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Crisis of Confidence or Bearishness?

We minced no words this morning. We hope our bullishness hit you like Mohammad Ali's right. We are the new bulls (for a “Trade”). Its global this time, and man is it bearish!

The European Union confidence charts are pretty straightforward. Buy Low.

The European Union confidence charts are pretty straightforward. Buy Low.

Yield curve: Steep and Steepening

As of yesterday there was a 235 basis point spread between 2s and 10s. This is great for the capitalists who have cash.

We thought we would front run CNBC and Fast Money by a few weeks and make a call out on the yield curve, which Keith has been highlighting in our morning meeting. In one sentence - it is steep and steepening.

We are not ready to call the end of recession (it has just begun), but, as many of you know, typically a steep yield curve will foretell an improving economy as demand for capital expands with growth. In the shorter term, the implied margins for a bank are inherently higher as they borrow short and lend long, which should lead to an easing of current credit market tightness. This is one indicator only, but it is on the margin positive, and worth highlighting. Everything in our macro model occurs on the margin.

The yield curve today, from 1-year ago, and from 1-month ago is highlighted below. Internally, we focus on the spread between 2s and 10s, which have steepened dramatically. As outlined below, the spread was at 60 bps 1-year ago, as of 1-month ago it was 191 bps, and today is at 235 bps.

Daryl G. Jones
Managing Director


Last week, Macau’s Chief Executive, Edmund Ho, proposed enabling legislation on Article 23 of the Macau’s mini-constitution. This article states that “Macau shall enact laws, on its own, to prohibit any act of treason, secession, sedition, subversion against” the Beijing government. The law, if passed, would be a major blow to free speech in Macau. It’s not a half court shot to assume that Beijing would be pleased.

We believe the law is likely to pass although it is by no means a slam dunk. Government officials tried it in Hong Kong five years ago but pro-democracy forces put the full court press on and stymied it. Macau is a different place without the democratic and freedom roots dug so deep as in Hong Kong.

Aside from supporting our pro-capitalism and pro-freedom teammates around the world why do we care? Mr. Ho is likely making this proposal for one or two of the following reasons:

• Curry favor with Beijing for a cushy job at the end of his stint as CE of Macau late next year
• Another attempt at a quid pro quo with Beijing regarding loosening visa restrictions

I don’t care much about what team Mr. Ho plays on in 2010 but any loosening of the current Guandong visa restrictions could spark a rebound for Macau casinos.

I doubt Macau will put up the same fight as Hong Kong

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S&P500 : Meltdown into the close

Keith and I were meeting with a major potential client yesterday in Greenwich yesterday and after a quick stop at MacDonald’s (where we did a channel check for restaurant guru Howard Penney – Howard, the coffee still sucks) made it back to the office for the Fed’s announcement. As were anticipating, the Fed cut rates by 50 bps, which benefitted our short U.S. dollar position.

Even more interesting was, as Keith called it, the “projectile sell off” into the close yesterday, which we’ve outlined in the chart below. In our opinion, this type of capitulation selling is clearly a bullish indicator as hedge funds are forced to sell stocks to raise cash into month end. It was clearly a “I need liquidity!” type move and on the margin a bullish indicator in our notebooks.

While we would expect to see more action like this in the coming months, they are, obviously, more indicative of bottom than a top.

Daryl G. Jones
Managing Director


Darden Restaurants has a significant amount of owned real estate (including buildings and Equipment) on its balance sheet ($3.0 billion) and have thought for years that equity investors do not assign the appropriate value to the Darden real estate holdings. As of May 28, 2008, Darden operated 1,702 restaurants (including 680 Red Lobster, 653 Olive Garden, 305 LongHorn Steakhouse, 32 Capital Grille, 23 and seven Seasons 52 restaurants). Of the company’s 1,427 restaurants open, 904 were located on owned sites and 798 were located on leased sites.

While owning a significant amount of real estate can provide a safety net to the company, removing the real estate can optimize Darden’s capital structure while improving investor perception and valuation on the core restaurant business. Traditionally, restaurant investor’s views real estate operations as a lower return proposition than the core restaurant business, thus creating an undervalued asset. Additionally, for the company to establish a permanent off-balance sheet capital financing vehicle for existing and future real estate capital needs would be extremely valuable for the entire enterprise.

  • In 1999, Darden formed two subsidiary corporations, each of which elected to be taxed as a Real Estate Investment Trust (REIT). Both corporations are currently holding certain restaurant real estate assets. Originally, the formation of the two REITs was designed primarily to assist the company in managing its real estate portfolio, reduce taxes, and provide a vehicle to access capital markets in the future. Upon a REIT spin-off, although we do not know if the tax implications would reverse, it is highly unlikely that the value of those tax implications would match the underlying value released as a result of the transaction.

  • In an attempt to determine the potential value of the stand-alone Darden REIT, it’s important to understand what the potential benefits and issues the company may face if it were to do a tax-free spin-off of its REIT. The Darden Real Estate Company would be an independent public company with its own Board of Directors and management team. A majority of the new company’s executives could be drawn internally from Darden, allowing the company to reduce its G&A costs. Further any additional property and leases would be negotiated on contributed property between Darden and the Darden REIT.

  • The following are some of the benefits that might accrue to the company if it were to spin-off its real estate business:

    Singular focus on the core restaurant business.

    Simplify balance sheet to include only core operations and a better valuation.

    Redeploy capital currently restricted by real estate in higher return restaurant business.
    Increase shareholder value with a significant share repurchase program.

    Reduce capital spending and significantly increase free cash flow.

    The Darden REIT will continue to aid Darden Restaurants in real estate solutions as new restaurants and concepts are added to the portfolio.

    Darden Restaurant will have Board level involvement at the Darden REIT.

    Darden Restaurant will be able to reduce depreciation expense

    Darden Restaurants will have the ability to transfer General and Administrative expenses to the Darden REIT.

  • The following are some of the disadvantages that we believe that Darden Restaurant might face:

    The company will incur lease expense on the currently owned properties.

    The Darden REIT will be organized with a master lease structure to allow for new properties to be added. Lease escalators are built in to future performance of the REIT.

    Darden Restaurants would lose flexibility associated with real estate ownership.

    Real estate is no longer available to pledge as collateral if needed.


“You been hearing about how bad I am since you were a little kid with mess in your pants! Tonight, I'm gonna whip you till you cry like a baby.”
-Muhammad Ali (1974, to George Foreman prior to the “Rumble In the Jungle” fight)

For the better part of this year I have been the annoying bear in some of the “hedgies” bonnets, and I am happy to be their little pet bull this morning, with a gun. One of our major investment strategy calls this year has been that 2008-2009 was going to most resemble the mid 1970’s. No, not a “mid cycle slowdown”; not the early 1990’s; and certainly not a “Great Depression”…

This brings me back to this day in 1974, when it was “global this time” and the entire world watched Muhammad Ali “Rumble In The Jungle” with George Foreman – he knocked him out in the 8th round. Sports fans will recall that it was the “Rope-A-Dope” strategy that Ali used to dizzy the dancing bear. Having been a growling bear for the better part of the last 12 months, I think I have learned a thing or two about dancing with them. You see, my Dad prepared me for this… but not by the avenue of his usual hockey lessons, rather by warning my sister Cheryl’s boyfriends that they “didn’t want to dance with the bear!”

Across the global macro risk factors that I grind through every morning, I have not had this many positive signals in my notebook since 2003. Everything that matters in my models occurs on the margin. While I am aware of consensus, I do not respect it for anything other than what it is – a leading indicator as to what part of the jungle I should be beating my own path down next. Bears don’t scare me. I know them well… and on nippy mornings like this, I get excited to dance with them.

So let’s dance… globally:

1. Asian Bears beware…
-China, Hong Kong, and Taiwan all cut rates
-“Heli-Ben” Bernanke dropped oodles of cash on Korea and Singapore, opening up $30B swap lines
-Hong Kong’s stock market closed up another +12.8%... pop, pop, bang! Rope-a-dope… pop!
-Korea, Japan, and Singapore closed up +12%, +10%, and +7.8%, respectively… pop, pop, bang!
-Asian currencies had their biggest up day in a decade… pop, pop, bang!

2. European Bears be worried…
-If prices close where they are trading now, this will be the 1st consecutive 3-day rally in Europe in October
-Germany is up another +4.6% after printing a NEW LOW in unemployment, coming in at 7.5% vs. 7.6% last month
-European “hedgies” are still whining about being run over by Volkswagens, or were those Porsches? Pop, pop, bang!@*%!
-Russian Bear hunters are back, putting up a +9.4% up day in their market; Russian stocks are +28% since 10/24… pop, pop!
-Russia’s Medvedev gives a state of the union address to the country today; fyi, it won’t be bearish!
-Eastern European countries like Hungary are getting bailout $ from the IMF and World bank; Hungary is +4% this morning… bang!
-France’s PPI inflation came in lower than expected for the month of September; deflation is taking hold globally…

3. Rest of the World Bears, you have a target on your heads…
-Middle Eastern stock markets (who have lost ½ of their value since May08’) are vying for their 3rd consecutive up day… pop, pop, bang!
-Oil is up +13% in 3 days post the “Heli-Ben” dropping of cash on emerging markets… if there is one thing that these countries like, it’s oil up!
-Copper and Nickel have had +12-14% moves to the upside since US rates were cut to 1%; beware of Peruvian bear hunters with guns!
-Brazil and Canada put in +4% up days; with the CRB Commodity Index +6% yesterday, you can’t be short them here…
-The Canadian Loonie has picked up +7% in 48 hours and we are long it via the FXC; I am Canadian, and I support hunting season!

This dancing is global folks. The US Dollar is down another -0.65% this morning, taking its 48 hour decline to -4.2% (we are short it via the UUP). You can thank the USS “Heli-Ben” for that! Pop, pop, bang! That’s the sound you’re going to hear in your newfound genius “short book” of “ideas” if you don’t recognize that being in 96% Cash (like we were in September) is the last thing you do when governments are giving away money for free!

I don’t have to agree with Bernanke, Paulson, or Foreman on much at all here. What I have to do, is be right. One of the toughest things for investors, boxers, and hunters to do is keep the mind focused when opposing thoughts enter the brain. Maintaining balance and sobriety under these emotional circumstances is the key. Otherwise, you are going to get “Rope-A-Doped”… pop, pop, bang!

I think there is at least another +9% left in this S&P500 rally. Our call on being net long China and Germany is starting to play out. Allow me to borrow John McCain’s calling card: “My friends”, the bears, I am calling all of you out of the bushes - let’s get ready to rumble!

Have a great day,

Long ETFs

FXC – Currency Shares Canadian Dollar Trust – The “Loonie” has rallied sharply in the last week, up +7.1%, on the back of a U.S. interest rate cut yesterday and strengthening commodity prices.

EWG – iShares Germany – The DAX is a positive outlier in Europe up +4.6%. Positive earnings reports from Deutsche Bank and Metro, a retailer, are highlighting this action. Unemployment fell slightly more than forecast for October coming in at 7.5%.

FXI – iShares China – The Hang Seng was up ~12.9% overseas and the largest gainer in Asian markets this morning.

EWH - iShares Hong Kong – The Hong Kong Monetary Authority cuts its key interest rate by 50 basis points, to 1.5%.

VYM – Vanguard High Dividend Yield ETF – This is a fund of the U.S. largest, blue chip companies and currently pays a dividend yield of ~3.7%. We like Dividends.

Short ETFs

UUP – U.S. Dollar Index – As we expected and noted yesterday, on the back of a U.S. interest rate cut, the U.S. dollar had its largest one day decline against a basket of currencies (based on ICE’s Dollar Index), since 1998.

EWU – iShares United Kingdom – The Nationwide Building Society reported that average cost of a home fell -14.6% y-o-y, the largest decline since the survey started in 1991. According to the Bank of England’s Blanchflower, “Interest rates do need to come down significantly – and quickly.”

Keith R. McCullough
CEO & Chief Investment Officer

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