"I'm not going to waste my time arguing with a man who's lining up to be a hot lunch."
-Hooper to Quint in Jaws (1975)
When I study real Bear markets, the Baby Bear that I first taught myself to trade in from 2000 to 2003, just doesn't measure up. The Bear of the early 1970's, however, was the real horror film thriller. She gave birth to all sorts of nasty stuff - like sharks.
Steven Spielberg capitalized on the horrors associated with an American nerve system wired to sky rocketing inflation, and released Jaws in 1975. The movie was based on a book by Peter Benchley, but the societal impact was transcending - fear what you can't see - and the movie absolutely nailed that all so elusive Holy Grail of relevance - timing.
We have coined a term here at Research Edge called "The Shark Line". Quite simply, that's the marked-to-market line in a stock, ETF, etc. that market participants should have a heightened sense of risk management around. What you can't see coming up from underneath the waters of consensus negativity can really bite.
Yesterday, after the SP500 broke out through its Shark Line of 762, I put up a real-time note to our Macro clients alerting them of Jaws - as Quint would say, "this shark, swallow you whole"...
The ONLY times that I will buy or cover a security that is UP on the day are when A) we cross the Shark Line or B) one of my analysts gives me an incremental piece of Research Edge. Boiled down to its bare bones, those two factors get priority focus in my real-time risk management process.
After the SP500 broke out through 762, the chase out of the water was on. This market doesn't trade on valuation right now. It trades on price momentum. What they call the "benchmark huggers" in the mutual fund community know this better than most. After we crossed the Shark Line, one of our more prolific mutual fund Portfolio Manager clients sent me the following note:
"Long-only investors, and particularly long only benchmark huggers whom we compete with start to panic when the market moves. So many of these funds are holding record cash levels, and even if you are at a modest 5-10% cash position, an index move can really hurt your performance. Consultants/pension funds may be a little more tolerant on the way down, but if a manger subsequently underperforms his/her index on the way up, the pressure can be excruciating. This is different for total return/absolute-return oriented managers (you, I believe belong to this category), as good total return managers do not panic as much because they have the advantage of pure beta. Relative to an index, this is mitigated. As such, benchmark huggers do panic because they hide behind index returns on the way down, but cannot hide if they are underperforming on the way up."
When this mother load of "cash on the sidelines" in the mutual fund community is married up with a bunch of underperforming "hedgies" who have no idea how to manage short exposure on the way up, what you end up with is exactly what you saw out there yesterday - bloody waters - and as Hooper explained "the height and weight of the victims can only be estimated from the partial remains"...
In the hedge fund community, I have worked with people who call this a "corn cobbing", "getting your face ripped off", and sometimes plain old "getting squeezed." It's all the same, and it can be painful, particularly if you haven't proactively prepared for it. You see, most people in this market still think that market crashes only happen on the way down - that's not how I think about it. To me, a crash is what happens on the opposite side of consensus expectations, on the order of a 12-18% move.
One week ago, I'd written that I had covered ALL of my short positions other than the US Dollar (UUP), Short Term Treasuries (SHY), and Corporate Bonds (LQD). I also noted that I have NEVER done that before in my career. While many people called that being a lot of things - now I can simply look back at the scoreboard and call that being right. NOT being eaten by a Shark that you have been studying every morning seems like a reasonable expectation you should have for a risk manager.
There are a lot o ways to look at yesterday's SP500 closing price of 778. It was a healthy +2% above the Shark Line, which incidentally was immediate term TRADE resistance (3 weeks or less). Now that resistance becomes support. It was +15.1% trough-to-peak from the manic media sponsored Great Depression low made on March 9, 2009 (I wrote a note then titled "The Great Recession: Why I'm Not Depressed...). And 778 SP500 was also +12% higher from where that silly community organizing wanna be USS Navy Captain, Barack Obama, suggested that the market looked "like a bargain."
So where to from here? Well, looking back at where Jaws came from is always crystal clear. As Captain Quint said "cage goes in the water, you go in the water. Shark's in the water"... and now we have to deal with the prices that remain.
I have immediate term TRADE resistance up at the 795 line. This puts us in a balanced position of risk versus reward (upside/downside is +/- 2%). I was first given the shark hunting gun at hedge fund in the year 2000. In that Baby Bear market of 2000-2003 the average trough-to-peak squeeze rally in stocks was just north of +17%. If we see that 795 print, that will have been a +17.6% move, trough-to-peak. I have seen this scary movie before.
My Partner, Howard Penney illustrates a TREND line breakout in Technology in his US Sector View report this morning. While there are now 6 out of 9 SP500 Sectors in positive TRADE territory, breaking out on a TREND basis is much more relevant/sustainable price action. Intermediate term TREND (3 months or more) resistance for the SP500 is up at the 830 line.
This time around, if you so choose to get back in these waters, my advice would be to keep your head on a swivel... trading and treading around the Shark Lines very carefully...
Best of luck out there today,
EWZ - iShares Brazil- The Bovespa is up 5.2% YTD. President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil cut its benchmark interest rate 150bps to 11.25% on 3/11 and will likely cut again next month to spur growth. Brazil is a major producer of commodities. We believe the country's profile matches up well with our reflation theme: as the USD breaks down global equities and commodity prices will inflate.
EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months. With interest rates at 3.25% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.
USO - Oil Fund- We bought oil on Friday (3/6) with the US dollar breaking down and the S&P500 rallying to the upside. With declining contango in the futures curve and evidence that OPEC cuts are beginning to work, we believe the oil trade may have fundamental legs from this level.
CAF - Morgan Stanley China fund - The Shanghai Stock Exchange is up +22.1% for 2009 to-date. We're long China as a growth story, especially relative to other large economies. We believe the country's domestic appetite for raw materials will continue throughout 2009 as the country re-flates. From the initial stimulus package to cutting taxes, the Chinese have shown leadership and a proactive response to the credit crisis.
GLD - SPDR Gold- We bought gold on a down day. We believe gold will re-find its bullish trend.
TIP - iShares TIPS- The U.S. government will have to continue to sell Treasuries at record levels to fund domestic stimulus programs. The Chinese will continue to be the largest buyer of U.S. Treasuries, albeit at a price. The implication being that terms will have to be more compelling for foreign funders of U.S. debt, which is why long term rates are trending upwards. This is negative for both Treasuries and corporate bonds.
DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.
EWJ - iShares Japan - Into the strength associated with the recent market squeeze, we re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".
EWU - iShares UK -The UK economy is in its deepest recession since WWII. We're bearish on the country because of a number of macro factors. From a monetary standpoint we believe the Central Bank has done "too little too late" to manage the interest rate and now it is running out of room to cut. The benchmark currently stands at 0.50% after a 50bps reduction on 3/5. While the Central Bank is printing money and buying government Treasuries to help capitalize its increasingly nationalized banks, the country has a considerable ways to go in the face of severe deflation. Unemployment is on the rise, housing prices continue to fall, and the trade deficit continues to steepen month-over-month, which will hurt the export-dependent economy.
XLI - SPDR Industrials - This group underperformed yesterday and remains broken on a TREND and TRADE duration. From a fundamental perspective, industrials are typically later cycle stocks and so should continue to underperform their early cycle counterparts.
DIA -Diamonds Trust-We re-shorted the DJIA on Friday (3/13) on an up move as we believe on a Trade basis, the risk / reward for the market favors the downside.
EWW - iShares Mexico- We're short Mexico due in part to the country's dependence on export revenues from one monopolistic oil company, PEMEX. Mexican oil exports contribute significantly to the country's total export revenue and PEMEX pays a sizable percentage of taxes and royalties to the federal government's budget. This relationship is unstable due to the volatility of oil prices, the inability of PEMEX to pay down its debt, and the fact that PEMEX's crude oil production has been in decline since 2004 and is down 10% YTD. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.
IFN -The India Fund- We have had a consistently negative bias on Indian equities since we launched the firm early last year. We believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit. Trade data for February paints a grim picture with exports declining by 15.87% Y/Y and imports sliding by 18.22%.
XLP -SPDR Consumer Staples- It underperformed the market again yesterday. We're positive on consumer staples for a TRADE, and negative on a TREND basis.
SHY -iShares 1-3 Year Treasury Bonds- On 2/26 we witnessed 2-Year Treasuries climb 10 bps to 1.09%. Anywhere north of +0.97% moves the bonds that trade on those yields into a negative intermediate "Trend." If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.
UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is up versus the USD at $1.3030. The USD is up versus the Yen at 98.6740 and up versus the Pound at $1.3906 as of 6am today
"I'm not going to waste my time arguing with a man who's lining up to be a hot lunch."
As a reminder, I think we are headed towards a perfect storm of positive fundamental inflection points. The real consumption delta turns positive, COGS declining while gross margin compares get easy, absolute SG&A cuts take discretionary spending down by 2-300bp, capex growth in retail goes from 10%+ down to -5% -- ALL AT THE SAME TIME! Talk about FCF pop…
What I’m interested to see is that there is one of these line items that people really don’t want to believe. You cannot argue with capex cuts or SG&A reduction. That’s simply because a bunch of CFOs stood up and proclaimed such as gospel (one of the few things in the model they can control). Initially, my assumptions on real consumption were the initial target – but once I walk people through the fact that it is the DELTA in real consumption that drives this model, I get less pushback there (i.e., for the delta to get worse, we’ll need to revisit the Great Depression.) Keith has been referring to our current situation as ‘The Great Recession’ and we are collectively firm in our view that we won’t revisit the doomsday scenario of the 20s and 30s.
The really big pushback has been on the Gross Margin line. We are 2 quarters into the biggest gross margin hit that this industry will have seen in history. Margins have been down 150bp, and are now looking at about -250bp. I am assuming that we hold this rate and then that the 2-year trend stays flat-out ugly into 2010. But to get there, it suggests that the 1-year trend turn up meaningfully in 2H. Let’s take off the simplistic ‘extend the trend’ modeling pants for a minute (that we never wear in the first place) and look at some real numbers and trends.
1) Anybody watching cotton prices? Check out my 3/15 post. It’s dropped like a stone back down to $0.50. Is this a huge component of the P&L? No. But even at 5% of COGS, it matters when it is down 40%. Anybody know what happens when absolute COGS dollars on a like-for-like item declines by 2%? Yes, more money is freed up in the supply chain.
2) Anybody watching China? The narrative here is so powerful. China accounts for 87% of US footwear consumption, and 30% of apparel (and growing). Let’s think about last year for a minute…
a. 2008 started out with the biggest snowstorm in China in 100 years. It completely shut down the Eastern provinces and the logistical infrastructure of the country was put to (and failed) the stress test. Factories were boxed into a corner.
b. The tragic earthquake in the spring was a double whammy. Not only did this test the infrastructure once again, but the ‘human factor’ prompted migrant workers – that account for about a third of production in the Pearl River Delta factories – to simply not show up. Migrant workers that don’t migrate? Yes, that’s a problem.
c. A third important point is that in advance of the Olympics, the Chinese government cracked down on sweat shops, and started to mandate that factories pay employees back-pay for unused vacation time. You know how Americans take 2-3 weeks of vacation per year at best? And how the Brits will commonly ‘go on Holiday’ for a 5-week clip at a time? Trust me; compared to the under-vacationed US workforce, the Chinese factory-worker culture makes us look like Americans are on permanent vacation.
d. What does all this mean? Natural disasters stressed output and tightened prices for exports in aggregate. Then the government decided to wipe out the ‘sweat shop’ factor to appease human rights activists. You might say ‘the Chinese don’t ‘appease’ anybody.’ Well, in the months alongside the Olympics – otherwise known as China’s coming out party – I’m willing to bet that China reigned in its pride and cleaned itself up a bit.
e. Oh yeah…did I mention that export taxes went up at a steady clip since 2006 as China changed its tax system to encourage local consumption over export? So we’re looking at a teens rate of import taxes…that has been recently reduced to zero. Yes, a donut.
f. Bottom line? China went through a 2-year capacity tightening phase, which pressured pricing in this industry. Using footwear as an example, there were 12,000 factories in the Pearl River Delta 2-years ago. Now there are about 6,000. That number stopped going down. Will it go up? I’m not sure. That will depend on demand. But price pressure out of China is easing on the margin, and arguably in absolute terms.
Our models are heavily dependent on rate of change. Just about any way I slice this onion, that gets better in 2H.
Our initial view was that since the extension was only for 2 months, it probably means that MGM is either: 1) close to some transaction, financing, etc (good) or 2) the banks are throwing MGM a short lifeline but really just postponing the inevitable foreclosure (very bad). After discussion with people very versed in bankruptcies and reorganizations, we believe #1 is possible but #2 is unlikely. This is probably not as binary a situation as it may appear.
Our main takeaway here is that MGM and the banks are in pretty much the same situation as before their amendment agreement. The banks do not want to foreclose and MGM needs to make progress on a long-term solution to its liquidity issues. We don’t think May 19th is a drop dead date. It’s a reevaluation date.
So what are MGM’s options? Pretty much the same as before. Importantly, MGM did not collateralize any of its assets, so that improves their position to get outside financing. Any solution will certainly involve asset sales. More amendments, sale leasebacks, an equity infusion, and debt swaps (higher rate for longer maturity) could all be part of the mix.
We’re disappointed that the company didn’t announce a more concrete solution. The duration of any definitive outcome is likely to be much longer than the amendment would indicate. We are pretty confident in that. MGM will continue to trade as an option with huge volatility. MGM promises to be very communicative with the Street, unlike the last few weeks. With the number of potential data points over the next several weeks/months, MGM could be an attractive trading vehicle, particularly given what is likely to be an active day for the stock today.
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The first chart details our industry wide projections for slots sales into new casinos and expansions and the year over year change. From the data, it’s pretty difficult to walk away with the conclusion that WMS has a lot of near or intermediate term growth, even if they resume market share gains. The numbers are pulled from our database of every new casino and expansion opening in North America over the next 2 years. The September quarter of 2009 is the only quarter through the end of 2010 where there is a positive delta in domestic slots to new/expanded casinos.
The second chart provides the projected growth by the Street. Currently, the consensus EPS estimates for 2H F2009 and full year F2010 are $0.81 and $1.63, respectively, representing growth of 19% and 14%. Meanwhile, we project total domestic slot unit declines for the industry of 44% and 22%, respectively, over the same period. That’s with a 25% increase in projected replacement demand! As can be seen in the first chart, slot unit sales to new casinos and expansions will be down even more. WMS would need to grow its market share by 10 percentage points to 32% to hit the Street’s domestic unit sales estimate of 19,000 slots in F2010, based on our industry assumptions.
Clearly, there is a big disconnect between the two charts. Market share gains and replacement demand won’t be enough to bridge the gap.
Does Bernie Madoff sit on the BOJ’s board?
Today was day 1 of the BOJ policy board meeting and the top issue on the agenda has been what to do to help prop up Japanese banks, which are straining under the weight of their collapsing stock portfolios in a vicious cycle that sends equities lower, in turn.
The banking sector rejected the opportunity to sell preferred stock to the government last December for fear that the stigma would cause a loss of confidence among shareholders and overtures by the central bank last month to purchase concentrated cross-holdings directly from the banks in off market transactions were rebuffed by CEO’s unwilling to publicly book losses (Japanese accounting practices are more opaque than those in the US).
After attempting to lead a horse to water but failing to make it drink on multiple occasions, the BOJ is now trying a new approach. A new program is being discussed which will provide up to $10 billion in subordinated loans to banks whose capital ratios have been decimated by declines in their equity investments.
The hope is that this measure will help maintain capital ratios to prevent spiraling liquidations in the stock market, but the modest size suggests that this is a “band aid” and the impact on domestic credit liquidity could be minimal. The bank is also expected to announce treasury buying to combat rising yield. As of this morning, the Nikkei had rallied 12.67% for the week into high expectations for these and other programs.
By our reckoning there may be good news here for the markets in the short term but not for the actual economy. Extending margin loans to levered banks to prevent them from being forced to sell stocks while buying debt to keep yields low strikes us as just delaying the inevitable. After decades of stagnation Japanese financials are living on borrowed time.
Into the strength associated with the recent market squeeze, we re-shorted the Japanese equity market rally via the ETF EWJ today. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. We will leg into our virtual short position at higher levels if the rally continues. Everything has a time and a price.
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