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Chinese Generals

Chinese Generals - asset allocation010609

“All men can see these tactics whereby I conquer, but what no one can see is the strategy out of which victory is evolved.”
-The Art of War, Sun Tzu

Whether it was Team Canada earning its 5th consecutive World Junior Hockey Championship over Sweden last night or our perpetual quest to have our feet on the floor to help our clients earn a world class annual return – it’s all one in the same. This is a global “Trend” that knows no time and no bounds – it’s all about proactively preparing yourself to win.

The Art of War is a Chinese military book that has had a meaningful impact on how many of the world’s top strategists think. At Research Edge, we religiously adhere to the core strategy of changing our positioning as facts and prices change. At its core, the Chinese lesson is that within the confines of a dynamically changing battleground one requires a process to respond not rashly, but quickly, and accurately.

This is why we “Trade” around our exposures and positions. We think we understand investment “Trends” as well as anyone, but what we respect above all else is keeping our feet moving in the face of “improbable” outcomes manifesting themselves into reality. If and when those “unexpected” outcomes occur (like say a +30% 6-day “re-flation” in the price of oil like we just saw), we have already proactively positioned ourselves with a defense that can quickly turn into an offense.

Notwithstanding the wonderful history lessons written by a 6th century BC Chinese strategist, today is just another day in The New Reality of investing in 2009. After all of the nonsensical narrative fallacies of 2008, it has actually proven to be “global this time.” Quantifying the “re-flation” moves that we have seen in stock markets from Hong Kong to Brazil is not a trivial exercise. After starting 2009 off with a meltup (Brazil is +10.4% in the last 2 days), the Hang Seng and Bovespa market indices have both climbed over +40% from their October/November lows! While the manic media was focusing on the “Depression” and “what Bill Ackman likes”, the Sun Tzus of The New Reality were marching forward.

Per his friends in the media, poor Billy Ackman ended up having a down -68% year in 2008. While calling that out onto the mat may be considered “mean” by the old boy network, I’d like to hold this media maven accountable for his performance. Not unlike highlighting Sweden’s loss last night, or Peyton Manning’s loss this past weekend, that’s just the way warfare in its highest halls of competition works. There will be winners and losers. There will be transparency and accountability. Gone are the days of investing in your best “hedgie” club’s “idea dinners”. Gone are the made up Madoffs… Gone, baby, gone…

China’s stock market tacked on another +3.3% move last night, taking its 2-day rally since the New Year’s break to +6.3%. Not that I am keeping track or anything, but our Chinese long position in the FXI etf is up +24.82% now since we bought it on October 6, 2008. For the better part of October and November, no one wanted to talk about that place with all the people – but they do now… especially as the Chinese government is starting to show the world some of the “tactics whereby I conquer.”

Rather than trade their market’s future (s) on what Barney Frank is chirping at Congress, the Chinese make their announcements surgically – and almost always after the markets close. This morning they “reiterated” that they have a “moderately loose” monetary policy. In English, that means “we will cut interest rates whenever we feel like it, because we can.”

Unlike the American, Canadian, or Swedish governments, the Chinese proactively prepared for this economic tsunami. After all, Wall Street’s “Chindia” thesis of 2007 had very basic implications that the Chinese had an “edge” on… like managing their fiscal and monetary policies ahead of their foreseeable domestic slowdown. Now that the dark clouds of sentiment have lifted, whether you believe the Chinese reported numbers or not, it’s hard not to see them self-perpetuating their own economic blue skies in early 2009.

I think China can and will cut rates by another 200-300 basis points. This will both deflate the Yuan, and “re-flate” Chinese Bonds. Since bonds in China actually earn a return that isn’t ZERO, this puts the “Treasured” US Bond market in a precarious position. The largest holders of US Treasuries are China and Japan. If Obama and Volcker don’t ultimately issue these Asian governments a return, my guess is that they will go find it elsewhere – God forbid they look to the Chinese bond market! Imagine that… investing in themselves…

From the Eurozone to the Philippines, we are being issued deflating Consumer Price Inflation reports again this morning. The Europeans saw December inflation drop to a new cycle low of +1.6% y/y growth, and the Philippines saw a 200 basis point drop in month over month inflation! This, as Tim Russert would say, “IS BIG!”, as it will continue to provide the cocktail for the New Year and New Reality’s global rate cutting party.

Beware however… not all ZERO interest rate regimes are created equal… and those countries who provide their citizenry with a rate of return on their domestic savings are watching every other country’s tactics very closely…

Until this interconnected global market’s critical battles have been won and lost, what consensus may not see yet “is the strategy out of which victory is evolved.”

The US Bond market is shaking, and it is making me nervous. My SP500 support level is now 889. Wait for your prices; don’t chase them.

Best of luck out there today,

Chinese Generals - etfs010609

Got Gold?

I am getting a lot of questions today as to why I haven’t bought gold (GLD) back. I think this is a good question, given that A) gold is down today and B) gold remains in one of the most obvious bullish quantitative patterns in all of global macro.

The answer is because I am cheap. That’s it – I admit it. I am stingy here on price. I have my buying range (see chart below), and I am sticking to it.

Buy Gold between $807-826/oz, and sell it closer to where we did on 12/29 and $896/oz. This is a very trade-able range, especially suited for the patient trader. We want to own “re-flation” before oil moves up +23% in a week (like it did last week), not after.

Keith R. McCullough
CEO & Chief Investment Officer

FSR - Matrix Exposure

I have made the call that I think full-service restaurants (FSR) will outperform in early 2009 as their top-line results improve, on the margin, or become less bad, largely from Obama’s expected fiscal stimulus plans. I have also said that from a fundamental standpoint, I would expect DRI and EAT to benefit more proportionally from any economic stimulus as they both have strong balance sheets and concepts that are not going away. That being said, all FSR operators would benefit.

All full-service restaurants faced two obvious fundamental challenges in 2008: deteriorating top-line results and historically high commodity costs, which combined drove average FSR operating margins down over 250 bps on a year-over-year basis in 3Q08. The third major issue that hurt FSR stocks in 2008 (on average, down 48% in 2008) was the fact that the industry as a whole significantly increased its leverage at exactly the wrong time. On a debt (including the present value of operating leases)/EBITDAR basis, average FSR leverage increased to over 4x’s at the end of 3Q08 from about 3.3x’s at the end of FY07. Unlike the first two challenges met by the industry, not all FSR companies exposed themselves to the liquidity issues that emerged. Although we would expect all of the FSR operators to benefit from marginally better sales trends in 2009 and lower YOY increases in commodity costs, particularly in the second half of the year, only those companies with strong balance sheets heading into the year are positioned to outperform. Using the industry average debt/EBITDAR ratio as a reference, BWLD, CPKI, DRI, EAT, PFCB, RRGB and TXRH stood out as the companies in the best liquidity position.

Again, I would expect all of the FSR companies to be helped by Obama’s anticipated stimulus package, but from a macro perspective not all of the companies’ restaurant bases are created equal. As we have heard on earnings call after earnings call, dining out trends have underperformed in certain regions of the country, particularly California, Florida and Arizona to name a few. DRI commented last month on its conference call, however, that it is seeing weakness across the country and that some of the regions that had been strong, Texas in particular, did soften up in the second quarter. Using those comments as a backdrop, I set out to determine which FSR concepts are more regionally exposed to the issues currently facing the U.S. consumer, specifically gas prices, unemployment and housing market weakness. From the companies’ labor cost standpoint, I also looked at which restaurant companies are located in states least impacted by both federal and state minimum wage increases in 2009. Please refer to the matrix below for details.

Based on my more positive bias toward EAT and DRI prior to doing this analysis, I was not surprised to learn that both of these companies’ restaurant bases are well positioned from a regional standpoint. I was surprised to see that TXRH, PFCB and RT all screened relatively positive as well.

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Got Yield?

With The Economist having our backs this weekend and reiterating all that is not created equal amongst the members of the European Union, we thought we’d send you an updated chart of country level 10 year yields. It doesn’t surprise us whatsoever that Greek, Italian, and Spanish bonds have widening spreads to that of the Germans. Both Germany’s balance sheet and economy continue to look best out of a deteriorating bunch.



"He who will not economize will have to agonize."

For those of us moving upward and onward in The New Reality, this past week was a fantastic one. We spent time with our families, rang in a New Year, and made some serious weekly returns!

However, getting all excited about the "Re-flation" call, AFTER deflated balloons found their first blast of air is not what I am in the business of doing. So don't expect me to be buying high in hopes of "selling higher" this morning. Hope is not an investment process. We'll let them buy what we have readily available for sale. Sell high, buy low.

The pundit patrol tends to mistake the definitions of "inflation" and "re-flation" for one and the same. They aren't! In sharp contrast to 1970's style inflation, this melting up the wall of consensus worry is simply a form of asset class mean reversion. Over the course of October/November, as US Treasury Bonds and US Cash became inflated kings, global equities in Brazil to global commodity markets were primed to see their dose of a fresh tire pumping.

While I do my fair share of tire pumping, my goal in 2009 is to keep pumping yours. We want to "pump you up!" If you weren't into the bearish notes that I had to painstakingly post at this time last year, here's my gift to the bulls out there who ended up being too bearish - after the worst stock market deflation since 1931, the SP500 raced higher for another +6.8% weekly gain last week, taking its cumulative "re-flation" from the freak-out "de-leveraging" November 08' lows to a whopping +24%. Aren't we allowed to be bullish, at a price?

This bullish stock market party that's been rocking since November isn't just local - last week the booty cam juiced it up and took it global! On Friday, the Brazilians jacked their market's music up to 40,244 decibels, closing up +7.2% on the day, taking its cumulative ascent to +37% since it's October 27th low. Last night, in Hong Kong they too rang the proverbial bullish gong, taking the Hang Seng up another +3.5% on the session, adding to its cumulative +41% "re-flation" run since October 27th! We remain "long of" both Brazil and Hong Kong via the EWZ and EWH etfs.

No, no, no... this is not inflation - this is "re-flation"... and it was all signaled by the solid gold album we've been signing to you via the artists formerly known as "prop desk" traders. As they were busy getting fired in November/December, the US Dollar and Hank Paulson were as well. These bullish American agents of change, alongside the largest rate cutting party in global history, continue to provide the backbone for my bullish stance on both global equities and commodities. That said, right here and now, don't forget that every investment thesis has its time and price.

Last night's "inflation" news in both Asia and Europe had deflationary trends. This continues to prove that if you hold a ball of negativity under water long enough, any hint of a release of that sentiment-oriented pressure is going to create a rather explosive move to the upside. Most, but not all of, Asian and European stock market strength this morning is being buoyed by deflationary Consumer Price Inflation readings in Italy, Spain, Thailand, and Indonesia. Consider Thailand's year over year CPI reading for December falling to +0.40%. That's not inflation folks - that's a bullish macro data point - one that shot the stock market in Thailand up +6.4% overnight!

Considering what's going on in the Gaza strip, one might have expected the regional stock markets in the Middle East to be concerned... not so much. Egypt is trading up +8.7% right now, Saudi Arabia +2.6%, and the United Arab Emirates +7.8%. As sad as it may sound, war is the mechanism that gets this region's most relevant currency (oil) higher. Oil, incidentally, "re-flated" right past our price target of $45.53 last week, closing up +23% on the week at $46.34.

Enough of all this "re-flation" stuff, let's turn the dial to growth... because that's where I am having a heck of a time trying to figure out who was bearish at this time last year that is dance party bullish this morning. Our pals over at Goldman are on the tape this morning reiterating their "view" that "there is no obvious drivers of growth" here in the USA. That was Jan Hatzius, their US Strategist, who was cited in the #1 Bloomberg article under "Economy" this morning titled "Engines of Recovery Flame Out." Were there plenty of compensation structures on Wall Street that "flamed out" in 2008? You bet your Madoff there were.... But, Jan, "C'mon Man" - it is 2009 this morning!

Our call has been, and remains, that there is going to be a "MEGA Squeeze" in the land of the US Consumer Discretionary stocks into and out of the "no drama" Obama inauguration and stimulus plan events (see my Partner, Howard Penney's, US Strategy note "Got MEGA" for more). MEGA not only represents the quantitative reality of the squeeze that we have already taken advantage of (the XLY, the SP500 Sector etf for Consumer Discretionary, is up +39% since the November 20th capitulation low), but it stands for Mortgages, Employment, Gas, and Assets. Don't underestimate that the last of the letters in that acronym, Assets, is THE DRIVER of US Consumer Confidence, and US growth. US stock prices are some of the most relevant Assets on the US Consumer's balance sheet - again, they are up +24% since November!

Can someone do me a favor and send this note, alongside Howard's Strategy piece, to the fine folks at Goldman. Jan needs to be aware of the "obvious drivers of growth", and we'd like to throw the guy a bone.

Don't buy the SP500 at 931. Wait for a correction. Our buying range remains what it has been (884 on the SP500 or lower). 
Buy low, sell high, and remember what Confucius says, "he who will not economize" and be patient on price, will ultimately "agonize."

Have a great week.


Chinese Chart Of The Day: PMI Accelerates, Sequentially

For the better part of the last three months, the bears have been stuck with a thesis we were flashing them 9-12 months ago – that China is “slowing”…

Well, like all great stories, there is an ending… and then, a new narrative finds new beginnings. This morning’s Chinese PMI accelerating sequentially (see chart) may not be a huge move on a nominal basis, but the point is that on the margin, the move was finally higher. Since the month of November couldn’t have been worse in terms of global trade, December was bound to be better than toxic – and it was…

Everything that matters most in our macro models occurs here – on the margin. This data point is now old news, and surely one that the China bears will have a tough time getting “unstuck” in their models; that’s if they have them, of course…

We remain long both China and Hong Kong via the FXI and EWH etfs.

Keith R. McCullough
CEO & Chief Investment Officer

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