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The Queen Mary Is Turning

“Future shock is the shattering stress and disorientation that we induce in individuals by subjecting them to too much change in too short a time. ”
-Alvin Toffler

So the US Government issues its “stress test” guidelines and everyone scrambles to trade the US futures on what they think this means. This isn’t complicated folks. This is called risk management. And the amateur kind, at best…

Putting the banks through the paces of 2 economic scenarios is what they are calling a “stress test.” While it’s both embarrassing and sad that most of these bankers didn’t use credible scenario analysis prior to the meltdown of our Financial System, I suppose ranting about that will be next to useless this morning. I think everyone gets that at this point – bankers and their levered long prop traders don’t do risk management.

The worst part about this “stress test” is that it’s based on government forecasts. Now that everyone in the Fed and Treasury didn’t proactively prepare for today’s current economic scenario, America’s banks are going to manage their business and capital structure around the forecasts of those same revisionist historians? C’mon Man…

President Obama is going to unveil his first budget this morning. Within it, he is going to remind Americans that the US deficit for 2009 will be in the area code of $1.75T. That’s “T” for TRILLION.

Losing “Ts” is bad. We don’t need a “stress test” to tell us that. All this tells us is that when it comes to US Government sponsored risk management – there was none. Maybe we need a stiff club to the forehead to remind us that crushing America’s balance sheet has an implication for US Treasuries. Boy did we get one last night! For the last few months, I have been worrying about the US Treasury Bond market shaking. Now it’s breaking…

Shaking should make a risk manager worry – breaking should make him move. Who is running the scenario analysis on this side of the risk management ledger? Timmy Geithner?

Yesterday, 2-year Treasuries got hammered and now the yield on those Treasuries is breaking out to the upside as a result. My “stress test” reveals that a 2-year yield anywhere north of +0.97% moves the bonds that trade on those yields into a negative intermediate “Trend.” When Trends break out or break down in global macro, you better be running some serious in house scenario analysis. Tail risk is real when this happens – and as my American Idol, Tim Russert, would have said, “This is BIG.”

Yields on 2-year Treasuries are busting out to the upside this morning to +1.09%. This interest rate is now comfortably above what I call Trend line resistance. If you pull up a 3-year chart on this you will see what I have been calling for since our 2009 Investment Themes Outlook call, “The Queen Mary Turning”…

What’s that? Just like a “stress test”, it’s not complicated – it’s when a massive long term Trend in global macro starts to change its long term direction, making its turn in the oceans of global macro asset allocation – once this momentum factor builds up enough steam, it’s almost impossible to stop.

So what are the implications? Well, the most important is that this signals that American cost of capital is going to start going up. After cost of capital goes to zero, you can imagine how that scenario analysis isn’t trivial. As cost of capital increases alongside access to it tightening, guess what you get? The mother load of bankruptcy cycles…

I am still short Blackstone, primarily because this is the 25-year Trend that has made them, and many other cheap leverage lovers, look genius. Not all Private Equity is managed the same and, to be clear, I think there will be some huge winners in Private Equity land who take advantage of this generational fallout. But the Private Equity that is over-geared right here and now into the Queen Mary’s turn, watch out – massive iceberg cometh…

There are two obvious ways out of this stressful situation: 1. You can blow up the Queen Mary (Bernanke levering his brains out buying Treasuries) or 2. Beg for someone else to buy them (China).

Blowing up the natural forces of free markets doesn’t end well. That’s what this Keynesian gong show we have had over the course of the last 12 months has hopefully taught us all. And begging just isn’t cool. It’s un-American.

Now never rule out the “nevers”, particularly when running real risk management models. Our government has proven to attempt to socialize the losses of financial engineers here at every turn. However, if we assume under one scenario analysis at least, that increasing the cost of American capital is going to morph into a long term Trend, what do we do? Buy more bonds? Uh, no…

The US Treasury market is one of the few (other than gold) bubble markets that has yet to pop…

The Chinese announced this morning that they are going to issue 200B Yuan in 3-year bonds ($29B in USD), and international bond issuance is starting to really take on a life of its own all of a sudden (in Indonesia they issued $4.5B worth of 5 and 10-year bonds last night).

Yes, the rest of the world is allowed to print moneys, just like we have…

No, the long term implications for all of this are not part of Timmy Geithner’s “stress test” of the US Financial system.

This is scary. I have moved back to 76% cash in our Asset Allocation Model as a result.

My immediate term downside target for the SP500 is 730 (4.5% lower), and immediate term resistance is at 785 (2.5% higher). I sold my long positions in QQQQ and SPY yesterday, dropping my Asset Allocation in US Equities to 12% from the 29% I was carrying into the open on Tuesday. I covered my short position in gold yesterday, and sold my long position in oil – both were profitable decisions, as I think will be managing legitimate “stress tests” in your portfolios, rather than government sponsored ones.

Be careful out there,
KM

The Queen Mary Is Turning - etfs022609


Be Careful: SP500 Levels Into The Close...

I’ve modeled this 3 separate times in the last 24 hours. The math is telling me that this bottoming process will be a slow motion version of what we’d have sans the Keynesian intervention – otherwise known as a train wreck.

In terms of modeling price momentum, Monday’s move to the downside was more important than yesterday’s reversal to the upside. Now my downside target for the SP500 moves all the way down to 729. In the chart below I have lined up where the sharks will be jumping. There are 2 important lines of immediate term “Trade” resistance to keep your eyes on - SPX 785 and 822 (dotted red lines). In the next few days, if we can’t close above that 785 line, the probabilities of seeing 729 go up.

Intermediate Trend line resistance is a long way from here, up at 865 (solid red line).
KM

Keith R. McCullough
CEO & Chief Investment Officer

DIN - Masking the Truth – Part 2

DIN CEO Julia Stewart said today on the company’s Q4 earnings call that despite the difficult environment that the company’s fiscal 2008 results were in line with management’s key targets, particularly as it relates to its Applebee’s refranchising goals. This statement is a little deceiving because although the company did complete the sale of 103 company-operated Applebee’s to franchisees in FY08 (in line with management’s initial guidance of 100), the after-tax proceeds generated from these 103 sales and 5 subsequent sales in 1Q09 of $61 million fell significantly short of the company’s initial 2008 expectations of $90 million to $100 million and revised guidance of $70 million to $80 million.

DIN initially set out to refranchise a substantial majority of the Applebee’s company-operated restaurants to realize significant costs savings. In reaching its goal of refranchising over 100 units in 2008, the company is on track to reducing costs. In this environment, however, there is more risk associated with having such a leveraged balance sheet, and according to the company, DIN ended the year with a Debt/TTM EBITDAR ratio of 6.77x (relative to the average casual dining company at below 4x at the end of 3Q08). The 2008 refranchising proceeds which came in 32%-39% below plan were integral to allowing the company to pay down more of its debt and yet, Ms. Stewart maintains that the company achieved all of its key targets in 2008. This is just not a true statement relative to the after-tax proceeds the company set out to achieve at the beginning of 2008.

The final number on average proceeds per unit for the 108 restaurants refranchised thus far is $565K. Again, this compares to management’s initial guidance of $900K to $1 million per unit given in February 2008, the revised estimate of $700K to $800K per unit provided in July 2008 and the implied $573K per unit given in the company’s 3Q08 earnings release. We know the first 26 restaurants sold for about $1.04 million per unit, which implies that the remaining 82 units sold on average for about $415K each.

Going forward, DIN expects to refranchise an additional 200 units in 2009. Management did not provide any guidance as to how much these sales should generate in after-tax cash proceeds, but said it will disclose more details once the company has entered into purchase agreements. Apparently, management does not want to get caught having to continually revise down expectations as it did in 2008.

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VIX: Charting Your Stress Levels...

Make no mistake, we are in a bear market and it is to be traded, aggressively.

Below I have drawn the “Trend” line for the VIX. Trend, in our models, means intermediate term. Intermediate term Trends matter in this market, especially when those Trends come under assault. On Monday, we took a good hard look at a breakout in volatility. Yesterday, the VIX faded right at its formidable Trend line of resistance. Stress levels came down and we found a real rally, on real volume, as a result.

The line in the sand here is at the 51.94. Today, the VIX is only up a percent to 46. On the margin, that’s relatively low stress given the down move we are seeing in equities. This could change however – and in a hurry – so stay in sync with me on 51.94, with the proactive plan to be covering/buying US stocks again on a breakdown in the SP500 below the 730 line, provided that this lower high in the VIX stays intact.

If the VIX closes above 51.94, those stress levels of 65-80 VIX of October/November will be in play.

Keith R. McCullough
CEO & Chief Investment Officer

EYE ON JAPAN: SOLAR ECLIPSE

Japanese export data for January registered at an abysmal -45.7% year-over-year. The decline in demand for Japanese products was felt hardest in the US, where the sequential decline exceeded 50% on a one, two, and three year basis. Imports declined 31.7% Y/Y for the month.

As job cuts pick up pace, Japan appears poised to submerge back into stagnation for a prolonged period as it waits helplessly for returning demand from abroad.

Although it is anticipated that Prime Minister Aso’s government will introduce new stimulus plans as the fiscal year draws to a close in March, internal data points like domestic auto sales (Toyota registered January sales at home that are the lowest since they began releasing data in 2001) and anecdotal media reports suggest that the Japanese consumers have begun to hoarding cash as they did during the “lost decade”, leaving the odds heavily stacked against any attempt to kick start internal demand.

The USA better be very careful in letting her Dollar reflate. The output of the Japanese Yen reflating in January is as ugly as it gets.

Andrew Barber
Director

CROX: Consider the Bone

In answer to the title, a bone = a stock near a buck. I realize that many institutions can't even consider a name like this. But that does not mean that I ignore it. The institutions that will end up caring the most are the strategic buyers.
Let’s accept a hard reality about Crocs. It is a brand. Period. Is it overdistributed, overhyped, and is the core product super ugly??? Yes, yes and yes. But where this company got itself into trouble is by not appreciating the core customer/business, and trying to grow it into fashion areas. Make no mistake – this is not like Ugg (which is better than Crocs). We don’t have to watch trends with the teenybopper crowd. They never wore Crocs anyway. Will a whole host of 8 year olds be wearing them this summer? You bet. Will a good international brand manager (the new CEO comes from Reebok Int’l – one of the few businesses at Reebok that worked) leverage that on a global scale? Why not?

I’m not saying that Crocs is a growth company. In fact, let’s assume the opposite. Let’s say that either the new CEO or a strategic buyer scoops up this company, takes the top line from the $847mm peak down to a core of $400mm and runs at an 8% margin (I can defend this rate six ways til Sunday). At $1.40, it suggests that this thing is trading at less than 2x EBITDA. Each 1x turn by that math is about $45mm in Enterprise Value. Not bad off a base of $86.

Is it scary to buy a name like this whose product is in a decline, management is in question, and 4Q financials have yet to be finalized? You betcha. Could there be accounting adjustments and charges under the new CEO? Probably. But this is a tough business to commit all-out accounting fraud to the extent that it will take an established brand with net cash and put it into bankruptcy.

I remain floored that no one has bought this at an $86mm EV.

If it’s not going bust, BUY THE BONE!

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