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Capitalism's Most Bullish Chart Bottoming Again?

Albeit at a “no drama” Obama pace, for 5 consecutive days, the slope of this curve has steepened. See the chart measuring the spread between 10s and 2s below. We like to see a positive and expanding slope to the curve because it allows for liquid long capitalists to make money off of the levered.

Borrow short; Lend long – that’s not a new investment model, but it is one that I need to see in order for The New Reality to prosper.

Flat yield curves beget banks taking on undue amounts of leverage in order to earn a return. I don’t do that. Call me conservative, or call me right. I think this is the kind of American Capitalism that people can buy into and trust.

LULU: Early Cycle Company Acting Mid Cycle-ish

The store growth slash overwhelmed the fact that the company managed its business like a retailer who has been in business for 30 years. As growth investors cycle out, this name is a gift.

What a flat-out weird quarter from LULU. Truly. Expectations were for a miss due to weaker comps, eroding gross margins, higher SG&A due to ERP investments, and inventory build. In actuality, the P&L looked better, the balance sheet looked exceptional, but store growth expectations were decimated. Bears definitely right on this puppy – though most probably for the wrong reasons.

Why do I say that LULU is acting like a mid-cycle company? Two main reasons…

1. The degree to which the company managed its inventories this quarter almost knocked me off my chair. Check out the SIGMA below. For 2 quarters straight, inventories built (and the multiple contracted), but then LULU took a massive V-shaped move to clean its balance sheet at the expense of margins (upper left quadrant). The key point here is that 80% of retailers revert to the lower left quadrant first – i.e. inventories building AND margins down – before taking any action. LULU is a step ahead. That’s unusual for a company like this where people so frequently question managements’ ability to execute.

2. The fact that LULU has secured only 5 real estate locations for next year on a base of 107 at year-end 2008 should scare even the most conservative growth investor at face value. Yes, it scared me as well. For most retailers, this behavior suggests management’s lack of confidence in its own growth platform. I don’t think this is the case with LULU. But it does show that the store growth strategy is part offense, and part defense.

a. The defensive angle is that company realizes that it does not live in a vacuum, and investing in a declining spending environment is risky business.

b. The offensive angle is that LULU fully realizes the leverage it holds with prospective landlords. LULU is taking a ‘come to Daddy’ approach to secure lower rents, which I like given that it will balance store-level economics as business shifts incrementally from 4-wall to .com.

c. The part of the growth equation that does not sit well with me is that a major theme next year, in my opinion, will be that the power brands that consumers want to succeed that also have the balance sheets to dominate the share-grab game and put weak competitors away will emerge the clear winners. LULU should be one of those. I’d rather see a more aggressive posturing here. They can afford it.

I still like the fundamental story here. Check out my 11/9 Post for the full thesis (I’m Finally On-Board with LULU”).

EYE ON REGIONALISM: The Swiss Vote in Another Right-Winger

In case you haven’t noticed, the Swiss do things differently. The country stays out of most military conflicts, is not part of the European Union, remains a “neutral intermediary” on the international stage, and the people speak any number of the country’s four official languages. So it should come as no surprise that their system of government looks different from the rest of Europe as well.

The governmental structure of Switzerland is important in the context of understanding yesterday’s election of conservative Ueli Maurer to the Swiss Federal Council, a seven-member (or four party coalition) executive council that operates as both a cabinet and collective presidency.

Switzerland’s Federal Council once represented all four major parties in the same ratio: two representatives each from the Free Democratic Party, Social Democratic Party, Christian Democratic Party, and one from the Swiss People's Party. This ratio changed in 2003 when Maurer’s People’s Party took an extra seat away from the Christian Democrats, having gradually amassed increased voting share to 29%, from 11% in 1987 to 22.5% in 1999.

Yesterday’s vote for Maurer was surrounded by considerable clout for his running mate for the People’s Party seat was Christoph Blocher, a sixty-eight-year-old billionaire industrialist who dominated political life for over a decade, transforming the Swiss People's Party from a small, rural party into a political machine firmly anchored to the far-right.

Blocher’s party emerged as the largest party in the coalition in 2003 and with it he was elected to a seat on the Federal Council. During his term he sparked much controversy in Switzerland and abroad with his anti-immigrant policies and musings. An example of the racism the party espoused is demonstrated in the below advertisement that shows three white sheep kicking a black sheep off the backdrop of the Swiss flag, with the bold black works “Create Safety”.

The racist suggestions in the message are clear; and this was a party poster that would have been displayed on any bus stop throughout the country.
Switzerland, a country known for its multicultural heritage nestled between France, Italy, Liechtenstein, Austria, and Germany has had its own cultural problems with immigrants. Much like the guest workers in Germany post WWII (see: ) Swiss society has integration problems with immigrant groups from the Balkans and Turkey in particular, with total foreigners living in Switzerland to be estimated at 20% of the population. Switzerland has some of the toughest naturalization rules in Europe. To apply you must live in the country legally for at least 12 years, pay taxes, and have no criminal record, making “integration” difficult. Although crime statistics are not definitive, many Swiss blame crime on the immigrants. In particular, the Swiss People's Party holds this to be true, and is their justification for deporting them and their families.

Returning to Maurer’s election to the Federal Council yesterday, it is important to understand that Maurer has been referred to as Blocher’s lackey over his political career. In 1996, at Blocher’s behest, Maurer was elected president of the Swiss People’s Party. His presidency saw the party double its voter base, establish itself in the French-speaking part of Switzerland, and in 2003 rise to the country’s strongest party. Maurer, who shares Blocher’s xenophobia, once said: “As long as I talk of negroes, the camera stays on me.” His conservative values have shown through with his comment, “"the downfall of our society."

Yesterday’s election of Maurer grabbed our attention for it confirms a current European thread of right-wing support. This was demonstrated in last week’s regionalism article on the legacy of Jörg Haider and the previous week’s look at multicultural tensions in Germany. The Swiss case further shows the integration problems of foreigners in continental Europe. The integration strain can be financial and cultural.

We’ll be following Maurer and Swiss politics in context of the Eurozone. We have recently sold our position in Switzerland on account of the country’s highly levered economy to the banking industry.

Matthew Hedrick

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Eye On The Obvious: Unemployment Is Bad

When jobless claims were released this morning, the typical fire engine chasing futures trader sold the lows to someone who gets it. Having CNBC give you their “up to the second” view on these macro releases has a more obvious implication than the fact that unemployment in this country is bad – they don’t have a real player taking more than “seconds” to take a breath, think, and give you a legitimate synthesis on how this jobless number fits within the game of expectations.

While it’s sad that people manage other people’s money by keying off of TV entertainers, it is what it is … and should be taken advantage of. That’s what real American Capitalists do. This morning’s jobless data was bad – we know this. After a peak to trough decline in the SP500 of -52%, the market knew this was coming too!

On both a one week and 4 week moving average basis (see chart) jobless claims hit new cycle highs. Stock markets are discounting mechanisms of the future, however, not the past. The best question you can ask yourself about this chart is what happens when it hooks down again? This is called mean reversion, and I wouldn’t be surprised to see a weekly number, within the next few weeks, coming in better on the margin.

What happens on the margin is what matters most to our macro models. We are more bullish on US Equities right now, not because the entire free world knows unemployment is bad – but because sentiment in this country is going from toxic to bad – directionally, that’s good.

YUM – Changes to the Growth Matrix in 2009

Over the past three years, YUM has not made any changes to its long-term earnings growth model. On an ongoing basis, the company still expects to generate 10% EPS growth, with China, YRI and the U.S each contributing operating profit growth of 20%, 10% and 5%, respectively. For reference, in the last 3 years, China and YRI have met and/or exceeded these targets while the U.S. has fallen short. The U.S. has not achieved 5% operating profit growth since 2002 and has been negative in four of the last six years. So, needless to say, growth in China and YRI have more than offset the weakness in the U.S. as the company has consistently grown EPS by at least 10% on an annual basis. In 2008, the U.S. accounted for about 40% of segment operating profit while China and YRI combined represented about 60% (YRI 30%, China 30%). YUM maintains that China’s operating profit contribution will continue to grow over time and should account for 40% of total company profit by 2017 (with the U.S. moving to 30%).

This is not new news and is the reason why investors have focused so much on YUM’s growth opportunities in both China and YRI, particularly as the U.S. economy has slowed. YUM’s international growth matrix has provided balance. What is new news is that in 2009, YUM expects China operating profit growth to slow to 15%-20%, YRI to decline 5% on a reported basis (up 10%, excluding foreign currency) and the U.S. to grow 15% (up 5% before expected G&A savings). YUM’s ability to achieve 10% EPS growth in 2009 will rely more heavily on the company’s growth expectations in the U.S. And, based on both the company’s track record of over promising and under delivering in the U.S. (please see post from yesterday) and YUM’s underperformance in the U.S. since 2002, this reliance on the U.S. significantly raises the risk that YUM will fail to meet its expectations.

Management stated a couple of times that its 15% operating profit goal for the U.S. in 2009 does not require heroic results out of KFC as it requires only 4% margin accretion (largely from KFC) or 5% operating profit growth from Taco Bell, Pizza Hut and KFC with the balance of the growth coming from its expected G&A savings. Although Taco Bell and Pizza Hut are expected to meet the company’s 5% operating profit target in 2008, KFC is expected to decline significantly. KFC’s same-store sales declined 4% in 3Q08 so getting to mid-single digit same-store sales growth and 5% operating profit growth in 2009 will require a dramatic turnaround even in light of the easy comparisons. As I have said numerous times before, in today’s difficult operating environment, easy comparisons no longer mean anything. Additionally, the company is still facing commodity headwinds in 2009, particularly in 1H09, which will make it even more challenging to grow margins in the U.S.

Add to the risk associated with growth in the U.S., the fact that YUM does not currently have any plans to buy back stock in 2009 so financial engineering will play less of a role in achieving targeted EPS growth than it has in the past. I cannot argue against wanting more liquidity in today’s environment. I do think management should have come to this conclusion sooner, however, rather than having levered up so significantly in 2008 to buy back nearly $1.7 billion of stock. Management highlighted that it will re-evaluate the credit markets and reconsider buying back stock and/or paying down debt in 2H09 if prudent so there could be some financial engineering to get to that 10% EPS growth after all.

Who Do You Want To Be?

“Those times when I’ve been down, when I’ve been kicked around, I hold onto those. In a way, those are the best times I’ve ever had, because that’s when I’ve found out who I am. And what I want to be.”
-Brett Favre

The most interesting reality associated with Favre’s quote is the context. After being named “Sportsman of the Year”, Sports Illustrated asked him what his favorite memory was, and that was his response…. I have kept this quote taped on the insert of one of my investment notebooks. I always re-read it when I am looking for the strength to take the shot that no one wants to take.

Being a bear for the better part of the last year has had its loneliness. This morning, you could fill a Christmas concert hall with naysayer “strategists” and television entertainers alike who are “bearish.” Taking the shot on the bullish side of China a month ago and taking it here in the USA this morning is all one and the same. It’s the one very few bears want to take. 2008 is over - and I guess they want to ride whatever it is that they are saying now out… There’s one big problem with that. This is a full contact sport, and the game is still on!

You see, the way the Street works is that “strategists” get overpaid to be stagnant. The longer they “stay with the call”, the higher the probability that they don’t ruffle any client feathers… or at least that’s what the leaders of ‘Investment Banking Inc.’ have taught them. Let’s wake up to The New Reality folks. We live in an interconnected world where global market factors interact expeditiously. The facts change daily, and when they do… Brett Favre would probably have my back in suggesting that you better have your head up.

That’s the only way that a 39-year old grey bearded man could still be marching down one of professional life’s toughest fields with a winning record. He’s a 3 time NFL MVP (1) for plenty of reasons, but I think the most relevant one is that it’s because he is a realist. He doesn’t get bogged down by his mistakes. He learns from them, and takes every snap for what it is – a new opportunity to do better.

Every day, I wake up at 4:03AM, and drive to New Haven, CT for one reason – to win. This is where the best team I have ever worked with will have the lights on. This is where the best questions are asked. This is where American Capitalism has re-found its footing.

Winning in the immediate term and the long term are two undeniably different things. And while many investors will tell you that “stylistically” they have different durations in their investment objectives, I won’t. I want to be right every single day. I am not ashamed of that fact. It is what it is. It took me a decade on Wall Street to remind myself of “who I am. And what I want to be.”

This morning, I am waking up to the most invested position I have held in 2008. I have the following Asset Allocation: US Cash 50%, US Equities 15%, Int'l Equities 19%, Commodities 16%. I am not getting invested for any other reason than to be right. Being right on Hong Kong being +41% since October or China +20% since November is not what waking up for this morning’s game was all about. Those are wins. Today is a new opportunity to add to and improve our record with our US stock market and global commodity market “Re-Flation” call.

Central Bankers around the world are going to get us all paid by doing nothing more than what Alan Greenspan did between 2001-2003. They are going to cut interest rates and devalue their currencies in order to re-flate. Taiwan cut interest rates by the most in 26-years last night taking their benchmark rate to 2%. South Korea cut rates by the most EVER, taking rates down by another 100 basis points to 3%. Don’t disregard the context of these coordinated Asian rate cuts – only 6-9 months ago (when I was bearish on Asia), these governments were raising rates!

Greenspan’s ghost has gone global folks. In Switzerland the government has effectively cut rates to zero on a real basis this morning, taking rates to 0.50%; Brazil is floating the trial balloon out to the trading community that they are ready to cut; and our Depressionista dog fighter pilot “Heli-Ben” is preparing to drop FREE moneys from the skies in t-minus a week.

This is why the US Dollar is getting smoked this morning – it is down -2.6% for the week. This is why the CRB Commodities Index is +6.3% for the week to date. This is why Russian, Middle Eastern, and Canadian equities are all rallying. Commodities are the most levered asset class bet on “Re-flation.”

I am less interested in throwing the capital allocation ball to any equity market other than the one receiver that’s wide open and staring me right in the face – she’s American, and no one thinks she can catch it, never mind running it down the field for six points. I understand the bears, because they have become me.

It takes a bear to know one. “Those times when I’ve been down, when I’ve been kicked around, I hold onto those…” I am ready for today’s 930AM game time. Ready… set… hut, hut, hut!  Let’s go get that SP500 target of 931!

Best of luck out there,

Long ETFs

DIA –DIAMONDS Trust Series – Oil is trading up to 45.93 this morning, which benefits key DIA components Chevron (6.36%) and Exxon Mobil (6.32%).

SPY-S&P 500 Depository Receipts – CME futures contracts traded below 886 before rebounding to 899 by 6:55 AM.

XLV Health Care Select Sector SPDR –Fitch Ratings issued a negative outlook for the US Healthcare sector yesterday with a bearish view on  pharmaceutical companies  and for-profit hospital operators and a stable outlook for medical device makers.

GLD -SPDR Gold Shares – Gold traded up to as much as $8.85, or 1.1%, to $819.45 an ounce and traded at $813.23 by 8:58am on the LME.

OIL iPath ETN Crude Oil – NYMEX contracts traded as high as 45.93 this morning on comments by Saudi Arabian Oil Minister Ali al-Naimi on anticipated OPEC production cuts.

EWG – iShares Germany – Germany’s Ifo Institute predicts the German economy will shrink 2.2% in 2009 and continue into 2010. The DAX is trading flat this morning, up 8.52 points, or 0.18%, at 4806.48.

EWH –iShares Hong Kong – The Hang Seng closed flat to 36.16, or 0.23%, at 15,613.90.

FXI –iShares China – The CSI300 closed down 2.39% to 2046.34. Consumer prices rose 2.4% in November from a year earlier, after gaining 4% in October.

Short ETFs

EWU – iShares United Kingdom – The FTSE100 is trading slightly up this morning, 0.57% at 4,393.46. The economy contracted 0.5% in the third quarter and the BOE predicts further contraction next year.

UUP – U.S. Dollar Index –The dollar fell to 1.3158 EUR this morning, the lowest level since October 20, while the pound rose to 1.4966 USD from 1.4785 yesterday.

FXY – CurrencyShares Japanese Yen Trust --The dollar weakened to 92.24 JPY in trading this morning while the Euro rose to 121.02.

EWY- The Bank of Korea Governor Lee Seong Tae and his board reduced the seven-day repurchase rate by one percentage point to 3% in Seoul today, the lowest since the bank began to set a policy rate in 1999.

IFN-India’s wholesale inflation rate fell to a seven-month low, suggesting further central bank rate cuts. Wholesale prices increased 8% in the week of November 29th from a year earlier after gaining 8.4% in the previous week.

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