The Last Stand of the Equity Bulls

This note was originally published at 8am on May 24, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“There are not enough Indians in the world to beat the 7th Cavalry.”

-George Armstrong Custer


I’m in the middle reading Nathaniel Philbrick’s book, “The Last Stand”, which is an account of General George Custer’s infamous defeat at the Battle of the Little Bighorn.   Even a novice in American history knows the outcome of June 25th, 1876, a day in which the 7th Cavalry Regiment was soundly defeated by the combined forces of the Lakota, Northern Cheyenne, and Araphao people on the Montana plains.


In total, according to archeologist reports, the 7th Cavalry suffered a 52% casualty rate.  The five companies that were directly under the control of General Custer fared much worse.  Near the end of the battle, Custer, and the troops directly under his control, found themselves in a weak strategic position on a hilltop, which would become known as Last Stand Hill.  According to almost all accounts, the Lakota completely annihilated 100% of Custer’s troops within an hour of initial engagement.   


Ironically, despite the inauspicious ending to his military career, George Armstrong Custer was probably one of America’s most celebrated cavalry commanders of his era.  While he finished last in his class at West Point, Custer had a meteoric rise in the Union army and at the age of 23, three days prior to the Battle of Gettysburg, was promoted to Brigadier General. 


At Gettysburg, Custer was credited with leading a mounted charge of the 1st Michigan Cavalry.  This charge halted the Confederate momentum at the Battle of Gettysburg, which would become known as the turning point of the entire Civil War.  Not only was Custer present at General Robert Lee’s surrender at Appomattox Court House, but the table on which the surrender was signed was given to Custer as a gift for his wife with a note from General Sherdian praising Custer’s bravery and his key role in the Union victory.


Perhaps, though, some of Custer’s early successes gave him some false confidence as it related to future military engagements.   According to reports from The Battle of the Little Bighorn, General Custer reportedly said the following shortly before his death:


“Hurrah boys, we’ve got them! We’ll finish them up and then go home to our station.”


With the history lesson complete, reading the story of Custer and the Battle of the Little Bighorn made me think contextually about the stock market.  In essence, I can’t help but wonder after a +95% move in the SP500 from the lows of March 2009, whether this is The Last Stand of the Equity Bulls.  Certainly, both price action and recent data suggests we are at a critical juncture.  As well, and not dissimilar to Custer, there is likely an over confidence bias pervading the stock market due to the expedited two year move off the bottom. (LinkedIn anyone?)


Just like the cavalry, we’ve been sounding the warning trumpets of our key 2011 investment theme that Accelerating Inflation will lead to Slowing Growth.  No doubt, we’ve been early sounding the trumpet, but the view is now playing out in spades.


A key tell for this theme has been the price of copper, which is down just over -10% on the year.  Dr. Copper is perhaps one of the most predictive markets for gauging future economic growth, especially from China, a nation that consumers 40% of the world’s copper.  In the most recent data from China, refined copper imports into China were down in April by -48% year-over-year and -17% sequentially from March.  On the LME, copper inventories are up +34% from their December 2010 lows.


In other industrial metals, similar trends are in place.  Lead inventories are up +53% this year to the highest level since February 1995, aluminum stocks are at near record highs and up +11% for the year, and zinc inventories are up +21% in 2011 and reached a 16-year high on May 18th.   Other commodities are signaling the same via price action with lumber down -28% in price in the year-to-date, rubber down -7%, and coal down -6%.  In aggregate, the commodity complex is clearly telling us that global growth is slowing.


While the most recent quarter of corporate earnings in the United States was decent, results, broadly, were characterized by margin compression.   This was a call our Retail team, led by Sector Head Brian McGough, was early and right in calling.  The bell weather indicator of cost inflation this quarter was Gap Stores, who cut their full year earnings estimates from a range of $1.88 to $1.93 per share, to a range of $1.40 to $1.50 per share due to “heavy cost pressure”.  Collectively, the “cost issue” was reflected in the number of quarters that “beat” earnings this quarter.  Incidentally, beats were down to the lowest level since Q4 2008 at 59.5%.  


With a couple more quarters of FIFO accounting and tough commodity input compares ahead for the stock market, the valuation / earnings growth story becomes less compelling for equities, especially in the context of a slowing top line.  Globally, slowing growth is being driven by the emerging world fighting inflation, with the most recent evidence being Chinese PMI coming in at a 10-month low.  In Europe, slowing growth is and will continue to come from massive austerity measures that are being implemented to, hopefully, head off massive debt restructuring.  While in the U.S., the consumer is facing a serious retrenching with U.S. average weekly earnings on a negative trend, unemployment numbers breaking out to the upside, and home prices continuing to be in free fall.


Despite the likelihood that corporate margins continue to compress in the coming quarters, which will continue the trends of slowing earnings momentum, those bullish of U.S. equities argue that yields on fixed income are so low that equities still offer a compelling risk / reward.  On some level we agree, as we’ve already made the case for the Fed to remain Indefinitely Dovish and James Bullard, the President of the St. Louis Fed, signaled as much when he said in a speech last night, “past behavior of the FOMC indicates that the Committee sometimes puts policy on hold.”


Being on hold is of course one thing, but not extending Quantitative Easing is quite another.  It is the later point that we believe the The Last Stand of the Equity Bulls is predicated upon.  Unfortunately, given the fact that reported inflation in the U.S. is actually set to accelerate, it seems unlikely that the Fed will re-up on Quantitative Easing in the short term.


Hurrah, equity bulls! Hurrah!


Keep your head up and stick on the ice,


Daryl G. Jones

Managing Director


The Last Stand of the Equity Bulls - Chart of the Day


The Last Stand of the Equity Bulls - Virtual Portfolio




TODAY’S S&P 500 SET-UP - May 27 2011


UST Bond Yields showing how bullish people are on the Growth Slowing trade this morning (bullish for bonds). 2s are immediate-term TRADE oversold at 0.48% and 30s at 4.22%, but this is really starting to look like May-July of 2010 in the bond market – they can run.


The Hedgeye favorite Macro long positions remain TLT and FLAT – and we bought our GLD back yesterday. If Growth Slowing and Deflating The Inflation (our Macro Themes) become consensus by mid-summer, all 3 of these positions should hold up just fine. Remember Gold acts best when real-interest rates imply negative yields.


As we look at today’s set up for the S&P 500, the range is 18 points or -1.18% downside to 1310 and 0.17% upside to 1328.









  • ADVANCE/DECLINE LINE: 1261 (+327)  
  • VOLUME: NYSE 846.11 (11.98%)
  • VIX:  16.09 -5.74% YTD PERFORMANCE: -9.35%
  • SPX PUT/CALL RATIO: 1.76 from 1.30 (+30.00%)



  • TED SPREAD: 20.84
  • 3-MONTH T-BILL YIELD: 0.05%
  • 10-Year: 3.07 from 3.13
  • YIELD CURVE: 2.59 from 2.59 



  • 8:30 a.m.: Personal income, est. 0.4%, prior 0.5%
  • 8:30 a.m.: Personal spending, est. 0.5%, prior 0.6%
  • 9:55 a.m.: UMich Consumer Sentiment, final: est. 72.4, prior 72.4
  • 10 a.m.: Pending home sales, est. M/m, (-1.0%), prior 5.1%
  • 1 p.m.: Baker Hughes rig count


  • EU Commission tables measure to ensure fluidity of the EU sugar market
  • Eurozone May Business climate 0.99 vs consensus 1.20 and prior 1.28
  • Microsoft CEO hints at tablet software - WSJ
  • Bank of America (BAC), Morgan Stanley (MS) pay more than $22M to settle wrongful disclosure on active troops - WSJ






  • Global Tire Demand Exceeding Supply Helps Bridgestone, Goodyear, Sumitomo
  • Corn-Planting Delays Signal Price Gain as U.S. Farmers Switch to Soybeans
  • Oil Rises on World Economy Outlook, Dollar; JPMorgan Sees OPEC Quota Gain
  • Copper Gains to Three-Week High on Indications of Stronger Chinese Demand
  • Thailand’s Sugar Exports May Surge to Record as Domestic Quota Lowered
  • Gold Heads for Second Weekly Advance on Europe Debt Concern, Weaker Dollar
  • Wheat Falls to $8.085 a Bushel in Chicago Trading, Erasing Earlier Advance
  • Copper Premiums in China Advance to Seven-Month High as Demand Recovers
  • Coffee Drinkers Won’t Get Break on Prices as Colombia Sees Global Deficit
  • Corn Demand in China Poised to Exceed Output for First Time in Three Years
  • Barrick Must Let Zambia Keep Equinox Shares as Part of Lumwana Approval
  • Mississippi Crop Cargoes Plunged 39% as Flooding Worsened: Freight Markets
  • Coal Set for Three-Year High on China Drought, Power Cuts: Energy Markets
  • Sugar Price May Gain Next Week on Signs of Increased Demand, Survey Shows







  • EUROPE: broad rally this morn but volume is sketchy; DAX (were long) wobbly at this level; Spain/Italy/Greece/Russia all broken TRENDs
  • UK May GfK consumer confidence (21) vs consensus (31)
  • Nationwide UK May house prices (1.2%) y/y vs consensus (1.7%)
  • European Automobile Manufacturers' Association (ACEA) Apr Commercial Vehicles Registrations in the EU +9.5% y/y





  • A bad week for Asian equities with China down 5 out of 5 days; Vietnam crashing, then bouncing hard (down -15.6% since May4); and Japan remaining abyss
  • Fitch revises Japan's outlook to negative from stable









Howard Penney

Managing Director

DKS: Sneaking One Past The Goalie?


Another deal for DKS? Accretive, perhaps. But incremental? Perhaps no. keep in mind that this might not be entirely incremental. Check out the timing of DKS’ prior acquisitions. July 2004. Feb 2007. Nov 2007. ALL of these deals occurred when the base business was slowing. We don’t want to suggest bad behavior in this instance when there’s not even a bid on the table. But this is an important factor to keep in mind if you see something hit the tape.



It looks like Texas-based Academy Sports may be on the block.


This shouldn’t come as much of a surprise given the lack of a clear succession plan following the passing of Academy’s founder Arthur Gochman this past October. It’s been a family run business through and through and while Arthur’s son has taken over at the helm, it makes sense for the family to shop the company to see what they can get with deal activity picking up in retail. With over 125 locations, Academy surpassed $2Bn in revenues back in 2007 according the company’s website and currently generates approximately $100mm in EBITDA – owners are looking for a 10x takeout offer.


A quick look at the company’s profile suggests that if competitors are looking at the deal, DKS is the most likely candidate. HIBB’s store format at an average size of 7,000 sq. ft. is a completely different concept altogether compared to Academy’s 60,000 sq. ft. box – they’re out. The Sports Authority while more similar in footprint at an average of 45,000 sq. ft. has a high degree of overlap with Academy locations so they would be forced to either close a substantial amount of stores or face some degree of cannibalism neither of which sounds appealing. Plus, TSA is still under the wing of Leonard Greene and waiting to come out. We cannot imagine that sponsors are willing to pump a billion dollars into this ill-timed investment.


That leaves us with Dicks. There’s virtually no overlap between the two companies and the average footprint is nearly identical with DKS over 50,000 sq. ft.   Also, Academy and its bankers are no dummies… They’re throwing out a 10x EBITDA multiple. Look at DKS’ past deals. Golf Galaxy and Galyan’s for 10.2x and 10.1x, respectively. (Chick’s, which it bought in 2007, was a small real estate play with undisclosed financials).


Academy is a quality retailer, and it dominates the space in perhaps the most important sporting goods market in the country. Will DKS pay 10x EBITDA? Without a doubt. Does the balance sheet allow it to do so? Probably.  With $500mm currently on the balance sheet and another ~$200mm in FCF expected this year, DKS could certainly make a bid and stay below 30% Net Debt/Cap.


In addition, DKS leases EVERY single store, and even most of the fixtures in its stores. Its strategy there is very aggressive. Could it restructure parts of Academy in a way that puts obligations off balance sheet? Probably. Does it bug the heck out of us that the Street continues to look through this for DKS – as if its most important asset (its stores) were free of a capital charge? Absolutely! But that probably won’t matter.


Depending on the financing structure – AND assuming that the reported $100mm in EBITDA is a real number -- a $1Bn price tag could be anywhere from $0.10-$0.20 accretive to the P&L.


But keep in mind that this might not be entirely incremental. Check out the timing of DKS’ prior acquisitions. July 2004. Feb 2007. Nov 2007. ALL of these deals occurred when the base business was slowing. We don’t want to suggest bad behavior in this instance when there’s not even a bid on the table. But this is an important factor to keep in mind if you see something hit the tape.


DKS: Sneaking One Past The Goalie? - DKS Acq Chart 5 11


DKS: Sneaking One Past The Goalie? - DKS LocationsAcademy 5 11





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Key Commodity Callouts : Long Gold, Short Sugar

Positions: Long Gold via GLD; Short Sugar via SGG


Below are six commodities that we’ve been particularly focused on this week, and our immediate-term call on each.


Key Commodity Callouts : Long Gold, Short Sugar - commmmm


Gasoline: We think that the dollar is going higher and taking crude oil lower in the immediate-term, particularly as oil was unable to get above its TREND line, $101.50, today.  And with refiners ramping up percent utilization by 310 bps this week, gasoline inventories built surprisingly.  Lastly, gasoline demand continues to slow, down ~2% year-on-year.


Natural Gas: Despite today’s larger-than-expected inventory build of 105 Bcf, natural gas is holding above its TREND line of support of $4.31/Mcf.  Also, the number of rigs drilling for natural gas has slumped to a 16-month low.


Gold: Keith bought gold today in the Hedgeye Virtual Portfolio.  With US Treasury yields falling, we think gold will continue to move higher, as it has to compete with real yield.  And on demand, Chinese investors are buying more gold than ever, and have overtaken India as the world’s biggest purchasers of the metal.  China’s investment demand for gold more than doubled in 1Q11, now accounting for 25% of gold investment demand.  Gold is the only commodity we are long in the HVP.


Copper: Indicative of Global Growth Slowing, copper is broken on the TRADE and TREND durations, with immediate-term resistance at $4.14/lb.


Corn: Adverse weather in the US mid-con is causing concern this spring that the U.S. corn crop will not be bountiful enough to help ease a globally supply shortage.  Prices are rising as soggy weather continues to create problems for farmers trying to plant crops in key growing states.  And with only as much as 20% of the crop planted in several states, concern (and higher prices) is warranted.


Cotton: Cotton is down 22% in the last two months and looks a lot like copper.  It is bearish on the TRADE and TREND durations, despite droughts in Texas that are likely to result in 2 million less bales of cotton produced.  As Texas plants about ½ of the U.S.’s cotton, a large-scale failure could resuscitate price, though we’re bearish until we see price confirm the story.


Kevin Kaiser



Chinese Thirst for Portuguese Debt, Go Figure

Positions in Europe: Long Germany (EWG)


The FT broke a story last night that the Chinese are interested in buying Portuguese bailout bonds from the AAA-rated European Financial Stability Facility (EFSF) rescue fund. The news, added a boost to the EUR-USD pair, marginally dipped Portuguese bond yields, and presents another turn in the headline risk surrounding the region’s sovereign debt contagion threats.


The news harkens back to this January when both China and Japan vocalized their support to buy European peripheral debt. You’ll remember that Norway’s sovereign fund also bought PIIGS paper early in the year, yet unlike China has not recently voiced interest in doubling down on the bet. The WSJ also reported last night that China bought a total of €1.1 billion of Portuguese bonds this year, which have seen a loss of at least 10%.


However, the news of China’s support for Portugal comes at a critical juncture following the country’s €78 billion bailout: in mid-June Portugal plans to raise €3-5 Billion in 10YR bonds (in its first auction following the bailout decision on May 3rd) and ~ €5 billion of 5YR debt at the end of June to meet nearly €10 billion in debt coming due in June. Clearly this handshake should encourage demand at future issuances, but at what yield premium? We wouldn’t put our necks on the line here as downside risk (including complete uncertainty surrounding Greece’s medium term state) remains significant.


Below we show a familiar chart of 10YR bonds from the periphery as a proxy for the risk trade. Notably, Ireland pushed above 11% day-over-day on the 10YR, and confirms that bailouts in and of themselves are not elixirs—we continue to press that the pain of the region’s sovereign debt contagion has a tail of 3-5 years as counties attempt to re-write years of fiscal imbalances.


Chinese Thirst for Portuguese Debt, Go Figure - a1


As the G8 Summit meets in northern France today, just this morning Eurogroup President Jean-Claude Juncker commented that the IMF may not release Greece’s tranche next month if an audit of its budget accounting shows that the country cannot guarantee financing for the next 12 months.  The EUR-USD largely shrugged off the "shock and awe" news, however, the CHF-EUR pair is on a tear, as the safety trade ramps up once again and strong trade data from Switzerland this morning:


Switzerland Trade Balance 1.52 B CHF APR vs 1.0 B CHF MAR

Switzerland Exports 7.9% APR M/M vs -3.1% MAR

Switzerland Imports 4.0% APR M/M  vs 1.8% MAR


Chinese Thirst for Portuguese Debt, Go Figure - a2


Our EUR-USD immediate-term TRADE range is tight = $1.39-1.43, with $1.41 being its new TREND line of resistance that is just broken. The USDX’s mild intraday up move is also propelling EUR-USD weakness. No doubt this is a volatile currency pair! Stay tuned.


Chinese Thirst for Portuguese Debt, Go Figure - a3


Matthew Hedrick


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower

Conclusion : The headline initial claims number rose 15K week-over-week to 424k (10k after a 4k upward revision to last week’s data).  Rolling claims fell 1.75k to 439k. On a non-seasonally-adjusted basis, reported claims rose 14k week-over-week to a new yearly high.


Jobless claims are now at year-to-date highs and solidly above 400K.  As you may recall, jobless claims above 400K will lead to a higher unemployment rate over time.  Aside from the general economic malaise we have been noting, the other key risk to employment is the end of QE2.  In chart 4 below, we’ve highlighted the relationship between quantitative easing and claims, which appears strongly correlated.  This is a point that even Bernanke highlighted in his recent press conference when he stated, “It’s not clear that we can get substantial improvements in payrolls without some additional inflation risk.”  In terms of sectors, accelerating jobless claims appear to be worst for the financial sector, which our Financials Team explains below.



It's No Coincidence That Claims Are at YTD Highs While XLF is at YTD Lows


We use claims as our primary frequency determinant in thinking about losses for the consumer book of balance sheet dependent financials. Thus, it is a critical signal that we remain right around the YTD high in rolling claims. The last time we saw such an inflection in the trend in jobless claims was summer 2010, a period in which the XLF lost roughly 20% of its value. Even with the XLF underperforming, we remain cautious given this continuing development on the jobs front. Specifically, it's our expectation that claims will, at best, stagnate post QE2's end and, at worst, rise. To this end, take a look at our fifth chart showing the overlay of jobless claims with S&P 500. The current divergence is among the widest we've seen in the last few years suggesting that either the market is due for a significant correction in the near-term or claims should fall precipitously in the next few weeks.


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d1


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d2


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d3



Two relationships that we are watching closely are the tight correlation between the S&P and claims and between Fed purchases (Treasuries & MBS) and claims.  With the end of QE2 looming, to the extent that this relationship is causal, it is quite concerning. 


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d4


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d5



Yield Curve Remains Wide


We chart the 2-10 spread as a proxy for NIM. Thus far the spread in 2Q is tracking 9 bps tighter than 1Q.  The current level of 260 bps is 3 bps tighter than last week.


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d6


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - d7



Financial Subsector Performance


The table below shows the stock performance of each Financial subsector over four durations. 


Jobless Claims Are At YTD Highs: The End of QE2 Will Take Claims Higher and Financials Lower - dd8



Daryl G. Jones
Director of Research


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