The Winds of Change

“There is nothing wrong with change, if it is in the right direction.”

-Winston Churchill


We are starting today’s Early Look on a more administrative note.  Our Founder and CEO Keith McCullough will be retiring as CEO of Hedgeye effective today, and going forward will be Chairman Emeritus of Hedgeye.   Keith’s decision was motivated by a desire to spend more time with his family and to pursue some long standing personal interests.  Later this morning, we will be announcing our new CEO, someone who we think will be able to rightfully build and grow on Keith’s legacy.  We wish you the best Keith! (If you would like to send Keith a personal note, you can email and we will forward it to him.)


With that, we’ll now turn back to the daily morning macro grind.  


Continuing on the theme of change, we want to highlight three key areas of risk management change that have been percolating over the last few weeks:


1.  TRADE Duration Change – 3 Weeks or Less – A key investment theme over the past two years, and really since the inception of the U.S. government’s weak dollar policy, has been the high negative correlation between the U.S. dollar and both U.S. equities and global commodities.  As we noted earlier this week in an Early Look, this has changed on a shorter duration.  In fact, currently the 3-week correlation between the USD and SP500 is +0.29.  So, while it is not strongly positive, it is positive and this is new.  We’ve long submitted that a stronger USD is ultimately positive for the U.S. economy and stock market and, on the margin, we are starting to see this reflected in market prices.  As you manage risk in your portfolios in the coming weeks, this is an inflection point of change to keep front and center.


2.  TREND Duration Change – 3 Months or More – Over the course of the last eight weeks, we’ve witnessed an extreme acceleration and deceleration in volatility (as measured by the VIX), which has been reflected in the price movements of U.S. stocks.   While the market has recovered from its March lows, the risks of The Inflation, sovereign debt, and interconnected global risk remain.  The obvious next potential negative catalyst is potentially earnings season in the United States, which will begin in fervor in mid-to- late April, where we will potentially see the impact of The Inflation tax on both consumer demand and corporate earnings. 


In the Chart of the Day, attached below, we’ve shown the volatility in the U.S. stock market from February 18th to the close yesterday.  In effect, we had a more than 10% move, which was 5%+ down and then 5%+ up.  At the same time, volatility in stock market prices, as measured by the VIX, had a comparable move up and then down.  While the last couple of quarters saw a steady climb in the stock market, beginning with the catalyst of The Bernank’s announcement of The Quantitative Easing Part Deux in Jackson Hole, the last 6+ weeks seems to be a new paradigm of price volatility both up AND down.


3.  TAIL Duration Change – 3 Years or Less – A longer term theme, or risk, that has developed over the course of the last month is accelerating geopolitical uncertainty in the Middle East and North Africa.  In early January, this all began with the Jasmine Revolution in Tunisia, which, at the time, was perceived to be limited in scope.  Since then civil unrest has spread throughout the MENA region and the threat of regime change is becoming the norm.  While some regime changes have been largely peaceful, like in Egypt, others have been much more violent, like Libya.  As the Obama administration continues to evolve their foreign policy strategy real time, these outcomes will remain largely uncertain. 


We wrote a note to our Macro subscribers earlier this week titled “Obama’s Foreign Policy . . . Bush Doctrine Take Two”, which compared Obama’s preemption, as he articulated in his speech earlier this week with the expression “refusing to wait”, to the Bush Doctrine, whose primary objective was to preempt threats.  As the Obama strategy continues to evolve, it is likely increasingly difficult that he can both “refuse to wait” in humanitarian interventionist situations, but also abide by his promise of “no boots on the ground”.  In any event, despite early gains by the Libyan rebels, Gadafi’s forces appear to be taking ground back, which suggests the Libyan conflict will continue much longer than was expected after the initial NATO intervention.  Oil, which is hitting a 30-month high this morning, implies as much and is also signaling that future stability in the Middle East is far from certain.


As we analyze the changes highlighted above that we have seen over the last few months and contemplate how to utilize them in making future investment decisions, it certainly seems that this is not change “in the right direction”.  This is true in that heightened price volatility and increasing geopolitical uncertainty are not positive.  That said, as it relates to future monetary and fiscal policy in the U.S., the positive correlation between a strong USD and equity prices is a positive change and hopefully a signal that The Bernank will heed accordingly. 


On the U.S. dollar front, our view, unlike perhaps the Obama foreign policy, has been quite clear and consistent. As Winston Churchill also said:


“When you have an important point to make, don't try to be subtle or clever. Use a pile driver. Hit the point once. Then come back and hit it again. Then hit it a third time - a tremendous whack.”


Best of luck out there today.


Keep your head up and stick on the ice,


Daryl G. Jones

Managing Director


The Winds of Change - Chart of the Day


The Winds of Change - Virtual Portfolio

CHART OF THE DAY: Keith's Retirement Volatility



CHART OF THE DAY: Keith's Retirement Volatility -  chart


We think ASCA will soon close a major refinancing that will reduce average borrowing cost and combined with the buyback, will be hugely accretive.  P/E multiples anyone?



For the first time in years, a gaming stock is looking attractive on a P/E basis.  That stock is ASCA and its earnings multiple on our 2012 estimate is only 9x.  It also carries the highest free cash flow yield at over 20%.  Sure, the huge free cash flow will go to paying down debt for a couple of years but longer term, the cash will flow to equity holders.


ASCA has a couple of near-term catalysts including improving regional gaming demand and a likely Q1 earnings beat.  The company should also close a major refinancing in the next week or two that will substantially lower average cost of debt.  The refinancing combined with the already announced buyback of stock from the Craig Nielsen Trust, should result in huge EPS and FCF per share accretion.


Our 2011 EPS estimate of $1.50 is substantially higher than the Street at $1.10, mostly as a result of the refinancing and share buyback.  Other discrepancies may include no cash taxes this year,  lower debt and the elimination of a significant amount of non-cash interest expense from the retirement of the swaps on July 19, 2010.  Our EBITDA estimate is also higher by approximately $6 million. 


Some analysts may have some of these factors reflected in their model.  We do not believe any other analyst have the refinancing in their models.  Per our math, despite the repurchase of 27 million shares, interest expense should not be that much higher.  Average borrowing rate could go down 120 bps, almost offsetting the $360 million increase in average debt for 2011 as a result of the buyback.  We think most analysts just assume a high yield raise and not a complete restructuring of the debt including a new credit facility.


In the years we’ve been covering ASCA, we’ve found that the best time to own it is when the FCF yield climbs over 20% and the company starts beating estimates.  We believe we are in that scenario here ahead of the Q1 earnings release.

Europe: Today’s Data Call-Outs

Below we provide brief commentary on today’s European data releases:




Ireland stress tests reveal that four banks need to raise €24 Billion in additional capital vs expectation of €27.5 Billion.

  • Hedgeye: Confidence in Irish banks is at rock bottom: the very need of the country to issue numerous stress tests confirms this point. Pumping in another €24 Billion on top of the €46 Billion injected in the industry over the last two years may ease market concerns in the near term, however the banks have a long road ahead from a financial and credibility perspective. While the government has pledged to provide the money, if the banks fail to raise it themselves, expect taxpayer unrest to grow as they are inflicted with more and more banking sector debt.  All the while, sovereign debt concerns continue to heighten. While there is a new coalition in power in Ireland, the track record of politicians underestimating the severity of the fiscal and economic conditions is causing some skepticism on the street. Tellingly, private sector deposits at Irish banks dropped at an annual rate of 9.8% in February, according to the Central Bank.

The breakdown of capital needs to cope with potential losses include:


AIB   €13.3bn

Bank of Ireland   €5.2bn

EBS   €1.5bn

Irish Life & Permanent   €4bn



Portugal’s debt (as a % of GDP)   8.6% in 2010 vs government expectations of 7.0-7.3%

  • Hedgeye: Portugal continues to shake and break, confirmed by government bond yields hitting all-time highs over German bund, after the resignation of its PM, Jose Socrates, last week following parliament’s rejection of additional austerity measures. Reducing the country’s deficit is a major focus of the country and market participants – the 2010 miss only heightens the probably that the country asks the EU (and perhaps IMF) for a bailout. S&P also downgraded Portuguese banks today following sovereign credit reductions from multiple agencies in the last weeks.

Eurozone CPI   2.6% MAR Y/Y vs 2.4% FEB

  • Hedgeye: Inflation ticket up again sequentially, increasing the probability that ECB President Trichet raises the benchmark interest rate next month. Our only pause is that given continued unrest in MENA and uncertainty in Japan the ECB may push out a rate hike to better assess the macro environment.

Turkey Q4 GDP   9.2% Y/Y vs 5.2%       [3.6% Q/Q vs 1.2%] 

  • Hedgeye: Growth continues to impress for a country that is often lumped in with the BRICs due to its emerging growth profile. While inflation remains an issue (4.2% FEB Y/Y), its equity has seen strong performance in the face of our call for there to be market headwinds from the unrest in MENA as Turkey imports ~ 93% of its oil and ~ 97% of natural gas, primarily from MENA countries.  To the contrary, the Turkish equity index (ISE National 100) is up 9.8% March-to-date and the eft TUR is up 14.7% over the same period! 

UK Nationwide House Prices   0.1% MAR Y/Y   vs -0.1% FEB   [0.5% MAR M/M   vs 0.7% FEB]

  • Hedgeye: Since hitting a peak in April 2010, the rate of price growth according to Nationwide’s House Prices survey has slowed every month since to a near term bottom in January 2011. Today’s March data point, albeit modest, is confirming an improving trend over the last three month. We’re not bullish on the country’s housing recovery or its economic performance versus Europe’s fiscally stronger nations (Germany, Sweden, and Poland). We are however bullish on the GBP-USD and the country’s credit market as Cameron and Co. promote credibility through austerity and give attention to cutting the country’s debt and deficit imbalances.


In Line:


Germany Retail Sales   1.1% FEB Y/Y   vs 2.6% JAN   [-0.3% FEB M/M   vs 0.4%]


Germany Unemployment Rate  7.1% MAR vs 7.3% FEB

  • Hedgeye: The unemployment picture in Germany has continued  to impress over the last 18 months.  Today’s print is further confirmation that the country properly managed the downturn through promotion of part-time labor and is now ramping up hiring coincident to stronger global demand. The unemployment change for March was -55K MAR to 3.01 Million (the lowest level since June 1992), beating expectations of -25K.

-Anecdotally, Volkswagen recently said it plans to create 50K new jobs, 6K of which in Germany. Robert Bosch (world’s biggest auto-parts maker) said it will add 9K graduates this year, 1.2K in Germany.


France Producer Prices   6.3% FEB Y/Y vs 5.6%      [0.8% FEB M/M   vs 0.9% JAN]


Spain Total Housing Permits   -15% JAN M/M vs -0.4% DEC    [4.0% JAN Y/Y   vs -6.3%]


Italy PPI   5.7% FEB Y/Y vs 5.3% MAR        [0.6% FEB M/M   vs 1.2%]


Italy CPI   2.6% MAR P Y/Y vs 2.1% FEB


Greece Retail Sales   -10.5% JAN Y/Y  vs -13.5% DEC



Matthew Hedrick


R3: M, FDO, GPS, Prada



March 31, 2011






  • The continued shift towards consumables at Family Dollar continues to be one of the primary contributors to both strong traffic and comp performance of late. While absolute inventory levels are on the rise, we view less exposure to and dependence on discretionary sales as a positive for top-line growth – a trend that’s important given the lower margins related with the category.
  • In a case that sounds eerily akin to American Apparel’s corporate culture, Marc Jacobs President Robert Duffy is being sued by the company’s former COO for producing a ‘yearbook’ of staff in the buff and forcing an employee to pole dance amongst other things. One of the unfortunate realities of a high unemployment rate is the level of antics like this and just how long they persist before an employee is forced to stand up and do the right thing.
  • When asked about the company’s unit growth strategy through year-end, Macy’s CEO Lundgren offered a varied outlook – a decline in the company’s Every Day Value business with planned increases in the International Concepts brand due to increased demand for the line even in the face of higher prices.



Prada File for IPO on Hong Kong Exchange - Prada SpA, the Italian maker of Miu Miu bags and Church’s shoes, submitted an application to the Hong Kong exchange to hold an initial public offering in the city by July, said two people familiar with the company.  The planned sale may give the company a valuation of about $10.7 billion excluding debt, said one of the people, who declined to be identified because the matter is private. Prada made the IPO filing yesterday, the people said. Prada, based in Milan, follows European brand-name companies including L’Occitane International SA (973) in selling shares in Hong Kong, where IPOs reached a record last year. The city is a popular luxury-shopping destination for tourists from China, which allowed individual travel to Hong Kong in 2003. Intesa Sanpaolo SpA (ISP), Credit Agricole SA’s CLSA Asia-Pacific Markets, Goldman Sachs Group Inc. (GS) and UniCredit SpA (UCG) are managing the IPO. Sally Kwong, a Prada spokeswoman in Hong Kong, declined to comment. <Bloomberg>

Hedgeye Retail’s Take: Just days after posting record profits, the luxury retailer has finally filed its long awaited IPO papers in Hong Kong with aspirations to float this summer. While hardly a surprise, the papers are not definitive until the deal is complete. As you may recall, this process has been delayed on three separate occasions over the last 10-years.


Gap Opens a Chinese Web StoreGap Inc. is selling online in China. This morning, Gap, No. 23 in the Internet Retailer Top 500 Guide opened an online store on Taobao Mall, one of China’s biggest business-to-consumer e-commerce marketplaces. Gap, which late last year opened Gap bricks-and-mortar stores in Shanghai and Beijing, initially will use its web store on to sell merchandise from its Gap, Baby Gap and Gap Kids brands, the retailer says. Taobao reaches 370 million registered users, Gap says. Taobao also receives more than 50 million unique visitors daily and features more than 800 million individual product listings. “Given China is the cornerstone of Gap Inc’s global growth strategy, we believe that partnering with Taobao, with its phenomenal reach all throughout the country, is an important next step as we build on the success we’ve seen so far with our store openings and e-commerce offering,” says Redmond Yeung, president of Gap China. <InternetRetailer>

Hedgeye Retail’s Take: Even more cost effective than partnering with local franchisees, selling through one of the country’s more popular web portals will help grow brand awareness ahead of future owned retail expansion. Given the company’s success selling through the e-commerce channel domestically, this is a no brainer – particularly with the number of stores in China growing from 4 to 12-15 this year.


Fed Says Credit Card Swipe Fee Regulations Will be Ready by Summer - Federal Reserve Chairman Ben Bernanke assured Congress Tuesday that the agency is on track to implement swipe fee reform regulations by summer that will save retailers an estimated $1 billion in fees. “Retailers want to begin passing on swipe fee savings to their customers as soon as possible, and today’s announcement means those plans will be able to move forward as planned despite the anti-consumer efforts of some in Congress,” NRF Senior Vice President and General Counsel Mallory Duncan said. “The Fed has received thousands of comments on this proposal and it is appropriate for that input to be carefully and thoroughly reviewed. If they take a few extra weeks, we understand.” “The banking industry and some in Congress want to delay swipe fee reform for as long as two years, but Chairman Bernanke has made it clear that the Fed doesn’t need a delay in implementation,” Duncan said. “Congress held seven hearings and ordered two GAO studies of swipe fees before enacting this law last year. Congress has made its decision and should allow the Fed to complete its work. Delay beyond this summer’s deadline would amount to a $1 billion-a-month bailout for big banks.” <SportsOneSource>

Hedgeye Retail’s Take: This regulation comes at a critical time for retailers just as input costs ramp into the back half. The question remains whether retailers will choose to enhance overall margins with the potential savings or put the cost savings back into price.



Disparity Between Advertising Dollars and Usage - Despite the projection that online advertising will increase its share of US major media ad spending by more than 10 percentage points between 2009 and 2015, spending on digital, including internet and mobile, has not yet risen to match consumption patterns, eMarketer estimates. Among the major media of television, internet, radio, mobile, newspapers and magazines, US adults still spend the most time each day with TV. eMarketer estimates adults watched television for 42.9% of the time they spent each day with those media in 2010, and ad dollars align closely, at 42.7%. The internet, by contrast, took up 25.2% of adults’ daily media time in 2010, but received just 18.7% of US ad spending.

Hedgeye Retail’s Take: Legacy media is still getting  over 25% of all ad dollar spend despite accounting for only 8% of where consumers spend their time. An even greater disconnect exists in mobile accounting for less than 1% of spend despite 8% of time spent. Our sense is that translation issues such as flash compatibility, text sizing, etc. play a key factor here, but don’t expect this spread to last for much longer as retailers commit to greater mobile visibility.


R3: M, FDO, GPS, Prada - R3 3 31 11



Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . .

On Monday we wrote a research note on the valuation of the SP500 using the Shiller CAPE P/E, which suggested that the market was overvalued by at least one standard deviation.  Not surprisingly the note elicited a fair amount of feedback, some positive, some negative, but mostly constructive and all worth contemplating.  Below I’ve categorized the main areas of feedback and attempted to address them appropriately.


1. On a relative basis aren’t equities still a good buy? 

Clearly, money managers need to make allocation decisions between stocks, sectors, and asset classes.  Therefore, one could argue, looking at U.S. equities on purely a valuation perspective and saying they are expensive only makes sense in the context of the investment alternatives, and the relative after-tax returns.


It is hard to disagree with that.  As investors, we have various options of asset classes from which to consider allocating our clients’ heard-earned capital.  On a very basic level, then, we should consider the relative value of bonds versus equities as an indicator of whether equities are truly expensive.  (The one caveat here is that we also don’t have to be fully-invested when there are as few opportunities for true value as there are today.)


To examine this relative valuation, we’ve taken a look at the earnings yield of the CAPE P/E versus the average yield of a 10Y AAA corporate bond going back to 1954.  In this analysis, a lower yield implies a more expensive asset class which is less appealing from an asset allocation perspective, in theory.  Currently, bonds, based on this proxy, are a cheaper asset class as they have a 5.2% yield versus equities with a 4.23% yield.


Interestingly, on a standalone basis, while bonds are expensive versus their historical standards, not surprising given the current interest rate policy of the Federal Reserve, they are not as expensive as equities versus their historical average.  In fact, 10Y AAA corporate bonds are currently only 0.74 of one standard deviation more expensive than their long run average yield of 7.2% going back to 1954 versus more than one standard deviation for equities.


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - dj chart bond yield


2. The CAPE P/E is based on historical earnings and equities are based on future estimates, so aren’t equities still cheap? 

While we would agree with this to a point, in aggregate it is important to remember that analyst estimates of future earnings are typically wildly disparate versus future actual earnings.  So, while the valuation of a stock, and equities broadly, will eventually reflect their future earnings or cash flow, looking at the broad forward earnings of a market is rarely a great gauge of the valuation of the market and whether it is cheap or expensive.


Simply put, forward earnings estimates are typically inaccurate and usually too high.  To highlight this, we’ve attached a chart below from McKinsey Consulting that emphasizes our point that EPS forecasts for the broad market are consistently grossly off their mark.  We would submit that the primary driver of this disparity is that the bottoms up earnings projections rarely include accurate economic forecasts.


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - 1


Obviously, we also have a negative view on future earnings based on corporate margins being very close to cycle highs as growth slows while inflation accelerates, so we have a hard time making the case that earnings will grow into their multiples. In addition, it is somewhat dangerous to make a “valuation” call on the collective sell-side’s earnings projections, particularly given their preponderance for inaccuracy.


3. The CPI is not a great gauge of inflation since it has changed over time, so how would CAPE P/E look with real inflation?


The calculation of CPI has changed many times over the last few decades with significant changes coming in 1983 when housing prices were replaced with owners’ equivalent rent and in 1999 when the Bureau of Labor Statistics stopped using Laspeyres indices in its calculation.


In the chart below, we have an estimate from of what CPI would look like from 1980 onwards if the calculation of CPI hadn’t changed. The obvious take-away is that inflation would be substantially higher.  


Whether we agree that CPI should be calculated the same now as it was 30+ years ago is not the point, but rather the point is that markets, commodities prices, and basic goods are indicating quite clearly that CPI understates inflation.  So, the question is, if we use a more realistic, and presumably higher measure of inflation, how would the CAPE P/E for the SP500 look?


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - 2


Shiller’s methodology for accounting for inflation is to use a CPI-adjusted S&P500 index and to then divide that by a 10-year average inflation-adjusted (using CPI) earnings to impute his CAPE P/E. Absent being able to actually recreate these numbers for a constant measure of inflation, which would presumably be higher than CPI, another way to look at this market valuation is on a nominal basis, which would at least normalize the valuation for changes in CPI calculations and allow us to compare apples to apples historically.


This analysis was actually done by Chris Turner (email me at if you’d like a copy of the paper with hat tip to a certain subscriber for pointing it out).  He found that by using nominal numbers, for both the index and earnings, that nominally speaking (which really only makes the measure of inflation constant) the market trades at a higher multiple historically (no surpise) and is about as overvalued as it is currently without such adjustments.


We would further submit, that in a period of higher inflation the inflation-adjusted valuation of the market would be higher since the price is based on current inflation, while the earnings is based on cycically smoothed inflation. Thus, if you believe, as we do, that inflation is higher than reported today, than the market is likely more expensive.  This is disconcerting because in periods of high inflation market multiples decline dramatically.


To the last point, the table below shows that as inflation accelerates, earnings multiples decline.  This occurs due to a combination of margin compression due to higher input costs, which slows earnings growth and naturally leads to lower multiples; as well as, to the point highlighed earlier, the relative value trade: as inflation goes up, interest rates will as well and bonds will likely become more appealing from total-return perspectve (so “The Flows” will follow).


Daryl G. Jones

Managing Director


Even If Stocks Are Expensive, Are They Still A Good Relative Value? Not So Sure . . . - 3

get free cartoon of the day!

Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.