“As always, if you listen to my advice, be prepared to be early!”
-Jeremy Grantham, May 2011
If you have not yet read Jeremy Grantham’s most recent GMO Quarterly Letter titled “Time To Be Serious (and probably too early) Once Again”, I highly recommend it. He’s been managing Global Macro risk for a long enough time to know that the best lessons in this business are learned the hard way.
Managing interconnected Global Macro risk is hard. So is keeping up with the required risk management reading that’s readily available to you. If you read too much groupthink, you’ll miss the deep simplicity of Mr. Macro Market’s signals. If you read too little history, you’ll miss the context by which the patterns of human behavior rhyme. Your reading needs to be focused and timely.
For me, it’s taken almost 13 years to realize that I read too much garbage and too little history. So, in the last 3 years I’ve worked on changing that. The plan on this front is always that the plan is going to change, but currently my reading process falls into two buckets:
- My pile
- My books
My pile, as my teammate of many years Tanya Waite can attest, is perpetually mounting. From my desk, to my bag, to airplane pockets around the world, my pile is my Princeton hockey player. I will fight it until I knock it down. My pile is a series of print outs (Grantham, Gross, etc.), white papers, and whatever else my team sends me that refutes or augments my current thinking.
My books, like my emotional baggage, are always with me – that’s why you’ll see me cite books in the sequence that I am reading them. I just finished reviewing “The Road To Serfdom” and “Undaunted Courage.” My challenge is to read at least 1 book every 10 days. On the plane to Denver last night, I was reading “The World In 2050” – more on that book and being long Northern Rim Countries (NORCs) in the coming weeks.
Back to Grantham’s problem of Being Early…
- Being Early to work isn’t a problem – it’s cool
- Being Early to mentally prepare for a game is better than being late
- Being Early in our institutionalized world of chasing short-term performance is also called being wrong
That’s Wall Street. In evaluating our professional competence, our process and principles can always be trumped by our short-term P&L. Are you wrong today because you are about to be right? Or are you right today because you are about to blow up?
These are fair questions. Clients shouldn’t have to pay for my pile or performance problems. We are overpaid to over-deliver over long periods of time. As Risk Managers, we are tasked with explaining to our clients what it is that we are doing and why.
As Grantham points out in his Quarterly letter, “we often arrive at the winning post with good long-term results and less absolute volatility than most, but not necessarily with the same clients that we started out with.” Isn’t that the truth? Your clients need to know your duration too.
Back to the Global Macro Morning Grind…
No matter where you go this morning, there it is – The Correlation Risk to the US Dollar Index. For the week-to-date, the US Dollar Index is down a measly -0.65%, but look at the pop you are getting in the big stuff that’s priced in those Burning Bucks:
- CRB Commodities Index = +1.7% week-to-date
- WTI Crude Oil = +1.3% week-to-date
- SP500 = +0.22% week-to-date
Ok, maybe a 22 basis point move in US Equities isn’t the kind of pop that would get you all fired up, but maybe that’s the point. Maybe people are starting to get the math. Since the immediate-term inverse correlation between the SP500 and the USD is -0.84% (extremely high), maybe people are starting to consider the other side of the immediate-term TRADE.
What if the US Dollar stops going down from here?
The answer to that question is a trivial one. US stocks and commodities corrected -3% and -9%, respectively, in the last 2 weeks of a USD rally. While a strong dollar is great for this country, it’s awful for stock and commodity markets in the immediate-term. Yes, Mr. Bernanke, the country and the markets are 2 very different things.
This is where all of my reading runs parallel with my risk management signals – and yes, there is also a huge difference between the research embedded in your reading and how you manage risk in your portfolio. Every once in a while a risk management signal jumps out at me that’s impossible to ignore. Currently that signal is an immediate-term TRADE breakout in the US Dollar Index.
If you were only to allow me one live market quote to manage all Global Macro risk on for the next 3 weeks, I’d take the USD Index. The line in the sand is currently $74.41. That’s my TRADE line – and my risk management process is to respect it until correlation scores tell me not too.
If $74.41 holds support, I sell stocks and commodities (that’s why I have sold all my Oil and Gold in the last 2 weeks). If $74.41 breaks, I’ll be forced to go back to speculating on what The Inflation trade can do.
Being forced to do things isn’t cool. But, like Grantham, I have learned to take a measurable level of risk to speculate in these correlation trades. On page 2 of his Quarterly Letter, Part 2 – “Time To Be Serious” – May 2011, this is how the self-effacing Grantham summed up the same:
“As readers know, driven by my increasing dislike for being early by such substantial margins, I have been experimenting recently with going with the flow. In defense of this improper behavior, rest assured that it was motivated not by chasing momentum, but by my growing recognition of the immense power – sometimes the thoroughly dangerous power – of the Fed.”
Being Early doesn’t work until it does.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Position: Short sugar via the etf SGG
Sugar has been leading the recent commodity sell off. In fact, sugar prices have been on a downward slope since their 30-year highs in February of $0.36/pound, falling roughly 40% since then, and sugar is now one of the most underperforming major commodities year-to-date, down roughly -16%. Despite this dramatic sell off, on a year-over-year basis the price of sugar is still up more than +40%, which we believe doesn’t reflect the coming supply/demand imbalance.
More recently, sugar rose for the 4th day in New York yesterday, the longest streak in more than 3 months, mostly due to -69% year-over-year lower production during spring harvest from Brazil, the top sugar producing nation. Production fell from 2.56 million metric tons to 795,000 metric tons from mid-March to the end of April.
Setting aside the short-term supply issues in Brazil, the International Sugar Organization (ISC) estimated last week that world supply, however, would exceed demand for the 2010-2011 season by 779,000 metric tons, despite the current slower flow of product from Brazil.
Our view, which is more bearish than the ISC, and consistent with a recent report from The Kingsman Group, a commodities market analysis and research firm, is that sugar’s excess supply level would be even greater, with a potential oversupply of north of 5.2 metric tons. The driver of this oversupply is more tepid demand growth combined with supply growth of more than 6% on a year-over-year basis.
From a correlation perspective, our correlation analysis appears to support this increased focus on supply and demand. While sugar has been the beneficiary of a weak dollar over the past two years, similar to the broader commodity complex, sugar has recently lost its strong negative correlation to the U.S. dollar. In fact, over the past 6-weeks, sugar’s correlation to the U.S. dollar is a statistically insignificant +0.15, with an r-squared of 0.02.
As the Inflation continues to deflate, we like sugar on the short side. Our levels are outlined below.
Daryl G. Jones
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Conclusion: Below we use two company-specific data points to illustrate further confirmation of the broader macro theme we authored at the start of the year: Growth Slows as Inflation Accelerates. In addition, we dive into why earnings have disappointed recently and why we expect this trend to continue.
Position: Short US Equities (SPY); Long a US Treasury Curve Flattener (FLAT); Long Long-Term Treasury Bonds (TLT).
McDonald’s: Taking Up Price on the Consumer (Accelerating Inflation)
A couple of weeks ago, MCD beat EPS estimates largely due to an acceleration of comparable store sales, which accelerated on both a one-year and two-year basis. While topline accelerations of this kind are nothing to scoff at, careful analysis by long-time industry veteran Howard Penney (Hedgeye’s Managing Director of Restaurants) shows that roughly 2/3rds of the reported comp acceleration was due to price increases. As such, we question how sustainable such topline growth is over the intermediate-term – a topic we dive into in greater detail below.
Staples: Guiding Down (Slowing Growth)
Trading down roughly (-15%) today, SPLS is the latest poster child for a) why you should never take a corporate CFO’s word for it at the peak or trough of the economic cycle; and b) why financial engineering such as share repurchases and off-balance sheet activity is not a reliable substitute for sustainable earnings growth (we’re short JCP in the Virtual Portfolio as way to express components of this thesis). The company took down its full year EPS guidance by (-10%) and revised down its comp projection to “low single digits” from “low-to-mid single digits” on a downwardly revised economic forecast of “very little improvement in the economy”.
Net-Net: Inflation Deflates Growth
While almost trivial, we think it’s important to remind everyone that Real GDP is adjusted for inflation via the GDP Price Deflator. In 1Q11, a +150bps acceleration in this index helped slow growth to a paltry +1.8% QoQ SAAR vs. +3.1% in 4Q11. Though we’ve seen some pullback in commodities prices as the Great Inflation Trade has started to unwind (Hedge Fund exposure to commodities dropped -15% wk/wk last week), we can be sure that prices on a reported basis will remain both sticky and elevated – at least for the next several months. On a real-adjusted basis, that’s not bullish for reported growth.
But What About Earnings?
While earnings do indeed remain the mother’s milk of the stock market, one has to be concerned with the prospect of companies en masse passing through costs increases to a jobless consumer struggling to find any semblance of wage growth.
While it’s true the market isn’t solely consumer facing, one cannot completely rule out the impact of consumer trends on the overall economy (70% of US GDP is household consumption). Misguided talk about “manufacturing” and “exports” aside, as the consumer goes, so goes the US economy. As such, we confidently contend the consumer matters to earnings at large.
As Brian McGough, our Managing Director of Retail, has pointed out in his recent research, the recent run-up in COGS increases have yet be fully realized on corporate income statements – if at all – due to the predominance of FIFO accounting and the lag time between when raw materials are procured and when the finished product is sold. The coming quarters should make for an interesting test of whether or not corporate America can continue to squeeze the consumer’s wallet, as well as a test of the bulls’ favorite saying when things start to break down: “The US economy is very resilient.”
While the US economy has indeed proven itself quite resilient over the last 230+ years, relative to intermediate-term consensus expectations of +3.3% GDP growth for 2Q and 3Q, our Centrally Planned equity market certainly isn’t resilient enough to handle the impact of Homeless Jobless Stagflation on corporate earnings – particularly as the life support otherwise known as QE2 is removed in six weeks.
We’re short the SPY in anticipation of the equity market’s multiple eventually reflecting economic reality, as opposed to the storytelling of the CFOs of cyclical companies talking bullishly about peak earnings in the rear view at the top of the economic cycle. Interestingly, as Headline Inflation is set to breakout to the upside in the coming months, the price investors are willing to pay for said earnings should begin to breakdown (see table below).
The recent beta-shift down into defensive sectors such as Healthcare, Utilities, and Consumer Staples, as well as long-term bonds busting a move out to the upside are not confirming the widespread optimism over the US economy on a go-forward basis. Earnings will disappoint – perhaps materially – in the coming quarters. In fact, as measured by the spread between the Percentage of S&P 500 Companies Beating Bloomberg Consensus Estimates and those Missing Expectations, earnings have already started to disappoint and we see this trend continuing.
A Bespoke Investment Group analysis of earnings trends throughout the broader economy tells the same tale of deterioration, with the “beat” ratio of the 2,132 companies they track falling (-700bps) QoQ to 59.5% in 1Q11.
Hold the line, bears.
R3: REQUIRED RETAIL READING
May 18, 2011
- Confirming the recent strength in strip centers, management of URBN highlighted that Anthropology and Urban Outfitters stores were strongest in lifestyle centers and both weakest in street locations. Mall performance on the other hand was mixed.
- An interesting similarity coming out of both Lowes and Home Depot is the strong performance in the kitchen category. While Lowes highlighted strong promotional activity as the key driver, Home Depot cited a greater emphasis on educating its associates as the primary driver of double-digit comps across most of the category, which it turns out drove 40% of increase in total ticket growth in the quarter.
- In a sign that consumer demand for aspirational product (i.e. higher ticket items) is still alive and well in the sporting goods industry, DKS’ management highlighted that higher end running shoes and the new $400 TaylorMade R11 driver were among the best selling items in their respective categories.
OUR TAKE ON OVERNIGHT NEWS
New Balance Creates Comfort/Casual Unit - New Balance is staking a bigger claim in the casual market. The Boston-based company has partnered with industry veteran Bob Infantino in the creation of DryDock Footwear, an independent business unit set up to develop its casual-comfort brands Aravon and Dunham. Infantino, most recently president of Clarks Cos. N.A., will assume the same role at DryDock. According to a company release, DryDock Footwear will be based in Boston, with Infantino spearheading development of the New Balance brands, in addition to creating new labels in the casual arena.“We’re getting together to do what [New Balance Chairman Jim Davis] did so nicely with [New Balance’s] size and width selection,” said Infantino, regarding the company’s initiatives. <WWD>
Hedgeye Retail’s Take: NB entering the brown shoe category instead of incrementally allocating capital (both human and financial) into taking share in athletic is an interesting turn. This is good for the incumbents – particularly UnderArmour.
Growth in Retail Container Traffic Levels Off - Import cargo volume at the nation's major retail container ports is forecast to level off this month at about the same numbers as last year after nearly 18 months of year-over-year gains, according to the monthly Global Port Tracker report released by the National Retail Federation and Hackett Associates. "After nearly a year and a half of volume increases, it's not surprising to see some leveling off," NRF Vice President for Supply Chain and Customs Policy Jonathan Gold said. "Retailers are being cautious with how much merchandise they import due to economic pressures such as higher commodity prices, but overall consumer demand remains strong." U.S. ports followed by Global Port Tracker handled 1.08 million Twenty-foot Equivalent Units in March, a gain of only 0.3 percent over the same month a year ago. The number was down 2 percent from February, traditionally the slowest month of the year. While the increase was small, it was the 16th month in a row to show a year-over-year improvement after December 2009 broke a 28-month streak of year-over-year declines. One TEU is one 20-foot cargo container or its equivalent. <SportsOneNote>
Hedgeye Retail’s Take: This comes as a surprise to us. After 2-years of pulling inventories down to borderline-unhealthy levels, shipments should be on the upswing. In the first quarter, it was clear that retailers/brands pulled product forward ahead of COGS increases – so perhaps volume took a breather. Another consideration is that volume is tracked in TEUs, or twenty-foot-equivalent units. This says nothing about how full the containers are. As oil prices rise, we tend to see logistics teams maximize space inside the container to mitigate the need for additional TEUs. Remember that in filling a container, you either a) leave free space, b) fill perfectly, c) ‘cube out’ (run out of space), or d) ‘weight out’ (don’t fill the visible space, but hit weight limit). Apprel and shoes don’t ever weight out, so this is all about cube optimization. We suspect we’re seeing that today. BUT, if we see a consistent downtick in unit volume, it will test our negative assertion that unit shipments will not be down meaningfully for the year despite higher costs.
Polo Ralph Lauren Wins Fragrance Case - Score one for Polo Ralph Lauren Corp. A New York federal judge ruled Friday that the U.S. Polo Association cannot use a horse-and-rider symbol evocative of Polo’s famed logo in conjunction with the word “polo” to market its fragrances. The USPA claimed that Ralph Lauren was “attempting to monopolize the depiction of the sport of polo,” by preventing it from using its “double horseman mark” on its recently launched fragrance products, according to the original lawsuit filed Nov. 13 in Manhattan’s U.S. District Court. After deliberation, Judge Robert Sweet denied the USPA’s request for a declaratory judgment, citing that the use of the double horseman image with the word “polo” infringes on Ralph Lauren’s “substantive trademark rights” as it would likely cause “consumer confusion.” As a result, the court granted L’Oréal USA Inc., Ralph Lauren’s fragrance licensee, a permanent injunction and ordered that all of the plaintiff’s claims be dropped.<WWD>
Hedgeye Retail’s Take: This is big for RL. The battle between these two has been in progress for well over a decade. For better or worse, most consumers see a horse riding jockey swinging a mallet on apparel and think Ralph Lauren. We didn’t think much of this until we got an email from Bob Store’s last year promoting USPA gear. The association can certainly claim the ‘authenticity’ factor, but the logos are unmistakably similar. Time for the USPA to update its logo.
Sears Sues Former Executive of Lands’ End - Sears Holdings Corp. has asked an Illinois court to stop former Lands’ End president Nicholas Coe from joining Limited Brands Inc. as CEO of its Bath & Body Works division. Sears says in court documents that Coe violated his non-compete agreement with the company and is asking for an immediate injunction and damages. Sears also names Limited Brands Inc. and its Bath & Body Works business entities in the suit and asserts the companies were aware of Coe’s severance agreement with Sears, which says Coe cannot work for a Sears competitor for one year after leaving the retailer. Lands’ End is a division of Sears Holdings Corp. In the court filing submitted yesterday to the Circuit Court of Cook County, IL, Sears says Coe submitted his resignation May 11 with the intention of joining Limited Brands May 16. <InternetRetailer>
Hedgeye Retail’s Take: Hmm, not exactly direct competitors, but SHLD looking to pull whatever levers it can here obviously.
Faster Fulfillment - As they build new warehouses and reconfigure existing ones, many web retailers are deciding that rising consumer expectations of fast and accurate delivery require new technology and new warehouse procedures. Few areas of e-commerce illustrate the cutting edge of warehouse management better than flash-sale retailing. In order to offer shoppers big discounts on small quantities for limited periods, web merchants must be able to buy, receive, inspect, pick and ship orders quickly. “The supply chain itself has been our Achilles’ heel in this company for the last couple of years, as it is for any company scaling like us,” says Christopher Halkyard, vice president of operations for Gilt Groupe Inc., which had Internet Retailer-estimated sales of $425 million last year, up 150% from $170 million in 2009. Gilt is No. 49 in the Internet Retailer Top 500 Guide. <InternetRetailer>
Hedgeye Retail’s Take: Gilt Groupe either has a better handle on its fulfillment now or is eating the cost in the near-term since we just received yesterday an email announcing they’ve reduced shipping and will cover return costs if you opt for ‘store credit’. The bottom-line is that consumers are getting used to free shipping – these guys are forced to follow suit or lose share.
Hublot Opens New York Flagship - Hublot has opened the doors to its New York flagship and unveiled a timepiece in partnership with amfAR here. The 3,200-square-foot store on Madison Avenue between 62nd and 63rd streets is one of five freestanding U.S. stores the brand plans to open in the next six months — and the first in New York. Currently, Hublot has stores in Boca Raton and Bal Harbour, Fla., Beverly Hills and the U.S. Virgin Islands, and future domestic locations include boutiques in Las Vegas, Palm Beach, Fla., and Vale and Aspen, Colo. — all opening between October and December of this year, according to Hublot’s chief executive officer, Jean-Claude Biver. <WWD>
Hedgeye Retail’s Take: Hublot has been opening stores more aggressively since ’08 when the company was in 100% cash according to CEO Biver. With only 28 stores globally, the brand is still small at retail, but is looking to change the buying habits of the U.S. consumer, who by and large is less apt to buy a luxury watch just because they can relative to Asian consumers. While we don’t love the timing heading into the 2H, the reality is that consumers looking to purchase a $100,000 watch are less sensitive to Main Street reality.
Wal-Mart in China E-Commerce Investment - Wal-Mart Stores Inc. is looking to further expand its reach into China. The retail giant said Friday that it’s buying a minority stake in Chinese e-commerce company Yihaodian in a deal that is expected to close within 60 days. Launched in 2008, Yihaodian sells groceries, consumer electronics, clothing and other items, and has an employee base of 2,000, according to Wal-Mart. “Online sales in China are growing rapidly and are projected to match U.S. online sales in the next few years,” Eduardo Castro-Wright, vice chairman of Wal-Mart Stores and chief executive officer of Walmart global e-commerce and global sourcing. “By investing in Yihaodian, we're continuing to establish a presence in this important e-commerce market, and are moving forward on fulfilling our aspiration of being the leading global multichannel retailer." Wal-Mart, which has 8,986 doors globally, has 328 stores in China, according to a March 30 filing with the Securities and Exchange Commission. <WWD>
Hedgeye Retail’s Take: With the aftertaste of the Alibaba debacle still palpable, it’s hard not to consider the risk in this strategy. Yes, the businesses are quite different and Wal-Mart could presumably acquire the business in whole if necessary, but we question the strategy from a branding standpoint. While the Wal-Mart nameplate has become synonymous with EDLP stateside even if at times that’s not the reality, selling goods through another branded site might jeopardize the valuable opportunity for brand-building in new markets.
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