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Under Attack

“Nobody ever defended anything successfully.  There is only attack and attack and attack some more.”

-General George S. Patton

 

The rose-tinted view that has driven the S&P to current levels, up 5.1% year-to-date, is becoming more and more difficult to justify.  As uncertainty around the Middle East mounts, highly significant factors behind the global economy, such as oil, are becoming more and more of a concern for investors.  The revolution sweeping through the Middle East is driving oil prices higher as the timeline, geography, and repercussions of the political turmoil remain uncertain.

 

Moody’s reminded us on Monday of the significant uncertainty surrounding the Eurozone’s sovereign debt issues.  In early trading today, Portuguese 10-year bonds fell for a third day, pushing the yield as high as 7.70% (the most since at least 1997) and the equivalent-maturity Italian yield climbed to 5% for the first time since November 2008.

 

With members of Ireland’s new government striking a fairly combative tone with respect to a prospective renegotiation of that country’s bailout, and other countries rolling over significant levels of debt in 2011, the media’s glare will shortly become more focused on Europe and her myriad issues.  Yesterday, the Euro fell the most in two weeks on all the uncertainty.

 

Here in the U.S., inflation is a tax on the consumer and, as such, the broader economy.  In fact, I would posit that inflation (inclusive of things people actually buy, like gasoline, food and clothes), is a more devastating drag on the consumer than allowing the Bush tax cuts to expire.  Inflation is taxation without the consent of the vast majority of those affected. 

 

With the past two years having seen the second largest upward two-year move in equities after the period from 1953 to 1955, inflation is derailing the markets to a greater or lesser extent depending on the market in question.  In the end, as in 2008, risk is always on and it is always interconnected.  As oil climbs higher, threatening growth at a time the U.S. economy can ill-afford it, the recovery scenario that has been priced into the markets starts to look less impenetrable, less defensible. 

 

Currently, my attention is firmly focused on the consumer.  The spread between consumer expectations and present situation sentiment or, as we like to call it, the Hedgeye Optimism Spread, is at peak levels.  Employment has been improving on the margin but, as I see it, two factors along the risk spectrum could spoil the U.S. equity market party that has been raging since 2010.  First, gasoline prices can keep doing what they’re doing.  Second, interest rates can go up.  The magnitude of a possibly interest rate increase is unknown but (think Volcker) there is precedent for sharp, short, expedient increases in interest rates when inflationary pressures merit it. 

 

The pressure for the USA to raise interest rates is growing by the day.  Jean-Claude Trichet is telling the world that Europe is ready to raise rates and Timothy Geithner (who met with Germany’s Finance Minister in Frankfurt yesterday), no doubt is begging them not to.  One small reason Europe needs to raise interest rates is the fact that European gasoline prices are at an all time record of $8.632 per gallon.  European Central Bank Governing Council member Axel Weber has stated that, “Inflation may be more sustained and more fundamental than the ECB’s latest projections suggest” and that he sees “considerable future price pressures.”

 

This divergence in rhetoric between the USA and EU poses an interesting dilemma for investors.  We know from experience that any faith in policymakers in Brussels or Washington being able to manage through this situation seamlessly is gravely misplaced.  We were reminded of this last week on CNBC when Alan Greenspan said, “The one thing we all pretend we can do but we can't, is forecast." 

 

Recently, a question we received from a discerning client prompted us to overlay the Hedgeye Optimism Spread against the Yield Curve in a chart.  The picture certainly tells a story; the escalation of easy money monetary policy in the United States heralded a period of high correlation between the Optimism Spread and the Yield Curve.  Apparently, rendering the country “awash with liquidity” instills a belief among consumers that economic circumstances are set to improve.  As Keith referenced in the Early Look from Monday morning, according to Jim Rohn, “For every promise there is a price to pay”.  Ultimately, a consumer facing mounting costs at the grocery store and at the pump is going to recalibrate expectations.   The U.S. consumer is now under attack as inflation squeezes like it’s 2008.

 

After losing some momentum in recent months, the recovery of new vehicle sales regained steam in February.  Having said that, GM and F stock can’t get out of their own way; GM is down 11.2% YTD and is trading below the $33 IPO price.  Is consumer pent-up demand supporting the rise in vehicle sales?  The stocks of the automobile makers are telling you a different story. 

 

Yes the labor market momentum is building, as expected payroll gains strengthened measurably in February, following the weather-induced weakness in January. The unemployment rate was a surprise at 8.9%, but it is likely an aberration as more discouraged workers than previous months did not enter the labor force.  We see an Intermediate term bottom in the unemployment rate.

 

The gradual improvement in the labor market is benefiting consumer income trends. Real disposable income growth late last year was the fastest since the fall of 2007. The rate of growth is still far from robust;  there are two factors that are limiting income: (1) the selective nature of the recovery, and (2) declining government support.

 

Despite a surge in personal income growth, real spending declined in January. Real personal consumption expenditures slipped by 0.1%, marking the first decline since April 2010. Nominal spending rose by 0.2%, which was about half of the average pace from the previous six months.

 

The inflation tax will likely erode the Hedgeye Optimism Spread as reality for the US consumer sets in.  According to the latest American Pulse™ Survey of 5,224 respondents, 80.3% of registered voters agree that the increase in gas prices is one of the worst problems affecting the United States.  The survey asked respondents to list the worst problems currently affecting the United States, and registered voters mentioned in order of frequency: unemployment (80.4%), rising gas prices (80.3%), weak economy (70.6%), national debt (69.4%) and rising food prices (61.9%).

 

The U.S. consumer is under attack and the bull case for equities to withstand escalating input costs is becoming less and less defensible.  We are expressing this view on US based consumption by being short MCD, WMT and TGT.

 

Function in disaster; finish in style

 

Howard Penney

Managing Director

 

Under Attack  - HP EL 3.9.11

 

Under Attack  - HP EL 2


Enabling Success

This note was originally published at 8am on March 04, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“He is able who thinks he is able.”

-Buddha

 

When I started this firm, I had a simple goal – to democratize the risk management process of a hedge fund. What does that mean? That means showing the world exactly what it is we do, real-time, in a transparent and accountable way.

 

What does a hedge fund do? You’ll get a lot of different answers to that question – and as industry supply of hedge funds continues to expand, you’ll get more hedge funds who really don’t do what I do – hedge. Some strategies are simply levered-long versions of mutual funds that charge higher fees. Those hedge funds tend to blow up when markets stop going up.

 

Enabling Success in a hedge fund model is best achieved by having short positions that don’t hurt you when the market goes up. It’s a trivial exercise to buy something when everything is going up – that’s called beta. Managing losses is the key to this game – not chasing relative returns.

 

I don’t run money anymore, and a lot of people still ask me why. Three years ago, I thought I might eventually go back to doing it again – not anymore. I’m having too much fun building a real company with real cash flows. I absolutely love reading and researching so that I can put myself out there every morning. The challenge for me isn’t how much money I make, it’s how big of an arena I can play this game in.

 

I’m certainly not walking through these thoughts for any other reason than this is what I am thinking right now. I only have 45 minutes to write you these missives every morning – so I have to roll with what’s in my head. That requires a risk management process in and of itself – editors!

 

Enabling clients to look inside our risk management process seems to be the most empowering part of what we do. In order to Enable Success in this business, I think you need to let independent minds explain their research perspectives so that you can weigh them against your own. Whether our research is top-down, bottom-up, or quantitative – it seems to elicit plenty of feedback. Constant feedback enables success too.

 

How have we enabled this research platform to deliver an 81.6% batting average on the short ideas since inception in 2008? It certainly hasn’t been by sitting on my positions. Short-And-Hold isn’t a repeatable strategy across market cycles inasmuch as Buy-And-Hold isn’t. If you want to compound positive absolute returns on the short side over time, you have to keep moving.

 

Enabling Success on the short side of your portfolio is also driven by finding asymmetric opportunities. Since I attach the Hedgeye Portfolio at the bottom of this note every morning, you can monitor this real-time. But the upshot of it all is that you can witness a raging bull-run in US stocks and, at the same time, find ways to make money on the short side. If you broaden your scope, there’s always a short selling opportunity somewhere.

 

When I was younger, I was pigeon-holed into following US Retail and Restaurant stocks – so automatically, I was handcuffed to fishing in the creek that was in my area code. I was in the right place at the right time however, because 2000-2002 were bearish US stock market tapes, so there were plenty of names that were going down. Timing, like gravity, matters.

 

As I get older, I’ve simply broadened my horizons to fishing in oceans around the world across asset classes. At the same time, I’ve expanded my research team to 40 people (the largest team I managed at a hedge fund was 6).  

 

Enough about that. I just felt like writing about it this morning. I think it’s important to be transparent about what it is we do.

 

Since I only have 15 minutes left, here’s what I’ve been doing this week in the Hedgeye Asset Allocation Model:

  1. Reduced my cash position from 58% to 49%, taking advantage of some lower prices earlier in the week
  2. Expanded my invested position in International Currencies (Chinese Yuan and Canadian Dollars) as the Buck Burns
  3. Expanded my invested position in German Equities (EWG) where we remain bullish
  4. Bought back Gold on yesterday’s correction (GLD)
  5. Stayed long Oil and Grains (OIL and JJG)
  6. Stayed long US Healthcare (XLV) – my favorite US Sector alongside Energy

On the long/short side of the Hedgeye Portfolio, the main investment theme remains being long of The Inflation:

  1. Long Stocks with top line leverage to The Inflation (bought Petrobras (PBR) this week)
  2. Short stocks without pricing power whose margins get jammed with The Inflation (McDonalds (MCD), Target (TGT), etc.)
  3. Short Bonds and Emerging Markets – The Inflation is bad for them

Yes, there are some names in the Hedgeye Portfolio that aren’t working – there always are. There are also names that don’t always fit the top down and quantitative themes we’re focused on like a glove. These are names that my analysts like on either a turnaround or operating basis (SBUX, WEN, IGT, etc.).

 

Altogether, Enabling Success in terms of asset allocation, security selection, or net exposure is really best achieved managing your mistakes so that they don’t suppress your ability to generate repeatable absolute returns across market cycles.

 

My sincerest thank you to all of you who have enabled this platform to thrive. We don’t have to wake up every morning looking for some central planner in government to help us employ people. In an industry that is in dire need of evolution, you’ve enabled us to be the change we want to see in the world.

 

My immediate term support and resistance levels for the SP500 are now 1318 and 1342, respectively.

 

Happy birthday to my baby girl, Callie.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Enabling Success - yy1

 

Enabling Success - yy2


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THE M3: SIDE-BETTING; NEW LRT LAWSUIT; SANDS ETG STADIUM

The Macau Metro Monitor, March 9, 2011


SIDE-BETTING TEN TIMES AS HIGH AS CASINO REVENUE Macau Daily Times

According to the US Department of State's International Narcotics Control Strategy Report 2011, illegal side-betting could total MOP 1.88 trillion, 10x the MOP 188.3 billion in Macau GGR in 2010.  Reiterating the junket concern in the August 2010 report, the 2011 report calls for "robust oversight of junket operators."  It classifies Macau as a “major money laundering” territory and a “jurisdiction of primary concern” and claims for the 1st time that local “financial institutions [are] engaged in currency transactions involving significant amounts of proceeds from international narcotics trafficking”. The reports stresses, “In addition to the existence of casinos, close proximity border with PRC [the People’s Republic of China] and Macau’s open economy, are factors that create a risk of money laundering and terrorist financing activities”.

 

However, the report does acknowledge that Macau continues to make considerable efforts to establish an anti-money laundering framework that meets international standards.  It states that the GIF (Financial Intelligence Office) should have access to all the currency transaction reports sent to the DICJ by gaming operators.

 

LRT PROCESS: NEW LAWSUIT FILED TO OBTAIN DOCUMENTS Macau Daily Times

The consortium between Bombardier Transportation and China Road and Bridge Corporation (BT CRBC) has filed a new lawsuit in Macau’s Administrative Court to obtain the release of documents and additional information regarding the public tender for the supply of the rolling stock and the system for the first phase of the Light Rail Transit (LRT).  The BT CRBC consortium claimed it was barred from analysing several documents from the LRT tender process.  The new lawsuit, filed on March 2, suspends yesterday’s deadline for lodging an appeal against the result of the tender.


SANDS MACAO LAUNCHES ELECTRONIC TABLE GAMES STADIUM macaubusiness.com

Sands Macao’s “Imperial Stadium” features live roulette and sic bo games with 100 individual electronic touch-screen stations, combining live dealers with electronic stations.



WMT: Virtual Portfolio Update

 

Keith shorted WMT in Hedgeye’s virtual portfolio with the view that inflation will become an increasing headwind for the company’s topline as well as for margins.   Independent of inflation, we’re already pre-disposed to be short WMT based the internal challenges the company faces to drive its domestic same store sales towards the first increase in seven quarters.  

 

The situation surrounding Wal-Mart’s internal execution in areas such as apparel and overall category management is nothing new.  Too much selection? Not enough selection?  Brands? Basics?  Management is hyper focused on turning things around, yet numerous strategy changes over the past year have yielded little in the way of tangible results. We do not see a meaningful and credible plan at this current time that suggest domestic sales can outperform an increasingly challenging backdrop for the company’s core consumer.  In fact, the company entered 2011 with total inventories up 11% against a 2.5% increase in sales.  Clearly not the “clean” start that instills confidence in the wake of rising costs and substantial volatility at the gas pump.

 

We remain concerned with the following near-term challenges:

  •  Management’s message now says the US goal of positive same store sales will “take time”.  The CEO acknowledged that issues facing sales (and their customers) were bigger than they “initially expected”.  Traffic is still a drag and likely to remain so given the law of large numbers that puts 1 in 3 Americans at a Wal-Mart each week.
  • The company cut capex by $1 billion for this year, after slightly raising it at the October analyst day.  While this is noteworthy because it shows some discipline towards capital preservation, we put the amount of the cut in perspective.  At today’s share price, WMT can buy an additional 19 million shares which represents a mere .005% of shares outstanding.  
  •  Inventories are high no matter how you slice it heading into this year.  Total inventories were up 11%, total sales up 2.4% at year end.  With a negative comp headwind, inventory pressure is likely to persist through the first half of the year leaving little chance for margin expansion.  From a timing perspective, this then rolls into the second half of the year which is the most uncertain time from an inflation and price elasticity standpoint.
  • The current four point plan aimed at fixing the US business is centered on price leadership, broad assortments, improved remodels, and focus on multi-channel.  None of this is revolutionary, but rather basic blocking and tackling.  Details surrounding these plans are also scant, at least as of 4Q reporting.  The first point of the plan is most telling however.  In order to maintain price leadership in a the wake of rising costs, we suspect WMT will be as aggressive as ever to protect its market share.  At best, this caps margin improvement in the near to intermediate term.

Eric Levine

Director


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