Instructing The Masses

“If the masses were going to run the world, they would need a lot of instruction.”

-Sylvia Nasar


That’s a quote from Nasar’s recently published book “Grand Pursuit” where she explains how one of Yale’s “great men”, J. Willard Gibbs (chemist, mathematician, physicist), thought about a globally interconnected world at the turn of the 20th century (page 147).


The late 1800s and early 1900s were a very formative time for the study of economics. That’s when mathematicians got involved. Quantifying the qualitative is important. The fear-mongering styles of Malthus, Carlyle, and Marx were replaced by new lines of thinking from the likes of Marshall, Schumpeter, and Fisher. Re-thinking was good.


Since then, we’ve had a long, hard, muddle through nerdy economic debates about Hayek vs Keynes, Rand vs Bureaucrats, and Capitalism vs Socialism. But we really haven’t evolved the process by which we apply modern day math (Chaos and Complexity Theory) to how we’re thinking about economies and markets.


Since Chaos Theory is the most relevant mathematical conclusion since relativity, I think there is plenty of re-working and re-thinking to be done. Instructing The Masses on how markets work will take time. It’s time that I am personally willing to make.


Back to the Global Macro Grind


One of the gaping voids that’s obvious to anyone who has studied a Yale or Princeton economics textbook is the behavioral side of markets that plays such a critical role in the decision making of market participants. Kahneman, Tversky, and Taleb have all contributed significantly to qualifying the impact psychology has on markets, but we are still in the very early days of applying these learnings.


Quantifying sentiment is very difficult. I’ve been on the road seeing clients from Denver to Kansas City to San Diego, Boston, and New York in the last 6 weeks – and the #1 question I get is “what are you hearing.”


What I am “hearing” and what my risk management models are seeing are quite often very different things. But since our industry has effectively become one gargantuan front-running exercise of trying to beat the market’s beta, it’s a question that modern practitioners of asset management have to constantly evaluate.


What’s sentiment right now?


Well, from a Global Macro perspective, there’s not one answer that fits nicely in a baby blue box with a Tiffany bow on it. Sorry. Asian stock markets continued to fall, hard, last night. China was down another -2.5%, and India remains under inflation’s pressure (Sensex down another -0.6%). The Euro, European Bonds, and European Equities remain a mess.


From a US stock market “sentiment” perspective, one of the best contrarian readings I can give you is measured by looking at the spread between Bulls and Bears in the II Survey (comes out every Wednesday):

  1. In late September, the spread was bearish (meaning more Bears than Bulls) on the order of -1900 basis points (19%)
  2. After October’s rally (the biggest ever in US stock market history), the Bullish to Bearish spread flattened to even
  3. This morning, the spread has widened to +1500 basis points (Bulls 47.4% minus Bears 32.6% = +15%)

And while that’s only 1 factor I’m observing in my multi-factor, multi-duration, risk management model – my spidey senses say that sounds just about right. Hedge Funds fear being short. Mutual Funds fear missing Santa Claus. Central planners fear-monger.


Back to where I started this morning’s note, I think we’re a lot smarter than staring at the futures on TV this morning looking for an emotional direction. Mediocre minds are not going to lead us anywhere but lower. We need to be the change we all want to see in our analytics.


While Big Government Interventionists and the ad dollars that support them think that all of this is going to end according to their central plan, globally interconnected markets have a not so funny way of getting in the way of that…


My Top 3 globally interconnected points confirming Asian, European, and North American stock market weakness this morning are:

  1. Chinese Demand: Hong Kong trading down -2% well below TREND line support of 20,297 on the Hang Seng
  2. Dr Copper: down another -1% to $3.48/lb, remaining in what we call a Bearish Formation (bearish TRADE, TREND, and TAIL)
  3. US Treasury Yields: continue to signal that both US and Global Growth are slowing (TRADE resistance for 10-yr yields = 2.15%)

Of course the Euro collapsing versus the US Dollar remains the #1 Correlation Risk factor affecting Global Macro markets. But you already know that – because our Instructing The Masses since founding the firm in 2008 has been consistently backed by the math.


My immediate-term support and resistance ranges for Gold, Oil, France CAC, German DAX, and the SP500 are now $1, $96.92-100.33, 3037-3176, 5, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Instructing The Masses - Chart of the Day


Instructing The Masses - Virtual Portfolio


Investors that put dollars behind the notion that “they can’t comp the comp” or “this will be the same old Brinker” will get run over, in my opinion.  I feel good about this one.


Outside of macro issues like consumer confidence, the lack of job growth and commodity pressure the restaurant industry is not in a recession.  There are companies that are struggling, but it's a great time to be taking market share and Chili’s is one of the brands that are best-positioned to take significant share.  As we recently saw from Olive Garden’s response to the $6 lunch, Chili’s does not just compete in the “Bar and Grill” space; the broader industry reacted to this price point.   


The title of this note sums up my thoughts coming out of the Brinker analyst meeting in Raleigh, N.C., this weekend which was one of the best EAT analyst meetings I have attended.  It was a great meeting for two reasons.  First, having the entire senior management team at the meeting in an actual restaurant where so many of the initiatives could be explained and debated sent a strong signal.  Second, the meeting was well-attended by a number of Brinker employees with varying skills and experience-levels that helped bring the whole picture together.


In terms of the sell-side community, the meeting was not very well-attended.  For me, this was an important meeting from which I gained a lot of insight.  I would find it hard to believe that any attendee could leave that meeting not feeling impressed by the Chili’s transformation and how it is playing out.


Brinker is another restaurant company that I have been covering for nearly 20 years.  I have seen the company transform many times from small cap Casual Dining start-up; Chili’s revitalization 1.0; the failed multi-brand company strategy; to a weakened industry leader that grew too fast and now on to the “industry innovator” and Chili's revitalization 2.0 we are seeing today. 


Say what you want about the management team, Brinker’s CEO, Doug Brooks is a survivor and now thriving under the new business model.  I also consider Doug one of the strongest CEOs in the industry and the survivor mentality is coming through in the in corporate philosophy of better before bigger. 


It also important not to lose sight of the fact that over two years ago, Doug brought in a new management team with fresh thinking to embark on Brinker’s new path.  Over the past three years, he has sold off non-core brands, bought back 20% of the stock and are now in the middle of what could be one of the most significant brand rejuvenations I have seen in casual dining.  There is a still lot of work to do but the pieces of the puzzle are in place. 


I remember walking out of the analyst meeting in March of 2010 and thinking they have finally found a way to have a real competitive advantage in the bar and grill space, but it could be bigger than that.  At that time, the story was about cutting margins and perhaps stabilizing sales trends but the investment community gave management no credit for technological advances which were, at the time, conceptual at best.  We are now seeing it come to life in the restaurant.


Management perfectly illustrated the impact of the restaurant innovations by displaying slides of time and motion studies that highlighted the difference between how crews work in the new kitchen versus the old kitchen.  The new equipment (ovens etc) simply the back-of-the-house processes and also allow more flexibility in terms of what the restaurant can serve.


Taken together, it’s all about improving margins, creating “less stress” for the employees, lowering labor costs and improving the food quality for the guest.  All of the above leads to more money in the pocket for the store managers!  Not a bad formula! 


While they have accomplished a lot since then from a margin stand point, the "technology" part is just coming to life now.  The sell-side is not giving them credit, because all of these “intangibles” are unquantifiable, so trying to imply what it means for same-store sales is an unknown - at this point.  The options the back-of-the-house technological improvements provide the concept with are more varied than I thought.  The Combi oven is a steamer/oven that allows the staff to cook ribs and pasta and is also self-cleaning.  The CTX oven is a conveyer-belt style oven that cooks quesadilla and other items and the Impinger oven allows the staff to cook flatbread and pizza.  There are many other platforms that the new technology opens to the company and, from a competitive standpoint, the Chili’s store-base will be peerless from a kitchen-technology standpoint.


With respect to this menu innovation, the meeting provided us with a chance to experience the new kitchen’s capabilities first-hand.  For part of the meeting we became guinea pigs in make shift “test kitchen” as the culinary team came to life showing us how that can use the technology to innovate the food.  In the coming years it’s likely that we will see food platform around pasta, flat bread dishes, pizza, fish and chicken. 


If you are a brand like Chili’s in a highly competitive segment like Casual Dining, looking to create new news that your competitors will not be able to replicate will be a real advantage.  My guess is that EAT has a multi-year head start on the competition and most of the smaller players will possibly never be able to compete.   Additionally, if a company is 95% franchised, it may be difficult to orchestrate such a system-wide overhaul as Chili’s is doing.


Judging by the type of questions being asked after the tour of the kitchen, there were some analyst that were starting to think a little differently.  People were asking questions like, “how long will it take for the competition to catch up to you?” and “Who else is putting this technology to work?”  This is the third time I have toured the “kitchen of the future” and I pick up new insights each time.  It is a game-changer for the Chili’s brand. 


The company did not change guidance and reiterated its capability to achieve  400 basis points of net margin improvement from its Plan to Win.  Given that they are half way home the numbers seem very believable at this point.  It's interesting that those detractors who were negative from the outset have now drifted their thesis to assume that the margin improvements are unsustainable and will compromise the customer experience.  I am extremely confident that the opposite is true and, unlike some detractors, I have taken significant time to investigate and analyze the company’s strategy and how it is being executed.   Management is confident, the staff is more content and less stressed and store managers are highly galvanized. 


I think the Chili’s momentum is real and will persist for quite some time.



Howard Penney

Managing Director


Rory Green



Early Look

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Trade Update: Santa Claus Isn’t Coming to Hong Kong This Year

Conclusion: We are fading consensus calls for Santa Claus by shorting Hong Kong as the domestic and global macro fundamentals are likely to continue deteriorating over the intermediate term. 


Position: Short Hong Kong Equities (EWH)


Earlier today, Keith shorted the Hong Kong equity market in our Virtual Portfolio. Putting on exposure to this increasingly high-beta market is a sign of our conviction in our research, specifically in our thesis that global growth is continuing to slow – particularly across Europe and Asia. Irrespective of consensus calls for a monster beta-chase into year-end, our proprietary analysis suggests that global macro fundamentals are highly likely to continue deteriorating over the intermediate term TREND and shorting Hong Kong remains one of our favorite ways to play this view.


It’s worth noting that when the same people (i.e. consensus) are telling you that “all the bad data is priced in, so stocks must go up” are the same exact people that told you “everything is fine, so stocks must go up” six months ago, you should be, at a minimum, concerned.


Going back to Hong Kong specifically, it has remained one of our top Asian short-ideas since May for the following factors: 

  • A) Pronounced domestic stagflation will continue to compress corporate earnings growth over the intermediate term;
  • B) An inflecting property market will weigh on credit quality across the banking sector; and
  • C)  Slowing global growth will weigh on Hong Kong economic growth, which is among the world’s top two trade-oriented economies. 

Point A:

Trade Update: Santa Claus Isn’t Coming to Hong Kong This Year - 1


Point B:

Trade Update: Santa Claus Isn’t Coming to Hong Kong This Year - 2


Point C:

Trade Update: Santa Claus Isn’t Coming to Hong Kong This Year - 3


We encourage you to review our recent work on this idea and the associated thematic analyses: 

Lastly, our proprietary quantitative risk management levels are included in the chart below.


Darius Dale



Trade Update: Santa Claus Isn’t Coming to Hong Kong This Year - 4

Defining Oxymoron: Management by Committee

Conclusion:  It seems unlikely that the Super Committee will reach their deadline of November 23rd.  Regardless, the debt ceiling will still get extended and automatic cuts will go into effect.  The later point is positive for our King Dollar thesis.

Position: Long the U.S. dollar via UUP; Short the EUR/USD via FXE

“I think this super committee is about as dumb an idea as Washington has come up with in my lifetime. I used to run the House of Representatives.  I have some general notion of these things. The idea that 523 senators and congressmen are going to sit around for four months while 12 brilliant people, mostly picked for political reasons, are going to sit in some room and brilliantly come up with a trillion dollars, or force us to choose between gutting our military and accepting a tax increase, is irrational.”


-          Former Speaker of the House and current Presidential Candidate, Newt Gingrich


As many of us who manage businesses or portfolios know full well, decision making by committee looks great on paper, but is typically ineffective in practice.  As if a committee wasn’t bad enough, the Joint Select Committee on Deficit Reduction (the “Super Committee”), which was created by The Budget Control Act of 2011, is comprised of twelve politicians (six from each party).   It should be no surprise then that the Super Committee is likely going to have a difficult time meeting its November 23rd deadline. 


In the table below, we’ve outlined the key members of the Super Committee, which is comprised of six Democrats and six Republicans.  Setting aside our legitimate concern that the Super Committee meetings are being held behind closed doors by non-democratically elected members of a sort of super Congress, we would be even more concerned if we believed the group could actually reach a resolution.   Given the highly partisan nature of Washington these days, we find it very unlikely that a compromise is reached or that any member of the Super Committee crosses party lines to reach a resolution.


Defining Oxymoron: Management by Committee  - 1. dj


According to InTrade, there is currently a ~15% chance that the Super Committee issues a recommendation by midnight on November 23rdon $1.5 trillion of cuts.  To be fair, and as outlined in the chart below, the odds have increased from 10% in early November, but still remain well off the 50% odds from mid-to-late October.  This implies worse than a 1/6 chance that a recommendation is made prior to the deadline.


Defining Oxymoron: Management by Committee  - 2. dj


The goal of the Super Committee is to agree on a plan for $1.5 trillion in deficit reduction over the next ten years by November 23rd.  According to


“This “Super Committee” can cut spending (including Social Security and Medicare), raise revenue, or propose a combination of both.”


In theory, the plan is then sent to Congress, where it is to be voted on by a simple up or down vote.  As such, it is not subject to amendments, “majority of the majority” blocks, or Senate filibusters.  After the simple majority votes in each house, the bill will then be sent to President Obama to sign.  The deadline for Congressional approval is December 23rd.


In the scenario that no agreement is reached by December 23rd, $1.2 trillion in spending cuts will be implemented across-the-board starting in January 2013.  (There would be no automatic revenue increases.)  These budget cuts are more commonly known as sequestration.   These cuts would exclude:  social security, Medicaid, veterans’ benefits, food stamps, and some other aid programs.  The key focus of these automatically implemented cuts would be the defense budget and discretionary spending, with a 50/50 split between each.  The White House has explicitly stated they will block any measures to water down the sequestration enforcement mechanism.


Preliminary estimates suggest if the automatically implemented cuts were to go into effect, a 7.8% average reduction would hit non-defense discretionary spending.   This is compared to annual growth rate of discretionary spending from 1971 to 2010 of 6.4%.  In fact, the only year-over-year decline occurred in 1996 with a -2.2% decline, which is highlighted in the chart below.  So, even if the Super Committee fails, the future deficit will improve on the margin.


Defining Oxymoron: Management by Committee  - 3. dj


In terms of impact on U.S.’s credit rating and potential for a default in the short term, a second debt ceiling increase of $500BN is scheduled to go into effect regardless of whether Congress passes the Super Committee’s proposal.  The process for the debt ceiling extension is that the President must request a further increase from Congress.  This request is subject to a motion of disproval.  The President can veto the motion and Congress can then override his veto by a two-thirds majority.   In all likelihood, this debt ceiling increase will pass.  Based on the projected deficit math, the second debt ceiling will allow borrowing to continue at current levels through the 2012 Presidential election, so there is no imminent risk of a downgrade on this basis.


The emerging outcome for the Super Committee seems to be some form of a two-step process given the current divide between Republicans and Democrats on the Super Committee.  In fact, Republican co-chair Texas Rep. Jeb Hensarling stated as much on CNN when he said:


“There could be a two-step process that would hopefully give us pro-growth tax reform.”


Not surprisingly, the divide is squarely across partisan lines with the Republicans currently unwilling to accept any increase in taxes and the Democrats just as unwilling to accept any major alteration in entitlement spending.  Indeed, while the Republicans have offered a proposal of $1.4 trillion in deficit reduction, it includes $500 billion in new revenue from capping individual deductions while cutting all six income tax rates by 20%.  In addition, it would extend the Bush-era tax cuts.


As is typical for politicians, the likely outcome of the Super Committee is that the can will be kicked down the road, even if they reach some two-step compromise.  As previously stated, though, this is not all negative as the deficit enforcement mechanism will kick-in, which is, on the margin, positive for U.S. deficit reduction.


Daryl G. Jones

Director of Research

Today’s European Data by the Charts

Positions in Europe: Short EUR-USD (FXE); Short France (EWQ)

French Risk Rising: Below we update our chart of French 5YR CDS and the spread between France’s 10YR bond yield and bunds. In both cases, we continue to see higher highs since the EUR was introduced. We remain short France via the eft EWQ in the Hedgeye Virtual Portfolio due to:

  • French debt could peak at 92.3% of GDP in 2013 (over the Reinhart &Rogoff 90% level that impedes growth), especially if the state has to take on more of the bank recapitalizations. Rough estimates suggest that France’s four largest banks need to raise over 40 Billion EUR to reach the 9% core tier 1 capital ratio.
  • A lofty schedule of debt maturities (+200 Billion EUR over next 6 months) and higher trending yields will make raising debt more expensive and put upward pressure on debt. France has the largest banking exposures to Italy of any country and has yet to significantly mark down its PIIGS paper.
  • GDP will take a hit, already revised down from 1.75% to 1% for 2012 by President Sarkozy. We think Austerity’s Bite and a prolonged effort by Eurocrats to keep the Eurozone fabric together will create an extended period of downside economic and market performance.  
  • A higher French unemployment rate (nearly 3% above Germany's) and the inability to drive economic growth through exports (like Germany) should prolong weakness in French fundamentals as stagflation takes hold into year end and in 2012.
  • A huge risk remains the downgrade of France’s AAA credit rating, including jeopardizing the EFSF, a facility that is built on its AAA credit rating to raise debt at “cheap” levels, and of which France is the second largest contributor.

Today’s European Data by the Charts - 1. g



German GDP Slowing: Like much of the Europe, we expect German growth to slow over the next 4 quarters. A look at the chart below shows that from a comparative perspective, Germany will have tough comps on a quarter-over-quarter basis for Q4 (bumping against +0.5%) and should have 4 tough quarterly comps on a year-over-year basis (circled in red below in the chart).


Further, readings from ZEW’s Economic Sentiment survey that is 6 months forward looking (yellow line in the second chart below) suggest similar downward pressure, recording a 3-year low of -55.2 in November.


Today’s European Data by the Charts - 2.g


Today’s European Data by the Charts - 3. g



UK’s Sticky Stagflation: As the chart below demonstrates, UK inflationary metrics are running high (most current reading down 20bps vs the previous month at 5.0% in Oct. Y/Y), which will further crimp growth. For the UK, a fall in energy prices could materially depress many of these readings and could be its saving grace.  


Today’s European Data by the Charts - 4. g


Matthew Hedrick

Senior Analyst

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