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Still short Mexico: The Drug Trade Is Cyclical...

EYE ON MEXICO
A brutal war is being fought within miles of the US border…

Late last month an ice chest was delivered to the police headquarters in Ascension - a Mexican town less than 30 miles from the US border. The chest contained four severed human heads - a message of intimidation from local drug traffickers.

The drug war in Mexico continues to escalate with atrocities that rival those occurring in the conflicts of the Middle East or Africa as revitalized law enforcement agencies are locked in a struggle with trafficking gangs that are entrenched in the economy after decades of corruption and incompetence on the part of previous officials.

In September, Finance Minister Agustin Carstens estimated that the conflict may be costing the nation as much as 1% of GDP growth annually. That estimate may be low; some Mexican academics estimate the total contribution of tourism to GDP at 8%.

With the recent slide of the Peso, Mexico’s fabulous beaches should be teeming with budget conscious tourists this winter. Instead, the violence has caused a chill for tourism has increasingly been commented on by industry observers. The latest warning issued by the US state department on October 18th contained the following message: “Mexican drug cartels are engaged in an increasingly violent fight for control of narcotics trafficking routes along the U.S. - Mexico border in an apparent response to the Government of Mexico’s initiatives to crack down on narco-trafficking organizations. In order to combat violence, the government of Mexico has deployed military troops in various parts of the country. U.S. citizens should cooperate fully with official checkpoints when traveling on Mexican highways”. This type of publicity will not help fill the beaches anytime soon.

Mexico is not alone in the fight. Last week president Calderon announced and intensified strategic partnership with Columbia in the fight against cocaine trafficking. In some ways, Columbia could provide the Mexican government with a blueprint for the way forward. President Uribe has made significant gains in recent years through relentless military action and a close partnership with the US government (under the Uribe administration over 900 drug offenders have been extradited to face trial in the US). Even if the strategy does succeed, the violence will likely get worse before it gets better as the traffickers come under more pressure and fight back harder. The criminals have the equipment to put up a fight - last week the Mexican army seized 314 heavy automatic weapons with a half million rounds of ammunition, 160 hand grenades and a rocket launcher from a single gang cell in Tamaulipas.

Mexico (EWW) is one of the few short positions that we have not covered on weakness this week.

Andrew Barber
Director

Yen putting in another top?

We had a preview of the world's largest carry trade unwinding in March, then the full movie plaid out on a CNBC channel near you in October. Scary stuff… particularly if you were short the Yen...

The November melt up is not unlike that which we have seen in the US$... it's just another reminder that levering up long with a cheap currency has another side to the trade.

October was a worldwide liquidity crisis capitulation. November is the thaw - it's a process, not a point. The Yen putting in a lower high on this latest liquidity rally will be too. We shorted the Yen today via the FXY (etf) in the Hedgeye Portfolio. Goldman was out positive on the other side of us.
KM

Why We Covered Our India (IFN) Short Today...

'You Tubing' ourselves is cool. It allows us to pump our own tires and also feel shame. Using the chart below as a proxy for our successes being short India in 2008 is the kind of You Tubing that we like!

As inflation began to accelerate (on the margin) in November of 2007, we became cautious on Asia, overall. Then, as Asian growth began to slow in Q1 of 2008 and inflation continued to ramp, we got aggressively short.

Today's inflation data out of India (see chart) confirms a new "Trend" (intermediate term) call we are making on Asia. We remain long China, and covering our short position in India. This isn't our religion. It's math.
KM

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Scary Chart For the Revisionist Historians

This was the worst weekly jobless claims report since 2 weeks after September 11, 2001. Is it scary out there? Uh, yeah... how scary versus what the market has priced in remains a better question. The S&P500 has lost -45% of its value.

We are not in the business of managing risk reactively. We are in the business of proactively preparing you for tail risk (like 6-7% unemployment) when we did 6-9 months ago.

This morning's news of 516,000 jobless claims is bad, but the market isn't crashing on it. See the chart below for why the ghosts and goblins of October 2008 are flailing around trading desks creating a narrative fallacy that this wasn't expected.

KM

KSWS: Opening Up Our Internal Debate

Very differing view on KSWS at our morning meeting today. Here are the pros and cons by the broader team…
We just got out of our morning meeting, and had a particularly spirited debate about K Swiss, and Casey Flavin’s posting from earlier. Casey and I took the special dividend as good for shareholders today, but limits the opportunity set to build create value with existing assets and acquire new ones on the cheap (there are many) with its pristine balance sheet. Also, business is not good, the company is entering new product lines with varying working capital requirements, and the time just seems too early for me to comfortably stomach.

On the flip side, our Macro team – Keith McCullough and Daryl Jones took the polar opposite side that this was one of the most capitalist-focused moves this market has seen of late. Dole out a quarter of your cash, and still leave the company with a solid balance sheet and a lot of dry powder to keep optionality high. If the CEO can pay himself and his team along the way, then all the better.

Feel free to email me your 2 cents. I’d love to hear your view. Right or wrong, I never come out of a debate less smart and informed than when I went in.

Casey Flavin
Director

YUM – U.S. Cost Cutting A Must

The Associated Press reported yesterday that YUM will be eliminating several hundred jobs and shifting up to a couple hundred more as a part of its U.S. restructuring plans. Company spokesman Jonathan Blum provided details, saying that several hundred jobs will be eliminated at YUM’s Louisville operations as well as at Taco Bell's headquarters in Irvine, CA, at Pizza Hut's headquarters in Dallas and in field operations nationwide. In addition, an unspecified number of cuts will be achieved by not filling open positions. Also, up to a couple hundred more positions will be shifted from YUM's corporate headquarters in Louisville to the company's brands. "We believe this will enable us to operate more effectively and improve our cost structure," Blum said.

YUM’s U.S. business has been significantly underperforming the company’s China and International segments and in each of the last two quarters posted operating margins that were down in the 200 basis point range YOY. YUM’s U.S. blended same-store sales growth finally turned positive in 2008 after six quarters of declines, but operating margins have not yet reflected this improvement. Management has attributed this profit underperformance to significantly higher commodity costs and continued weakness at its KFC brand, which posted a 4% decline in comparable sales in the most recent quarter. The company continues to maintain that it will be able to turnaround KFC in 2009 and generate profit growth, but this relies largely on the success of its 2Q national launch of Kentucky Grilled Chicken.

Additionally, management outlined on its 3Q08 earnings call an aggressive U.S. cost reduction initiative to help yield improved profitability in 2009. At the same time, YUM is proceeding with its refranchising plans and is still targeting U.S. company ownership of below 10% by the end of 2010, which would also improve U.S. margins. Management has commented, however, that although still on plan, current credit conditions have slowed down the timing of these refranchising transactions. The company expects its cost saving efforts net of the operating profit foregone from refranchising to boost FY09 U.S. operating profits by about $30 million.

Yesterday’s announcement signals that YUM is proceeding with its U.S. cost reduction plans, which is a welcomed sign because the U.S. still accounts for about 40% of the company’s expected 2008 total operating profit. Outside of these expected cost savings, however, a return to U.S. profitability still relies on several questionable factors: improved commodity costs; profitable same-store sales growth (difficult in today’s highly promotional environment); the success of Kentucky Grilled Chicken and a turnaround at KFC; and the credit market’s impact on YUM’s refranchising efforts.

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