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“What is defeat? Nothing but education; nothing but the first steps to something better.”
-Wendell Phillips
Pittsburgh Steelers linebacker, James Harrison, had to learn defeat before he found his Super Bowl victory last night. The NFL’s Defensive Player of the Year was cut by the Steelers on three separate occasions and, at one point, almost went back to being a bus driver.
How sweet victory was for this 242 pound linebacker after running back the longest interception in Superbowl history. As Harrison was lying exhausted on his back in the end zone John Madden’s comment summed it up – “no matter what this replay reveals, you gotta give this guy a touchdown.”
To truly appreciate victory, one has to be educated by defeat. The US stock market was reminded of as much this past month. In the end, it was actually the worst January ever. Yes, ever, is a long time. The Steelers record setting 6th Superbowl victory comes on the heels of a record setting SP500 performance for January of down -8.6%. This miserable defeat was actually a good margin past the prior record of -7.7% in January of 1970.
Interestingly, on a peak to trough of the month basis, the SP500 dropped from 934 on January 6th to 805 on the 20th – that was a -13.8% smashing… then it rallied +8.5% straight up and into a recklessly CNBC instigated “bad bank bailout” lower high of 874 (which we sold into and took our cash position to 82%), before being clobbered by the reality of a broken quantitative “Trend” – make no mistake, this tape remains fundamentally and quantitatively broken. That’s why I moved our Asset Allocation model to 86% cash on Friday.
Our Hedgeye Asset Allocation model finished down -1.74% for the month (no stocks, just ETFs). While I am sure that wasn’t the worst performance in the league, I am not pleased with it. No excuses – we move forward into February. In order to proactively look forward, I always take the time to look back. Looking back at January a few very important “Trends” (intermediate term) re-established themselves.
For the US stock market, the most negative Trend that re-emerged in January was the strengthening of the US Dollar. The greenback “re-flated” to the tune of almost +6%, and in terms of historical monthly moves go, that was a big one. As we shift into an Illiquidity Crisis from the Liquidity Crisis of October/November, US cash is asserting itself as king. Those who own both the liquidity and duration associated with their investments are winning. Those who are levered up long and illiquid are losing.
For global equities, there are positives and negatives emerging out of The New Reality that all equity markets no longer auto-correlate. This is also a function of the Illiquidity Crisis, and you can see this in terms of how global equity markets traded again overnight. China, which re-opened post the Chinese New Year break, closed up another +1% last night, taking the Shanghai Stock Exchange to 2,011, and +10.5% for 2009 to date. Meanwhile, stocks in India got smoked, closing down another -3.8% on the session, taking their year to date losses to -6%. “Chindia” does not exist. China owns liquidity – India does not.
In the game of geopolitics, “Putin Power” is also losing its liquidity. The Russian Trading System is getting pulverized again right now, trading down another -5% this morning in the face of a domestic currency crisis. Russia is the only major economy whose stock market is trading below the October lows, and it’s trading a good clip below it at that (-7.5%). Without petrodollars, Putin’s liquidity goes away.
European stock markets continue to swoon as their Illiquidity Crisis continues to manifest. Nine out of the top ten credit default swap moves in 2009 (at the country level) are European countries for a reason. Spain is #3 on that list, behind Ireland and Belgium, and Spanish stocks are getting whacked for another -3% down move so far to kick off the week. To speculators formerly known as Spanish bulls, wasn’t levering up your economy fun? Leverage works both ways folks…
Not all markets in global equities are going down. Alongside this impressive Chinese move, the Brazilian stock market (which we are long in the Asset Allocation portfolio via EWZ), is up +4.5% for 2009 to date. On Friday with the SP500 down another -2.3%, Brazil outperformed again, flashing a positive divergence and losing only 83 basis points on the day. Brazil has an organic domestic growth engine that seems to be pushing forward, without using excess leverage. Imagine that…
Back to the USA, importantly, we are seeing a very welcomed steepening of the yield curve. This morning’s spread between 10 and 2 year US Treasury yields has widened once again to +191 basis points. This is a very positive development for those who are liquid (borrow short, lend long), and a dangerous one for anyone locked in that Illiquidity trade that Barron’s gave us the knucks with on this weekend’s cover (private equity “Ka-boom”).
As cost of capital on the long end of the curve continues to rise, and access to capital continues to tighten (for those who were addicted to borrowing it), look for more winners and losers to emerge. The defeat that you’re seeing out there in this interconnected global marketplace is real, and it will be a long long time before some of these leverage only compensation structures are allowed to return to prime time.
While hope is not an investment process, at this stage of the game I can only hope that Americans have been educated by all of this – after another crushing month in our stock market, “education is nothing but the first steps to something better.”
Best of luck out there this week.


Education - etfs020209

Eye On Re-Regulation: Where There's Smoke...

A Culture of Compliance
- Alan Greenspan
We hear it at every regulatory review, every audit, every SEC Chief Compliance Officer Outreach session – firms must establish a Culture of Compliance. This means that the principals of the firm must be visible enthusiasts of compliance with the rules and regs and incidentally, of running an ethical business. Remember that one of the most referenced sections of the FINRA Rule Book is called “Rules of Fair Practice”.
Market regulation is an attempt to promote fairness of outcome, in a situation where we already know the moral quality of the input.
It is thus striking to hear the outrage resounding through the halls of power as Senators and members of Congress stand up and lambaste Wall Street for the recent decades of excess. We remember the scene in October of last year, when Chairman Henry Waxman grilled Chairman Greenspan on whether he now, in light of the disaster wrought by decades of non-oversight of the financial markets – now that the world has reaped the whirlwind sown by irrational exuberance gone unchecked – now, Chairman Waxman asked a simple question.
“Were you wrong?”
Greenspan: “Partially.”
That one word says it all. Allow us to point out the fallacy in Chairman Greenspan’s self-serving and laconic answer.
A manufacturing process with a 99% success rate is considered successful because a one percent failure rate is Statistically Insignificant. If you are the customer, and your purchase came from that one percent, you experience a 100% failure. Clearly Quality Control depends heavily on one’s perspective.
Another analogy. A revolver which has been emptied of its bullets is safe. One can cock and pull the trigger, cock and pull the trigger without harming anyone. But if one were “partially” wrong, and there remained one bullet… As Chairman Waxman famously stated in another context, “Twinkies don’t kill people.”
The fallacy behind which Chairman Greenspan was hiding – in his ineffably byzantine verbiage, and cloaked by his basilisk stare – was no different from what we have heard in direct terms from the entire Greek Chorus of Wall Street executives, from Dick Fuld and Bob Rubin, right down to your personal stockbroker: Nobody could have predicted this!
The very purpose of regulation is to acknowledge the devastating character of outlier events. Events which are, by definition, unpredictable as to timing, unimaginable in their nature and, when they do occur, impossible to counteract. Mr. Greenspan, in your role, being “partially” wrong is being Dead Wrong.
The dialogue started with Chairman Waxman asking bluntly whether Chairman Greenspan believed that he bore personal responsibility for the financial meltdown. Greenspan’s answer, introduced with a highly dismissive “Let me give you a little history, Mr. Chairman,” ultimately wound down to his acknowledging it had been a mistake not to impose tighter controls. Chairman Greenspan’s self-confessed error was “presuming that the self-interest of organizations – specifically banks and others –was such that they were best capable of protecting their own shareholders.”
At one point Chairman Greenspan was heard to mutter “when the facts change, I will change”. This sound bite from John Maynard Keynes has gotten excessive airplay recently from people of whom it is visibly not true and has become as pervasive and as grating as the Macarena.
Chairman Paulson, for example, does not change his behavior to fit the facts. He changes his script to make his pitch more effective, which is the job of every salesman. But his diversion of the TARP money to Wall Street appears to have been the plan all along (remember Paulson’s insistence in the initial TARP hearings that the money be handed over with no oversight and no possibility of future challenge by Congress or the courts).
And Chairman Greenspan did not change his behavior. He was so in love with being The Maestro, it never occurred to him he might need someone else’s point of view. In his testimony before Chairman Waxman, he ended up admitting that he does not understand how the world works after all. This, he assured Chairman Waxman, came as a shock to him.
And the world marched in lockstep behind the Maestro. Right off a cliff.
Before we attack management for not setting a Culture of Compliance within the firm, we must look to the will of the people. One could search in vain over the past ten years or more for the Culture of Compliance in the world of government regulation, in the hectorings of the nation’s media, and in the desperate pleadings of a broad swath of the public. It wasn’t there.
We are now witnessing a Super Bowl of Monday Morning Quarterbacks. But the world has run on Gordon Gekkoism for a generation, spurred on by those responsible for making and enforcing the rules. The foreign governments who now blame America for their demise were ramming their excess liquidity down our throats and screaming “More! More!” as US bankers, unhampered by such quaint notions as the Prudent Man Concept created ever higher-yielding (because ever lower-quality) paper.
Politicians were bloated with the knowledge that America was prospering on their watch. Some actually took credit for it. We did not require the Culture of Compliance in a market in which prices were rising with no end in sight. Oversight would have hampered capital formation.
Senators Charles Schumer (D-NY) and Richard Shelby (R-AL) have proposed a bill that would add staff to the FBI, the Justice Department, and the SEC. The SEC piece, $20 million out of a total of $110 million, is earmarked for 100 new Enforcement Division employees. At current SEC pay grades, this means bringing in a hundred a hundred junior Enforcement attorneys. These are typically one or two years out of law school, and willing to take a lateral move in order to build their resumes.
A little history is useful. President Bush requested the SEC budget for 2005 be raised from $893 million to $913 million – a 12.5% increase. This was based on a proposal from then Chairman Donaldson which would have increased the SEC staff by over a hundred new hires. Congress approved only $888 million, a decrease from 2004. The following year, President Bush asked for less than $200,000 additional funds, having apparently seen the wisdom of curtailing regulatory excess.

Last year’s SEC budget was only increased by $28 million, used to fund pay raises and merit pay increases for existing SEC staffers. Because of the budget constrains there were no plans to expand either staff or programs in 2008. Staffers were told to expect to take on extra duties, particularly overseeing the approval and registration of new credit rating agencies. With everything going so well, why expand regulation?
We urge the Senators to push for more money now. If you can’t get regulatory funding approved in today’s environment, you will never get it.
Congress must make it possible for the SEC to attract serious Wall Street talent. A hundred junior lawyers is not enough. It will take them several years to learn the industry. By which time, if the markets have recovered, they will be out looking for jobs in the private sector.
Meanwhile, there are dedicated and seasoned compliance and internal audit professionals who could be brought into government today, and whose operating knowledge of Wall Street could revolutionize regulation. We think Mary Shapiro would go for this for the obvious reason that it would give her a real toolkit, but also for the less obvious reason that the culture of Wall Street would help her cut through the entrenched bureaucracy and restructure the Commission into a more effective body.
Senators Schumer and Shelby should add enough money to the SEC portion of their bill to bring in seasoned talent. Fifty Wall Street compliance and audit professionals could be brought in at compensation levels in the $250,000-$500,000 range. These would be senior people with decades of experience and a telling eye for what is wrong – and right –with financial firms and processes. If creating this level of SEC employee would upset the bureaucratic applecart, then set up a three-year program where a team of fifty consultants is hired to run an agenda crafted by Chairwoman Shapiro. In times like these, Senators, we do not need more legislation that will make you look virtuous, while throwing too little money at a problem. You went All The Way with urging Wall Street to get us where we are today. You should do no less in helping dig ourselves out of this pit.
Still, hiring a hundred junior attorneys is a start. It addresses the problem at hand.
You’re So Thain
“The Fixer” has run into a multi billion-dollar brick wall of his own construction. We applaud personal loyalty, a commodity in all too short supply in the world. Yet we take issue with the letter written in Mr. Thain’s defense by his one-time employer, John Reed, Retired chairman of Citigroup, published in the Financial Times (January 30, page 10, Letters, “Move Away From The Superficial And Spin In Your Thain Comments”). Mr. Reed raises high points of John Thain’s career, which we acknowledge: the giant impact he had as chief executive of the New York Stock Exchange with his radical modernization program, and the subsequent highly successful IPO of the NYSE.

But Mr. Thain also oversaw the payment of bonuses to Merrill executives at the end of a disastrous year. The standard justification on Wall Street is that employees who have performed should be compensated for that performance, regardless of the profitability of the institution. This gives those responsible to the shareholders no incentive to act responsibly. And inexplicably, boards of directors, auditors, regulators, and the shareholders themselves have all been on board with this for many years. It is the culture of Wall Street, and we as a nation adore it.

President Obama has attacked last year’s bonuses as being “shameful”. Over $18 billion was paid out on Wall Street in a year that saw the demise of the entire industry. Bloomberg reports that the industry also cut some 260,000 jobs this past year. Call us Socialists, but spreading that eighteen billion around would have meant each of the 260,000 could have been paid close to $70,000, still considered a living wage in most of the galaxy. It may not cover the upkeep on a Park Avenue triplex, but as Alfred E. Newman says, It is easier to live within an income than without one.

Mr. Reed overlooks the sin of Merrill Lynch – the Stain of Thain. It may be business as usual to pay bonuses in a year in which the firm racked up billions in losses. But now they must also make their case to the taxpayers and on the front page of every newspaper. Can Thain & Co. really say that they executed, but the rest of the world failed to cooperate? It worked for Bob Rubin. It worked for Alan Greenspan. We are afraid, Mr. Thain, the buck may have finally come to rest.

In contrast to the Curtains of Thain, during a lull in an Oval Office briefing President Obama looked around at the carpeting, the prints and paintings of former presidents, and the collectible commemorative plates, all courtesy of President and Laura Bush’s design team. The President was heard to muse aloud, “I’m not a plates kind of guy.”

When all is said and done, John Thain and the Merrill executives who were prematurely bonused on his watch should probably be allowed to keep the money. It may be completely legal. Congress allowed TARP to be rammed through without any controls or oversight; the Bank of America acquisition of Merrill was signed off on by senior management and by the Board of Directors. All of the folks who had the real responsibility in this matter failed to exercise it. There was, in short, no Culture of Compliance.

But we think Thain and his cronies get clawed back. Andrew Cuomo is determined to get the State’s hands on as much Wall Street bonus money as possible, and he would likely have the full support of President Obama. It would be seen as a resounding moral victory, even though its legality may be questionable. Thain is the gold-encrusted canary in the coal mine of Wall Street compensation. Right now his air supply looks awfully thin.

Regulation We Can Believe In
“A child of five would understand this. Send someone to fetch a child of five.”
- Groucho Marx

President Obama gets it. Chairwoman Mary Shapiro gets it. Now we are being treated to yet another person in government who Gets It. We hope she will be heard, and not silenced.

Federal Reserve Governor Elizabeth Duke (WSJ, January 28, page A4, “Fed Governor Duke Takes Dissenting Role”) “became the first official on the central bank’s Board of Governors in more than a decade to vote against fellow governors.” The opinion that is causing all the brouhaha? Governor Duke dissented from “the decision to let GMAC LLC change its charter to become a bank holding company.”

Is it really ten years since there was disagreement among the Fed Board of Governors? Sounds like no one is doing their job.

Follow the money: GMAC becomes a bank. GMAC gets money from TARP. GMAC tells its shareholders to relax, because now they have ample cash so those GMAC shareholders don’t have to dig into their pockets. GMAC’s shareholders are Cerberus Capital Management, who also own Chrysler. John Snow, CEO of Cerberus, sends Chrysler’s CEO, Bob Nardelli, to Washington to beg for the billions. Nardelli, in a moment of practiced haplessness, testified before Congress that Chrysler needed taxpayer money because it could not ask for money from its shareholders. In response to the obvious question, (“Cerebrus is rich. Why don’t they come up with the money?) Nardelli stated that did not know anything about Cerberus’ money, because all he does is run a car company.

Governor Duke is not an economist, but spent her professional career in banking. Knowing the banking industry as she does, why does Governor Duke think granting bank status to GMAC would be a bad idea? She says “My perspective is entirely from the standpoint of how individuals and businesses make decisions. In a lot of ways, they don’t make decisions in the way economic models assume.”

Finally, someone who knows the players. This should be the paradigm for regulation going forward. Government must turn to industry and bring top executives into public service. It has always been a hard sell, but if it cannot be done now, it will never happen.

Alas, Governor Duke, think of the suffering that could have been prevented if you and Chairman Greenspan had shared a cup of coffee, say twenty years ago. Now that you are in the public eye, we wish to offer you a word of caution: Republicans have no monopoly on bad decision making and Groupthink. The notion of a Motown bailout had President Obama’s imprimatur too. Cerberus may not be the kind of entity you want dashing off with taxpayer monies, but flies in the ointment do not do well when trillion-dollar programs need to be rammed through in haste, with neither analysis nor oversight.

Governor Duke, please remember Sheila Bair and think before you speak. You wouldn’t want Treasury Secretary Tim Geithner to think you are Not A Team Player.

Moshe Silver
Director of Compliance
Research Edge LLC

Chart of The Week: January 2009

What a ride January ended up being. In the end, it was actually the worst January ever. Yes, ever is a long time.

January’s record setting SP500 performance came in at -8.6%, and good margin past the prior record of -7.7% in January of 1970. Interestingly, on a peak of the month to the trough of the month basis, the SP500 dropped from 934 on January 6th to 805 on the 20th – that was a -13.8% swan dive… then it rallied +8.5% straight up and into a CNBC instigated “bad bank bailout” lower high of 874, before being eaten by the shark line (see chart below), where we we’re fortunate to proactively move to 82% cash.

On the week, the SP500 was down -0.7% (our virtual portfolio was -0.4%). It was that 2-day shark bite (Thursday-Friday) that seemed to catch some people off guard.

Our Hedgeye Asset Allocation model ended up down -1.74% for the month (no stocks, just ETFs). While I am sure that wasn’t the worst performance in the league, I am not pleased with it. No excuses – we move forward into February.

Keith R. McCullough
CEO / Chief Investment Officer

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Quote Of The Week: Barack Obama

"That is the height of irresponsibility. It is shameful… Part of what we're going to need is for the folks on Wall Street who are asking for help to show some restraint, some discipline and some sense of responsibility" –Barack Obama

This quote, and Joe Biden officially welcoming “organized labor back to the White House” sealed the deal this week for the US stock market to have its worst January ever (down -8.6% vs. January of 1970 which was next worse at -7.7%).

Pictures are often more powerful than prose. The Reuters picture in Joe Nocerra’s NY Times article (below) captures a look on Timmy Geithner’s face that I found to be a metaphor for a lot of things, not the least of which is a New York banker who should be grateful to now be receiving a stable government paycheck. The good ole boy days of the self perpetuating bullish narrative fallacy are gone.

This altogether scares Wall Street, and it should. Unionization (Biden) is no different that Re-Regulation (Obama) in that no matter what your politics are, they have the factual impact of depressing the corporate profit margins of some of the fat cats in America’s corporate Board Room.

Make no mistake, there are plenty of corporate execs who completely missed proactively preparing for this downturn – this isn’t just a Wall Street thing. They paid themselves large to overbuild capacity at a global economic top (Coach, Target, Caterpillar, etc…), and they’ll keep paying themselves as they fire people at the bottom.

While the pricing in of this corporate incompetence isn’t new (the Dow has only 400 points left of downside if the 4 US financials in the Dow actually went to zero), it is surely a reminder that The New Reality that we have been belaboring for a long time now, is here.


We’re not always right but I think we’re accumulating a pretty good track record. Our process marries fundamental analysis with Keith McCullough’s macro/market view and his quantitative factor model. This process drives the stock selections that comprise our Hedgeye portfolio. Keith pulls the trigger and his record speaks for itself.

The table below lists every hypothetical trade made in the Hedgeye portfolio in the gaming, lodging, and leisure sectors. I’ve also included the unrealized gains and losses from names in the current portfolio.

US Market Performance: Week Ended 1/30/09...

Index Performance:

Week Ended 1/30/09:
DJ (1.0%), SP500 (0.7%), Nasdaq (0.1%), Russell2000 (0.2%)

January (A) and 2009 YTD:
DJ (8.8%), SP500 (8.6%), Nasdaq (6.4%), Russell2000 (11.2%)

Keith R. McCullough
CEO / Chief Investment Officer

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