians have understood this. [For example,] out of 100 Asians who can afford a $100,000 watch, 99 will buy it…out of 100 Americans who can afford a $100,000 watch, 20 will buy it.” On growing retail during global weakness, “In the Chinese culture, they say, “You fight the disease when you are healthy.” More and more we will discover that problems have to be solved when you are in good health. We prepared ourselves for the crisis…we were 100 percent cash when the crisis came. We had no debts, no leasing, no bank relations, nothing. So when the crisis came, nobody told us what to do. If you owe nothing to the bank, you can say, ‘Go to hell. I do what I want.’ <WWD>

Hedgeye Retail’s Take: Interesting cultural difference as it relates to brand importance as a status symbol.


Crocs Pays for False Antimicrobial Claims – Crocs, Inc. has agreed to remove language on product packaging and pay $230,000 to resolve cases involving unsubstantiated antimicrobial claims for several types of its shoes, according to the Environmental Protecton Agency. “EPA will take action to protect the public against companies making unverified public health claims,” said Jim Martin, EPA’s regional administrator in Denver. “Unless these products are registered with EPA, consumers have little or no information about whether such claims are accurate.” The case involves several styles of Crocs shoes that included unsubstantiated health claims on product packaging in violation of the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA). The company also made similar claims in advertisements and on their web site. Crocs has agreed to stop making such claims and has cooperated fully with EPA enforcement staff. “We’re seeing more and more consumer products making a wide variety of antimicrobial claims,” said Sandra Stavnes, director of EPA’s technical enforcement program in Denver. “Whether they involve shoes or other common household products, EPA takes these unsubstantiated public health claims seriously.” Under FIFRA, products that claim to kill or repel bacteria or germs are considered pesticides, and must be registered with the EPA prior to distribution or sale. <SportsOneSource>

Hedgeye Retail’s Take: Yet another branded retailer removing environmentally beneficial/green claims once questioned by a credited agency. While the company has marketed footwear directly to medical professionals, our sense is that sales are largely tied to the products comfort above all else. Needless to say, the negative headlines continue for CROX.


Online Ad Spending Set to Break Records - New peaks in spending each year through 2014 After 2009’s downslide, US online ad spending in 2010 will rise by 13.9%, reaching a record $25.8 billion. And in that same vein, internet adspending will hit new peaks in each of the following four years, passing $30 billion in 2012 and breaking the $40 billion barrier in 2014.The more granular quarter-by-quarter picture shows a record spend of $6.42 billion in Q3 2010, as reported by the Interactive Advertising Bureau and PricewaterhouseCoopers (IAB-PwC), followed by a new record of $7.25 billion in Q4, according to eMarketer projections.“A spending peak in Q4 is likely, primarily because Q4 has been the biggest quarter for US online ad spending every year but one since 1999,” said David Hallerman, eMarketer principal analyst and author of the new report, “US Ad Spending: Online Outshines Other Media.”<emarketer>

Hedgeye Retail’s Take: In what appears to be a pocket of strength within the advertising industry, online advertising is expected to grow at a double-digit rate over each of the next 4-years while total media spending is expected to grow by only +2.9% reflecting increasing retailer interest in the channel.


R3: BBY, CROX, Luxury Watches, and E-commerce Spending - R3 1 3 11


China's Inflation May Cool With Factory Slowdown - China’s inflation may cool after manufacturing growth slowed in December because of a tighter monetary policy and the closure of energy-wasting and highly polluting factories. A purchasing managers’ index fell to 53.9 from 55.2 in November, China’s logistics federation and the statistics bureau said Jan. 1. Manufacturers’ input costs rose at a slower pace, the report showed. Premier Wen Jiabao is seeking to limit bank lending and inflows of capital that could fuel inflation after a record expansion in credit drove the nation’s recovery. The central bank raised interest rates on Christmas Day and, six days later, the currency regulator said it was expanding a program to let exporters keep revenue overseas. “A slower but still robust pace of manufacturing expansion is welcome because overheating is a risk policy makers want to avoid,” said Shen Jianguang, a Hong Kong- based economist at Mizuho Securities Asia Ltd. who has worked for the European Central Bank and the International Monetary Fund. “Another rate hike could come as soon as this month.” <Bloomberg>

Hedgeye Retail’s Take: Slowing input costs to manufacturers a positive change on the margin as it relates to further cost inflation out of China, however more importantly is the extension of a program that allows Chinese exporters to park foreign currency earnings in overseas accounts. Recall that more recently, Chinese businesses were starting to deny foreign-based orders – particularly those denominated in USD due to the Fx risk.




The Macau Metro Monitor, January 3, 2011



According to the Ministry of Trade and Industry, an advanced reading shows that Singapore GDP grew 14.7% in 2010, its highest annual growth ever.   For 4Q, GDP grew 6.9% on an annualized basis, missing economists' estimates of 9.2% growth.  Economists also expect the prelim estimate of 14.7% to be revised higher in February when December activity is taken into account.  However,  they note that going into the first quarter of 2011, the economy is losing momentum as the 4Q data was boosted by distortions in the manufacturing data.  Economists predict GDP growth of 4 to 6% for 2011.



According to the Urban Redevelopment Authority, S'pore 4Q private home prices rose 2.7% QoQ to another record.  It is the 6th quarter-on-quarter advance, although the slowest during that period.



Total gaming revenues up 67% in December.  Market shares similar to last week.



Macau finished December very strong.  Total gross gaming revenues were HK$18.3 billion, up 67% YoY and 9% sequentially.  We don’t yet have the complete property breakdown (Rolling Chips, VIP, Mass slots) but market shares are presented below:




Market shares were very similar to what we reported last week.  Wynn and MGM continue to roll with shares well above their trailing 3 month average.  LVS at 16.4% fell a full 100bps sequentially from its 3 month average, and 530 bps YoY.  LVS grew its gaming revenues 26% YoY, pretty good on an absolute basis, but below the market growth of 67%.  This trend will likely continue throughout 2011.


Outside of the market share shifts, what was most interesting about the month was the second half strength.  The following chart shows weekly revenue per day averages.



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