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The New Off-Price Retail Paradigm?

Ever have one of those situations where your logic, gut, and calculator all tell you different things? I’ve got that with TJX and off-price retailers. I think that’s the next shoe to drop in ’09.

I’ve been struggling with the analysis below for the past hour. The first chart shows the spread between the cash cycle for the apparel brands vs. the off-price retailers. As the brands profess to have found religion on inventory management, the cash conversion tightened between them and the off price retailers. Makes since due to meaningfully less inventory built up in the system. Then the second chart shows that there is a 0.57x relationship between changes in this cycle and EBIT margins for off-price retailers such as TJX and Ross Stores. The simple conclusion? That cash spreads have inflected, and as they build it is a positive for the off-price retail channel.

I don’t buy this.

I’m absolutely not being contrarian for argument’s sake. But I simply don’t think that the past seven years are an appropriate gauge of the relationship between off price retail and the rest of the supply chain. The past seven years were golden. Even the worst of the worst could make money. Strong consumer spending, $4bn+ in annual sourcing dollars injected into the industry, FX tailwind, etc… The number of apparel/footwear retail bankruptcies was less over the past seven-year period than at any other time in history. But this is a New Reality. The bankruptcy rate has started to tick up – and will do so much more meaningfully in 2009. Fans of TJX will tell me that this means better inventory for TJX. I say that this means that a new off-price retail channel will be created where one previously did not exist as legacy stores go bust. The magnitude of excess inventory will be too much for the existing off-price channel to bear.

With this channel currently running near peak margins (see Exhibit 2), there’s not a whole lot of room for error.

Keep Your Eye On the Cash Cycle

The direct transfer of cash from footwear brands to manufacturers in Asia is unmistakable. But why should it stop here?

My team and I geeked-out this weekend in analyzing balance sheet trends between different segments of the apparel and footwear supply chains. One trend that jumped right out at me was in the footwear space, and the direct transfer of value from the US to Asia. Over the past seven quarters, the cash cycle for the footwear brands went up by 30 days, or 25%, to 143 days. Over the same period, the Asian Manufacturers saw a 20% improvement in its cash cycle to 117 days.

Another notable trend on the chart below is that as the Brands became increasingly stressed from a cash standpoint, they passed it through to the retailers – or at least attempted to. There was never a quarter in the past seven where both the brands and the retailers improved their respective cash cycles simultaneously.

Given capacity closure in Asia – especially China – I remain convinced that the pendulum will swing further into the hands of the sourcing side of the equation. Will the cash cycle continue to erode for the brands? Yes, it should. .If not, then there is an equally unappealing option – paying higher prices for COGS (otherwise known as FOB). A worst case would be higher FOB and less favorable cash terms. We have not seen that yet, but there’s no reason why it can’t happen.

Eye On Regulation

This is a commentary on recent regulatory developments from our Director of Compliance, Moshe Silver, an industry expert who has held senior positions at major asset management and brokerage firms and brings a wealth of experience and insight to our team. Moshe has agreed to share his thoughts with our audience in a regular weekly report.

We believe in a collaborative network of thought. We believe that everyone that works in the industry can benefit from his insights.

Keith McCullough & Andrew Barber
Research Edge LLC
Regulatory tidbits for the week ending Friday 14 November 2008

Last weekend’s Wall Street Journal featured a story (page B4) headlined “SEC Won’t Discipline Its Enforcement Chief”, which puts to bed the flap over allegations of misconduct by Linda Chatman Thomsen, head of the SEC’s Division of Enforcement. The problem is, the bed appears to have been short-sheeted.

The short version is: (Paragraph 3 of the Journal’s story) – “One report by the [SEC office of the] inspector general found Ms. Thomsen had improperly released information about an insider-trading investigation involving hedge fund Pequot Capital Management and John Mack, a well-known Wall Street executive. The inspector general concluded Ms. Thomsen improperly relayed information when she told lawyer Mary Jo White, who was working for Morgan Stanley’s board and vetting Mr. Mack as a potential chief executive, that there was smoke but not fire in the investigation.”

The Financial Times on-line edition – FT.com – writing on Sunday 8 November, reports that SEC chief administrative law judge Brenda Murray ruled last Friday that Ms. Thomsen did not deserve to be disciplined for her actions. In a revealing paragraph, the story says that Judge Murray found Enforcement Chief Thomsen’s actions to be exempt under the SEC’s code of conduct, because her remarks to attorney White were in the context of activity, in which Ms. Thomsen was discharging “other official responsibilities.” Just what were those “other official responsibilities”? Again, according to the FT.com story, Judge Murray found that, in view of the important position in the financial markets occupied by Morgan Stanley, Ms. Thomsen was properly discharging her responsibilities by providing the information.

Ms. Thomsen had been accused of improper conduct relating to her role in the 2001 investigation of a windfall $18.9 million profit at a firm whose CEO was a business partner of John Mack, and the subsequent termination of the SEC staff attorney who sought to subpoena Mr. Mack in connection with the transaction.

The New York Times reports, on 10 November, that a Senate investigation agreed with the 191-page report issued by the SEC’s Inspector General H. David Kotz, who found “serious questions about the impartiality and fairness” of the Pequot investigation, and recommended that the Commission consider disciplinary action against Linda Thomsen, as well as against Mr. Aguirre’s direct supervisor, Robert Hanson, and assistant director of enforcement Mark Kreitman. For the record, we note that Judge Murray’s findings exonerated both Ms. Thomsen and Mr. Hanson, but that no determination has yet been reached regarding Mr. Kreitman. This sounds like someone may be retaining a spare goat, just in case a sacrifice is called for.

It is interesting to note that the SEC’s own legal process finds that it is appropriate for the Enforcement Chief to be tipping off the private sector as to the status of an ongoing investigation. Mind you, we make no value judgment on this determination. It has long been a commonplace of the US economic system that “Free Markets”, in AmeriSpeak, really means “Regulated Markets,” and more often than not, “Manipulated Markets”. And who better to manipulate a market than that market’s own regulatory authority?

Of course, now the vultures are coming home to roost. Morgan Stanley, headed by Mr. Mack, is the recipient of a Federal banking charter, and a large dose of taxpayer largesse with which to stuff its internal ATM (“Avarice Titillation Machine”). This means that Mr. Mack, who is so above reproach that he doesn’t even need to be investigated, now gets to go back to the tables where he can continue to pay himself handsomely for continuing to place losing bets on black, this time both paying his own compensation and placing his wagers with my money and yours.

Let us not be needlessly ironic. If the Feds believe there are entities in the market that are so important that the “official” position of the law enforcement agencies should be to shield them – if the Feds believe the Morgans and Goldmans and Bears of the world are too important to the global financial system to be permitted to fail – then this is a truly appropriate use of taxpayer dollars. We should rally in our thousands to show our support for the embattled Messrs Mack and Blankfein, Kohlberg and Schwartzman. God bless America, and God bless our Chief of the SEC Division of Enforcement!
In other news…

The SEC and the CFTC are engaged in a high-stakes turf war over who will get to regulate the market in Credit Default Swaps (CDS). Why would anyone in their right mind want to be put in charge of toxic waste cleanup? Two possible answers spring to mind.

First, whoever steps in now can only be a hero. Like the closer who is called to the mound for the ninth inning with his team down by two runs: all he has to do is hold the other team. He cannot lose the game officially; and if his team scores, he will be the winner of record. Here, no regulator can possibly do a worse job of regulating the now-unregulated marketplace. Anything at all will be seen as major progress, and the turmoil in the rest of the world will probably ensure that the mere fact of putting someone visibly in charge will mean that this vast market will drop its Red Alert status in favor of the next emergency du jour.

Oh, and second… Chairman Cox, in his testimony before Congress last month mentioned that this is a $58 trillion notional market. According to a report in NSCP Currents (January/February 2008) SEC civil fines and disgorgements are actually down year-over-year, from $3.3 billion in fiscal 2006, to a paltry $1.6 billion in 2007 – a 52% decline. The article goes on to observe that recent years have seen an increase in the number of small fines, and a “dramatic decline in the number of large sanctions”. We are sure that tackling the CDS market will give its new regulator ample opportunity to shake a tree or two, where even the low-hanging fruit is going to be very juicy indeed. Which agency is going to get first crack at this new honey pot? We surmise that the size of the kitty itself may be sufficient to force the merger of these two agencies into a single Uber-regulator. Stay tuned.
In other news…

We were impressed by the position of Acting (and outgoing) CFTC Chair Walter Lukken. Speaking on 11 November at the FIA Futures and Options Expo in Chicago, Mr. Lukken made the unusual observation that rules-based regulation doesn’t work and called for the creation of a new regulatory system to stand firmly on three legs: a Systemic Risk Regulator, a Market Integrity Regulator, and an Investor Protection Regulator. Bit by bit, we seem to be getting the notion that principles-based regulation makes sense.

There was an old saying in the brokerage business: a lawyer is someone you go to after you break the law; a compliance officer is someone you go to before you break the law. Meaning that the job of the compliance officer is to tell you how to break the rules without getting caught. How many times in the course of my career have I been told in all seriousness – by the owners and senior executives of firms, by the top producing traders and salesmen at firms – indeed, by the outside counsel of firms –we want to operate in the Grey Area.

Rules are signposts. Like trees on a ski slope, you don’t want to crash into them. But as long as you can steer around them, there is nothing to prevent you from tearing down the trail. In the financial services industry (an odd appellation – who gets “served”? not the investors!) is to use the rules as an early-warning system which enables participants to channel their unrestrained greed into areas where regulators have not yet figured out how the money is made. As rules proliferate, the clever players migrate to uncharted waters. In mathematical terms, they move out of the fat part of the distribution and into the statistically-insignificant tails. Rules are by their nature conservative, and rule-makers tend to be backward-looking. Rules are always made to prevent yesterday’s violations and yesterday’s disasters. Thus, as new rules fill up the already highly populated center of the bell curve, the creative professionals move farther out along the tails. Where more money is to be made, at the cost of more risk to the system. And, the more risks that get regulated away as they come to light, the more extreme are the new risks that the whiz kids and Masters of the Universe create. As we point out in every macro call: everything important in our world happens at the margins. At the margin of financial markets regulation lies an abyss of risk. On ancient European maps of the world, the unexplored regions were represented by the legend “Here be dragons.” Did you not get what is wrong with this system? Do you get it now?

Thanks to Acting Chairman Lukken for spelling out a sensible approach to a regulatory structure. Mr. Lukken leaves out the sticky bit about implementation. There is so much embedded bureaucracy, so many careers that have been built on the rules-based hierarchy, that Mr. Lukken’s recommendation turns out to be a generational change. In order to make anything like this work, lots of people in government will have to be fired.

Sounds like a good idea to us.

Moshe Silver
Director of Compliance
Research Edge LLC

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Eye On Volatility: What's Your Duration?

The VIX’ trajectory may have turned, but volatility is still sky high…

As we commented on Nov. 4th, equity volatility appears to be showing signals that it is finally receding. Although it’s still too early to call, we have some data points to support this thesis:

• Despite several sharp intra-day spikes that brought it close, The VIX has still not clawed its way back to close over 67 since October 28th.
• Since October 27th the VIX has closed below the realized 30 day volatility of the S&P 500 in every session. Remember that the VIX measures volatility implied by front month options, as such it indicates anticipated near term volatility.
• VIX futures maturing in December and January hover still lower -near the 50 day moving average, indicating the boys in Chicago expect that equity volatility will start coming back closer to historical norms over the coming months.
• Keith tracks the VIX in the same manner as he tracks cash indices and his models suggest that it runs out of bullish “Trade” momentum around the 70.94 level
Even if implied volatility levels are starting to decline however, they are still at historical high levels and provide both significant risks and opportunities.

Traders on the opposite tails of the investment spectrum (arbitrageurs and market-timing thrill seekers) will be looking to play this anticipated mean reversion in their own way. Those guys know what they are doing (or think they do), so I won’t waste any time on what strategies they may implement.

What I do want to underscore however, is that there are some very attractive opportunities for long/short and long only equity investors with mid and longer-term durations to capture value from the inflated premiums in the options markets right now. For the most part, these strategies will tend to fall into one of 2 categories: collecting premiums by selling expensive near term options in-line with a fundamental view on the underlying equity, or capturing longer-term directional exposure “cheaply” by exploiting steep implied volatility curves.

If any subscribers are interested, I would be happy to address specific strategies in the context of your portfolio. You can reach me at

Andrew Barber

Quote Of The Week: George W. Bush

"The record is unmistakable: If you seek economic growth, if you seek opportunity, if you seek social justice and human dignity, the free market system is the way to go. And it would be a terrible mistake to allow a few months of crisis to undermine 60 years of success."
-George W. Bush

With ole Bushy heading out the door, it's nice to see that he can get his words “unstuck” from time to time. This quote was from his speech at the Manhattan Institute earlier this week. I doubt he wrote it ... but it made me think of "The New Reality", nevertheless.

For any capitalist, it’s very hard not to appreciate the first part of the quote. If you genuinely want to be the change that you see needed in this world, you’re going to need the economic freedoms associated with a free market system. However, I would not mistake this “want” as one that Republicans alone can reserve as a special part of their “fiscally conservative” club membership. This is not the exclusive “want” of centrist Democrat capitalists either. This has always been the “want” of American Capitalists.

I have a problem with the assumptions imbedded in the second part of the quote. There is a gross duration mismatch here between rhetoric and reality. Unfortunately, this is going to be the hallmark of the Bush Administration’s failed management process. From the outset, they have managed the US Financial system reactively rather than proactively. Paulson and Co. are reacting to “a few months” of crisis, rather than having proactively prepared for it.

By my math, 60 years ago was 1948. You see, I take the President of the United States words quite literally… and there were a lot of American Capitalist battles won/lost in between then and now that laid the foundation for what we realists call “economic cycles.” Not all of these cycles have been good in the last 60 years. Not all of them bad. “The record is unmistakable.”

Hank Paulson’s last capitalist title was CEO of Goldman Sachs. While it would be hard to believe that the inspiration of his move to head the US Treasury was so he would not have to pay taxes (selling over $500M in GS stock, tax free), it would be even harder to believe that he left GS fully understanding the monster he helped create. Most of the financial leverage in our economic system was born out of the broker dealer SEC rules changing in 2004 (Bush de-regulation) which allowed firms like Goldman and Lehman to lever their brains out. Hank “The Market Tank” Paulson was one of the architects of this economic disaster.

The structural foundations of this “crisis” didn’t come out of nowhere a “few months ago”. It was only 28 months ago, in fact, that Bush signed off on Paulson’s Captaincy. As another Bush Captain, Donald Rumsfeld, proved in the end, managing crises that you help perpetuate is a loser’s game. Being unprepared is as much a capital mistake as being unaware.

It’s time to get real here. It’s time to position this economy for “The New Reality.” If American Capitalists seek being a part of it, they better demand wholesale changes to our economic leadership lineup, immediately.

Keith R. McCullough
CEO / Chief Investment Officer

Chart Of The Week: Shark Hunting

“This shark, swallow you whole. Little shakin', little tenderizin', an' down you go. And we gotta do it quick, that'll bring back your tourists, put all your businesses on a payin' basis. But it's not gonna be pleasant.”
-Quint (Jaws, 1975)

Suffice to say, this week wasn't one for the faint of heart. Shark hunting never is…

If you're in the "all in US$ cash" camp, that and gold worked, closing +1.5% and +1% on the week, respectively. If you were in the shark infested waters with us, it was a full contact sport.

The chart below paints the lines where we made calls this week. "Beware Of The Squeeze" (11/12) played out twice over the span of a very volatile 48 hours. From 1PM on 11/13 to the closing bell, we saw a +10.5% squeeze in the SP500, then from 1PM on 11/14 we saw a milder version of the same, but a +4.5% two hour move in the SP500 nevertheless.

We issued 12 sell/short orders on the Hedgeye Portfolio on 11/14. Our get long for the squeeze call was not one that we were going to sit on forever. Just after 3PM on Friday, we issued a note calling out stiff shark bite resistance at SP500 920.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.37%
  • SHORT SIGNALS 78.32%