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Dr. Copper's Writing a Divergent Thesis

 

Conclusion: Price momentum is slowing in copper.  The industrial metal is now bearish on TRADE duration and that has our attention.  The fundamentals – supply and demand – confirm the price breakdown; thus, we do not see the pullback in copper as a buying opportunity

 

Dr. Copper's Writing a Divergent Thesis - copper price

 

China consumes ~40% of the world’s refined copper – 4x as much as the U.S.  Historically, copper prices and Chinese growth have been positively correlated.  However, just as at a point higher oil prices are bad for economic growth, so are higher copper prices.  The chart below illustrates this point.  The Chinese stock market and the price of copper closely mirrored each other for the first half of 2010.  But when copper crossed over $4.00/lb in October 2010, the two diverged meaningfully.  At a point reflation becomes inflation, and inflation hampers growth.

 

Dr. Copper's Writing a Divergent Thesis - shanghai

 

The method through which higher prices stymie growth is lower demand.  Consumption of copper in China peaked in early 2010, and has trended down since:

 

Dr. Copper's Writing a Divergent Thesis - copper3

 

As consumption slows, inventories build.   Here is what that looks like in China:

 

Dr. Copper's Writing a Divergent Thesis - copper4

 

What about the developed world?  After China, the largest consumers of refined copper are the US, Germany, and Japan.  Here’s what consumption of copper looks like in those countries:

 

Dr. Copper's Writing a Divergent Thesis - copper5

 

Obviously, developed economies cannot be relied upon to pick up the slack for a marginal slowdown in Chinese copper consumption.   And recently copper inventories at the largest copper warehouse in the world – the London Metal Exchange – have built aggressively.  When China slows, copper inventories build:

 

Dr. Copper's Writing a Divergent Thesis - copper6

 

Lending to the inventory builds, copper production (mining) is strong, increasing 7% in 2010 year-over-year:

 

Dr. Copper's Writing a Divergent Thesis - mine production

 

Inflationary pressures (copper included) have forced the Chinese to tighten monetary policy, leading to slower growth.  Slower growth has led to a decline in copper consumption, though we have to not seen the impact of that feed through to the price of copper until very recently.  We contend that copper traded away from the supply – demand fundamentals beginning in late 2010, and simply inflated.  After all, the correlation between the USD and the price of copper is -0.80 over the last year. 

 

If inflationary pressures subside and copper returns to the fundamentals, lower demand and higher supply will take the metal lower.  We will be watching the TREND line of support ($4.25/lb.) closely.  If that line breaks, look out below.

 

Kevin Kaiser

Analyst


The Daley Show: What Impact WIll the New Chief of Staff Have on Obama?

Conclusion: We’ve recently been reading Jonathan Alter’s book, “The Promise: President Obama, Year One”, which is a thoughtful overview of President Obama’s first year in office.  We’ll leave a scorecard of that year to the punditry and historians, but one interesting take away from the book was the management hierarchy within the Obama White House.

 

Our friend Karl Rove has loudly criticized the power structure within the White House based on the number of staff, which by his count is almost 3x the number of people that were in the Bush White House.  In his view, the Obama structure is very political and laden with academics.  While this could be true, Alter provides a slightly different perspective of the current White House staff.

 

According to Alter, President Obama took a memo from his staffers on a trip to visit his ailing Grandmother in Hawaii in late October of 2008.  The topic of the memo was who was to report to whom in the White House.  As Alter wrote:

 

“Under one flowchart, a dozen senior staff would report directly to the President.  This was the way disorganized Democrats always seemed to do it, going back to JFK and Jimmy Carter.  Clinton followed the pattern and it contributed to the “college bull session” nature of his early tenure.  Obama chose Pete’s other chart, the one labeled “collaborative hierarchy.”  This centralized all power in the Chief of Staff’s office so that there was no confusion on lines of authority. The new Chief of Staff would have much more power on paper than many of his predecessors.”

 

So despite the highly populated White House, President Obama actually has theoretically set up a management structure that is quite focused with the Chief of Staff as the real power broker in the White House.

 

The other key decision was obviously related to the type of person that should be the Chief of Staff.  President Obama veered away from having a full principal (according to Alter, this is a powerful elected representative or someone of cabinet rank) as Chief of Staff, and instead selected Rahm Emanuel who was considered half principal, half staff. 

 

The new Chief of Staff, Bill Daley, actually diverges quite widely from the half principal model as he is, in fact, a former cabinet member as Secretary of Commerce under President Clinton and also a senior executive at many corporations, including the former President of SBC Communications.  In effect, we now have a White House that has established the role for a powerful Chief of Staff, and a Chief of Staff who is very powerful.  Therefore, in evaluating future decisions of the White House, it will be important to understand the background and influence of Daley.

 

Daley is a lawyer by training and has been either on the Board of, or worked for: Boeing, Merck, Boston Properties, JPMorgan, and SBC Communications.  He was also President Clinton’s advisor on NAFTA.  In sum, he certainly appears to be pro-business and an advocate of free trade.  Interestingly, and perhaps not surprisingly, the appointment of Daley has seen mixed reviews from President Obama’s base. Per Wikipedia:

 

“Daley's appointment was "vociferously condemned" by "leading progressive voices" including MoveOn.org, Rachel Maddow and Keith Olbermann of MSNBC, while being enthusiastically supported by JPMorgan Chairman and CEO Jamie Dimon (who first suggested Daley), the Chamber of Commerce, the Third Way, and Karl Rove. The choice was questioned due to the fact that "Daley was an outspoken opponent — in public — of two of Obama's most prominent legislative items: health care reform and the financial regulation bill's consumer protection agency."

 

The key danger we potentially see is that Daley may be too much of a principal to be effective in this management role, which may require as much in the way of logistics as actual decision making.   The other potential issue of course is hubris.  As we reviewed this past Sunday’s morning political shows, this is the key risk that jumps out at us from the early versions of The Daley Show.

 

On Meet the Press this Sunday, David Gregory started his conversation with Bill Daley talking about the price of oil and uncertainty in the Middle East.  To say he was less than on his game, might be an understatement.  He seemed rattled by some of Gregory’s questions and his answers were often full of platitudes, which showed a limited understanding of core issues.

 

The one response that intrigued us was when Daley responded in the affirmative that President Obama would consider tapping the Strategic Petroleum Reserve (SPR) to offset rising oil prices.  While on the margin this might have an impact, the issue is not supply, so increasing supply actually has limited benefit.  In fact, currently crude stockpiles in the U.S. are 1.4% over year ago levels, which is also above the prior five year range. So, the U.S. is solidly supplied with oil.

 

Given this, if the White House does tap the SPR, oil prices might go higher.  For starters, the SPR only holds ~724MM barrels, so at full U.S. consumption there is only ~34 days of supply, or roughly 2 months supply if we just account for covering imports.  The point being that the SPR does not have a lot of supply and should likely only be used in a period of real extremes.  If not, the risk is that tapping the SPR could signal to the market that oil is more scarce than reality.  It is likely no surprise, as a result, that the oil price has effectively not budged since Daley’s statement.

 

As you think about the coming months and years of the Obama Presidency, stay tuned to the Daley Show.  Our Hedgeyes will be focused on it. 

 

Daryl Jones

Managing Director


SONC: BETTER BUT NOT OUT OF THE WOODS

Sonic is trading higher today on preannounced comps from yesterday and a sell-side upgrade this morning.

 

Yesterday, Sonic management indicated that sales for both company-owned drive-ins and the system were positive for the second fiscal quarter ended February 28, 2011.  The company estimates that system-wide sales for the quarter (2QFY11) increased by between 1% and 1.5% (company-operated stores up 2.2%).  While this is encouraging in that it is a positive number – the first since 2QFY08 – I would think it imprudent to chase this stock today. 

 

I struck a fairly positive tone when penning my last note on SONC titled, “SONC: LESS BAD IS GOOD”, on January 5th.  While I did state that the company was “not out of the woods” from a top line perspective, I was certainly becoming more positive on the margin.  The Street’s bearish sentiment on the name also made the name more attractive.  The system-wide comp for this quarter, assuming it falls at the midpoint of the estimate range provided by management, will imply deterioration in two-year average trends from 1QFY11 of 150 basis points. 

 

The reality is that over two months have passed since my aforementioned post on Sonic and much has transpired since then.   Coincident and lagging indicators, like employment and personal consumption, have shown some improvement and/or stabilization.  Commodities have increased greatly in the last two months, however, and I believe greater sales growth than +1%-+1.5% (versus a -13.2% year prior) will be required to absorb such cost inflation.

 

Guidance provided following results in January for FY11 top-line trends was suitably vague; management stated that “sequentially improving same-store sales throughout the fiscal year” would be based on “sales-building initiatives”.  While 2Q’s preannouncement certainly meets guidance from a one-year standpoint, the two year number is concerning because clearly the compare was easy and they become more difficult going forward, but also because commodity costs – as shown in the charts below – are through the roof.   For reference, to simply maintain, not improve, the 2QFY11 level of comp growth in 3QFY11 on a one-year basis, it would imply about a 350 basis point acceleration in two-year average system-wide comp trends.  To me, this seems aggressive.

 

Like a lot of restaurant companies, I feel that SONC is understating the real inflation numbers it is going to see.  The company previously guided to between 1% and 2% commodity inflation for the year and, while the majority of their basket items are hedged for the year, the company is purchasing beef on a short term basis. 

 

Regarding beef prices management stated that it expects, following mid-single digit gains in 1QFY11, “to see kind of a comparable year-over-year increase, maybe even flattening out in the third [fiscal] quarter”.   Beef prices have, although volatile, made higher highs and lower lows since early January.  Since the earnings call, beef prices are up 4%.

 

SONC: BETTER BUT NOT OUT OF THE WOODS - live cattle

 

Of course, commodity costs impact SONC’s operations in more ways than one.  Gasoline prices are up over 14% since the earnings call for 1QFY11 earnings was held.   This is obviously relevant for all QSR chains but given that SONC’s system is exclusively drive-in, the company is particularly exposed to gas price inflation.  The company will have approximately 0.5% of price on their menu in 2Q and 3Q; considering the cost of gasoline as part of the cost of a trip to SONC, I am confident that additional price won’t be well-received by the Sonic customer.   I think it is unlikely traffic will come to the rescue either – 2QFY11 comps flattered to deceive.

 

 

Howard Penney

Managing Director


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Greek 10YR Hits All-time High!

Positions In Europe: Long Germany (EWG); short Italy (EWI)

 

In continuation of a note published yesterday titled “European Sovereign Debt Concerns Have Not Gone Away: Red Flags from Greece and Portugal”, today the yield on Greece’s 10YR bond hit an all-time high of 12.9%, rising 51bps d/d, and Greece's Athex Composite (equity index) slid -3.8% . As borrowing costs push up following yesterday’s credit downgrade of Greece by Moody’s, investors are rightfully shaking in their boots. 

 

Today the country auctioned 6-month bills worth €1.625 Billion at a yield of 4.75% versus a previous auction of similar maturity of 4.64% in February. Foreign buyers represented 31% of the auction, in line with the average, and the bid-cover ratio was 3.59.

 

However, the increase in yield bucks a trend we were seeing in auctions from peripheral countries year-to-date in which yields came in lower than previous auctions, a reflection of confidence in foreign buyers (namely China and Japan) and that the EU’s comprehensive package to bailout the periphery would be favorable to countries like Greece.

 

That tide however has turned in last days, as uncertainty mounts over the specifics of a bailout package for the region, especially as the all-important German voice has become marginally more assertive on its notion of bailout and crisis management terms. This includes firm opposition to the rescue fund directly purchasing Eurozone member government bonds and a stricter stance on debt and deficit levels and fiscal consolidation mandates.

 

Now, given Moody’s decision yesterday to downgraded Greece credit rating by three steps on rising default risk (Ba1 to B1), investors are shaking as Greek bond yields rise. 

 

This month, Greece is bumping up against a hefty €12.41 Billion in Debt maturities (€10.56 Billion in Principal, and €1.85 in Interest), of the some €53.07 Billion due this year. With the country's fiscal state severely imbalanced [the country's debt as a percentage of GDP stands at 144% and its deficit is -15.4% of GDP], we'd expect to see Greek markets underperform as Europe lacks a unified voice on the conditions for a comprehensive bailout package to be decided at the EU Summit on March 24-5. 

 

Matthew Hedrick
Analyst

 

Greek 10YR Hits All-time High! - mh4


That Facebook comment from your broker? SEC is reading it.


Lower-Highs: SP500 Levels, Refreshed

POSITION: No position in SPY

 

Consolidation or correction? Well the correction part has been solved for – at least the first 3% of one. Since the hyped-up highs that we established in the SP500 on February 18th, the US stock market looks a lot like Japan’s – struggling to convince itself that this time is different.

 

The best way to answer how something isn’t different is to look at what is actually happening: 

  1. Inflation is slowing global economic growth – that’s happened many times before , across many economic cycles
  2. The US Dollar Debauchery and correlation risk associated with it isn’t any different than France, Britain or Japan trying the same
  3. Asset Prices, whether they be US Homes or US Stocks, are making lower long-term highs in terms of prices 

Obviously between all of the correlation risk and storytelling about growth, no matter where you stand on the “fundamentals”, you’ll have to agree with one major birth child of all this US Government Intervention and Central Planning – volatility. Price volatility is back – and the VIX has moved back to a bullish position on both our TRADE and TREND durations with considerable support around the 18 level.

 

Getting above the 1316 line this morning in the SP500 has been inspirational, but we think this low-volume rally associated with dollar UP/oil DOWN will run out of steam at another lower immediate-term high of 1333.

 

In the immediate-term, the best way to play price volatility is to trade it. Use 1 as your intermediate-term risk management range. In the Hedgeye Portfolio, I am leaning long (15 LONGS, 9 SHORTS), but I’ll keep that exposure on a short leash.

KM

 

Keith R. McCullough
Chief Executive Officer

 

Lower-Highs: SP500 Levels, Refreshed - 1


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