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Oil: Solidly In Contango...

Bearish short term, but longer term production issues are likely…

Keith mentioned in the morning meeting today that he thinks Oil looks broken technically. Our range for buying and selling Oil (using West Texas Intermediate per barrel as a proxy) are sell levels at $72.10 and buy levels at $60.82, which is a wide and very tradable range. This bearish technical view also coincides with a bearish futures market, which, as outlined in the chart below, is solidly in contango as futures prices are much higher than the near month contract.

In a contango scenario, inventories should be driven up for refiners and producers as they hold the commodity since it is worth more in the future. Obviously this is indicative of weak short term demand. The most recent data from Master Card confirms this as motorists consumed 6.4% less gas in the past week compared to a year ago, so even though gasoline is back in the mid $2.50 per gallon range demand is still anemic.

While we have a bearish short term view on Oil based on declining demand, the longer term production issues remain and will likely only be amplified when global growth again accelerates. The implications of the credit crunch and recession are that investment in Oil exploration is slowing and will continue to slow, which eventually will eventually lead to a supply driven rally in oil.

The Executive Director of the International Energy Agency Nobuo Tanaka stated on October 28th that “the financial crisis may delay oil projects and lead to serious supply crunch.” The IEA will likely reflect this expectation of lower investment, and increased potential for production issues, when they release their annual energy outlook in London on November 12th.

Daryl G. Jones
Managing Director

China continues to shake hands, as the global economy shakes...

Last quarter, China shook hands with the world (Olympics). Last week, China shook hands with Russia. This week China sends an envoy to Taiwan.

The domestic economy is now China's focus. The Chinese government has a stated objective to double disposable income for the 750 million people they have living in the countryside by 2020.

There are a variety of economically simulative measures that have been taken (land reform, lease rights, etc...) to help get them to this goal. However, the political measure of solidifying global trade partners may be as relevant as anything that’s currently changing for the Chinese.

Everything that matters in our models happens on the margin. The rate of change in China is slow, but it is steady and material.

Ostensibly, these meetings in Taiwan will result in more collaborative trade relations. Taiwan's new President, Ma, is certainly banking on it.

Stay tuned...

Germany (EWG): Relative Strength Is Broad Based Across Economic Factors In Our Models...

This morning’s German PMI numbers are stronger than the overall Euro zone.

NTC research released the Eurozone PMI Manufacturing index levels for October today. As expected, the surveys came in at significantly bearish levels with the aggregate Eurozone at 41.1 -lower than any point in over ten years.

The German PMI index registered at 42.9, 1.78 points higher that the aggregate, 1.39 higher than the UK and 2.29 higher than France.

The relative resilience of German manufacturing so far supports our continuing thesis that the economy there is sounder structurally than the remainder of the major European nations. They are less levered. Boring is good.

As the data changes, so will our positions. For now however, the math continues to support our thesis that Germany is poised to outperform its neighbors and partners.

Andrew Barber

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It's Time

“What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”
-Warren Buffett

How prescient the “Oracle of Omaha’s” simple statements continue to be… this past week’s action across stock markets, globally, implied that consensus couldn’t have possibly have been realistically understood. Since the 10/27 lows, the Hang Seng Index and the S&P500 rallied +30% and +15%, respectively. If you weren’t short that, or “all in” on the “going to cash” call, congratulations! US denominated cash ended up losing over 4% in that same period of time.

Bottoms are processes, not points. We have been hammering home that we see a bottom forming in consumer and investor confidence, globally. While any data set can get worse, we are paid to be realists, not alarmists. Provided that Obama wins tomorrow, the election math implies that over 50% of American voters will soon see the USA as a better place than it was yesterday (see out Macro note titled, “Could Obama Signal A Bottom In Confidence”, 10/31).

Daryl Jones wrote an outstanding thematic piece for our ‘RE Macro’ clients this weekend titled “Eye On Behavioral Finance: The Power and Pitfalls of Confidence” (www.researchedgellc.com, 11/2). This is clearly one of the misunderstood frontiers of finance, and one that we will continue to explore in the coming months. Wall Street has had a long history of “old boy club” investing based on what Nasim Taleb labels “narrative fallacies” (story telling that supports your invested position). As this weekend’s ‘Economist’ notes on its cover, “It’s Time” – it is time for these reactive and qualitative investment management styles to take a turn warming up the bench. It’s time to proactively manage risk. It’s time to quantify all investment scenarios. It’s time to ‘You Tube’ our business for what it is, and rebuild it.

Despite all of the excuse making in the market place, two of the last three weeks have been positive ones for the S&P 500. Stock markets, globally, are beginning to discount better than toxic expectations for the immediate days ahead. Alongside the aforementioned rallies in the US and Asia, Europe is trading up for the 5th consecutive day this morning. We are long Germany via the EWG exchange traded fund where the stock market has appreciated +17% since the 24th of October. Unemployment in Germany remains low, and inflation readings have began to abate. This is progress.

Progress, at least in capital markets, can reveal itself in many forms. One of the most critical ones is expectations. This morning the European Union is leveling expectations for 2009 by cutting its economic growth outlook to zero. Yes, zero… Could they be worse than zero? Sure. Is this easier to swallow than the unrealistic expectations of the said economic forecasting savants of horse and buggy whip investment banks past? Definitely.

Alongside credit markets thawing, and yield curves steepening, our expectations for appreciation in our equity portfolio allocation continues to be positive (see ‘Hedgeye Portfolio Allocation’ above). Away from the US Dollar underperforming last week (we are short it via the UUP etf), so did gold. Gold wasn’t down much, but the point is that it was down – like credit spreads and slopes, this is one more global macro sign of stress in the global economic system abating.

Context is always critical, and you don’t need to look too far from the vacuum of available financial media to come to realize that, on a week over week basis, last week saw the S&P500 +10.5%, the CRB Commodities Index +5%, and the Volatility Index (VIX) drop -24%. Just as ole Bushy gets to see Hank the Tank’s “Investment Banking Inc.” ice get “unstuck”, he’ll be waving goodbye to the prospects of John McCain leading another reactive “B” Team at the US Treasury into 2009’s global economic battle.

Nobel Prize winning economist, Robert Aumann, who is holds a special place in my investment heart for his game theory conclusions, came out this weekend simply calling Paulson “not smart.” At least I have some decorated company in my camp now. Perhaps the most important catalysts of an Obama victory, will be a wholesale change to the American lineup at the US Treasury.

Team “Buffett, Volcker, and Summers” has a better than bad ring to it… with all time lows in US consumer confidence in our rear view mirror, that might very well be all this stock market needs in order to support the current squeeze. Everything that matters in markets happens on the margin, and “how realistically you define” what you may not know is going to occur next. Keep your eyes open for more of the unexpected.

Have a great week,

Long ETFs

JO – iPath Coffee – India’s Coffee Board estimates January – October exports increased 3%, slightly more than anticipated after problematic weather.

EWG – iShares Germany – Commerzbank to receive 8.2bn in EUR from the government after a write down. The stock is up +6.8% post the announcement.

FXI – iShares China – China’s state news agency reported that the central bank removed temporary controls on loans to bolster economic growth. China Purchasing Managers Index fell to 45.2 in October from 47.7 in September, the largest contraction since the survey began.

EWH - iShares Hong Kong – The “hairy crab index” has dropped between 30 – 50% in recent months, which is used as a proxy for consumer luxury spending in Hong Kong.

VYM – Vanguard High Dividend Yield ETF – Credit Default Swap contracts on the CDX North America Investment Grade Index of 125 companies in the U.S. and Canada increased 5 basis points to 203 on Friday.

Short ETFs

UUP – U.S. Dollar Index – The USD is down for the 4th straight day against a basket of currencies and ahead of the ISM manufacturing report in the U.S. this morning.

EWU – iShares United Kingdom – European Commission data estimates UK debt levels will exceed 60% of GDP in 2010. PMI data indicates that manufacturing has declined for 6th consecutive month.

IFN – The India Fund – Central bank lowers benchmark rate by 50bps to 7.5% and the reserve ratio by 1% in surprise move. The reserve ratio cut is expected to add $8.1bn to India’s financial system.

MCD – McCafe – Collecting trench data

“Looks like desperation to me! Telling us they've got it all figured out and are ready for national prime-time and then start tinkering with the basic product???”

“What the WSJ did not report is that the testing in Detroit is a result of the proven fact that the African American consumer has little interest in the fancy coffee drinks. Remember, all of Michigan has had these products for over two years so they've proven the weakness in the urban setting.”

“Even though sales aren't strong the outstate MI, stores sell two specialty coffee drinks for everyone one sold in Detroit metro. So this means that the sales of specialty coffee index at about 75% for AACM to the General Consumer Market during promotional periods. During sustaining periods without heavy promotion sales in the AACM is about 50% of the GCM. Hence the change in formulas (adding chocolate) being tested in Detroit”!


I’ve got a simple thesis on the slot business. Senior corporate management will control the slot Capex decisions in 2009 for the casino operators. I’m not sure the analysts are considering this important observation in their estimates nor are the suppliers in their guidance.

Casino operators are preparing their Capex budgets right now. I know they’re scared. Gaming revenues are down considerably and September was one of the worst months ever. Most importantly, senior managements are very worried about liquidity and covenants, particularly in the first half of 2009. Slot Capex comprises the largest part of maintenance Capex and is the easiest to delay.

I think the suppliers are overestimating 2009 slot demand. Part of this miscalculation is the classic forecasting error of assuming that current trends will continue. Additionally, the suppliers are getting indications of slot demand from casino level management. Unfortunately, 2009 slot decisions will be made at the corporate level and not at the casino level. Another price of excessive leverage.

The chart below examines current Street estimates for slot unit demand and revenue for the first half of 2009. For the Big Three, Analysts are projecting market growth in both metrics over this time period. In the case of BYI and WMS, the estimates are even less believable. I understand that both companies have stolen market share from IGT and may continue to do so. If you believe, as I do, that unit demand and revenues will decline in the first half of next year, further market share shifts would have to be dramatic for WMS and BYI to hit those numbers.

Analysts projecting growth in first half of 2009

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