“Epidemics are sensitive to the conditions and circumstances of the times and places in which they occur.”
Epidemic might be the right word to describe the environment in the USA that has ensued since Bernanke’s speech in Jackson Hole and the 96.3% move in the S&P 500 since March 2009. There are many corners of the world that are looking at the USA and the policies of the Federal Reserve and clearly believe that we are pouring gasoline on a blazing hot fire.
The past month’s protests in North Africa and the Middle East were partly linked to surging agriculture costs and according to the UN, countries in Latin America are most at risk of food riots as prices continue to head higher. According to the World Bank, rising global food prices have pushed 44 million more people into “extreme” poverty in developing countries since June. Yet the USA and the S&P 500 continue to power forward like they are impervious to these issues.
Not so fast…. The question is when, not if, Chariman Bernanke will pull the punch bowl on the current liquidity binge. The increased civil unrest that ensues around the world will continue to put incremental pressure on him to alter the current policy. The scary part is he needs to do it sooner rather than later and chances are it’s going to happen at exactly the wrong time.
Just by chance, what if we get a hint of a FED exit strategy today at 2 pm just as the “storytelling” is reaching a feverish pitch? I’m hearing people talk about stocks, saying, “This time it’s different!” Or how about this one, “margins don’t matter!” Or better yet, “consumer companies are impervious to rising input costs!” Over the next 12-months we are going to be able to produce some serious You-Tube moments that will last a lifetime.
Of course margins don’t matter – until they do. Consumer companies are impervious to rising input costs – until they are not. And we are at the tipping point!
It seems like yesterday that Malcolm Gladwell published The Tipping Point: How Little Things Can Make a Big Difference. Gladwell describes a tipping point as “the moment of critical mass, the threshold and the boiling point.” In nearly every situation there is that moment in time when the world is ready to follow the leader or “the trend.” Right now, that leader is Chairman of the Federal Reserve, Ben Bernanke and the trend is excess liquidity that is leading to higher inflation and higher stock prices.
The critical element of the U.S. economy that is not benefitting from the Federal Reserve’s actions, in real terms, is the consumer. I believe that the consumer is reaching a tipping point. Accelerating demand is critical to maintaining profitability in an accelerating cost environment. What we saw yesterday from the retail sales data was perhaps an indication that the consumer is beginning to slow down.
In the face of non-confirming data, observers with a conflicted or biased view often look for any other metric, or any other narrative, to justify a prior perspective. Revisionist versions of the truth are offered with adroit semantic maneuvering and frantic searching for the comfort of a confirming thesis.
One narrative being promoted at the moment is that consumers are willing to pay above market for “green” products from “socially responsible” companies. This may be true to a degree, but deflecting the clear truth behind the data, be it Retail Sales or otherwise, with qualitative narratives that are entirely subjective, is not a practice I subscribe to. If consumers see raising prices in the absence of a corresponding growth in personal disposable income, there is likely going to be a change in consumer behavior.
As Gladwell wrote, "Ideas and products and messages and behaviors spread like viruses do.” At present, it is clear that many ideas and messages have spread rapidly around investor circles. Sectors of the market are trading at premium multiples largely because of the free-money policy of the Federal Reserve. The confidence that this instills in investors seems to trump any concern about companies’ ability to control their input costs from now on.
For many companies, the cost of raw materials is rising at a faster pace than revenue and we have only just begun to see the impact on margins. Rising costs take time to flow through to the bottom line. Rhetoric from management teams, against all of their incentives, has been decidedly cautious with respect to their commodity cost outlook. As we move through the balance of 2011, the squeeze on profit margins will be more pronounced than most analysts expect.
The Empire Index' Prices Paid index, which climbed to a two-and-a-half-year high of 45.8, was supportive of my theory yesterday. Quoting directly from the press release, "The prices paid index climbed to a two and-a-half-year high in February, but the measure for prices received was little changed, suggesting some pressure on profit margins." That’s right – margins are contracting, not expanding.
How the consumer reacts to increased inflation pressures will be the tipping point for the market. Across a wide spectrum of the S&P 500, companies are seeing margins contract, and some are more confident than others in their ability to pass on price to customers. A growing percentage of companies will be unable to increase price at all, or fast enough to offset margin contraction, without hurting top line trends. The economic recovery is in its embryonic stages, unemployment remains high, and consumers are keeping a tight rein on spending. How much inflation can they take before spending begins to suffer?
I heard some supposed experts on CNBC say that $5.00 gas will not affect consumer spending. It’s this kind of storytelling that is sign of pure excess.
Perhaps yesterday’s Retail Sales was the first glimpse of this trend. Retail Sales growth missed Street expectations. The trajectory of 4Q10 sales trends cannot continue with inflation accelerating and job growth proving to be highly inadequate as an offset.
Over the next two days we will be getting more inflation readings from the PPI and CPI. While these two numbers are conflicted calculations, they will both point to accelerating inflation. For proof of this trend, last night in an interview on Bloomberg, Richmond Fed President Lacker (non-voting FOMC member in 2011) said that US inflation may accelerate in H2 of 2011 as firms seek to recoup higher commodities and health care costs.
And Joe six pack is going to roll over and say thank you very much!
Function in Disaster; finish in style
This note was originally published at 8am on February 11, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
Lorri: “So how does it feel to be the oldest rookie in the last 30 years?”
Jimmy: “I don't know... I'm tired.”
-Rachel Griffiths and Dennis Quaid in The Rookie
Alongside “Invincible” (starring Mark Wahlberg and Greg Kinnear in 2006), “The Rookie” (Dennis Quaid and Rachel Griffiths in 2002) is one of my favorite ‘true story’ Disney movies of the last decade.
I’m an athlete, so these are my confirmation biases. I get it. And I’m proud of it. While trading markets may not be a full contact sport, there’s definitely a score and the non-athletes in the game are some of the most competitive people I have ever played with and/or against.
There are plenty of Rookie Trader mistakes that people make in this business. I am certain that I have made all of them, multiple times. Most of the time, that’s the only way a risk manager can mature in this business – by learning with live ammo.
Currently, we have a Rookie Trader learning on the job as he trades America’s balance sheet. Like Jimmy Morris did, he has some of the credentials to play in the Big Leagues. He’s one of the oldest rookies we’ve put in the game. And, if you didn’t notice, on Wednesday in front of Congress, he looks tired.
Tired and old is hardly a bad thing. I’ll still put the original Thunder Bay Bear (my Dad) up against any young buck who wants to try to hold up a retaining wall (we might just have to jack him up with some coffee first!). But tired, old, and inexperienced is not the kind of trader I want at the helm of my firm or family’s future.
Every week the Federal Reserve issues its version of transparency and shows us both the size and components of the Fed’s balance sheet. In the last 2 weeks, this is what Ben Bernanke has been doing – buying bonds, aggressively:
Yes, I am capitalizing the B’s and T’s so that you can hear me now…
Over the same 2-week period, this is what the US Treasury Bond market was doing:
So… what does this mean? drum-roll … The Rookie Trader at the helm of the US Federal Reserve is committing one of the cardinal sins of risk management – he’s getting bigger and more aggressive on the way down!
Again, remember that The Ber-nank’s promise of perpetually low interest rates and that the Quantitative Guessing II (QG2) is the elixir of Big Government Intervention life has A) never been tried before, B) no risk management scenarios in the case that the trade goes against him, and C) no one to tap him on the shoulder and stop him from trading.
When I was given my first book to trade in 2002 (at our hedge fund we called it a “carve-out”), I had 2 bosses and an entire trading desk overseeing everything I did. Stop losses, shoulder taps, personal embarrassment – there were plenty of governors managing my mellon. But this guy has none.
No real-time accountability. No modern day risk management system to stop him out. Nothing.
And this he’s betting with $25-31 BILLION DOLLARS a week!
To put those Burning Bucks in context for you… and yes I realize our entire culture and country is numb to what a US Dollar is worth anymore… pressing a one-way bet with $30 BILLION Dollars a week would be the equivalent of 3 Steve Cohens taking all of their capital and having them all buy the same security, at the same time, with no hedges and no other positions…
Welcome to Centrally Planned America 2.0. with the Rookie Trader starring as your Almighty Central Planner.
In other news this morning, as US interest rates continue to push higher (2-year yields are now up +166% since Bernanke made his QG2 promises of “low interest rates and price stability” at Jackson Hole), I see nothing but price volatility.
1. Pepsi (PEP) – a $100 BILLION snack and beverage company cut its EPS targets for 2011, and the stock hit a fresh 3 month low on big volume. Management cited soaring commodity costs and uncertainty about when the said US economic recovery will actually be felt by consumers.
2. Bunge (BG) – a $10 BILLION agribusiness and food service company said it would no longer issue earnings guidance because volatility in the commodity markets have made forecasting increasingly difficult.
3. Bolivia – a country with 11 million people saw its President, Evo Morales, pull himself from all public appearances as food riots have erupted across the country and Bolivian miners, who are evidently upset, are starting to throw sticks of dynamite at government people.
I know, who cares about Egypt, India, and Bolivia? The Rookie Trader says US Monetary Policy gone bad has nothing to do with what’s happening anywhere in the world, including his home team’s bond market.
My immediate term support and resistance levels for the SP500 are now 1311 and 1334, respectively.
Best of luck out there today and have a great weekend,
Keith R. McCullough
Chief Executive Officer
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.
Hedgeye bought IGT in the firm’s virtual portfolio yesterday. Here’s why.
IGT is 9% below its year to date high and our macro/trading team thinks right here is a great entry point. The stock was added into the Hedgeye virtual portfolio yesterday at $17.00. They see short-term upside to $17.99 (TRADE line resistance) and downside to $16.61, suggesting a favorable near-term upside/downside ratio of +5.8%/-2.7%.
Our fundamental view matches up with the quantitative set up. Earnings estimates finally look conservative as IGT maintains a number of margin levers while we wait for the long term growth picture to come into focus. We think that could come sooner rather than later.
The inevitable acceleration of replacement demand will be the big catalyst and we may be seeing signs of that emerging. Both PENN and MGM made positive comments regarding slot purchases on their recent earnings conference calls. New markets will layer growth on top of the normalization of replacement demand. While new markets (international and domestic) should provide long term growth, the news flow should be positive as state legislatures try and solve the massive budget issues. Gaming has become a politically palatable solution as state revenues can be enhanced without raising taxes or cutting spending.
From a fundamental perspective, we think we are at the beginning of a 3-5 year bull slot cycle. Now, the near-term quantitative trading set up matches our enthusiasm for the long-term fundamentals.
Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.