Destroyers of Capital

Destroyers of Capital - asset allocation012109

“If an idiot were to tell you the same story for a year, you would end by believing it.”
-Horace Mann

Herein lies the crisis of confidence that remains with the US stock market. If you want to wake up this morning believing that the market cracked yesterday because of Obama, go right ahead and believe that narrative fallacy – if you just don’t like the man, stand up and blame him – that’s easy enough to do. The reality is that this market is swooning because the Destroyers of Capital are crashing.

I have called this a Crisis of Credibility. I have called Investment Banking Inc. a horse and buggy whip compensation structure. You can call the US Financials Sector (XLF) what you wish. At -36% for the year to date, in a year that is less than 3 weeks old, we can all call this another crash.

Crashes in my models are 3 standard deviation moves within the duration I build into my investment thesis. For others, crashes are simply what happens when they invest alongside professional story tellers – otherwise known as idiots. If that’s a word that’s too hard to read, too bad – Wikipedia says “idiot is a word derived from the Greeks as a person lacking professional skill… in Latin the word “idiota” means uneducated or ignorant person.” In this regard, what would you call Hank Paulson?

The best news this morning is that Hank Paulson, Chris Cox, and hopefully Vikram Pandit are going away. In any other high paying profession – say medical practice – the professional lack of skill of these said economic savants would have them barred. The revisionist historians are pretty good at understanding how Donald Rumsfeld’s ignorance and hubris led is to where we ended up in Iraq – it will not take them very long to lay the accountability cards face up on the purveyors of capital destruction. Hank Paulson and Investment Banking Inc, tag – you’re it.

With the SP500 down a third of what the US Financials are, that still puts them down by a lot for 2009 to date. Yesterday’s -5.3% move came on better than average volume and a breakout in volatility (as measured by the VIX Index). While SP500 805 is still +7% from its November lows, the bear claws have every right to be swiping at anyone who calls themselves bullish – for that, I’d say that in the USA, China, and Gold at least, since late November I am accountable for what I have been saying. In those respective asset classes, I have been bullish, but at very specific prices.

One fund that mimics my daily entry/exit points had me up close to +9% in December, and now down close to -2% for January to date. I will make no excuses for being down for 2009 to date. I get up every morning and do my best to “make the call” – when I lose people money, it’s my fault, not the market’s. My current Asset Allocations model has a 64% position in Cash and a 6% position in Gold.

The Destroyers of Capital have perpetuated a compromised view by taking tax payer moneys and blowing it up in smoke. Whether you call Pandit cutting Citigroup’s dividend to a penny this morning embarrassing, or just more of the same versus expectations is not the point. The point is that these people continue to pay themselves massive compensation structures to not only be un-transparent, but to be un-accountable. Who in their right mind is ever going to trust these people ever again?

The Chinese certainly don’t – a few weeks back, Destroyer of Capital BAC, sold their equity in Chinese banks in their face. When men are desperate, they sell what they can, not what they should. This compromise of the American bankers system’s handshake, sadly, will have long term repercussions. I pray that the Chinese don’t start unloading US Treasuries en masse. Blowing up the last bubble market that remains (Treasury Bonds) might even make me depressed.

This morning you are going to hear the pundit patrol jump on their meme machines and start telling you that the answer is to “nationalize the banks.” Well, that sounds interesting, but take a visit to the Russian stock market, or the Irish one for that matter, and let me know how that goes. Whether you are nationalizing your natural resource enterprises (Russia) or your banks (Ireland), you are the only market’s going down as fast as the US Financials right now. CNBC better be careful what their crackberry entertainers wish for.

Russia broke its October lows yesterday and hasn’t looked back. Trading down another -1% this morning at 509, the Russian Trading System has lost -25% of its value since Christmas, and now even on up days for oil (oil shot up to $41/barrel this morning), the market has NO confidence all over the offer. In Ireland, they moved to nationalize the banking system last week, and inclusive of this morning’s -3.6% drop, you have an Irish stock market that’s lost almost -20% of its value in the last week alone. Them be crashes folks. The Destroyers of Capital are now wrecks on this interconnected global market’s shore.

Brazilian stocks broke my quantitative levels of support intraday yesterday, so I sold them. Managing risk is more about taking small losses before they become large ones than anything else. That’s just a process that I have had to learn the hard way. All of those who did not respect capital, especially your capital, are still in the process of being educated on this front. Illiquidity and leverage are the weapons of mass destruction that Hank Paulson never understood.

China is literally the only major economy in the world that has a stock market that is healthy across my quantitative factors. China closed down, barely, last night taking the Shanghai Index to 1985. There is formidable support at the 1948 line on that index, and there should be. These communists turned hybrid capitalists are the only allocators of capital who own the liquidity associated with a healthy balance sheet…

“Lacking professional skill” or being “ignorant” are no longer acceptable in The New Reality. Be accountable. Be transparent. Have a handshake that people can trust – the “idiots” and Destroyers of Capital are finally being handed their walking papers. For that, we should all be thankful.

Best of luck out there today,

Destroyers of Capital - etfs012109


We’ve gone through the painstaking details of the credit documents, worked the math, and performed the analysis. In other words, we’ve done the work. The good news: it looks like LVS will probably clear its 7.0x Consolidated Leverage Ratio covenant on its US facility, due primarily to a creative definition of Consolidated Adjusted EBITDA. The bad news: we can’t say the same for the Maximum Consolidated Leverage Ratio in their Macau facility.

As can be seen in the first chart, LVS should make it through 2010 without breaching the leverage covenant in the US facility. At the end of 3Q08, LVS just skated under its maximum allowable leverage under its US facility with leverage of 7.45x vs a 7.5x test. Subsequently, LVS raised $2.1BN of cash through an equity and preferred offering. Total Consolidated Debt is defined as total debt at the US subsidiary level less cash in excess of $75MM. We estimate that net debt goes from $4.15BN in 3Q08 to $2.8BN in 4Q08. The US facility’s definition of Consolidated Adjusted EBITDA also allows for up to $100MM of equity contributions ($50MM per every other quarter) for every TTM period to be counted as an addback to EBITDA. The facility also allows for the addback of interest on its $250MM 6.375% Sr Notes. Therefore our leverage calculation for 4Q08 drops to 5.5x, before climbing to 6.3x in 1Q09. Without the $58MM in addbacks to Adjusted EBITDA, LVS would most likely breach the 7.0x leverage covenant in 1Q09.

Now the bad news. Even if LVS clears the debt covenants in its US Credit Facility, it may not be out of the woods. According to our calculations as seen in the second chart, the company is dangerously close to tripping its Maximum Consolidated Leverage Ratio in their Macau facility and will likely trip the covenant in the 2Q09. Similar to the US Credit Facility, the Macau facility allows for numerous addbacks to its Consolidated Adjusted EBITDA calculation, including (for a TTM period) up to $80MM of equity contributions, $10MM of corporate expenses, $15MM of non-recurring charges, and $10MM in uncapitalized non-recurring expenses in relation to a financing transaction. However, given the current debt balance in Macau, minimum required EBITDA to meet the leverage test would need to grow $220MM over TTM EBITDA in 3Q08 by 2Q09 to make-up for the step-down in the allowable leverage ratio from 4.5x to 3.5x, and by $387MM by 4Q09 when maximum allowable Consolidated Leverage steps down to 3.0x.

Given our views of Macau fundamentals, we believe that despite the opening of the Four Seasons last quarter and newly in-place cost controls, LVS’s Macau EBITDA will only experience modest growth in 2009. The Macau market faces many challenges including player credit, new competition, and visa restrictions. Barring an asset sale, we do not see how LVS can avoid tripping their leverage covenants in Macau. Unfortunately for LVS, the market for retail and condo/hotel assets could not be worse right now.

Anna Massion

Eye On Leadership: 100 Days, Obama's clock starts with S&P 805

100 Days

“He’s the absolute right commander in chief . . . You know whether it was Lincoln, Roosevelt. And, I would say Obama, you couldn’t have anybody better in charge.”
-Warren Buffett, January 19th, 2009 on Dateline

President Obama was inaugurated as the 44th President earlier today and he will be entering office with some of the highest expectations of any incoming President. This is both a blessing and a curse. The naysayers obviously argue that he can only fail given the high expectations that come with being compared to some of the most prominent Presidents in history, as Warren Buffet compares him to above. On the flip side, he has the approval rating, and thus the mandate, to accomplish a great deal in his first 100 days in office – a time period which often marks the success or failure of a President’s term.

Keith and I have spent the last few months reading, discussing and referencing Franklin Delano Roosevelt. In many ways, he is the most appropriate Presidential comparison for President Obama. FDR gained the Presidency in a time of severe economic crisis and inherited the office from a predecessor, President Hoover, that was broadly unpopular.

FDR is one of the more widely studied Presidents in history and while conventional wisdom has concluded that he was a great President, that conclusion is certainly open to debate. The success of FDR’s first 100 days is less open for debate and will provide a framework to evaluate Obama’s early success. If we were to characterize the template of success from FDR’s first 100 days in three words, they would be communication, action, and flexibility.

FDR’s inaugural speech had one of the now most frequently quoted lines from any inaugural speech:

“Let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts.”

Ironically, the power of this line was not recognized until well after the speech was given and the major newspapers of the day did not even highlight this line in their reporting of the speech the next day. Nonetheless, the speech was raved about by the papers and introduced an engaging Presidency that was in sharp contrast from the Hoover Presidency. FDR spoke openly with the media, on good terms, and, even more importantly, communicated directly with the U.S. people primarily via the radio through his Fireside Chats.

The power of communication is obviously difficult to quantify, but can be seen in the numbers of opinion polls and the actions of the public. FDR’s second major speech was his first Fireside Chat. The subject of this speech was the run on the banks that was occurring in the U.S. at the time. In the speech, FDR attempted to explain, in simple terms, the importance of the banking system and in keeping your funds in the bank. In the following line he also went so far as to shame citizens who withdrew money from the banks:

“I can assure you, my friends, that it is safer to keep your keep your money in a reopened bank than it is to keep it under the mattress.”

With this speech, and the confidence it once again gave people in the banking system, FDR reopened the banks the next day and the banking system broadly saw a massive inflow of deposits.

Undoubtedly Obama has among the more impressive oratory skills of any politician we have ever seen on the national stage and his inaugural address from just hours ago will be one that will be reflected on for month and years to come. Beyond this first speech, a significant indication of Obama’s initial success as President will be the willingness of American consumers to reassert their confidence and engage in commerce in the coming months as they did with FDR by putting their money back into the banking system.

Once inaugurated, FDR did not waste his popularity or the political capital that the election had bestowed on him. In his first 100 days, from roughly March 9 to June 16th, 1933, FDR sent an unprecedented number of bills to Congress, which all passed easily. Among the major bills that were passed by Congress during this time period were the bill that created the Federal Emergency Relief Administration, the Civilian Conservative Corps, the Reconstruction Finance Corporation, and the Tennessee Valley Authority. Congress also gave the Federal Trade Commission broad new regulatory powers and provided mortgage relief to millions of farmers and owners.

While there are parallels between 1933 and 2009, we are not nearly in the state of economic crisis that faced FDR as he entered his Presidency. Most notably in 1933, the bank system was effectively frozen, unemployment was near 25%, and GNP over the course of three years had fallen by close to 25%. Clearly, President Obama does not face an economic crisis of the same magnitude that enabled FDR to get broad legislative support for his initiatives, but Obama’s recovery bill, The American Recovery and Reinvestment Bill of 2009, which now amounts to over $825BN seems likely to get passed in the first few weeks of his Presidency.

The final key component to FDR’s success in his first 100 days was a willingness to be intellectually and ideological flexible in looking for and adopting solutions to the economic crisis. As Margaret Ferguson of the Indianoplis Star recently wrote:

“ Roosevelt's greatest strength was that he offered solutions but avoided ideological grandstanding. If a program failed, Roosevelt did not hesitate to reject it and move on.”

Obama has already shown a flexible willingness to work across party lines, which has been emphasized by consistent outreach to his former Presidential Rival, Senator McCain.

It seems likely that Obama’s predecessor, President Bush, saved Obama the unpopular requirement of bailing out the nation’s banking system, although there is some likelihood, at least based on how the stocks of Citigroup (down -18% as of 3pm today) and Bank of America (down -21% as of 3pm today) are trading, that more capital is required. Generally speaking though, Obama now has the opportunity to implement change, which is manifested in his recovery plan to promote a more broad based consumer led recovery, but he has retained the flexibility to tweak this plan as needed.

In his first week of office, FDR left the White House, partly as a shot at his predecessor Hoover who famously told FDR that the President visits no one, and paid a call on retired Supreme Court Justice Oliver Wendell Holmes on the occasion of his 92nd birthday. According to his former clerks Tommy Corcoran and Donald Hiss, Holmes told the President:

“You are in a war, Mr. President, and in a war there is only one rule, “Form your battalion and fight.”

President Obama has followed this advice well. He has formed a solid economic battalion in the way of Summers, Geithner, and Volcker (to name three) and is charging forward with a large and broad based recovery plan. Even the most partisan of Republicans will have a hard time not supporting President Obama over the next 100 days.

Daryl G. Jones
Managing Director

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Over the weekend the Melbourne Institute Monthly Inflation Gauge was reported (official CPI data is only released quarterly by the Bureau of Statistics) with a year-over-year growth level of 2.23%. The continuing decline in inflationary pressures leaves more room for Governor Stevens and his team at the Reserve Bank to cut rates from the current 4.25%.

For the Australians declining inflation is a double-edged sword since the collapse of the commodity bubble of 2008 has dramatically dampened short term prospects for the country’s GDP. Q4 import/export price statistics slated for release on Wednesday will provide an insight into how large the impact of declining metal and fuel prices may be.

We have long admired the resolve that Mr. Stevens and his predecessor Ian Macfarlane used in rate policy during the white hot growth of 2006-2008; their policies left the land down under with plenty of room to cut rates. Unlike Brazil however, Australia’s declining commodity export revenues are not offset by massive internal consumer demand, leaving them vulnerable to long term deflationary pressure.

We will continue to watch Australian equities, which we have owned on several occasions over the past two quarters, if only for a short term “Trade.”

Andrew Barber

SP500 Levels Into The Close

This is getting nasty, and if it weren’t for Gold (GLD) and the VIX not confirming … yet… I’d say we are on the precipice of another SP500 crash. Crash? Yes – the horse and buggy whip US Financials (XLF) are crashing – as they should.

Looking at the chart below, you’ll see my refreshed levels to manage around if we don’t crash. Selling SP500 866 is the dotted red line – that’s where any immediate term “Trade” to the upside runs out of gas. Selling SP500 883 is the new intermediate term “Trend” line – make no mistake, its bearish out there. The US Financials, as a sector, are down -30% for the year to date!

The buy/cover for the immediate term “Trade” line is 803. If you’re in the SP500 crash camp, a 3 standard deviation move in my model will get you SP500 771. That’s another -4% more pain to carry (or risk) if you cover/buy at 803. This Crisis in Credibility has proven to be both well deserved, and painful to the stock market for 2009 year to date, but I still do not think the SP500 will make a lower low versus November’s 752.

Keith R. McCullough
CEO & Chief Investment Officer

Eye On Leadership: President Obama

Transparency, Accountability, and Trust - we like that message, and if only in rhetoric, that's where Obama sides with Research Edge's vision of The New Reality.

Bank of America is no longer America's once vaunted investment banker. Blackstone's lack of transparency is not the new American capitalists interpretation of where this country is headed. Those two stocks are down -19% and -11% today for reasons that are unique to their very own shortsightedness.

Trading down another -9% today, the US Financials (XLF) have already crashed in 2009. Tomorrow that will be yesterday’s news.

For the year to date, we have a developing story of the excesses unwashed meeting their maker. At down -30% for the year to date, in a year that is only 20 days old, today we can say goodbye to the horse and buggy whip thought processes of the leverage cycle past. Goodbye and Good luck.

Before we can “dust ourselves off, and rebuild it”, the SP500 needs to rid itself of the market cap associated with the banking system’s Crisis in Credibility. Everything starts with confidence. Obama has that - and yes, the best things in life take time to build.

We are most likely going to test my downside SP500 support line of 818 in the meantime.

Keith R. McCullough
CEO & Chief Investment Officer

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