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Germany: Is the bottom in sentiment in?

The German ZEW survey shows investors are becoming less negative on the economy… Since everything that matters in our macro models occurs on the margin, this is important.

The Centre for European Economic Research (ZEW) produces its benchmark sentiment indicator by surveying 300 analysts and institutional investors to capture the sentiment of Germany’s “smart money”. After declining sharply since Q1, the latest index ZEW data suggests that sentiment troughed in October and is turning less negative as the impact of government’s bailout programs start to be felt. The index level released today for November was -53 -up 10 points from last month.

While not a good indicator of the mood of the general population, the ZEW has demonstrated value as a leading indicator over the past decade. We are long German equities via the EWG (etf) and we continue to view Germany as the strongest of the major European economies on a relative basis. We expect that if domestic investor sentiment truly has found a bottom for the near term that many other investors will start to share our view.

Andrew Barber
Director

GS: California Conflict?

Allegedly, a Goldman report advised betting against CA’s credit…

The LA Times reported this morning on a confidential Goldman Sachs research report issued in September that advised institutional investors to hedge exposure to (or establish a short on) California debt. It is no surprise that investors would receive this advice - California has been hit hard by the current financial turmoil and Governor Schwarzenegger has issued numerous dire warnings about a potential budget crisis as the credit markets began freezing up over the summer. What IS surprising, perhaps infuriating, is the source. As an underwriter and advisor, Goldman has received millions in banking fees from California bond issues and it has significant advisory and asset management relationships with pools of public capital throughout the golden state.

This conflict will likely come as a shock to California’s lawmakers who could be forgiven for assuming that, as a reputable investment bank, Goldman’s first loyalty would be to its customers and that it would avoid conflicts of interest by helping one customer profit from another’s misfortune. In this case GS apparently event tried to broker both sides of the transaction –according to the LA Times piece Goldman “regularly urged” California to trade CDS contracts on its own credit itself.

A Goldman “spokesman” was quoted saying the firm was no longer providing that advice without elaborating…

The bankers and traders that built Goldman Sachs over the first half of the last century recognized that the trust of their customers, over the long term, was worth more than any opportunity to extract a quick profit. In those days, of course, GS was still a partnership and the long term interests of the firm and those of its customers were closely aligned.

The fact that the firm’s share price is up almost 3% today on the news that they have alienated the largest municipal borrower in the nation may be an indication that the days of that kind of long term thinking is a thing of the past.

Andrew Barber
Director

Cozying up to TED!

We are going on 6 consecutive weeks of this spread narrowing. This is one of the major reasons why we are deploying our oversized position in US Cash into global equities. See the chart below - this is not that complicated.

When this spread was widening (August to October) we moved to 96% cash. Now it's narrowing, and we have moved to 59% cash. A narrowing TED spread is a measure of counterparty risk – it is not the only factor in our multi-factor global macro model that is signaling to buy stocks, but it is an important one.

Storytelling and narrative fallacies are currently running rampant on the Street. When we look back on this buying opportunity in 3 weeks, this is one of the many macro factors that the revisionist historians will cite. You can 'You Tube' me on that.
KM

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China: Another Positive Data Point

This morning's consumer price inflation report (CPI) out of China came in much better than we or the Street were expecting. At +4% inflation growth for the month of October, the Chinese are seeing inflation rates at almost 1/2 of that seen prior to the Olympics - this is good!

The October report is down from September's deflating reading of 4.6% (see chart). Alongside the $586B stimulus package, fundamental economic "Trends" in China are starting to improve, on the margin.

In our macro models, everything that matters most occurs on the margin.
KM

SBUX – MANAGEMENT CAN PUT ON A GOOD SHOW

I can almost guarantee that Howard Schultz did not want to report a loss this quarter – the press would have skewered him. I know that seems stupid but I can actually see him thinking that way. I know this has nothing to do with an analysis of the SBUX quarter, but what more can be said about this quarter that has not already been said. I continue to think that SBUX is one of the companies that we want to own coming out of the cycle we are in, but trying to pick the bottom of the cycle is proving treacherous.

The case for SBUX is clear; (1) A global brand, selling a habitual product, operating in multiple distribution channels, (2) $1.0+ billion in operating cash flow, and (3) a strong balance sheet.

The case against the company is also clear; (1) consumer demand for premium coffee, (2) excessive growth of the past may have hurt the brand, and (3) a new, extremely powerful competitor.

  • So it has boiled down to trying to pick the bottom and when things will become “less bad” for the company. When things stop getting worse it can get better. Right now it looks like fiscal 2Q09 will be that quarter. When the company was focused on non-stop growth it tried to broaden the appeal of the concept. Today that strategy is costing the company dearly. In a challenged economic environment there are a number of consumers who just cannot afford SBUX anymore. Starbucks, however, is not going away and at some point the company’s traffic declines will stop. The question is what percent of its customer base will go away before this group of core consumers emerges? 3%, 6%, 9% - who knows! I don’t think its 15%!

    As of fiscal 4Q08, U.S. traffic declined 5%. The company commented that this quarter may represent the bottom in that metric. The way the math works that may be true as it relates to the level of customers coming into the store, but the street’s math looks at YOY comparisons and 1Q09 marks the company’s most difficult comparison for the year so the YOY decline could look worse in 1Q09. From the street’s perspective, the company will most likely not see a YOY improvement in traffic trends until fiscal 2Q09.
  • There is no rush to run out and declare a bottom for SBUX. Management is doing what they need to do to address the issues that plague the company. Having said that, I’m sure there is still a lot of fat to cut from the corporate structure so the company can earn $0.70 or better in FY 2009 (flat YOY), despite the level of same-store sales. That should provide support for the stock in the $8-9 range. If we can prove that the company will only lose 5% of its customer base the next 3-6 months should represent the bottom in the stock.

'The Bifurcation Trade' Emerges into ’09

The gaping hole between economic reality and Street earnings estimates is no secret to anyone. What is increasingly news to me is that the gap is beginning to narrow.

Fundamentally, not much has changed over the past three months. Organic sales are under pressure, order cancellations are up, FX benefits are going the other way, pricing power is negative, GM% eroding, and SG&A is heading higher. We’ve been pretty vocal that margin assumptions still need to come down next year by 2-3 points in aggregate. Unfortunately, we’re nowhere close yet as it relates to estimates. That’s the bad news.

But multiples as low as 2-3x EBITDA on certain names in the space (i.e. ANF) account for this to some degree. The kicker is that over the past week, we saw the greatest estimate realignment we’ve seen in this group since the recent downturn began, with EBIT margin estimates coming down a full 45bps. For an entire industry of stocks (there are 60 in our index), that’s pretty meaningful.

This is not the bottom. Far from it. But it gives me greater confidence that ‘The Bifurcation Trade’ in retail will be the big theme for ’09. Some companies will dominate (UA, RL, LULU, ANF and FINL), while others will show their real pale or dying stripes (DKS, GIL, DSW, BWS, GES).

Casey Flavin and Brian McGough

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