Japan: A Fiat Fool’s Game

Conclusion: Buying the dip in advance of the recovery story in Japan is as consensus as buying the top in Japanese equities was in February. Don’t be pulled into this value trap. Further, we use historical data to show how current Japanese monetary and fiscal policy may have Japan en route to 1930’s-40’s-style stagflation.


This morning, it was confirmed that foreign investors bought a net ¥955B ($11.8B) worth of Japanese equities last week – the most since 2004 – as “buy the dip” took on a whole new meaning. In comparing the week ended March 18th to similar weekly data, Japan’s Ministry of Finance confirmed that this is “substantially the most on record”.


In conjunction with the report, we also received more confirmation that the “flows” indeed drove the Nikkei 225 to its latest lower-high on February 21st, as foreign institutional investors were weekly net buyers of Japanese equities from Oct. 29 through Mar. 18 – the longest streak since the 26 weeks through Dec. 9, 2005. That’s not at all insignificant, as roughly 70% of the trading volume in Japan is the result of foreign institutional transactions – likely because most Japanese aren’t gullible enough to buy their own equities after two decades of lower-highs and lower-lows.


The comments provided by Richland Capital Management’s Alex Au to support our view that foreign  investors have been and continue to plow money into Japanese equities because they are “cheap”:


“Foreigners are probably not necessarily bullish, but are thinking they can buy some cheap stocks at that moment.”


Given that foreign investors have been net buyers since October, the phrase “doubling-down” certainly comes to mind.


Switching gears, our bearish thesis on the Japanese economy hasn’t changed since early October. If anything, the accompanying sovereign debt issuance acceleration resulting from the reconstruction costs (upwards of ¥25 TRILLION or $308.6B) further depresses Japan’s long-term growth prospects. Empirical studies have shown sovereign debt buildup past the Rubicon of 90% Debt/GDP structurally impairs an economy’s long-term growth prospects, and Japan, with its ~210% ratio, has been no exception.


Japan: A Fiat Fool’s Game - 1


Given the last eight centuries of history’s lessons, the following questions should be considered: 

  • If you’re buying Japanese equities because they are “cheap”, what earnings forecast are you using?
  • What’s your duration?
  • What GDP forecast are you using and have you modeled in a potential 3-6 month slowdown?
  • What’s your inflation forecast? 

Regarding duration, anyone who’s in it for the long haul needs a refresher on history’s lessons, which indeed show us that buying and holding Japanese equities has been arguably the worst trade of the last twenty years.


Japan: A Fiat Fool’s Game - 2


Regarding growth, we’re almost certain the Keynesian Kingdom will find a way to pull-forward future demand to help finance this earthquake. We caution, however, that merely REPLACING what has been LOST due to the recent tragedy with unprecedented levels of government leverage is NOT growth. Using earthquakes, tsunamis, and nuclear meltdowns as catalysts on the long side are not investment processes we subscribe to at Hedgeye.


Regarding inflation, we got some positive news this morning that Bank of Japan Governor Masaaki Shirakawa is opposed to monetizing the aforementioned recovery-related sovereign debt issuance, out of fear it may stoke inflationary pressures. This is in stark contrast to the recent proposals out of the DPJ and LDP calling for the BOJ to monetize the incremental debt issuance, out of fear the additional supply wouldn’t be adequately absorbed by the market – i.e. the bureaucrats fear a higher cost of capital looms in Japan’s near future if more and more JGB supply hits the open market (exactly what the long-term component of our Japan’s Jugular thesis forecasts).


Currently, the BOJ limits itself to purchasing long-term JGB debt on the secondary market consistent with the amount of banknotes in circulation, meaning that the BOJ has "spare capacity" to purchase around ¥20 TRILLION yen to purchase long-term JGBs – on top of its current purchases of ¥21.6 TRILLION annually and its current Asset Purchase Facility, in which it is buying ¥5 TRILLION of short-term JGBs.  The issue with the current political proposals lies in the fact that the BOJ is reluctant to outright monetize the government’s debt by funding it on the primary market.


In spite of Shirakawa’s warnings about the inflationary impact of debt monetization, as well as the potential blow to Japan’s international credibility, Japanese legislators have pushed on, invoking parallels to the Great Depression – the last time the Japanese government used a special circumstance to justify funding a substantial increase in debt and deficit spending via BOJ debt monetization:


“Bank of Japan bond underwriting is a policy that is evaluated highly worldwide because it helped Japan recover from the Great Depression before others.” – DPJ member Yoichi Kaneko


“If this isn’t a special situation, what is?” – LDP member Kozo Yamamoto


Shirakawa aptly responded:


“If a central bank starts to underwrite government bonds, there may be no problems at first, but it would lead to a limitless expansion of currency issuance, spur sharp inflation and yield a big blow to people’s lives and the economy, as has happened in the past.”


As a recap, in 1932, Japanese Finance Minister Korekiyo Takahashi boosted spending by 34% with the aid of BOJ monetization, which peaked a year later at 89.6% of JGB issuance and continued for the next 14 years until the end of WWII. Takahashi was later assassinated in 1936 when tried to rein in these expansionary policies to fight inflation. It appears that even 80 years ago, those that get paid by The Inflation don’t like it when the government pulls the plug any more than they do today…


All told, if Japan is to avoid the structural stagflationary problems that persisted throughout the 1930’s and 1940’s whereby consumer and producer prices eventually grew at YoY growth rates north of +40% and real GDP growth slowed sequentially for nearly 15 years, the bureaucrats would be well-served to heed Shirakawa’s warning. Unfortunately, with the yen trading down on the day in spite of the BOJ’s sobering comments, we, alongside the global currency market doubt they will.


Darius Dale



Japan: A Fiat Fool’s Game - 3


Keith McCullough ’99 and Daryl Jones ’98 (both members of the 1998 NCAA hockey team) will be hosting a tailgate party at their offices in New Haven on March 25th starting at 1pm in advance of the NCAA games in Bridgeport.  Their office is located at 111 Whitney Avenue, which is between Trumbull and Bradley.  This the Taft Mansion, and the name of their company is Hedgeye Risk Management, which is on the façade of the building.  Keith and Daryl would like to invite all members of the Yale Athletic Community to this event.


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Notable news items/price action over the last twenty-four hours.

  • MCD franchisee Arcos Dorados files for IPO up to $1.08 billion.  The group sees proceeds of $163.5m coming from the deal.
  • DRI reported Q3 EPS $1.08 from continuing operations versus the Street expectations of $1.05.  The company guided to +1.5% to +2.0% blended comps but the 3Q number came in at 0.9%.  More on the quarter to follow the conference call today.  The company received a $0.03 benefit from the favorable tax rate this quarter.
  • WEN received a positive write up on, expounding on a note by Morgan Stanley predicting that breakfast sales could reach up to $250k per store.
  • KKD gained 3.4% on accelerating volume following the distribution deal with SYY that closed this week.
  • SBUX traded up 2.4% on accelerating volume.  This stock is the best performing stock of the last week.
  • KONA gained 12% on accelerating volume.



Howard Penney

Managing Director

Tan Socks

This note was originally published at 8am on March 22, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I ribbed Ben for wearing tan socks with a dark suit.”

-George W. Bush, "Decision Points"


I finished reading President George W. Bush’s “Decision Points” yesterday. He ends his biography with a chapter titled “Financial Crisis” – and I’ll start this morning’s Early Look re-thinking the same.


Newsflash: the most recent “Financial Crisis” that Big Government Interventionists perpetuated before they allegedly came to our rescue is long gone. There’s always a crisis somewhere, and I can guarantee you that we’ll have another one in Global Macro markets as soon as consensus concludes we won’t. The #1 headline on Bloomberg this morning is “All Clear Sounded As Markets Shrug Off Black Swans.”


The long-term crisis that markets and Canadian-American small business owners like me are currently facing isn’t that of 2008. It’s a Crisis of Confidence. Not only in America, but around the world, investors who have embraced both the uncertainty and interconnectedness of Global Macro markets are asking themselves whether or not the so called concept of American style “free-market” capitalism is dead.


Sure, if you socialize enough losses… and pay off enough politicians… in the end, a lot of people will be just fine with this – but a lot of people won’t be. That’s why contempt is brewing in the bellies of conservative Americans who have just about had it with Washington’s centrally planned free lunch.


The storytelling of 2008 is over with. The decision point for 2011 is choosing between the individual liberties embedded in the US Constitution and Big Government’s heavy hand of intervention.


This won’t be easy. American Sacrifice never is. George W. Bush should be commended for being transparent and accountable in admitting that he, like most of us, made plenty of mistakes. In the end, I think he’ll admit that perpetually empowering The Man With The Tan Socks was one too.


In his final chapter, as Bush agonizes through the short-term decision making process as to whether or not the US Government should socialize the system for the sake of the “free-market” system itself (ironic way of looking at it really), he circuitously keeps coming back to his roots: “My friends back home in Midland are going to ask what happened to the free-market guy they knew.” (page 460)


I think that’s a very good question President Bush. One that we need to start answering as a country – and soon. Global Macro markets wait for no one – certainly not this time. Memorializing the Bush Tax Cuts works for me, but not Ben and Hank’s modern day expression of socialism.


Flashback: Ben Bernanke and Hank Paulson – “Their opposing personalities could have produced tension. But Hank and Ben became perfect complements. In hindsight, putting a world class investment banker and an expert on the Great Depression in the nation’s top two economic positions were among the most important decisions of my presidency.” (George W. Bush, “Decision Points”, page 452)


Ok. Well there are more than a few ways I can go at that – but what I really want to do is focus on the future. We don’t need an investment banker and a Great Depression historian running economic policy today, tomorrow, or the day after that. Notwithstanding that the US Federal Reserve isn’t supposed to be tied at the hip to the US Government (politicization) to begin with, we don’t need any of this scary storytelling anymore either.


What we need is a proactive Global Risk Manager at the helm of the highest office of the United States who starts by getting these colluding central planners out of our way. What we need is a Strong US Dollar that isn’t being conflicted and compromised at every whim and turn of our US fiscal and monetary policy. What we need is for someone to stand up and take our free markets back to where they came from.


Back to today’s grind…


This morning what you are seeing in Global Macro markets is a massive tug-of-war between the Keynesian Kingdom begging the US Government for Quantitative Guessing Part III (QG3) and the latest version of America Shrugged (Atlas Shrugged, coming to movie theatres near you on April 15th).




I was on Kudlow last night, and Larry came around to the forecast that I’ve been lobbying him with for the last 6 weeks – Growth Slowing As Inflation Accelerates (Stagflation). This morning you’re seeing more sell-side estimates follow the leader. Consensus estimates for Q1 US GDP Growth have now dropped to 3.35% versus the 3.5-4.5% numbers US stock market bulls were throwing around recklessly a month ago.


As this morphs into consensus, I think the proverbial Battle of the Bulge will be in the US Treasury market where short-term yields (2-year yields in particular, because that’s where The Bernank’s politicization is) can’t make up their mind as to whether or not GROWTH SLOWING gets The Bernank back in the game with QG3 or INFLATION ACCLERATING keeps him in his new geopolitical box.


British attempts to socialize their currency and country seem to have a funny way of being tested and tried before America’s political aristocracy tries the same. In the end, maybe it’s simply because they are older than we are – maybe that just means they get to try to answer President George W. Bush’s question about who the “free-market guys” are first…


The Stagflation Report out of the UK this morning makes the output of former British PM Gordon Brown’s left leaning Keynesian Kingdom policies crystal clear. They pounded the British Pound until they removed Brown from office (he lasted 2 years, 319 days) and now, as a result, on a year-over-year basis the UK inflation rate has risen to +4.4% CPI for February (vs 4.0% January).


Both the Euro (ripping higher) and European stocks (breaking down) are baking in BOE and ECB rate hikes as being for real all of a sudden. That’s how managing Global Macro risk in these interconnected times works – suddenly. And I don’t need a historian in his Tan Socks being advised by America’s crony banking cartel to lead me, my firm, or family through that.


My immediate-term support and resistance levels for WTI crude oil are $97.03 and $103.01 per barrel, respectively. My immediate-term support and resistance levels for the SP500 are now 1277 and 1311, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


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“Let him that would move the world, first move himself.”


Working closely with a European over the past year has been a learning experience for me.  Europe’s history has always been fascinating, of course, but the future of Europe is now highly topical as uncertainty mounts and political turmoil seems more and more likely to cross the Mediterranean and bring tectonic shifts in the power structure of the continent.  Having a European on the team helps me to get a different perspective on events over there.  It’s been educational!


One small thing I’ve realized is that European names often sound far more grandiose than the names I grew up around.  For instance, economist and former president of the Deutsche Bundesbank, Axel Weber, does not sound like a man you’d want to mess with.  The time has come for Portugal’s travails to garner some media attention and, with it, another interesting name has been brought to my attention.  Jose Socrates.


While I have a firm interest in politics in this Republic, and therefore have a passing interest in the origins of Western philosophy, I must confess that my weekend reading list is not heavily weighted towards political philosophy.  In yesterday’s Early Look, Keith referenced the Portuguese Prime Minister Jose Socrates, and his recent decision to step down.  Relative to some of his fellow eurocrats, Socrates showed a degree of humility in tendering his resignation this week in light of the escalating sovereign debt issues in Portugal. 


His namesake that lived in Athens over 2,400 years ago was tried and killed for disrespecting the gods and corrupting the youth of Athens.  Rather than plea for his life and compromise principles he held dear, Socrates accepted the death that preceded his death as part of the social contract between himself and society.  He refused, as a matter of principle, to pursue conventional politics.  In fact, in The Apology, he is depicted as an individual that took pride in distancing himself from public office, reflecting that he was “really too honest a man to be a politician and live”.  As the quote at the head of this Early Look indicates, Socrates’ view was that people should adjust themselves, and their views, to fit the world and its realities.  Clearly this is not a tenet that has been held by many politicians, in 400 B.C. or 2011 A.D.!  It seems that Keith, in his disapproval of Professional Politicians, is in good company.


We do not see 2011 as the year opacity died in Washington D.C.  It will likely survive as long as this Union does.  However, we are aware of the increasing premium Americans are placing on transparency, accountability, and trust.  Twitter, YouTube, and the general proliferation of easy-access information – and the thirst for it – underline this trend.  As a sanity check, simply observe the steady decline of self-professed leaders stepping into the political arena.  Transparency separates the boys from the men, the principled from the corrupt, and the industrious from the idle.  We believe demand-driven transparency is coming to America in a big way.  It is no longer a choice of politicians and public figures to be forthright or not; individuals are demanding it.  That was our call when we opened the doors at Hedgeye in 2008, and it remains our call today.


Being cognizant of the fact that our role is to help our clients make money and, more importantly, not lose any, I have applied the Socratic Method in consulting some colleagues about some of their best fundamental ideas.  The Socratic Method searches for general, commonly held truths that shape opinion, and scrutinizes them to determine their consistency with other beliefs. 


This Method rhymes with our modus operandi at Hedgeye: upon gaining conviction in a fundamental thesis, each vertical filters the idea through our Macro process in order for the idea to ultimately become a call we communicate to clients of the firm.  Below, I outline some broad parameters impacting our current investment approach from a fundamental perspective:

  • Job creation is a net positive, but too slow for a real robust recovery
  • Inflation is real, despite what Bernanke and everyone who is long oil/energy tells us (bullish on oil)
  • Government support for consumer income will diminish beginning 2Q11 (short large, cumbersome consumer businesses)
  • Focus on some basic consumer services that are less discretionary (eating out and/or dental needs)
  • Think local – what can consumers do to entertain themselves while not driving too far (casual dining/regional gaming)

Here are some ideas from the research team using me as a filter, with one caveat -- Keith has not signed off on them with his quantitative models as a long or short.  The ideas would all fit in the intermediate term TREND duration:


Financials: Today at 11am we are rolling out a Hedgeye Black Book highlighting TCF Financial (TCB) as a SHORT.  Our horizon for TCB is over the next 2-3 quarters.  Our Financials team’s core thesis is that the street is underestimating credit losses in the consumer loan book at TCB.  We think there’s downside of 20% over 6-9 months.


Energy: Long SUNCOR Energy (SU). As global geo-political tensions mount, particularly in the Middle East where nearly 60% of the world’s proven reserves lie buried, oil deposits in low political risk countries as Canada are increasingly more valuable.  Our favorite among these attractive Canadian Oil Sands companies is Suncor (SU) which has no exploratory risk; price and operating leverage are strong tailwinds. We consider it cheap with more upside potential than downside risk; SU is underpriced in the market by ~20%. With Brent crude oil at ~$115/bbl and SU 87% oil weighted, price momentum is a strong tailwind, as SU has a 0.69 positive correlation with Brent.


Gaming: This was a difficult choice given the group’s recent performance.  The Gaming team has been very positive on IGT but could not go with name today given the +5.04% move yesterday.  I like the Ameristar Casino (ASCA) story.  ASCA is a best in class operator that should be able to beat the quarter.  The MACRO environment is stable relative to other gaming operators, the company has easy comparisons, and the FCF yield offers some downside protection.


Restaurants: I continue to be positive on SBUX, but I’m going with Brinker International (EAT).  I recently met with management in a market where the company has recently reimaged 16 stores and they appear to be hitting the company’s hurdle rates for return on investment.  The best way to describe how the company is thinking about the remodels is that they don’t want to simply “preserve the status quo.”  Like our Gaming, Lodging and Leisure team’s view of ASCA, I think the earnings estimates are low for the current quarter.  I still like the SHORT side of MCD, and we are currently short that stock in the Hedgeye Virtual Portfolio.


Retail: One name that has been in and out of the Hedgeye Virtual Portfolio and a high-conviction SHORT is Carters (CRI).  What we see, that the street does not, is that margins will unravel by 400bps in 2011.  The retail team posted a note on 9/16/10 with the title “CRI: One of the Worst Stories in Retail.”  Now that is conviction.  Other SHORT names to consider are J.C. Penney (JCP) and Wal-Mart (WMT).


Healthcare - I’m going with DENTSPLY International (XRAY).  The Hedgeye Healthcare team has been conducting a series of calls with dentists focusing on our MACRO survey work.  The bottom line is that our demand model is forecasting rising visit volume, driven by per capita visits by age and employment status.   In FY 2011, our model suggested some improvement in US patient visits and we assumed some improvement in mix from patients signing on to “treatment plans” that dentists are selling (this is consistent with what dentists are suggesting in our calls).  EPS growth should accelerate in FY2011 as the US market improves, particularly in the second half as employment gains among younger workers accelerates.      Another long in the Healthcare space is Baxter (BAX).  BAX is insulated from much of the global macro turmoil as their IVIG business returns to price and volume growth, but it is less interesting at these levels based on our fundamental factor screens.  I would defer to Keith as to what he thinks might be a good entry point.  The fundamentals suggest the stock is in need of a catalyst or a pullback.  Lastly, their Japan exposure is not insignificant.


I apologize for the longevity of this Early Look.  I’ll leave you with some parting words from the Athenian Socrates ahead of the weekend:  “Enjoy yourself -- it’s later than you think”.


Function in disaster; finish in style,


Howard Penney

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