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S&P 500 levels at the open: Tight range

Keith is in New York this morning for a number of meetings, but we wanted to pass on his S&P500 levels that he called in this morning. He is a buyer at 833 and a seller at 885. He is also a buyer at a VIX of 72.73. Keith’s quantitative models reset continuously during the day, but these were the levels as of 9:30 am.

Daryl Jones
Managing Director

1 hour not 24

US Cash 67%, US Equities 14%, Int'l Equities 19%

“What Kiefer Sutherland does in 24 hrs, we attempt the Wall Street equivalent every morning in just 1.” – Howard Penney
If you don’t have teenagers in your household perhaps you can’t appreciate the TV show 24.  It takes Kiefer Sutherland 24 hours to assess the landscape, identify both the problems and opportunities, develop a plan to win, and execute upon it – all while tackling volatile changes in the day-to-day operational climate.  Keith McCullough does it for our clients in one hour.  The Research Edge morning meeting is scheduled to last one hour (but with diatribes it can easily turn into more), with Keith using the first 20 minutes to create a mosaic of how the world is intertwined from an investment standpoint.  Appreciating the Research Edge Trend vs. Trade mentality, Keith is clearly more constructive recently on the US than most strategists.  His note on 11/12/08 “Beware of the Squeeze” had nine factors that work the bullish scenario and he increased his weighting in the US market.  At Research Edge, we now stand at US Cash 67%, US Equities 14%, and International Equities 19%…
As a consumer analyst that is the only hour in the day that I feel better about the market and the direction we are headed.  I don’t need to patronize Keith, but for the first 20 minutes his Marco narrative as the facts stand today can actually make you feel much better about where we are in the cycle, and that the worst of the destruction in the market is behind us.  As an aside, 99% of the people reading this note don’t get the benefit of that hour, but it can happen if you so desire (I’ll save those details for another forum). 
Coming out of the morning meeting I’m determined to find some name in my group that is going to work on the long side. Unfortunately, it does not take long before reality starts to set in – the consumer is in real trouble.  I end up looking for companies where the news flow is “less bad” and all I can hope for is a short squeeze. That is no way to invest and a great way to lose money.  Unfortunately, basic Graham and Dodd analysis is not holding up, it does not matter if you are buying a stock on the basis of asset value, free cash flow yield or an EBITDA multiple; no metric seems to be working.  The root of the problem is that sales continue to disappoint and margins are being squeezed to levels that are impossible to model.  But Keith would say “US Consumer Discretionary stocks have been crashing for longer/further (peak to trough decline from 07’ is now -55%), and now the Street is bearish on spending!” I know I see that every day, but when is the consumer going to start spending again?
In my lifetime, changes in economic activity have been closely related to growth in consumer credit and the biggest driver of incremental consumer credit has been the growth in residential mortgages.  Those days are over.  Given the actions the government has taken it’s easy to argue that the appropriate steps have been taken to stabilize the financial system, which should invigorate the credit markets and allow businesses to lend so consumers start spending again – but when?  Where are they going to get the money?  If consumers have equity in their homes today, the last thing these people are going to do is borrow more to spend!  In fact the opposite is happening as more banks are requiring consumers to put more equity in their homes.
I know gas prices at the pump are approaching $2, which will put more money in the consumer’s pocket, but job losses and higher mortgage rates can eat that benefit up in a heartbeat.  I can easily give you a list of 10 companies that need to see an immediate reversal (next six months) in consumer spending or they will need to shrink significantly in order to survive.  As more companies shrink to stop the bleeding, more consumers will be out of work and the further we get from the bottom of the economic cycle.  It’s hard to paint a picture on how we get out of this destructive downward cycle.
Yes, my day-to-day conversations with companies, suppliers and industry insiders are downright depressing.  I realize, however, that most industry executives lack the foresight to see an inflection point when business will turn – for better or for worse. This is when marrying a Macro process with Micro analysis matters most.
I really want to be wrong this time on my industry outlook and I’m looking forward to 8:30 am so I can get out of this funk even if it’s only for an hour!
Howard Penney
Managing Director
Long ETFs
EWA –iShares Australia – Three month interbank rates rose in Australia for the second day to 4.63 as counterparty risk concerns continue to stifle liquidity. Babcock & Brown (EWA: 0.05%) announced layoffs totaling 2/3rds of head count by 2010 as the company attempts to avoid default on debt.
EWG – iShares Germany – During an interview yesterday government economic adviser Beatrice Weder di Mauro said that a 1% contraction of the German economy cannot be ruled out.   Hypo Real Estate (EWG: 0.15%) successfully placed 30 billion EUR of bonds including 15 billion in notes secured by the German government.
FXI –iShares China –The CSI 300 gained 113.34 points, or 6.2 %, and was the only index component declining for the day. State Administration of Foreign Exchange announced new regulations to limit deferred payments for exports beyond 90 days to prevent increased capital outflows.

 VYM – Vanguard High Dividend Yield ETF  -- The Markit CDX North America Investment-Grade index rose 14 basis points in New York yesterday to a record 228 as the CDS market continues to focus on counterparty risk from the Auto sector.
Short ETFs
UUP – U.S. Dollar Index – Economists polled in advance of Today’s CPI figures anticipate a decrease that could be the most rapid in decades.
EWJ – iShares Japan -- Toyota Motor Corp. (EWJ 5.61%) and Nissan Motor Co. (EWJ: 0.64%) each made negative comments today as Toyota announced further production halts in North America while Nissan guided second half profit to zero. The Nikkei 225 declined by 0.7% to 8,273.22.
FXY – CurrencyShares Japanese Yen Trust -- The yen climbed to 96.71 against the dollar on speculation that the scope of the proposed US automaker bailout may expand.
Brian McGough
President and Director of Research


CPI numbers came down a seasonally adjusted 1% month over month, the largest single period decline since the index was first tracked in 1947. Although declining commodity prices had been widely factored in by the market, the deflationary pressure appears to be exceeding the expectations of most economists as CPI excluding food and energy, core CPI, fell for the first time since the index was adjusted in 1982.

The specter of real deflation probably wasn’t the driving force behind the sell-off in futures this morning and the drop in housing starts will likely get a lot more attention in the media, but we will keep our eye on any evidence that suggested we are witnessing the start of systemic deflation.

Hank Paulson and Ben Bernanke still have control of the pump and the needle for the next 60 days, it remains to be seen how fast and high the ball will bounce after they hand it off to the new team on the bench.

Andrew Barber


Replacement demand is obviously more difficult to predict than slot sales to new and expanded casinos. We’ve already thrown our hat in the opinion ring on replacement demand (“CAPEX, COVENANTS, AND CORPORATE CONTROL”, 11/2/08). We’re pretty negative but only time will tell on replacements.

What is indisputable (for people willing to do the work) is that non-replacement sales will fall off a cliff in 1H 2009. We estimate a 60% year over year decline in unit sales to new casinos and expansions over that time period. There just aren’t a lot of new opportunities and the comp is extremely difficult. The M Resort in Las Vegas, PENN’s Lawrenceburg expansion, and Sands Bethworks are the only major shipments expected in 1H 2009. As can be seen in the chart, 2010 will not provide a recovery either. Q4 2008 looks pretty good and maybe that is why the slot guys seem overly optimistic right now. The good times won’t last.

Despite the liquidity crunch and significantly fewer new casinos and expansions, analysts somehow believe BYI and WMS can grow revs by almost 10% and total unit sales growth for the sector in 1H 2009 will be positive. Go figure.

Major drop-off beginning in 1H 2009


I continue to hold a very sober view of 1H CY2009 slot sales. Analysts are forecasting 10% revenue growth for BYI and WMS and positive slot unit sales for the sector over this period. As we wrote about in our 11/02/2008 post, “CAPEX, COVENANTS, AND CORPORATE CONTROL”, slot Capex is likely to drop off dramatically in the first half of next year as CFO’s strive to avoid liquidity crises. In addition to a replacement push back, demand for slots at new casinos will be way down in 1H CY2009. We estimate unit sales to new casinos will be cut in half over that time.

Estimates probably need to be reigned in for all of the suppliers. However, BYI looks to be more protected with almost 50% of its revenue derived from what we would consider “in the bag” sources. WMS is expected to generate only 35% from such sources. No company would be in good shape if slot sales fall to zero in 1H 2009, nor are we predicting they will. There are new casinos opening next year but it is conceivable that replacement demand could get cut in half or even by 75%.

“In the bag” revenue sources include lease and participation revenue (which we’ve discounted given the environment) and deferred revenue. Due to accounting regulations, BYI has deferred a significant amount of revenue. We estimate a little under 20% of projected revenue is derived from deferred revenue versus virtually zero WMS. This provides a nice cushion in a temporary slot slowdown. Both companies should source 30-35% of revenue from participation and lease revenue.

Considering relative valuations and expectations and BYI’s earnings cushion, BYI’s stock may be in better shape to weather a temporary slot drought.

SP500 Levels Into the Close: Buy'em!

As of the 3PM refresh, my models are signaling 1-2% downside and 6-7% upside from the 833 line we issued in our Early look.

BUY "Trade" line = 818.11
SELL "Trade" line = 885.67

The SP500 is setting up here to close at a lower low. On the margin, that's bearish. In conjunction with this event, Volatility and Volume are not confirming higher highs vs. those seen during the thralls of October 2008. On the margin, that’s bullish.

Hank “The Market Tank” is done. The CPI report tomorrow will be bullish. Buy’em!

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