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Hypnotic Markets

“The only time I have problems is when I sleep.”

- Tupac Shakur

 

In Greek mythology, Hypnos is known as the god of sleep.  His palace was a dark cave where the sun never shone.  The palace itself had no gates or doors, so that he would never be awakened by sounds from doors opening and closing.  Unlike Hypnos, global macro markets, especially in these interconnected times, never sleep.

 

The most noteworthy news overnight, not surprisingly, comes fromEurope.  The first Italian bond auction of the week was held this morning and it was, on the margin, successful. Italysold 9 billion euro of 6-month bills at 3.25%, which was dramatic improvement over the last auction on November 25ththat sold at a yield of 6.5%.

 

As Greek mythology tends to work, Hypnos’ brother was Morpheus, the King of Dreams.  So, while you may still be asleep, especially given the holiday shortened week, the paragraph above is not a dream.  The Italians actually did have a better than expected bond auction this morning.  If there was any disappointment, it was likely in the tranche of 2013 zero coupon Italian debt that was auctioned this morning.  The Italians were able to sell only 1.7 billion euro of the maximum allotted 2.5 billion euro.

 

Certainly though, we need to jot down this auction as a positive data point in our notebooks, as it is a sequential improvement.  The true test of whether there is an improved appetite for Italian sovereign debt will occur tomorrow.  In tomorrow’s auction, the Italians will attempt to sell up to 8.5 billion euro of 3, 6, and 10-year debt.  In theory, if the Long-Term Refinancing Operation, or LTRO, of the ECB is even moderately successful, then tomorrow’s auction should see some improvement over the prior comparable auction.

 

Yesterday in an intraday note to our subscribers, we wrote a note titled, “The LTRO is No Bazooka” (email if you’d like a copy) and highlighted the following key points:

 

“In the chart below, we’ve highlighted the ECB liquidity facility going back one year and in the inserted chart going back roughly one month. The key takeaway is that the ECB liquidity facility, which is used by European banks to effectively park money, hit a new all-time high at 411 billion euros this morning and has been increasingly rapidly since the inception of the LTRO just over a week ago. In fact, the day before the LTRO was put into effect, the ECB facility was at 265 billion euro and as of this morning has increased by 146 billion euro, or more than 70% of the incremental liquidity from the LTRO.

So, not only is the LTRO not being used as a bazooka by the European banks, but these banks are parking the borrowed LTRO money with the ECB rather than using it to buy sovereign debt, and thus are experiencing a negative yield on the trade.”

 

Given the results of the Italian bond auction this morning, there is some evidence the LTRO is being used as the fabled bazooka.  Ironically, though, the amount of money parked at the ECB’s liquidity facility increased dramatically overnight to a record of 452 billion euro.  This is an increase of 41 billion euro from the prior day. We would caution reading too much into the “successful” Italian bond auction as clearly the risk aversion trade remains in full effect.

 

In other European news, the prominent Spanish newspaper, Expansion, is indicating that Rajoy may force Spanish banks to cut the valuation of the real estate assets on their books by up to 20%.  The fact that Spanish banks still need to write down real estate assets on their balance sheets should not be terrible surprising to anyone.

 

Spanish home ownership rates are above 80% on the back of cheap long-term mortgages, often up to 40 and 50 years. As well, the government encouraged home ownership by making 15% of mortgage payments a tax deduction.  The Spanish real estate bubble makes Phoenix and Florida housing look like a value investment.

 

Unfortunately, the Spanish real estate market isn’t likely to improve anytime soon. Specifically, in October, Spanish real estate loans decreased for an18th straight month and were down 43.6% year-over-year.  Our long term analysis has shown that demand for mortgages is one of the best predictors for future real estate prices.  Therefore a 20% cut in the valuation of real estate assets for Spanish banks seems more than reasonable.

 

On the domestic front, Bloomberg this morning is predicting that 2012 could be the biggest year for IPOs since 1999.  Given the current filings, internet IPOs may raise more than $11.0 billion in the coming year.  In the face of heightened volatility and a 2011 that was lackluster in terms of equity offerings, raising only $156 billion in 2011 versus $252 billion, the onslaught of internet offerings seems a bit excessive.  Undoubtedly, even Dionysus, the Greek god of partying and excesses, would agree with that.

 

Keep your head up and your stick on the ice,

 

Daryl G. Jones

Director of Research

 

Hypnotic Markets - DJ chart EL wednesday

 

Hypnotic Markets - hvp12 28


THE M3: FLYOVER APPROVED; MBS SUES 5 GAMBLERS; MACAU UNEMPLOYMENT

The Macau Metro Monitor, December 28, 2011

 

 

FLYOVER FOR COTAI APPROVED Macau Business

A source from the Lands, Public Works and Transport Bureau said the license to build a pedestrian flyover connecting Sands Cotai Central and Venetian Macau was approved in October.  The flyover will be equipped with lifts, regular stairs, rolling stairs and air conditioning.  The flyover will also have direct access to the street on both sides.

 

The construction of a second flyover has also been already agreed upon between Sands China and MPEL to connect the Venetian Macao and City of Dreams.  The project has been submitted to the government and is currently waiting for approval.

MBS HAULS 5 GAMBLERS TO COURT TO RECOVER $7.5MM Strait Times

Marina Bay Sands is suing 5 high-rollers in court for $7.5MM in debt.  Although the amount is relatively small compared to its total revenues, MBS is probably pursuing legal action as a deterrent measure.

 

MACAU EMPLOYMENT SURVEY FOR SEPTEMBER - NOVEMBER 2011 DSEC

Macau's unemployment rate hit another new low at 2.3% for Sept-Nov 2011, down by 0.1% point over the previous period (Aug-Oct 2011).  The total labor force was 345,000 in Sept-Nov 2011 and the labor force participation rate stood at 72.5%, with total employment decreasing by about 1,800 over the previous period to 336,000.

 



Dickens' Lead

This note was originally published at 8am on December 23, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Lead on! Lead on! The night is waning fast, and its precious time to me, I know.”

-Scrooge

 

The next 72 hours of our lives in the McCullough household will be some of the most magical of the year. My little girl Callie is old enough now to be aware of Santa. My son Jack, well, he’s probably already peaked at what’s in store for him.

 

What’s in store for all of us at Christmas time is the wonderful gift of time. Time away from the office. Time away from the screens. Time with the people we love.

 

When Charles Dickens published A Christmas Carol on December 19th of 1843, it was perceived to be a dark time in Britain. It was a time of hunger. It was a time of class warfare. These are the times we want to avoid.

 

While the “tale has been viewed by critics like T.A. Jackson and Paul Benjamin Davis as an indictment of 19thcentury industrial capitalism” (Wikipedia), I prefer the context of the economic historian James Henderson as “an attack on Malthus.” (Grand Pursuit, page 6).

 

Reverend Thomas Robert Malthus is well known for this fear-mongering forecasts about population declines that never came to fruition. He and Thomas Carlyle became the most recognized “political economists” of their time by capitalizing on the Hungry Forties with charlatan lines of storytelling that were not only dark, but backward looking.

 

Dickens embraced the idea of uncertainty as an opportunity for change. Scrooge was his metaphor for the progressive side of capitalism, illuminating the human heart as the source code for morality.

 

Today, while Republican and Democrat fear-mongering views about our lives falling over the precipice into the depths of another depression may have captured the headlines of those who are weak enough to believe them, I know you are all stronger than that.

 

Leadership, principles, and values start in your home. Lead on!

 

Back to the Global Macro Grind

 

I think most Americans have figured out this year that what the stock market does on each and every tick is not what this country runs on. It may not run on Dunkin’s stock price either, but it certainly rides into your favorite coffee shop on the purchasing power of a Dollar, every day.

 

The most bullish Christmas Carol I can sing to this country this weekend is that the US Dollar Index has risen from the dead. After testing a 30-year low in April of 2011, King Dollar’s ascent has already added up to a +10% gain.

 

Even the crown of a sheepish looking Political Economist in Chief’s head cannot take the shimmer of hope of continued currency strength away from us this weekend. And while hope is not a risk management process, it will most certainly remain the fulcrum of my daily prayers.

 

Ben Bernanke wants you to believe in fear so that you will accept a 0% return on your hard earned savings. He wants you to believe that the price you pay at the pump doesn’t take away from what you might be able to put in the bucket when that Salvation Army bell rings.

 

This is not a political attack. This is called leading from the front lines every day with a progressive idea that our political ideologues on the US economy have not had the courage to try.

 

By simply getting the US Federal Reserve’s Quantitative Easing out of the way and putting a governor on government spending’s slope, consider what’s happened in the last 6-9 months:

 

  1. US GDP Growth has risen from +0.36% in Q1 of 2011 to +1.8% in Q3
  2. US Unemployment has fallen from 9.2% to 8.6% and weekly jobless claims are now hitting YTD lows
  3. US Consumer Confidence hit a fresh 6-month high yesterday at 69.9 on the University of Michigan survey (vs 67.7 in NOV)

If I have written this 100 times in the last 6 months, I’ve beaten it onto the Wall Street 2.0 Tape (Twitter) with 10,000 tweets:

 

Strong Dollar = Strong US Consumption = Strong Employment

 

Lead on, my capitalist friends, lead on!

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), and the SP500 are now $1569-1622, $105.95-108.11, and 1228-1259, respectively.

 

On behalf of my family and firm, Merry Christmas!

KM

 

Keith R. McCullough
Chief Executive Officer

 

 Dickens' Lead - EL

 

Dickens' Lead - vp 12 23


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LV STRIP: THE GREEN STREAK SHOULD CONTINUE

A modest gain in Strip revenues expected for November. 

 

 

NOVEMBER PROJECTIONS

 

Based on our airport/taxi predictive model, we estimate Strip revenues grew 2-6% in November, assuming normal slot and table hold.  McCarran Airport passenger traffic increased 3.9% YoY in November—the 11th straight month of growth, and Nevada November taxi trips eked out a 1.2% gain.  Statistically, the McCarran data is a better predictor of slot volume while taxi data correlates more highly with table volume excluding baccarat.

 

Strip performance could have been even better if not for the abnormally high slot hold of 8.2% last November.  However, the difficult slot comp is reversed in December when slot hold was only 5.7% versus a normal 7.0%.  Baccarat volume should look very strong while slot and other table volume should register low single-digit volume gains.  All in all, November was likely a solid month on the Strip. 

 

LV STRIP: THE GREEN STREAK SHOULD CONTINUE - 3


SIGMA Says

Our SIGMA framework is predicated upon the relationship between a company’s sales/inventory levels relative to margins, a major theme headed into the fourth quarter.

 

Recent incremental shifts in the SIGMA suggest some retailers are better positioned for a more competitive year-end while others are not. The key callouts include WMT, FL, TRLG, SKX & HD looking incrementally more favorable while BKE, M, SKS & LULU look more precarious.

 

Here are the more noteworthy Q3 shifts (both positive and negative on the margin):

 

THE GOOD:

 

WMT: After running negative for 5 quarters, the sales/inv spread turned positive in Q3 with WMT US & Sam’s clubs comps exceeding guidance and inventory growth slowing on the margin (down 4 pts to +7.5%). This comes at a time when WMT is outperforming its peers this holiday and comps are beginning to turn.

 

“We're very well positioned with inventory in both store and online for the fourth quarter…. We have the assortment our customers are looking for, both in-store and online. We have the inventory they need and we have the prices that can't be beaten.” –Bill Simon, President & CEO WMT US Stores

 

SIGMA Says - WMT

 

 

HD: The Sales/inv spread expanded 3 points in Q3 after making its biggest sequential move in 2Q11 since the start of ‘09. The spread now sits at +7%, the highest point since the first quarter of 2008 while margins have been expanding for 9 quarters in a row. Can it really get much better? This is one of the names where the SIGMA is so bullish that it is almost bearish.

 

“We're thrilled with our inventory performance, and we've just spent a lot of money transforming our supply chain, so we're hoping to see this come through. As you know, we have committed to get a full turn of improvement over the next several years. If you look at where we are seeing it, part of it is really just in terms of the quality of the inventory. Our clearance levels are as low as they have ever been in our company history.” –Carol B Tome’ CFO

 

SIGMA Says - HD

 

 

FL: The spread slowed 3 pts to +9% in 3Q11 but has remained positive for 8 quarter in a row with margins expanding in each of those periods. Revenue growth continues to run 2X inventory growth which has driven a reduction in markdowns and as a result has kept margins on the upswing in both apparel and footwear.  

 

“Our clean, fresh inventories have allowed us to keep reducing our markdown rates in almost every division….. Margins remain on the upswing in both categories as well as in accessories and we see ongoing opportunities for further improvement.” – Lauren B. Peters CFO

 

SIGMA Says - FL

 

 

SKX: The SKX Sales/Inv spread improved 13 points in Q3 as they lapped 70% growth in Q3 inventories LY. As a result, inventories were down 27% on a 26% decline in sales. The SIGMA’s clockwork move suggests trends are improving on the margin, but be mindful of the incremental inventory coming on to support the company’s ramp into fitness in the 1H F12 that will likely curb near-term sales/inventory progress.

 

“We cleared out excess inventory in the third quarter and are pleased that our margins which were 42.5% for the third quarter of 2011 have returned to their historical norm, a reflection of selling more inline product.” – David Weinberg, COO/CFO

 

SIGMA Says - SKX

 

 

TRLG: Inventories improved sequentially for the third quarter in a row down 14 points to +5% YoY. While the top-line mirrored the inventory trends and decelerated on both the 1 and 2 yr, the spread jumped 11 points to +12% with EBIT margin improving incrementally as well.

 

Well, some of the things we've been doing from an inventory perspective is really just pulling together the team to analyze our production plans in relation to our sales plans….. We're comparing our balance this year to last year, we just got a better approach to managing the production, linking it up with current sales forecasts and trends to avoid building any type of excess position especially in the warehouse.” – Peter F. Collins, CFO

 

SIGMA Says - TRLG

 

 

GCO: Sales growth continues to outpace inventory growth despite inventories up over 20% YoY for the 5th quarter in a row. The spread improved 8 points to +12% marking the strongest relative growth position since the beginning of 2008 reflecting both better assorted inventories as well as stronger performance across all channels of late.

 

“So, right now, we're in a position where we are less broad, more deep. That should help sell-throughs, both in terms of having a greater percentage of hot products in the stores, but also when you get down to the final run, you have much more efficient use of your inventory. So, we are in that very good position.” – Robert J. Dennis CEO

 

SIGMA Says - GCO

 

 

PETM: The sales/inventory spread has been improving on the margin for 4 quarters while operating margin expansion has consistently improved to the tune of 30-80bps. Average inventory/store continues to be well controlled coming in flat YoY which is meaningful given guidance for a more promotional fourth quarter.

 

“The second drainer (referring to negative impact on margins) was we were a little bit more promotional in some of our traffic-driving items this quarter. We made some decisions early in the quarter to go that direction. And that'll continue through probably the end of December.” – Lawrence P. Malloy, CFO

 

SIGMA Says - PETM

 

 

 

THE BAD:

 

BKE: Buckle’s inventory position was up 27% on 12% growth in sales. The company increased its denim inventory to avoid missing out on sales a la Christmas 2010. The opportunistic approach drove the sales inventory spread down 10 points to -14%, the company’s lowest position since 2003. This is the most aggressive bet on Holiday 2011 we’ve seen in retail hands down. Given the company’s posture into year-end, the outcome will be binary.

 

“Well, last year, we felt like we missed some business by being too low on our denim inventory, as well as certain top categories. And also, in the Men's outerwear, we did not have everything shipped to us last year. So we improved our inventory position there. So we felt that our inventory – we wanted to capitalize on some of the opportunities for holiday on several of those categories.” – Dennis H. Nelson CEO

 

SIGMA Says - BKE

 

 

GIL: Inventories were up 73% in Q4, up 13% sequentially on +30% sales growth – not good. With screen-printing demand off sharply, both the sales/inventory spread and margins are likely to remain under pressure through the 1H of F12.

 

“Weak demand and increasing competitive pricing pressure in the screenprint markets have continued into the first quarter of fiscal 2012….. The significant destocking of distributor inventories in the first quarter has resulted in excess inventories building up at the manufacturer level and to further discounting in order to try to maintain capacity utilization at capital-intensive producing mills.” – Laurence G. Sellyn CFO

 

SIGMA Says - GIL

 

 

LOW: The sales inventory spread eroded 2 points to -3% in Q3. While the deterioration in itself is minor, the swing from the danger zone into the red zone to preserve margins while allowing inventory  growth to exceed the top line is dangerous. Unlike Home Depot’s more aggressive approach to pricing, LOW has kept promotional activity subdued at the expense of sales while guiding to an improved inventory position at year end.

 

“Within appliances we chose not to match some competitors' extremely aggressive third quarter percent off promotions.” – Rick D. Damron, EVP Store Operations

 

SIGMA Says - LOW

 

 

LULU: LULU’s sales inventory spread fell over 50 points in Q3 due to inventory growth accelerating from +34% in Q2 to +77% in Q3; the spread now stands down (46%). The last time LULU saw inventory growth exceed sales growth, its behavioral response was far better than it should have been for such an immature company. We should see the same this time around. For additional insight on the massive swing in the SIGMA, see our 12/1 research note “ LULU: Respect History.”

 

“So that's the cycle we're committed to really ending and I'd rather be sitting here telling you we're in a great inventory position that's up than be sitting here quarter-after-quarter talking about being down, because then the cost is big to our guests and it's big to our brand long term. So we really are excited about where we are for inventory because it's with relief we can turn our energies to other things and we know what we have in the mix for Q4 and into Q1 is what the guests wants.” – Christine McCormick Day, CEO

 

SIGMA Says - LULU

 

 

M: After 8 quarters in the sweet spot, Macy’s sales/inventory spread fell 6 points into what we refer to as the “denial quadrant.” Shifts into the red zone suggest a company is propping up margins while allowing inventories to build- this is not sustainable. History proves that higher inventories are manageable if profitability is up… until they aren’t.  For more detail on Macy’s Q3 SIGMA move, see out 11/9 post “M: Bad Risk Reward.”

 

“Planned promotions tend to be profitable. It's only when inventory is out of line with sales, which in our case is not the case, where you get excessive markdowns and margin hits. But in terms of promotions, I think it's going be pretty much as it's been the last couple of years, which is very heavy.” – Karen M. Hoguet

 

SIGMA Says - M

 

 

SKS: The sales inventory spread was down 1% in Q3 following 8 quarters in the “sweet spot”. Year-end inventory growth has been guided to slow below expected top line growth in Q4; however, current levels have driven incremental discounting into the holidays.

 

“Consequently, we believe that higher than planned inventory levels in these areas may require incremental year-over-year markdowns as we move through the traditional end of season clearance period.” – Ronald L. Frasch, CMO

 

SIGMA Says - SKS

 

 

TIF: Inventories were up 25% in Q3 despite favorable compares due to a 58% increase in raw material inventories. While the increase in raw materials has been to facilitate the expansion in jewelry assortment and drive sales, the sales/inventory spread  fell 16 points to -4%.

 

 

“The Tiffany & Co. brand remains strong, customers are increasingly attracted to our well-designed high-quality products, our stores have strong inventory positions, we have a well-developed and efficient infrastructure, and we have a solid balance sheet to pursue our expansion plans.” –Patrick McGuiness, CFO

 

SIGMA Says - TIF

 

All in, there has been a considerable shift of positive sales/inventory spreads turning negative in Q3. While this has been due in some part to lighter than expected sales growth, inventory growth is the real callout here and one of several reasons for our continued concern over industry margins headed into the 1H of F12. The companies we’ve highlighted above include those we see as more favorably positioned as well as those in a more precarious position given the current environment.

 

We have a library of SIGMAs for each of the retailers listed below. We’d be happy to pass these along at clients' request.

 

<chart16>

 

 


The LTRO Is No Bazooka

Conclusion: The proceeds from the borrowings from the LTRO by European banks are seemingly being deposited into the ECB liquidity facility and not being used to purchase sovereign paper. This is validated by three key measures of risk: German short term bund yields, the TED spread, and Italian 10-year yields.

 

The most recent purported panacea to emerge in the European sovereign debt crisis was the recently announced Long-Term Refinancing Operation, or LTRO. The LTRO, by mandate, provides 3-year loans to European banks at a 1% interest rate. Initially, the program was deemed a massive success as 523 banks “oversubscribed” and took 489 billion euros from the LTRO.

 

Unfortunately, the actual injection of liquidity was substantially smaller than 489 billion euros. According to our preliminary analysis, the roll over of short term debt, from 7-day to 3-month paper, actually took up the majority of the LTRO and, in fact, the actual incremental liquidity increase was likely closer to 210 billion euro, a far cry from the original headline number.

 

Aside from injecting much needed liquidity into the European banking system, which on the margin the LTRO did do, the consensus perspective at the time was that the LTRO was in effect a back-door bazooka. As such, this facility would be utilized by the banks to purchase European sovereign debt, which would in turn alleviate some of the funding pressure in the sovereign market. Based on the most recent data from the ECB, the LTRO does not appear to have been used for this purpose.

 

In the chart below, we’ve highlighted the ECB liquidity facility going back one year and in the inserted chart going back roughly one month. The key takeaway is that the ECB liquidity facility, which is used by European banks to effectively park money, hit a new all-time high at 411 billion euros this morning and has been increasingly rapidly since the inception of the LTRO just over a week ago. In fact, the day before the LTRO was put into effect, the ECB facility was at 265 billion euro and as of this morning has increased by 146 billion euro, or more than 70% of the incremental liquidity from the LTRO.

 

The LTRO Is No Bazooka - ECB

 

So, not only is the LTRO not being used as a bazooka by the European banks, but these banks are parking the borrowed LTRO money with the ECB rather than using it to buy sovereign debt, and thus are experiencing a negative yield on the trade. As noted above, European banks borrow at 1% from the LTRO, but when parking money with the ECB only get paid a 0.25% yield. So rather than taking any risk in buying European sovereign debt, the banks are, seemingly, willing to take a 75 basis point negative carry trade on this liquidity.

 

Not surprisingly, given the actions that European banks are taking, which signals they see more and not less risk on the horizon, the TED spread hit a new YTD high this morning, which in our view is the most appropriate measure of systematic risk in the banking system. As well, we’ve highlighted in the charts below that German 1-year Bunds are approaching close to YTD lows, at less than 0% yield, and Italian 10-year bonds are approaching YTD highs in yield, at north of 7%. The later point is the most disturbing in the face of sizeable Italian bond auctions this week, but together highlight that risk aversion is heightening in Europe.

 

The LTRO Is No Bazooka - German1F

 

The LTRO Is No Bazooka - Italy10F

 

The LTRO is certainly not a panacea and, clearly, not even the fabled Bazooka. In reality, the market is actually looking right through the LTRO and looking directly at the estimated 800 billion euro of Eurozone sovereign debt that needs to be refinanced next year and the 230 billion euro of European bank debt that needs to be refinance in Q1 2012.

 

Daryl G. Jones

Director of Research


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