The Merrill Lynch High Yield index declined to a yield of over 20%, as of yesterday, to the surprise of almost nobody. In a market where the spread between agencies and treasuries is still over 160 basis points there is no chance of finding buyers for paper that actually has investment risk. I read a book once that compared arbitrage to picking up nickels lying on the ground while trying to dodge steamrollers –this market feels more like the ground is covered in silver dollars and everyone has their arms in casts.

Traditionally the order of risk dictates that capital flows as follows: arbitrage, relative value and then directional. The theory goes that, as capital seeps into the markets, it tends to pool in the lower ground first picking off attractive riskless (or risk defined) spreads. Therefore by extension lower rated paper shouldn’t rise until after arbitrage spreads begin to contract - In other words only when sufficient liquidity returns to the market to take out low hanging fruit will investors start to focus on individual corporate risks and actually figure out which ones are worth buying.

Until then it’s all just junk.

Andrew Barber

Eye on China: Capitalism continues to expand

Prompted by falling global crude prices China announced today its intention to introduce a domestic fuel tax, indicating a bold action towards a more market-based fuel pricing mechanism. Fuel prices are expected be cut in the coming days (“as soon as possible”) by 12-20%. Analysts predict that the pump price cut should offset any fuel taxes, with the tax meant to replace road tolls as a means to fund highway construction.

Shares of Chinese oil refiners surged today, with top Chinese refiner Sinopec Corp closing 10% higher in Shanghai. China’s petroleum industry, long monopolized by large state-owned enterprises such as the China National Petroleum Corporation (CNPC) or NYSE- listed PetroChina, China Petrochemical Corporation (Sinopec), and China National Offshore Oil Corporation (CNOOC), has transformed to allow private petroleum enterprises, including the establishment of Great United Petroleum Holding Co (GUPC) as well as overseas companies like Shell and BP.

While this is an immediate benefit for Chinese refiners and integrated energy, which drove most of the surge in the Chinese stock market overnight, it is also another key data point supporting our bullish thesis on China. As other countries are reregulating and limiting free markets, China is in fact adopting capitalist policies.

Matthew Hedrick


The latest data shows that, in the scramble to buy US treasuries in recent months as the global markets imploded, the Chinese are the “winners”. The Treasury Department’s estimates for September show that China’s Treasury securities holdings increased to almost $600 Billion, placing it ahead of Japan as the single largest holder of Uncle Sam’s IOUs. Japanese holdings actually decreased by $13 Billion for the month as the Yen rallied against all major currencies.

A quick look at the charts below gives you a good understanding of the foreign policy component of the economic jigsaw puzzle that president elect Obama and his team will inherit. With China increasingly funding the US deficit the relationship between Washington and Beijing will become increasingly complex.

Andrew Barber

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Consumer Trends - 1 hour Not 24

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!

Notables in Sports Apparel Sales This Week

Outerwear lost out to lower-priced fleece – favoring Russell (Berkshire). As such, UnderArmour, Columbia and North Face (VFC) all lost 2-3 share pts. UA and COLM will bounce back. Not sure about VFC.

Total sports apparel had a tough week vs. last year (+ only 1.3%) – but the trend continues to improved on a 2 and 3-year basis. I’d be shocked if this not accelerate further in the next two weeks due to the recent cold snap in the Northeast.

To that end, it’s fascinating to e to see that the three brands that are sensitive to a shift in mix at this time of year to higher-priced outerwear all lost 2-3 points of share sequentially – this includes The North Face, Columbia, and Under Armour (see charts below).

The big winner for the week? Russell Athletic. Yes, you heard me right…Russell Athletic, sister company of Fruit of the Loom under the Berkshire Hathaway umbrella. Russell’s share is up 500bps to 8.45% and is largely driven by a push into the higher end fleece business.

The real question for me is whether this will serve as a cheap substitute for otherwise highly technical and more expensive product from the incumbent brands.

I’m most worried about VFC’s The North Face label – which has been seeing a meaningful rollover in average price point. Columbia and Under Armour have both been steady, and have inventories in check. TNF is less certain to me given my view that the brand is losing leverage with retailers as it moves forward with its own store growth plan. Let’s not ignore that TNF is upwards of 1/3 of VFC’s cash flow.

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

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