Gold, Equities, and the US Dollar...

Last week, Gold (GLD) and US denominated cash (UUP) underperformed US equities meaningfully. At the margin, this augured profitably for us, as we spent the better part of the back half of October deploying our 96% Cash position into global equities.

When "Heli-Ben" drops cash from the heavens, and interest rates fall to sub zero (on a real basis), the last thing that is going to earn you a return is cash. This chart shows last week’s relative performance of these 3 asset classes. Math and Macro don't lie. People do.

FINL: CFO Departure Does Not Alarm Me

I always cringe when a story I like has a CFO change. While Dollar Tree is no prize, Kevin Wampler leaving The Finish Line to be CFO of DLTR is a step-up for him. This was not a departure because fortunes have changed and FINL needs a fall guy, but rather an offensive move by Wampler to be the top finance guy at a company 7x the size of FINL (even though comp scales appear to be fairly similar between companies -- as outlined below). I can never say it is a ‘non event’ when leadership changes, but I’m looking for things to be rather smooth here – especially with zero debt, no covenant and credit exposure, a healthy lease portfolio, and an improving product cycle.

‘The Question’

The purpose of “The Question” is to get to the bottom of key issues of investment significance, and to call out those companies that are particular standouts (+ and -).

With Obama looking increasingly likely to take the election, he has been very outspoken about passing the Employee Free Choice Act, which would eliminate the secret ballot making it much easier to unionize. This in turn would result in higher wages and benefits.
Food and labor costs represent 60-70% of the cost of running a restaurant. I have no idea where Obama stands on food costs or if any of his policies will cause an increase in the cost of food. Labor costs represent 30%+/- of that total. Over the past three years, the industry has faced significant labor inflation and thus lower margins. Unfortunately, there is not much the industry can do. In this environment you can’t raise prices and you can’t cut labor or you will lose customers. The restaurant industry is one of the largest employers in the United States. Given the current environment, if Obama’s policies accelerate labor inflation, it will only cause more companies to go bankrupt and increase unemployment. How does anybody prepare for that scenario?

This is the question I threw out to some key executives within the restaurant industry. I have included a couple of the more interesting responses:

-The key will be whether or not the Republicans can hold 40 seats in the Senate. 40 seats will allow them to filibuster any bill proposed by the Democrats including the Employee Free Choice Act which if passed, will neither be free nor a choice (Please sign this card Mr. Penney…and we know where you live!). If the Republicans can’t hold a 40 seat minority, the first target will be Wal-Mart followed by Target, Home Depot, Lowe’s etc. Restaurants will be further down the list starting with McDonald’s and Burger King. Eventually, they will get to casual dining. However, it may be a tougher sell for restaurants with a primarily young and transitory workforce. Just like healthcare (which we offer from day one and most of our employees decline), I suspect restaurant industry workers see their jobs as less of a career and more of a stepping stone to bigger and better opportunities and thus may not find value in unionizing.

-Although I believe it would be tough to unionize pizza delivery drivers, we have actually seen sporadic attempts to do so. We believe the Employee Free Choice Act would make it easier to do so, and we strongly oppose it. With a democratic presidency and congress, we are sure to pass it.

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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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