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Thanking You

Thanking You - asset allocation123108

“We think it’s a mistake for managers to use gates and other tools to limit investor access to their funds”
-John Paulson (December 2008 Paulson & Co. letter to investors)

In December of 2007, most of those who gave me their attention recall my introduction of a pending investment theme for the hedge fund community (for 2008) called “Redemptions and Litigations.” I lost some so-called “friends” in the business for taking a stand on that front – other than being in the business for 10 years, who was I to question the golden geese?

While most are sending around their revisionist historian year end “review” today, I am locking arms with you, our clients, and moving this ball forward. The aforementioned Paulson quote is, of course, from THE Paulson who was right in 2008. The one who manages $36B, knows how to manage risk in down markets, and knows exactly what to do to his competitors when he sees them making excuses.

“John Paulson blasts hedge fund managers” – that was good enough for the Top 3 on Bloomberg this morning, so it should be good enough to get me out of the dog house of being the antichrist of the “hedgies”. My New Year’s wish has already been fulfilled – not all hedge funds are “hedgies” - thanking you, God!

Looking ahead is always more challenging than looking back. Looking back provides you with lessons to improve your process. Looking forward provides the tremendous opportunities associated with The American Dream – on Wall Street, they call it “making the call.” On Main Street, they call it “getting it right.” On field’s of professional sports, they call it “winning.” That’s my prediction for 2009 – winners and losers will continue to differentiate themselves. There is no such thing as a free lunch anymore. This is not a time to throw up “gates.” It is time for our industry to abide by the client’s expected principles of transparency, accountability, and trust.

We’re all done with the “Investment Banking Inc.”, “Private Equity Mania”, and “Hedgie” calls. We’re all done with that other Paulson, because in t-minus a few days, he’s as gone from this global macro picture as are the three aforementioned fascinations.

We’re looking forward to new leadership. We’re looking forward to risk management. We’re looking forward to seeing The New Reality play itself out.

So what’s “the call" Mr. KM? What do we do in the new year? Well… to borrow one of the greatly overused lines in corporate culture, “those are great questions!”

In The New Reality, however, what we do is do what we have been doing. We get our feet on the floor earlier than the competition, and we grind through the morning’s facts around the globe. As the facts change, we will. That’s pretty much it.

This morning’s positives far outweigh the negatives. This is the developing “Trend” of The New Reality. So on a day when everyone who is travelling is saying “it’s quiet” out there, allow me to submit a list of 9 real-time global facts that juxtapose that narrow conclusion:

  1. The SP500 had its best move in 2 weeks yesterday, putting its “re-flation” to 18.4% from the 2008 panic low of 752

  2. The range of the SP500 continues to narrow as volatility continues to crash; the VIX is at 41.63, down -48.5% from its 2008 panic high

  3. The US market’s breadth continues to expand, yesterday’s advance/decline line was lopsided to the bull side at 79% vs. 19%

  4. The Asian Equity market continues to “re-flate”; Hong Kong closed up another +1.1% overnight, taking its gains to +30.6% since it’s November low

  5. The European Equity market is putting in day 3 of its immediate term squeeze rally; the FTSE is +1.3% - that too is +18% higher from its lows

  6. The Equity markets levered to global “re-flation” (Brazil, Russia, Canada, Australia, etc…) continue to make higher lows

  7. The CRB Commodities Index is stabilizing in the range where we have issued our 1st bullish buying signal in years (CRB 209-219)

  8. The “re-flation” leading indicator correlation (Gold vs. the US$) continues to signal buy Gold (GLD), short UUP (US Dollar etf)

  9. The Reference Rate (3-mth LIBOR) is down again today at 1.44%; breaking down as global market sentiment indicators make higher lows

I usually stop at nine, simply because everyone else issues their “top 10.” Why is consensus 10 instead of 9 anyway? Why does everyone agree to agree that the 200 day moving average is “the line”? Why did we believe in the “golden era” of all that was levered up?

The year-end review, should be about asking THE QUESTIONS that no one has either asked, wants to ask, or in the hallowed halls of the Street’s investment elite is ALLOWED to ask. I have only had 10 years watching this story play itself out, so you don’t have to take it from me… but if John Paulson signs off on this line of thinking, will you take it from him?

I love THE questions; I love THE debate; and I just love THE game. Thank you for putting up with my rants this year. Thank you for letting me express my investment ideas in an unencumbered forum.

Thanking you all for giving my team and me the opportunity to be a part of your investment debate in 2008. We’re looking forward to earning your trust in 2009 and beyond.

Best of luck and health to you, your respective teams, and families for the new year.
Keith R. McCullough

Thanking You - etfs123108


WHEN LESS IS EVEN LESS

We all know business in the gaming sector is tough, as it is for most consumer discretionary industries. Unlike the regional markets, Las Vegas is getting smacked around on two fronts. Visitation is down huge, but so is gaming revenue per visitor. In fact, the downward trajectory in gaming revenue per visitor is greater. Not to throw salt into the wound but this analysis excludes plummeting room rates, which is a much higher margin revenue source than gaming.

As the following chart shows, the year-over-year changes in win per visitor and total visitation tracked each other pretty closely until to the boom years in the middle of the decade. No doubt fueled by the positive wealth effect of skyrocketing housing prices, customers spent like drunk sailors not only in the casino but on room, food & beverage, retail, and entertainment. The planes and rooms were already full, so casinos jacked up room rates, table betting minimums, ticket prices etc, and they tightened the slot odds. All of this contributed to inflated spend per visitor.

We’ve got a long way to go before this bubble completely deflates. It’s payback time for the consumer.

The spending bubble is deflating

WHEN LESS COULD BE MORE

In every single regional gaming market, revenues are flat to down. The driver in each case is fewer admissions (visitors). The more the merrier of course, but there is a silver lining. Revenue per admission is tracking much better than total admissions and is even up in some markets on a year over year basis.

Higher spend per visit is bullish for two reasons. First, it is the lower end customer that is cutting back on visits. The lower end customer is less profitable so margins could potentially hold up better than the revenue declines would otherwise suggest. Second, the pattern of visitation in 2008 tracked gas prices pretty closely. Intuitively, this makes sense. Gas consumption comprises a greater share of a lower end player’s wallet. High gas prices probably had a big impact on the lower visitation numbers. With prices plummeting, visitation could begin to improve.

The chart below plots the year-over-year average change in regional visitation, revenue per visitor (admission), and gas prices on a trailing twelve month basis. With the exception of the 1999/2000 period, visitation and gas prices consistently move in opposite direction. A significant number of new properties and expansions caused the 1999/2000 distortion.

Win per visitor, on the other hand, seems unaffected by changes in gas prices. Since lower visitation is the sole driver of the regional revenue downturn in conjunction with skyrocketing gas prices, it is intuitive that the recent plummet in gas prices could spark a revenue rebound or at least some stability.

In a sector with rampant investor pessimism (see “A TALE OF TWO YEARS”, 12/26/08), low gas prices could provide a spark of optimism as we head into the New Year.

Gas prices drive visitation but not revenue per visitor

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Is Money Supply Inflationary? You Bet Your Madoff!

The Federal Reserve reported their Money Stock Measures yesterday and November showed a y-o-y increase of M2 money supply of 7.6%, which is the highest y-o-y growth rate in the last 12 months and, as seen on the chart below, is on an accelerating trajectory. Undoubtedly, money supply only accelerated in December as the Federal Reserve became even more focused on deflationary pressures and the need to stimulate growth.

We would expect money supply to continue to grow, especially since there no longer exists the “policy lever” option to adjust interest rates now that the current target rate for federal funds stands at 0 - 0.25%, or effectively zero. As Fed Chairman Bernanke outlined in a 2004 speech:

“Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

Bernanke’s remarks lead us to believe that the next policy step is to “print” money. More money ultimately results in the declining value of money, which is always inflationary.

We have been a bit of a lone voice beating the “re-flation” drum in the past few weeks, but this report from the Fed seems to suggest, especially if the money supply continues to accelerate, that “reflation” is not a matter of if, but when.

Stock markets are certainly “re-flating” today.

Daryl G. Jones
Managing Director

The New German Flat Tax on Capital Gains

A new German tax code will be taking effect on January 1, 2009. Until the end of this year the current code for many investments—including stocks or funds—are exempt from tax on profits if one has kept investments for longer than one year. For other forms of profits, such as dividends, the so called “Halbeinkünfte-Verfahren” was applied by taxing only half of the profits with one’s normal income tax rate.

Come January 1, 2009 a new tax code will replace the old code with a flat tax of 25% (plus solidarity money for the former East German states and church tax). This would result in a maximum tax of 28% for future profits from investments. This means, any investments made before the end of the year will be taxed according to the old rules even if it matures or is sold in ten years time.

For many investors the new flat tax will represent a tax increase on investments. Certainly with any tax code there will be exceptions and ways to work around the code, yet the present income tax rules demonstrate that for even the highest income earners (who are taxed at the highest rate at ~45%) the new tax is incrementally higher. Here is an approximate breakdown of current taxable income by income bracket:

Taxable Income (in Euros) for a Single Person Taxable Income (in Euros) for a Married Couple Marginal Tax Rate (2008)
0 - 7,664 0 - 15,329 0%
7,665 - 52,152 15,330 - 104,304 ~15-42%
52,153 - over 104,305 - over ~42-45%

This switch will create organizational stress for investors who will now have to separate “old” investments from future ones in order to avoid problems with tax authorities.

Matthew Hedrick
Analyst


The Bullish Reference Rate

I use 3-month LIBOR is a reference rate, not only for those who need to borrow at LIBOR “plus” but as a measure for global counterparty risk.

Alongside the US Dollar (“re-flation”) and a VIX (volatility) indices breaking down, this crashing of LIBOR is amongst the most bullish macro indicators in my playbook.

Below, we have attached both the “Trade” and “Trend” lines for 3-month LIBOR. Both have been broken. Both are bullish for Equities, Commodities, Bonds, and Real Estate, in the immediate term.
KM

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