The VIX is receding, finally

The VIX is receding, finally

From technical perspective the VIX looks poised to decline. It has already traded at levels today below its 30 day moving average, as well as the 30 and 90 day realized volatility for the S&P 500.

If you read our work regularly, you know that we watch the VIX closely. Since the second week of October, we have viewed the wild gyrations of the “fear index” as the volatility equivalent of a short squeeze, where those very few arbitrageurs left in the options markets with capital have had the heads of the many without it caught in a vise.

The models employed by the designers of the VIX assumed that implied volatility could be extrapolated by backing out the known factors (maturity, difference between the strike and underlying) and a series of assumptions (e.g. cost of funding). The implicit assumption of this methodology is that the option premium reflects the ability of a trader to execute a delta hedge in the underlying market simultaneous to trading the option. Obviously, if a trader cannot execute a hedge due to choppy markets (or say, a short sale ban) or if he has no funding available, he will not be able to manage risk efficiently. If the trader is a market maker, and therefore OBLIGATED to show a price, he will show one with a premium that is either so richly priced he has a high degree of confidence that the premium will offset any loss or it will simply discourage anyone from trading with him (more often the preferred outcome).

As such, it is our opinion that the VIX here is still not really measuring equity investor sentiment, even though it has come down by more than 40 points from its high. Instead the VIX appears to remain more a measure of liquidity in the risk markets, which have been severely disrupted.

The decline of the VIX towards levels which appear more “normal” compared to longer term historical averages is inevitable. As a former colleague of mine recently commented “It would be nearly impossible for realized volatility to persist above 50 forever. At that level everything would hit zero eventually and there would be no more market.”

Andrew Barber

Australian Sobriety: Monetary Policy, The Right Way...

This is easily one of the best Macro charts in the league. The Reserve Bank Of Australia's czar, Glen Stevens, has nailed the global macro call every step of the way.

Look at this chart below. Today, that 75 basis point drop you see in the blue part of the chart was a man with a plan. Stevens not only predicted that commodity inflation would go higher, faster, but he proactively managed his country's reserve rate to that proactive prediction. Now he is one of the sober few who has both a rate a of return to deliver to those in his country who save, and some room to breathe. He’s at 5.25% and “Heli-Ben” is at 1%.

My hat is tipped to you, Sir Stevens - great job!

Eurozone inflation comes down from the peak...

Dare we call this a peak, but we just did…

Eurozone PPI came in better than terrible today. On balance, this is bullish for European Equities (we like Germany the most).

Eurozone PPI figures for September were released this morning, coming in slightly better than expected as dropping commodities prices provide relief for EU purchasing managers. Arriving on the heels of last Friday’s October consumer inflation numbers, which also came in lower, the latest PPI appears to clear the way clear for the ECB rate cut later this week which the market is already factoring in…

With factory gate prices declining alongside the Euro, European industry now has a decent chance to compete for regional demand, particularly in the low labor cost Eastern European and Turkish markets.

Andrew barber & Keith McCullough
Research Edge LLC

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DF –Trends Are Moving in DF’s Favor

The bad news is that there are a handful of issues that continue to overshadow DF’s underlying market opportunities. First, the company has been plagued by commodity cost volatility, particularly as it relates to milk, butterfat, diesel, natural gas and resin costs. In 3Q alone, non-milk costs increased over $13 million from 2Q. Second, Horizon Organic continues to put pressure on WhiteWave-Morningstar segment profitability as industry oversupply has led to declining retail prices at the same time raw organic milk prices have climbed significantly. Third, recessionary headwinds combined with historically high commodity prices have put increased stress on the fluid milk industry, which is driving market price volatility. Fourth, DF is a highly leveraged company at a time when investors are frightened by illiquidity.
  • The good news is that most of these issues are abating and even turning favorable. As it relates to DF’s key commodity inputs, costs have already started to come down. In 3Q, milk prices were down 12% YOY but still up 7% sequentially from 2Q. For fourth quarter-to-date, milk prices have declined 24% YOY. The company’s diesel, natural gas and resin costs also all declined sequentially in October from 3Q levels. Higher butter prices (up 13% in the quarter) contributed to the 4% profit decline at the WhiteWave-Morningstar segment. DF utilizes a pass-through pricing mechanism as butter prices change on a monthly basis, but if prices increase rapidly it can create a pricing lag effect so the company was unable to keep pace with the significant increases in butter prices. Management sees these prices stabilizing in November and December and rolling over so Morningstar’s profitability should benefit from lower costs. As management stated, “We're finally catching up with a trend that's coming to an end. So, classic Class 2 butter fat pricing dynamic. Right? Typically, you don't see a march up of 10 consecutive months like we've had this year, but the trend is ending and we've been pricing against the trend and doing our best to anticipate the trend. So we believe that you'll see Morningstar move back into a more profitable posture as the trend ends.” Although management expects its key input costs to be favorable on a YOY basis, they stressed that their current FY09 EPS guidance of approximately $1.40 is based on conservative commodity cost assumptions due the recent volatility experienced.
  • In addition to higher butter costs, Horizon Organic also negatively impacted WhiteWave-Morningstar profitability in 3Q as industry organic milk retail prices have not kept pace with rising raw organic milk costs. In 3Q, Horizon Organic’s retail pricing increased 11.8% YOY on top of the 4.9% increase in 2Q (follows 4 quarters of pricing declines). DF also saw private label prices increase during the quarter but by about half of the magnitude taken by the branded players. On a positive note, management sees industry supply growth slowing significantly over the next 6 months which should boost prices over time, but they have not planned for any meaningful rebound from Horizon Organic in FY09. Like the company’s other commodity inputs, management does expect raw organic milk costs to begin to rollover as feed costs abate which should benefit Horizon Organic’s profitability despite the less than favorable retail pricing environment. Despite the challenges at Horizon Organic, the company expects stronger results for WhiteWave-Morningstar going forward, beginning with a return to profitability in the fourth quarter.
  • As it relates to the competitive fluid milk environment, DF continues to gain volume share (up 3.2% in the quarter relative to the industry’s 1.3% increase). This 3.2% volume increase (200 bps from acquisitions) compares to its competitors’ estimated 0.2% volume growth in 3Q. DF is seeing increased competitive pricing as the industry pushes to sell increased volumes in today’s recessionary environment. In the short-term, this increases management’s lack of visibility and cautious stance. Management indicated that based on current retail pricing combined with current commodity cost pressures that many of its competitors are struggling and are not earning their cost of capital. This type of environment over time can lead to two outcomes (or a mix there of): some of these competitors will go away and/or the industry will have to return its focus to building margins by increasing prices. Both of these outcomes will work to DF’s favor. Struggling competitors will provide DF with the opportunity to grow its market share and a returned focus to industry profitability will also boost DF’s profitability.
  • Although DF’s financial leverage is concerning, relative to other conference calls I have listened to recently, the Q&A session was not bombarded by questions regarding DF’s current debt to EBITDA levels and covenants, which leads me to believe that investors are not extremely concerned. The company has generated $75-$100 million in free cash flow in each of its last 3 quarters and expects to achieve $75 million plus in 4Q, which management believes will allow DF to close out the year at a debt to EBITDA ratio of below 5.25x relative to its covenant of 5.75x. By the end of 2009, the company expects this number to fall to 4.5x (relative to its covenant step-down to 5x). Management stated that it is comfortable that it will remain half a turn ahead of its covenant step-down.

Headline Of The Day: "The New Reality" bites!

Our friends at Street Account hit us with this today, "JPMorgan Chase has closed its proprietary trading desk" -- Financial News ...

This is great news for the US financial industry. The compromised, conflicted, and constrained "Berlin Walls" of "Investment Banking Inc." continue to fall, one by one.

Running a prop desk on the other side of your client businesses just won't make sense to anyone with a pulse and a ‘You Tube’. The transparency and accountability pants are going to finally be worn in this business. Today, is another great day for the “New Reality” of American Capitalism.



India’s markets rally but the data remains overwhelmingly negative

Stocks rallied in India today for the fifth consecutive session, fueled by the central bank’s surprise rate cut and reserve requirement reduction, with financials in particular rebounding from earlier lows. Comments from the minister of finance indicated that the Reserve may open 100 billion INR credit lines to both National Housing Bank and Small Industries Development Bank to increase flows for mortgages and small companies -adding to bullish public sentiment. Meanwhile the rupee was up on heavy US Dollar selling by banks.

We expect this relief buying to lose steam as rapidly as it arrived when domestic Indian investors (who are largely funding this rally, despite some media reports that foreign buyers have started to dip their toe in the water again) shift their attention from inflation to dimming growth prospects.

Trade data for September, released yesterday, is hardly encouraging. Export numbers reached their lowest growth Rate since November 2005 while trade deficit figures, despite coming in better than 3 out of 4 prior months due to declining commodity prices, still represents a 133.37% increase over the same month last year.

The current administration’s public stance is that, although a slowdown is now a foregone conclusion, GDP growth should maintain above 7% annually –enough to sustain job growth. This is wishful thinking. In a nation attempting to balance socialism with a stratified society where 25% of the total population subsists below the poverty line, job growth is critical for any party wishing to maintain power. This leaves Singh & co. little choice but to keep promoting a rosy picture before next year’s election.

One part of the government’s narrative -that the diversification of India’s export markets towards greater trade with OPEC nations and emerging Asia will insulate GDP growth from the slowdown in the EU and US, while at the same time heralding cheaper commodity prices as an inflation fix, sounds like suspiciously circular logic.

We continue to take a negative view on India’s short-term and intermediate-term prospects as the combination of a cooling global economy with short-sighted government policies stand to continue weighing heavily on the “I” in “BRIC”.

Andrew Barber

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