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Preparing For Tail Risk

“I’ll study and get ready, and then the chance will come.” –Abraham Lincoln

That’s always been a favorite of quote of mine. From playing on the ice of Northern Canadian outdoor rinks, to driving up highway 95 these days in the early mornings – preparation has always trumped all else.

I often wonder how Vladimir Putin thinks on this front. One of my investment themes in 2008 has been to have an “Eye On Putin Power” - his recent attacks on Georgia remind me that preparing for the geopolitical tail risk associated with his ambitions to revive Russia as a dominant world power is paramount. After seeing oil prices correct for a -22% down move, I hardly believe that we can chalk up the timing of his “being at war” to irony. To the prepared, timing is everything.

You’d be hard pressed to convince me that the Chinese weren’t as prepared for their masterful opening ceremonies as any nation has been in world history. At times, the Olympic “bird’s nest” was borderline intimidating. China is not America. Russia clearly is neither. Understanding where global equity markets are headed next will require a healthy level of preparation. Of that, I am certain.

China’s stock market got crushed by a wider margin than its basketball team did yesterday by Team USA. The Shanghai Composite Index closed down another -5.2% overnight and has lost -9.7% of its value in and out of its Olympic launch. Suffice to say, this has to be more alarming than the 2,008 synchronized Chinese men banging on electric war drums Friday night.

The other side of commodity inflation deflating (CRB Index down another -7% last week, Oil down -8%, and corn hitting 4 month lows), is that Asian economic growth is slowing to a halt. No, the word “halt” is not my exaggerating. After printing a horrible GDP growth number for Q2 last night at +2.1% (which is down from Q1’s +6.9%), the Government of Singapore guided the world to NEGATIVE EXPORT GROWTH expectations for the balance of 2008. No, this has not happened in Asia’s most relevant port country since 9/11. This is not good.

Although I bought the S&P 500 via SPY’s on Friday morning (see timing of note on our Portal), this should be understood for what it is – a “Trade”. July was one of the worst months for US hedge funds on record. Energy and fertilizer stocks can indeed go down at the same time that fund of funds demand weekly performance. Plenty of PM’s are getting bounced around the Olympic rings here and, as a result, the deflating inflation “Trade” still has legs. I am moving my immediate term topside target in the S&P 500 to 1303 this morning (I was at 1299 prior).

I wrote a note this weekend on TED spreads remaining ominously wide (3 month LIBOR versus 3 month Treasuries). That negative “Trend” has not changed this morning; neither has Putin’s rhetoric. Russian tanks are moving deeper into Georgian territory; war planes have not calmed their attacks.

The US Dollar’s +3.4% melt-up from last week may have a lot more to do with what’s going to happen to the geo-political landscape next. Global Peace has been as positive a global “Trend” as any in the past few decades. It has undoubtedly contributed to falling risk premiums, globally, and unprecedented cross border trade. I pray that this doesn’t change, but I am preparing for the tail risks nevertheless.

Good luck out there this week,
KM



EBO > EAO

My partner Keith McCullough recently coined the phrase “earnings before Obama” or EBO. With a supportive congress, President Obama is likely to follow through on Candidate Obama’s populist rhetoric. I see four areas where Obama’s policies could drive EAO below EBO.

• Taxes – Corporate income taxes may or may not rise but personal income and capital gains taxes are certainly headed higher. “Hidden” taxes and fees on corporations would likely increase.

• Interest rates – In another post today I addressed the likely EPS hit from bank line refinancing. This was before even considering macro level interest rates which are likely to rise under an Obama administration advised by Paul Volcker. Attacking inflation could certainly benefit the long term economy but near term profits would suffer.

• Regulation – We’ve had a de-regulating trend in this country for nearly 30 years. Obama would likely reverse that positive trend and with it force up compliance costs.

• Labor – This is a biggie for my companies. Obama favors the “Employee Free Choice Act” which I’ve discussed in previous posts. Despite opposition from liberal stalwart George McGovern in Friday’s WSJ, this democratic congress favors the union initiative to oust the secret ballot in union elections. An open petition or “card check” will certainly result in more union victories. Higher wage costs, reduced labor flexibility, and lower productivity should follow.

I do not write a political blog and Research Edge is not a political firm. Like most firms we have diverse individual views but we do share at least one important value: objectivity. So while I’m not expressing a political opinion on whether an Obama presidency is good for America, I am trying to make an economic call that Obama will not be good for consumer stocks.



Chinese Wage Inflation De-bunked...

Inflation needs to be understood on two fronts, not just the commodity front. On the wage front we have a dynamic situation whereby inflation in Asia and Eastern Europe is running well ahead of that being realized in the West.

What China and Russia will have to deal with in the coming months is not unlike the ominous combo that Nixon faced here in the 1970’s – wage and price spirals occurring in tandem. Both countries look to be sustainably pushing towards wage inflation of +20% year over year growth.

When I posted the chart of Chinese wage inflation earlier in the week, I had questions in reply asking what the numbers might look like if I looked at urban workers versus those driving the numbers in rural China. Edge always lies in the question, and I think that is the one to ask. According to the Xinhua article on July 28th out of Beijing that was pulling numbers from the latest issued by the China National Bureau of Statistics, “urban workers' per capita salary averaged 12,964 Yuan (1,878 U.S. dollars) in the first half of this year, up 18 percent year-on-year.”

So, yes, the wage inflation number appears lower on the urban side of the ledger, however it’s still running at a considerably higher rate than reported Chinese CPI which is running around 8% for the same time period.

On Tuesday, we’ll have our eyes on the latest Chinese inflation report for July. It is global this time, indeed.
KM
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A Two Horse Race

There’s no question in my mind that the US footwear environment is shaping up to be a 2-horse race from a brand perspective. This is all about Nike and Under Armour.

I say that tongue in cheek, as we’re talking about a company with 35% share vs another with 1% share. But that gap will close to some degree. Will it come out of Nike? No way!! Nike won’t let that happen, and it has the deep pockets to prevent it. But that’s bad news for New Balance (10% share) Adidas (6%), and Reebok (3-4%).
  • I still think that the big winner is FL and FINL. The brands don’t compete on price, they compete on innovation. That brings traffic back to performance channels – from fashion channels (ie Journeys, and even dept stores).
  • How does it end? Nike maintains share or a growing market, Under Armour takes up share dramatically (from 1% up to 3-4%) but at a 300-500bp margin hit, AdiBok takes it on the chin with growth and margin as Reebok all but goes away in the US, and the athletic specialty retailers (FL, FINL) actually start to comp again.
  • Added consideration. With AdiBok tanking in the US, and with my prior post about how Adidas and Reebok basketball players are in the pole position with NBA jersey sales in China, one needs to ask if Nike is overspending to protect share in the US and is exposing itself in growthier markets?? Could Adidas be playing a pretty good game of chess after all? Make Nike spend up in one market to dominate in another? Definitely an issue to dig into.
Under Armour is the sole share-gainer in US footwear aside from Nike.
Nike is simply crushing it in the US.

Merrill Lynch (MER): To Short Or Not To Short?

From Wall Street’s vaunted CEO’s, we’ve all seen our fair share of what my favorite hockey Coach used to call “misinformation” in 2008. Most of these CEO’s have either been fired or are currently under fire, however. Save one John Thain, who is actually Merrill’s new face, but not a new one to the Street.

Goldman Sachs has produced some interesting politicians as of late. John Corzine, is suffering from bad public opinion polls as the Governor of New Jersey. Meanwhile, Hank Paulson is doing his best to admit that he has no idea what to do for the next 3-6 months before he loses his job as the Secretary of the Treasury. Then we have Mr Thain, another Goldman alum, who is one of those guys that apparently thinks he is so smart that he can fool everyone with “misinformation”, including himself.

In Merrill’s recently filed 10Q, Thain’s latest disclosure was that the $4.3 Billion stake that he announced Merrill was selling back to Bloomberg wasn’t exactly a cash deal. In fact, Michael Bloomberg didn’t really give Merrill any cash at all. Merrill gets $110M in cash, and the rest in long term notes! Yet, John Thain was waiving Merrill’s sale of their 20% stake in Bloomberg as a liquidity event? I don’t get it. I guess he is hoping no one does.

We have our eyes on Thain’s concept of transparency. This is the 2nd time he has been ‘You Tubed’ in less than a month. For one, that’s hard to do; secondly, it’s just embarrassing. Insiders bought a pile of MER stock at $22.50/share at the end of July, but that certainly doesn’t mean much to me. Insiders have been buying stock in poorly managed companies at terrible prices since November of 2007.

Merrill is one of those companies that I am looking to re-short into this latest market rally. I like to sell high, and cover low – I do not have a position currently, but I will if the stock fails at my resistance line of $28.66. At 4.1% of the float, the stock has a shockingly low short interest relative to the risks implied in their equity valuation. This company has negative cash flow from operations and will have no visibility on paying their dividend if the US economy deteriorates to the extent that it has the potential to from here.

My math says that a drop from $28.66 to $22.50 is a -21.5% decline, and I’ll happily cover the stock alongside any insiders who are brave enough to buy more on that downside test. If the stock can close above $28.66, I’ll stay on the sidelines and refresh this point of view as the facts change. For now, be weary of what this company states as facts.
KM
  • If MER fails at $28.66, I'll be shorting it.
(chart courtesy of stockcharts.com)

Footwear Market Looking More Stable

The footwear industry finally seems to have stabilized in the US after nearly 10 weeks of cycling one of the most intense periods of discounting in years. Undoing last year’s sins when aggressive pricing drove clearance activity, we’ve recently had +10-20% selling price gains offset by commensurate unit sales decline.

We’re finally back at zero barrier – at almost the exact point when back-to-school sales start to pick up. Translation? We’re back to a point where these numbers gain increased relevancy on many fronts. My team and I will be watching them like a hawk.

Given the conservative fall buying I’m seeing out of many of the footwear retailers, I like how things are shaping up. I’m, still liking FL.

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