Eye On Leadership: October 19th,"The World Turned Upside Down"

October 19th

On October 19, 1781 the most powerful empire on earth was humbled by a ragged upstart nation. Tradition has it that when the British army marched out from the battlements of Yorktown for the surrender ceremony its band was playing “The World Turned Upside Down” –appropriate for a moment when the accepted world order suddenly and permanently changed. One of the Continental Army officers present that day was Colonel Alexander Hamilton, the future architect of the US financial system.

In 1987, 206 years later to the day, the accepted order of the capital markets suddenly and permanently changed when an unprecedented stock market crash revealed a Wall Street populated by emperors wearing no clothes. In the wake of the crash, the perception of systemic market risk had to be recalibrated and a whole new breed of financial engineers began to construct an infrastructure for the new reality. Over the next two decades they would introduce terms like “hedge fund”, “portable alpha” and “market neutral” into the lexicon of investors globally.

Today, as I reflect on the current situation –the wreckage of the markets and the failure of international financial leadership, I draw this conclusion: the rules have not changed, they no longer exist. Your models no longer work, your methodology is no longer relevant and your credit is no longer good. Welcome to the new reality.

This is not a negative. Like a temporary vacuum created by an explosion to put out an oil rig fire, this global meltdown has sucked the oxygen out of the room and created opportunities for those of us who are brave enough to step into the void. This is exhilarating stuff to consider –the opportunity to abandon broken processes and build new ones.

In the coming months the financial media will be dominated by post mortems and witch hunts; the political community will be focused on playing the blame game and the new-old order on Wall Street will try to pretend that they can return to business as usual. Ignore them all.

Reality has changed. The only correct course now is forward.

Andrew Barber

Headline Of The Week:

I know, I know... we had this call 9 months ago... so I will let the media take it from here...

However, one quote comes to mind when I think about all of the pushback I got on this from the said industry savants:

"Nobody is thinking about you... unless you tell them about their faults...
Then, you can be sure that they are thinking about you...
They are thinking about killing you!"
-Roger Rosenblatt, (PBS and Time Contributor)

I, and many of you, have been overpaid to analyze industries with a fine tooth comb. Why it was contrarian to take a step back and analyze our own industry from a supply and demand perspective will remain a question in my mind for the rest of my life.

Chart Of The Week: American Consumer Confidence...

As one of my favorite analysts, Sherlock Holmes, always said, "sometimes, there is nothing more deceptive than an obvious fact." There is nothing to be contrarian about when it comes to this chart.

Michigan Consumer confidence got absolutely crushed this week, coming in at 57. Finally, instead of having to endure these last 9 months of hedge fund hotel screaming in my inbox about how I am being too bearish on where the US consumer is headed next, the worst report since 1978 will remind them that the 1970's were not a good time to "buy on valuation" (stocks troughed at 8x EPS).

My World Series Consumer team of Brian McGough, Howard Penney and Todd Jordan have been doing outstanding cycle work as of late. Managing tail risk is what we do, and the US consumer spending scenarios that they have come up with for 2009 are a long long way from consensus. This ain't Kansas, and I ain't Toto. This is math.

Be careful out there if you are getting levered up long in Consumer Discretionary. Your idea is interesting, but it’s not unique, and it’s too early. Within our RE sentiment framework of “Bullish, Bearish, and Not Enough” of one or the other, I still do not think that consensus is "Bearish Enough".

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Proving that housing was actually the dominant variable in driving gaming demand was an important revelation. We posted “IT’S THE HOUSING, STUPID” on July 17th and the data has continued to confirm our thesis. At the time, employment levels were thought to be the number one driver but, statistically speaking, housing renders the employment variable to almost insignificant status. Brian McGough’s recent analysis in “STATE OF THE CONSUMER: HISTORY 101” provides more evidential back up and a terrific explanation of the wealth effect. It now seems so obvious why we all thought gaming wasn’t cyclical. The overall economy and employment levels have ebbed and flowed but housing prices have risen consistently since the mid 1990s.

So have gaming revenues. I’m looking at the chart and I’m not getting a peaceful, easy feeling.


Below I’ve re-posted an excellent consumer piece by my partner, Brian McGough. I’d also like to use this as a follow-up to my 7/17/08 post “IT’S THE HOUSING, STUPID”. In that analysis I found housing prices to be the most significant driver of gaming revenue; more than employment levels, GDP, the alignment of the stars, etc. I think we’ve found the answer to why gaming is cyclical this time. Keep that in mind as you read through Brian’s consumer treatise that follows. Scary stuff.


One thing I’ve learned at Research Edge is how to be a student of history, and understand how the sins of the past shaped the challenges we face today. The evolution of the wealth effect is classic.

One of the biggest drains on the consumer today is the fact that the personal savings rate is hovering near zero. Yes, we debate academically as to how it is calculated, and how it could technically go below zero (which it has). But let’s look at the big picture here. The chart below says it all.

1. Starting in the Regan/Volcker years and all the way through the end of the Clinton era (when the tech bubble burst), we had a 20-year uber-bull market for equities driven in part by systematic cuts in interest rates to drive consumer spending and keep the economy cranking forward.

2. Once we saw George W. come into office, the equity markets took a pause, but the housing market went parabolic.

3. Put those two together and what do you get?? What I’d consider a 27-year wealth effect. By the way, that’s within 5 years of the average age of a Wall Street analyst. Sad.

4. While this freight train rolled on, the consumer took down the savings rate from the peak of 11.2%, to less than 1% today. As a frame of reference, China’s savings rate is near 40%.

5. Now what? Housing values are deflating, and equity markets do nothing but go down. My sense is that consumers take whatever they can and actually save a bit for once. In fact, it was fascinating to see that the tax rebate checks that hit this summer went almost entirely to beef up savings (the rate temporarily bumped to 2.5%) and repay debt.

As sure as the sun will shine, this savings rate needs to head higher. The order of operation will need to be 1) survive (buy essentials, etc…), 2) pay down debt/save money, 3) buy a $500 cashmere sweater at Saks.

Brian McGough
President and Director of Research


While there will always be issues around the use of discounting, the difficult economic environment leaves few other options. Recent NPD data suggests that discounting has been driving traffic in this tough economic environment, particularly when gasoline prices reached $4.00 a gallon. The key issue to watch - can restaurant companies develop promotions that consumers find attractive while maintaining margins?

It comes as no surprise that consumers are looking for savings in these tough economic times and some restaurant operators have responded by offering very attractive price points. Over the past three months, 23% of all visits to restaurants included some form of discounting. According to NPD, deal visits were up 9% versus last year. During the same period, non-deal traffic declined by 1%. For the past three quarters, all of the industry’s traffic growth has been driven by the resurgence of value positioned promotions.

While increased dealing can be found in both the Quick Service and Casual Dining segments, most of the increase in deal activity has taken place in the Quick Service arena. Over the past 3 months, QSR deal traffic was up 10% versus last years. During the same time, deal traffic was up 6% at Casual Dining restaurants. For both segments, non-deal traffic was negative.

In this environment, positive same-store sales can be a misleading indicator of a company’s health. Those companies that are discounting heavily today will pay the ultimate price in the end.

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