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Forecasts of Doom

This note was originally published at 8am on July 25, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Plainly, MacArthur’s bleak assessment of the situation, his forecasts of doom, had been wrong.”

-David McCullough (“Truman”, page 834)

 

We’ve all experienced getting too bearish at bottoms. Historically, when this emotional capitulation comes from the political leaders of our country, we often look back at their Forecasts of Doom as the catalysts for change. Politics are a lagging indicator.

 

While I’m not sure I’d be accused of being bullish on Keynesian Economic policies or their impacts to the US Dollar since the 2008 US stock market crash, I’m certainly not the US Dollar bears’ huckleberry on this matter right here and now.

 

Not to name names, but PIMCO’s Mohammed El-Erian has been getting plenty of air-time in recent weeks (Barrons this weekend, Bloomberg article again this morning, etc.) talking up the credit risk in US Treasury Bonds.

 

Not to callout timing, but this has been El-Erian’s view since PIMCO effectively sold almost all of their US Treasury exposure in Q1 and Q2 of 2011. While I respect Bill Gross and all of his risk management accomplishments over the years, his partner’s Forecasts of Doom for the US Treasury Bond market have not only been wrong since March, but they are wrong, again, on this morning’s Debt Ceiling “news.”

 

The “news” on anything being commandeered by central planners of the 112thCongress is that the news is going to change. This weekend’s “news” of a Debt Ceiling debate failure may have been good for the Sunday talk show ratings, but it wasn’t bad for what matters to markets – the marked-to-market rating on US Treasury Yields.

 

If you didn’t know that market prices don’t lie (politicians do) – now you know. Or at least Mr. Macro Market in US Treasuries thinks he knows. Here’s this morning’s reaction to the “news” of doom:

  1. Short-term Treasuries (2-year yields) – didn’t move 1 basis point versus where they were priced into the end of last week (0.39%)
  2. Long-term Treasuries (10-year yields) – moved a whole 2 basis points versus Friday to 2.98%

But Mr. El-Erian has a Top 10 article on Bloomberg’s most read that delivers the headline “El-Erian Says US Vulnerable To Downgrade”… Qu’est ce qui se passe avec Le Analysis if the market isn’t reacting to PIMCO’s bleak assessment?

 

I’m long US Treasuries and have been writing about why since we launched our Q2 Macro Themes at Hedgeye in April. Sure, partly because I’m bearish on US Growth (Mr. El-Erian says he’s bearish on US Growth, but evidently not Bearish Enough or he’d be long the long-bond).

 

As most of the lagging of lagging indicators (Moody’s, S&P, etc) downgrade the likes of Greece (again!) this morning, I’m moving the Hedgeye Asset Allocation Model to its most invested position of 2011.

 

Yes, we still have 40% Cash – but that’s less than the 67% Cash we held at the end of February when Wall Street/Washington expectations for growth were will too high by about a double!

 

Ahead of this Friday’s preliminary US GDP Growth Report for Q2, Hedgeye’s estimate for US GDP Growth remains 1.7%-2.1%. Since the government, to a degree, makes up this number, we make up a range of expectations around current made-up numbers.

 

Here’s where the Hedgeye Asset Allocation Model stands as of this morning:

  1. Cash = 40% (down from 46% last Monday)
  2. Fixed Income = 24% (US Treasury Flattener and Long-term Treasuries – FLAT and TLT)
  3. International Equities = 12% (China and S&P International Dividend ETF – CAF and DWX)
  4. Commodities = 9% (Gold and Silver – GLD and SLV)
  5. International Currencies = 9% (US Dollar and Canadian Dollar – UUP and FXC)
  6. US Equities = 6% (Healthcare – XLV)

Obviously as Global Economic Growth Slows and Fiat Fool Policies whip around between Europe and the US like a ping pong ball (see our Q3 Macro Theme presentation, “Policy Pong”), we don’t want to be “fully invested” – not with our own money at least.

 

As for today, what we’d like to do on this “newsy” morning is sell some Gold high and buy some US Equity and Currency exposure low. We get the bleak assessment about Congress and a President who has a hard time making hard decisions. We also get that markets discount the obvious – and we could very well be looking at “news” of a Debt Ceiling resolution by the end of the week.

 

My immediate-term support and resistance ranges for Gold (long), Oil (no position), and the SP500 (no position) are now $1590-1619, $97.72-100.24, and 1322-1349, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Forecasts of Doom - Chart of the Day

 

Forecasts of Doom - Virtual Portfolio



Institutional Constraint

“We have many constraints as investors.”

-Seth Klarman

 

Baupost’s Seth Klarman is no stranger to going to cash. Neither is he shy about telling it like it is about how the game of Institutional Asset Management works. The aforementioned quote has nothing to do with the self-directed individual investor. It has everything to do with Institutional Constraints.

 

“Constraint”, per Wikipedia, “is an element factor or a subsystem that works as a bottleneck. It restricts an entity, project, or system from achieving its potential with reference to its goal.” Institutional Constraint isn’t what Klarman calls it, but I think he’d agree.

 

In Grant’s back in Q1, Klarman said “we want short-term performance, and are measured by this. There is enormous pressure from clients for short term performance. Mutual funds compete in a relative space. What’s important is absolute returns. The way people do this is forced mediocrity. To do absolute performance, you have to bet against the crowd sometimes.”

 

Sometimes betting against the crowd too early makes an investor wrong. Sometimes betting against your current positioning can make you less wrong. In a market like this, where Institutional performance chasing is one of the most misunderstood long-term TAIL risks we’re observing, price levels matter – big time. So does considering them on a multi-factor, multi-duration basis.

 

What does multi-factor mean?

 

First, let me tell you what it doesn’t mean:

  1. Point and click 1 factor models of simple moving averages (50 day, 200 day, etc)
  2. Being sucked into the Sentiment Vacuum of 1 topic (Debt Ceiling is the #1, #2, and #3 most read on Bloomberg this morning)
  3. Considering Global Macro risk from the vantage point of 1 country and/or 1 asset class (“what’s the Dow doing?”, c’mon)

Within the construct of Chaos/Complexity Theory (my modern day market practitioner’s answer to stale academic Keynesian Dogma), multi-factor is as multi-factor does. You need to build a risk management process that absorbs multiple price, volume, and volatility signals, across multiple asset classes, and across multiple durations.

 

If I had 10 Chinese Yuans for every person I’ve met in this business who says “well, the chart looks good”, I’d have a lot more money to fund Hedgeye’s growth. What, precisely, do charts mean? The answer to that is as simple as the deep simplicity Chaos Theory aspires to achieve. The chart looks as good as the math you have embedded in the picture!

 

If bells weren’t going off in your Global Macro Risk Management Process yesterday, I suggest you get a new one. Here are some of the alarms going off in mine that had me take my Cash position back up to 46% from 37% (where I started the day):

  1. EUROPE – both European stocks and bonds are turning into a proactively predictable train wrecks. Our research catalysts remain crystal clear (accelerating debt maturities for the majors through September) but, more importantly, now all of our TRADE and TREND lines across every major European stock and bond market (ex-Russia) have been broken and confirmed by volume and volatility studies.
  2. USA – stocks broke their intermediate-term TREND line of support (1320 in the SP500) and short-term bond yields finally busted a move above my 2-year yield TRADE line of resistance (0.41%).  Credit risk derived by market morons in Congress will be priced on the short-end of the curve (where Bernanke has tried to mark it to model for 2 years), so watch that 0.41% line like a hawk.
  3. GLOBALLY – China’s Shanghai COMP TREND line = 2831 (broken); India’s BSE Sensex TREND line = 18,578 (broken); German DAX TREND line = 7251 (broken); FTSE TREND line = 5985 (broken); SP500 TREND line = 1320 (broken); Russell2000 TREND line = 827 (broken); WTIC Oil TREND line = 103 (broken); EUR/USD TREND line = $1.43 (schizophrenic).

No one at Hedgeye has ever said 2011 Global Growth or 2H2011 Earnings Expectations were priced properly. If you close your eyes to all of my quantitative and research factoring across asset classes and just focus on those 2  - they are VERY large fundamental factors to consider having market impact above and beyond these yahoos in Congress.

 

Look, I’m not saying I got all of this right. What I am simply saying is that we, as a profession, can get a lot better at this if we just open our minds to re-thinking risk and re-working our asset allocations as the big factors are changing. The market doesn’t care about our respective investment styles, compensation mechanisms, or Institutional Constraints.

 

My immediate-term ranges for Gold, Oil, and the SP500 are now $1, $96.03-100.32, and 1, respectively. I cut my US Equity exposure to 3% (from 9%) in the Hedgeye Asset Allocation Model yesterday.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Institutional Constraint - Chart of the Day

 

Institutional Constraint - Virtual Portfolio


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.64%
  • SHORT SIGNALS 78.61%

SKX: Respect The Cardinal Rule…

There are not a lot of cardinal rules in Retail investing. One of them is to never try to bottom-tick Skechers.

 

 

The tail end of fad-induced runs in retail are never pretty and SKX is no exception. While we’d like to give Skechers some credit for taking its lumps this quarter and getting more aggressive about reducing inventory, the reality is they had no choice. In addition to trying to sell through remaining product at the twilight of its relevance, SKX is starting to ship its next generation running and other ‘performance’ product for BTS. Of course "tests’have been positive", but aside from the fact that no CEO will ever state that tests aren't working, retailers are going to be understandably cautious before buying a front row ticket to toning part deux.

 

This one is going to take more than one quarter of pain to recover. We know full well that by the time we get any clarity, the stock will have moved on us. Furthermore, our SIGMA analysis below shows that despite the horrific (-65%) sales/inventory spread, that’s actually a sequential improvement from 1Q. The icing on the cake is that the most favorable stock price movement is associated with a move from the lower left quadrant to the upper left. And it looks like that’s where SKX wants to go.we think that some of this is already baked-into a low teens stock. And with a complete lack of clarity as to how the company unloads the remaining half of its excess toning inventory, coupled with the fact that we’re shaking out at $0.85 for next year we still don’t like this name here at $14.50.

 

Despite the silver lining of continued strength in the international business up 35%, domestic sales were down by the same magnitude and we expect this trend to continue driving total revs down 10% in Q3. While SKX is starting to rein in costs, gross margin variability continues to be a key issue that will have the company fighting to breakeven for the remainder of the year. Competition is getting tougher, and there’s no guarantee that this event is truly a kitchen sink event.

 

Again, there are not a lot of cardinal rules in Retail investing. One of them is to never try to bottom-tick Skechers.

 

SKX: Respect The Cardinal Rule… - 321


We Wouldn’t Want to be Glenn Stevens Right About Now

Conclusion: RBA Governor Glenn Stevens could shock the Australian economy into a pronounced economic downturn by looking through the current slowdown and hiking rates within the next few months, but given recent economic data it seems more likely that the tightening cycle has peaked in Australia.

 

Position: Short the Aussie dollar (FXA).

 

Reserve Bank of Australia governor Glenn Stevens has his work cut out for him. On one hand, he’s got to deal with a confluence of inflationary pressure at multi-year highs. On the other hand, broad-based slowing of Aussie economic data has become hard to ignore. Recessionary? Perhaps not, but we certainly would not rule that out at this juncture. Needless to say, we expect next Monday’s RBA monetary policy announcement and the accompanying commentary to be market-moving, given the increasingly divergent nature of Australia’s economic fundamentals.

 

We are short Australia’s currency as of this afternoon and think Stevens would be borderline crazy to hike rates at any point over the intermediate term. As we outlined in April, the bias of risks to Australia’s developed-world-beating benchmark interest rate of 4.75% is heavily skewed to the downside in our opinion.  Our view is divergent from the global FX market, which is is clearly pricing in additional RBA rate hike(s) on the heels of this week’s acceleration in CPI and PPI – both to 10-quarter highs.  Given the rapid appreciation of the Aussie dollar over the last twleve months (+23.3%), much of this is likely priced in to the currency, which makes the risk/reward compelling on the short side.

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 1

 

Interestingly, both the interest rate futures market and interest rate swaps market are pricing in RBA hawkishness (on the margin) on the heels of today’s CPI report. Rate futures suggest a 28% chance of an RBA rate cut by December, down from 100% just two days ago. In the same time period, swaps market expectations for RBA rate cuts over the NTM nearly halved, falling from -42bps to -23bps, and those same expectations went from signaling an 8% probability of a rate cut to a 2% probably of a rate hike next Monday.

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 2

 

Interestingly, Australia’s one-year inflation swap rates hardly budged. The securities, which exchange fixed payments for returns equivalent to Australia’s CPI over the specified duration, have been in free-fall since mid-to-late April (right around the time we introduced our Deflating the Inflation thesis). The short-to-intermediate-term slope of this market is in unison with our call that the intermediate-term peak of commodity prices is in the rear-view mirror, which should help converge Australia’s headline CPI towards its core CPI rate at -90bps below.

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 3

 

Perhaps the most important driving force behind the muted reaction in Australia’s inflation swaps market is a glaring lack of consumer demand, which may force Aussie retailers and service providers to discount aggressively in order to sell-through product.

 

Anecdotally, Australia’s second-largest department store chain, David Jones Ltd., cut 2H earnings guidance to -12% from +5% just two months ago. Our daily grind through Australia’s economic data suggests this micro-level activity is both pervasive and supported by the top-down trend we’re seeing across the Australian corporate sector. A recent quarterly Deloitte survey of 100 CEOs of large, listed enterprises found that only 23% of respondents were positive about the financial outlook for their company – the lowest level since the survey began in 2009 and a near -50% decline from 1Q11. Moreover, Australian deposit-to-loan ratios (a gauge of corporate willingness to invest) at 1.25x are at the highest levels since the thralls of the financial crisis, according to a recent East & Partners study.

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 4

 

The widespread bearish sentiment in the Australian corporate sector is largely driven by a weak Australian consumer. Since mid-to-late 2009, Australian consumer confidence and retail sales have made a series of lower-highs and we see further downside over the long-term TAIL. This is driven by a weakness in Australia’s residential real estate market, which, in turn, drives Australia’s household savings rate to new highs (the current 11.5% reading is just -10bps below a 25-year peak). We would expect to see this trend continue over the long-term TAIL absent any material easing in monetary policy. We are not alone in this regard; a recent National Australian Bank residential property price index designed to predict home value values on a one-year forward basis showed a -1.4% decline in the 12 months from 2Q11 (vs. +0.6% in the 12 months from 1Q11).

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 5

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 6

 

Some key metrics to consider regarding Australia’s property market: 

  • Nearly 2/3rds of Australian citizens own homes (population = 22.5 million);
  • Roughly 90% of encumbered households have variable-rate mortgages (rate hikes are incredibly painful);
  • At 155% of disposable incomes, Australian households are more +16.5% more levered than U.S. households were just prior to the financial crisis (133%);
  • Australia has the most unaffordable housing in the English speaking world, according to a January Demographia survey (6.1x gross annual household income vs. 3x in the U.S.); and
  • A recent Zillow.com survey confirms the Demographia survey results: the median house price in Australia ($503k in May) is nearly 3x that of the U.S. ($184k in June). 

Judging by this data snapshot, which shows an over-levered consumer facing exorbitant housing prices, it should come as no surprise to see that demand for mortgages in Australia has plummeted to the lowest levels ever in May (+6.2% YoY). Ever, as they say, is a long-time. Moreover, a pickup in mortgage delinquency rates, which hit a record high of 1.79% in 1Q11 according to Fitch Ratings, should put incremental pressure on Australia’s banking system at large and may slow credit growth to other parts of the economy in the event of a systemic buildup in reserves. It’s worth noting that mortgage debt represents 59% of total Aussie bank credit.

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 7

 

Oddly enough, Australia’s unemployment rate has trended down on both an intermediate-term and long-term perspective and remains just +10bps above its post-crisis low. Additionally, a long-term investment boom driven by the mining industry should continue to exert downward pressure on Australia’s unemployment rate. On the flip side, robust RBA expectations for the long-term TAIL of Australia’s labor market need to be tempered, as we strongly believe Prime Minister Julia Gillard’s carbon tax legislation will slow the rate of investment in this sector – widely noted to be the only beacon of light in Australia’s labor market. The other three main labor market sectors (manufacturing, services, and construction) continue to show material signs of weakness.

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 8

 

We Wouldn’t Want to be Glenn Stevens Right About Now - 9

 

Should Australia’s labor market weaken incrementally, we feel Australian economic growth could be at an even greater risk.  As well, we think that Glenn Stevens could shock the Australian economy into a pronounced economic downturn by looking through the current slowdown and hiking rates within the next few months. He could also choose to ease consumer fears regarding additional tightening and provide much-welcome support to Australia’s ailing retail sector and housing market by cutting rates. Either way, we are comfortable shorting the Aussie dollar at this price.

 

Darius Dale

Analyst



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