Looking at one of the key risk management relationships we’ve been working with in calling for this 6% correction (the inverse relationship between the SP500 and the VIX), we’re at a spot here today that I would consider a Short Covering Opportunity.
- The SP500 is immediate-term TRADE oversold
- The VIX is immediate-term TRADE overbought
That should not be mistaken for a “buying opportunity” on the long side. At least not in terms of ramping gross long exposure aggressively. Not yet. What I see for the immediate-term TRADE is a Short Covering Opportunity in oversold positions (book gains) and a modest asset allocation to US and German Equities.
In the Hedgeye Portfolio these are the moves I’ve made into the market close:
- Covered short position in SPAIN (EWP)
- Covered short position in EMERGING MARKETS (EEM)
- Covered short position in WALMART (WMT)
- Covered short position in INDUSTRIALS (XLI)
- Bought long positions in HEALTHCARE (XLV)
- Added to long position in GERMANY (EWG)
Let me know if you have any questions. All of these moves tick live with time stamps on our site at Hedgeye.com.
Keith R. McCullough
Chief Executive Officer
Yesterday, in the Hedgeye Daily Outlook, our risk management call out was to watch the VIX. In it, I advised that “the VIX is going to blowout into bullish long term TAIL if it closes > 22.03; that’s not something you want to mess with if it holds.” Since the close on Monday, the VIX is up 23.3%, trading comfortable above 22.03.
Looking the chart below, it is clear that the VIX could still go a lot higher from here. Last year, during the peak of the Sovereign debt crisis, the VIX traded at 45.79. The average of the peak VIX levels during the past 6 major crises that impacted global financial markets comes to approximately 50, which would represent 48% upside from here.
As we always say, risk is always on. Clearly, events in Japan are tragic and deeply saddening. However, the systemic risks in Japan from an investment perspective remain: demographic headwinds and staggering government debt being the most prevalent. These risks will not go away and, if anything, the unfortunate severity of the earthquake, tsunami, and ensuing (and continuing) radiation crisis will likely increase uncertainty and heighten concerns about economic growth from here. Furthermore, the government’s handling of the crisis is being heavily criticized, as is evident by the trend on twitter from Japanese people ordering Prime Minister Kan to wake up: #han_okiro. Tellingly, yesterday, some users were switching to #kan_netero, meaning “Kan, stay in bed”.
The media is currently focused on Japan. As is tradition, mainstream media likes to focus on one thing at a time. As events in Japan continue to captivate viewers of the most prevalent news sources, the unrest in the Middle East continues. The uncertainty that this wave of political agitation can bring to global markets, particularly those most closely tied to oil, is likely to cause significant volatility if regimes continue to fall. Footage of unarmed civilians being shot at point blank range by Bahraini military forces speaks to the gravity of the situation in Bahrain at present.
Another small island country, Ireland, is also worth monitoring from a risk management perspective. A tiny economy by comparison to the larger EU, Ireland’s economy is heavily burdened by a debt-laden financial sector that was 100% guaranteed by the country’s last government. At present, the new Irish Taoiseach, or Prime Minister, is refusing to budge on EU demands to raise its corporate tax rate from its current level of 12.5% towards the European average of 23%. As a result, Ireland is being denied its request for a reduction in the interest rate on its bailout loan from the EU/IMF. Given the contentious nature of this issue, and the fact that a failure to reach resolution could spur contagion in the Euro zone, it is worth monitoring closely. Our Macro conviction is that the EU is likely to kick the can down the road as debt ratios go higher and higher. Markets applauded the European debt crisis package on Monday, to a degree, but Ireland is systemically important part of Europe’s sovereign debt conundrum and the situation could deteriorate if the current impasse between Dublin and Brussels persists.
Clearly, risk is always “on”, whether or not the media is focused on them at this particular moment. The recent downgrades of Portugal and Spain by Moody’s remind us of this. As the current crisis in Japan intensifies, questions mount as to whether or not the FED suggested yesterday that QE3 will not be needed, inflation accelerates, global growth slows (downward GDP revisions), and the Euro-zone debt crisis looms large in the background, a melt up in volatility could be just around the corner.
The VIX is immediate-term overbought. Over the intermediate term, we have the range for the VIX getting as high as $35 or $40.
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Weekly athletic apparel sales remain healthy through the first two weeks of March extending a strong finish to February. Both the athletic specialty and department/mass channels improved on the week while sales in the family channel slowed on the margin. Most notably, ASPs declined in both the athletic specialty and family channel for the fourth straight week. However, unit volume continues to outpace ASP declines. On the contrary, ASP increases have impacted sales momentum in the discount/mass channel as unit sales remained negative for the third consecutive week. Sales growth was strong across all regions with very few exceptions. The Pacific region stands out as being a laggard with momentum still positive but slowing over the prior two weeks.
Lastly, we note that athletic apparel faces its toughest compares in the coming week as it faces the Easter shift. Once past last year’s Easter comp (April 4th) compares get progressively more favorable over the next 3-months.
Darden is scheduled to report fiscal 3Q11 earnings next week on Thursday, March 24 after the market close. The company held a two-day analyst meeting on January 31 and February 1 and provided a mid-quarter update on earnings and comp guidance. Although the company cited an estimated negative 80 bp impact from weather and a 20 bp hit from the Lenten season shift into fiscal 4Q11 this year on fiscal 3Q11 blended comps (60 bp Lent shift impact at Red Lobster), the company’s second half blended comp guidance of +1.5% to +2.5% assumes a significant acceleration in two-year average trends across each of its three major concepts. Specifically, management guided to +3.0% to 3.5% same-store sales growth at the Olive Garden in fiscal 2H11, flat to -0.5% comp growth at Red Lobster and +4.0 to +4.5% growth at LongHorn Steakhouse.
For fiscal 3Q11, management stated that it expects comps to come in at +1.0%, or just below the mid-point of the targeted 2H11 comp range after adjusting for the negative weather impact. This +1.0% comp growth would translate into a 280 bp acceleration in two-year average trends from the prior quarter, which seems aggressive, particularly given the recent trends at Red Lobster. It is important to remember, however, that management gave this guidance two months into the quarter and recently reported Knapp track trends point to sequentially better casual dining trends in February. That being said, I am modeling a slightly lower 0.7% blended comp estimate for the third quarter as I am not yet convinced of the timing of the turnaround at Red Lobster. This 0.7% estimate still assumes a 260 bp acceleration in two-year average trends, and that includes the negative impact from weather.
Red Lobster’s same-store sales growth has fallen short of street estimates for the last three quarters and its underperformance relative to Knapp Track trends widened to nearly 3% during fiscal 2Q11 on both a 1-year and 2-year average basis. Management attributed the weakness to the fact that affordability has become a more important consideration for its core customers and that Red Lobster’s promotions were not properly addressing that need for value. In October of fiscal 2Q11, the company altered the way it was advertising its featured menu items to include specific price points rather than just starting price points in order to provide what it called “price assurance” for its customers. Management also introduced more affordable items across the menu.
The company highlighted the sharp jump in Red Lobster’s comp growth in October and November to +1.8% from -6.6% in September as proof that these pricing changes are causing the tide to turn at Red Lobster. On a two-year average basis, comps improved an impressive 470 bps in October but then decelerated 125 bps in November, which is still much better than the extremely weak results seen in September. Management stated during its analyst meeting that trends in December and January, after adjusting for weather, were in line with October and November levels, which implies about 1.0% same-store sales growth on a reported basis when you adjust for the estimated negative 80 bps from severe weather.
Given the concept’s recent underperformance, I think investors will be most focused on whether Red Lobster was able to sustain these improved trends in February. For reference, it will be important to focus on two-year average trends in February because Red Lobster is facing a much more difficult comparison from February 2010 of +7.5% relative to the -8.5% comp in January 2010. In addition, the company’s estimated 60 bp negative impact from the shift of the beginning of Lent into 4Q11 this year will hurt reported February results. Taking this all into consideration, I am modeling a -2% comp for Red Lobster in fiscal 3Q11 (slightly below management’s -1% guidance), which assumes a nearly 450 bp acceleration in two-year average trends. This estimate is aggressive, but we know the December/January trends were positive and industry trends improved in February. The company will need to sustain the assumed significantly higher fiscal 3Q11 level of two-year average trends, relative to 1H11 levels, during the fourth quarter in order to hit its targeted fiscal 2H11 Red Lobster comp growth of flat to -0.5%, which could prove difficult.
As I stated earlier, DRI’s fiscal 2H11 comp guidance for both the Olive Garden and LongHorn implies a sequential uptick in two-year average trends, but given these concepts’ recent performance and the industry’s recently reported improved trends in January and February, the guidance does not seem to be as much of a stretch. On a one-year basis, however, the comps will likely be much better during the fourth quarter than the third quarter as a result of easier comparisons and the expected reported weather impact in fiscal 3Q11. Management’s fiscal 3Q11 blended comp guidance of +1.0% implies a 2% to 4% comp during the fourth quarter to achieve the targeted fiscal 2H11 +1.5% to +2.5% growth range.
Relative to earnings, rising commodity costs are definitely a concern for Darden. During the company’s fiscal second quarter earnings call, management guided to a +1.0% to 1.5% increase in fiscal 2H11 commodity costs and to flat FY11 food and beverage costs as a percentage of sales. A little over a month later, the company raised this inflation guidance to up 1.5% to 2.0% but did not comment on food and beverage costs as a percentage of sales. Given that commodity costs moved higher and the company updated its blended comp guidance to +1.5% to +2.0% from 2.0%, food and beverage costs as a percentage of sales will likely move slightly higher on a full-year basis, which will have a negative impact on margins in 2H11 relative to the first half when food and beverage costs as a percentage of sales declined.
I am expecting restaurant-level margins to continue to improve during the second half of the year, however, as the YOY bp change comparisons get easier and same-store sales trends should come in better, particularly during the fourth quarter. Additionally, Darden achieved significant leverage on the labor line during the first half of the year, which I expect will continue and help to offset some of the commodity cost pressures. Further helping the labor expense line is the company’s new direct labor optimization initiative, which it is rolling out later in the year. Management anticipates this effort will generate modest savings during fiscal 4Q11 and then ramp up significantly next year, ultimately delivering $30 million to $40 million in annual savings when fully implemented.
I am currently modeling full-year earnings of $3.37 per share, which is in line with both the street’s estimate and the high end of management’s full-year guidance. Relative to consensus EPS estimates, however, I am $0.02 shy of the third-quarter estimate and $0.02 higher for the fourth quarter.
Conclusion: Portugal is shaking with a heavy load of its debt (principal + interest) for 2011 coming due over the next 3-4 months; this is combined with a credit rating downgrade this morning, and push backs on its austerity programs to narrow its high debt and deficit imbalances. Bailout cometh?
Positions in Europe: Long Germany (EWG); Short Spain (EWP)
As the spotlight returns to Europe’s sovereign debt and deficit issues, Portugal continues to melt. All the macro signals we follow suggest that Portugal will likely follow its peers Greece and Ireland and require a bailout to meet its fiscal imbalances. The supporting evidence includes:
- A hefty schedule of debt (principal + interest) that comes due in the months of March, April, and June (or ~ €16.1 Billion), accounting for nearly two thirds of its debt obligations for 2011 (or ~ €25.4 Billion). So far the country has sold ~ €7 Billion in bonds of its €20 Billion target this year. (See chart below)
- Portugal’s credit rating was cut 2 steps by Moody’s today to A3 (or 4 steps from junk), citing the country’s “subdued growth prospects” and “the implementation of risks for the government’s ambitious fiscal consolidation targets.”
- Portugal’s Finance Minister Fernando Teixeira dos Santos acknowledged today that the country's current borrowing costs aren't sustainable in the medium and long term, according to the WSJ.
The combination of a substantial near-term load of debt payments due with a downgrade of its credit rating suggests that the yield premium to issue Portuguese debt will continue to push higher, making it harder to finance its near-term issuance, all of which increases the probability that the country asks for outside support. In an auction of 12-month treasury bills today worth €1 Billion, the average yield paid was 4.331%, up from 4.057% two weeks ago.
And the risk management signals that Portugal is near asking for a bailout include:
- Sovereign CDS suggests the risk trade is definitely “on”, and has been for over a year. Since a year-to-date low in Portuguese CDS on February 3rd at 389bps, CDS is up 30% to 507bps. Like we saw in the case of Greece and Ireland, when the 300bps level was violated to the upside, a bailout of the country came within weeks. Portugal broke out convincingly from the 300bps level in early September of last year. (See chart below)
- Like CDS, the risk premium to own Portuguese debt is also reflected by the government’s 10YR bond, which shows yields increasing 100bps year-to-date.
Finally, PM Socrates announced late yesterday that opposition lawmakers’ resistance to additional budget cuts announced last week to meet deficit targets threatens a “political crisis”. Socrates and his Socialist party, which does not have a majority in parliament, has put forward an overly ambitious target (in our opinion) to cut the country’s budget deficit from 9.3% of GDP in 2009 to an estimated 7% in 2010, 4.6% in 2011, and to the EU limit of 3% in 2012. The government issued austerity measures in late September 2010 that included a 5% wage reduction for public sector workers earning more than 1,500/month, a hiring freeze, and an increase in VAT from 21% to 23%. Now the government is calling for new austerity plans to control operational and administrative expenses.
Today Socrates said that the plan for the new cost cutting measures would be announced before the EU Summit on March 24-5 and acknowledged that if the new austerity measures are voted down in parliament, his government would likely face early elections.
Given the political consternation about the size and shape of its austerity program combined with the near-term forces of rising debt costs into a schedule of sizable payments coming due and estimated -1.3% GDP in 2011 (expect tax revenues to be down!), we think the probability of a near-term bailout in Portugal has greatly increased. We can’t be certain of the position Eurozone leaders will take on Portugal in the days ahead, especially ahead of the EU Summit on March 24-5, but we’d expect the market to continue to punish Portugal as uncertain surrounds the collision of its fiscal and political imbalances and near-term debt obligations.
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