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When it comes to inventories heading into holiday during a recession, less is definitely more. Here are the names with the biggest and least margin risk.

Yeah, business stinks – we all know that. But it’s times like these that separate the winners from the losers. Let’s take a quick look at the standouts over the past quarter in managing inventories relative to sales. You don’t need to be a retail genius to know that a lean sales/inventory spread (sales growth > inventory growth) sets up for a positive gross margin event in 4Q – well needed in this climate. Lululemon, UnderArmour, Liz Claiborne, Timberland and Ralph Lauren are my favorites in that context. On the flip side, watch out for expectations to be in synch for names like Abercrombie, Volcom, Skechers, J Crew, DSW and Brown Shoe.

Eye On Leadership: Jack Bogle

“The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as something grand and beautiful and noble, well worth the toil and anxiety."
- Jack Bogle, Founder of Vanguard Group

“Good people do not need laws to tell them to act responsibly, while bad people will find a way around the laws.”

Since we are located on the fringe of Yale’s campus in New Haven, CT, the Yale Daily News (“YDN”) tends to be one of the many daily newspapers our research team reads every week. It is the United States’ oldest college daily newspaper (although the Harvard Crimson disputes that claim) and has been the starting place for many successful journalistic careers, including Henry Luce, William F. Buckley, John Hersey, Pete Axthelm, and Dana Millbank, to name a few. From our perspective, it is worth reading because it offers a view into the current mindset of college students.

On December 4th, 2008, we picked up a copy of the YDN and a headline on the front page article read, “A Job on Wall Street: Are you Crazy?” The insinuation being that not only were jobs tougher to come by on Wall Street, but, and not surprisingly, the allure of such jobs had faded meaningfully. This was reinforced by a recent talk Keith gave to a group of students who were emphatic in their disdain for finance and the said “leaders” that run these major financial and investment banking firms. Smart, motivated graduating seniors want to be proud of their emerging careers and that pride begins with picking an industry that has integrity and respect.

The events last week relating to the fraud of Bernie Madoff’s hedge funds obviously even further tarnish the financial industry. We discussed Madoff this week on our portal, so won’t rehash the facts again, but the extent of the fraud is breathtaking and is estimated, in some reports, at over $50 billion. Ironically, while Madoff was not a household name, both he and his firm were considered long time leaders in the financial industry.

As a slight digression, not everyone bought into Madoff’s returns. We reread a May 2001 article from Mar/Hedge this weekend , which was entitled, “Madoff tops charts; skeptics ask how”. This is a major publication in the hedge fund industry and a must read for anyone allocating capital to hedge funds. According to the article, from June 1989 to February 2001 “it (Madoff’s fund) would rank as the best performing fund for the period on a risk adjusted basis, with a Sharpe ratio of 3.4 and a standard deviation of 3.0%.” The returns appeared to be too good to be true, and were.

As I reflected on Madoff this weekend (admittedly, many of the details are yet to come), I found it incredibly difficult to understand how a man could live his entire life under such a fraudulent scheme. Not only did he cheat his friends, close associates, but, ultimately, his own sons turned him in. In my mind, it would be better to be destitute and unknown than to live an entire life based on a lie, but, of course, Madoff thought otherwise.

The unfortunate implications of the Madoff fraud are that confidence in the “old boy” financial services industry will deteriorate further. While mistrust in the leadership of the industry is certainly well founded, I do think it is important for us to value the Madoff situation appropriately as his actions appear be an outlier, even for a terribly conflicted and compromised industry. While reading this morning, I a read article online by psychologist Juliann Mitchell about sociopaths and she wrote:

“It is typical for sociopaths to engage in illegal or deceitful behaviors. Compulsive lying is the norm. Guilt and remorse are not in their vocabulary. All sociopaths are incapable of feeling sorrow or sadness for their wrongdoings and destructive behaviors. Any tears you might see are for themselves. “I am crying because I got caught, not because I am sorry for anything I have said or done.”

Madoff was clearly a sociopath and, therefore, in a league of his own.

As the Madoff scandal and the failed leadership of Investment Banking Inc. are leading to a crisis of confidence in the financial industry and creating real doubts by our leaders of tomorrow, it becomes even more important to highlight that there are many great leaders in finance. These are people that have built long and successful careers on the pillars of integrity, transparency, and trust. One such person is Jack Bogle, the founder of the Vanguard Group.

John Clifton “Jack” Bogle was born on May 8, 1929 in Verona, New Jersey. Bogle went to Princeton University and while at Princeton happened upon an article in Fortune about the emerging mutual fund industry. Eager to write a thesis about a topic that had not been widely studied, Bogle wrote a successful thesis about the industry and was awarded with a job at Wellington Management, where he worked for the next 23 years and ultimately became CEO. Bogle left Wellington in 1973 and founded Vanguard in 1974.

The rest, as they say, is history. Vanguard today manages over $1.3 trillion and is the largest pure no-load mutual fund company in the world.

In a 2003 speech at the Harvard Club of Boston, Bogle said:
“The extensive study of the industry (in his 1951 senior thesis at Princeton) that followed led me to four conclusions: One, that mutual funds should be managed in the most “efficient, honest, and economical way possible: and that fund sales charges and management should be reduced. Two, mutual funds should not lead the public to the “expectation of miracles from management,” since funds could “make no claim to superiority over the (unmanaged) market averages.” Three, that the “principal function (of funds) is the management of their investment portfolios” – the trusteeship of investor assets-focusing on the performance of the corporation . . . (not on) the short-term public appraisal of the value of the share (of stock).” And four, that “the prime responsibility” of funds “must be to their shareholders”, to serve the individual investor and the institutional investor alike.”

These are fairly basic principles that embody transparency, accountability, and putting the client first. Bogle developed these principles as a senior at Princeton over 50 years ago and has managed his businesses based on them ever since.

The quotes from Plato and Bogle at the start are meant to emphasize two points. First, capitalism and the pursuit of profits can very much be a noble endeavor. Secondly, bad people exist and they will find ways around our laws. Careers like Bogle’s tell me one thing, incredible profits and success can be found within the framework ethical conduct and, in fact, and a long term legacy is almost impossible without that ethical foundation. We need to encourage our leaders of tomorrow to study the careers of people like Bogle, so they will realize that there is much to be proud of in the investment management industry.
Biographer Richard Slater described Bogle’s life as “evolutionary, iconoclastic and uncompromisingly committed to the founding principles of putting the interests of the investor first . . .” There is clearly a vacuum of leadership in the financial and money management industry at the moment. While the lack of credible role models justifiably concerns the leaders of tomorrow, this leadership vacuum will also create opportunities for people to lead themselves, to define “The New Reality”, and to aspire to become the next generation’s Jack Bogles.

Daryl G. Jones
Managing Director
111 Whitney Avenue
New Haven, CT 06


Eye On The Energy Threat: Ukraine’s Geopolitical Impact

A recent top business story in the Russian Times included a short article on Ukraine’s failure to pay state-owned Russian gas giant Gazprom $2.4 billion in debt.

This impasse between Ukraine and Russia is nothing new, yet there are multiple contributing factors that make Ukraine an important country in our global macro dialogue, including: (1.) the geographic significance of a major Russian gas pipeline running through the country that services Europe, (2.) the politically divided Ukraine with recent signs of EU-centric orientation, and (3.) heightened policy between “The West” and Russia, including measures by the European community to reduce its dependence on Russian energy.

Ukraine’s geographic location is an important one that plays into its geopolitical influence. It’s situated with Belarus to the north as a strategic land buffer between Russia and Europe. While increasingly more pipelines are being built to service oil and gas from Russia and the Caucasus to Europe that don’t directly cross Ukrainian or Bulgarian territory (e.g. under the Black and Baltic Seas), currently the Russian pipeline Druzhba (or “Friendship”) running across Ukraine services 80% of the gas the EU receives from Russia. This is a considerable number, especially with context—Russia exports about a quarter of the EU’s gas.

For years, Ukraine enjoyed cheap gas prices as part of the Soviet legacy. That changed in 2005 when Ukraine decided to switch to market prices for transit through the country. Gazprom, the largest extractor of natural gas in the world, was all too happy to accommodate Ukraine and consequently drove up the price of gas. Ukraine’s first refusal to pay higher prices resulted in Gazprom shutting off supply on January 1, 2006. Hoping to circumvent the action, Kiev decided to siphon off gas from the pipeline, which resulted in the disruption of gas deliveries to Europe.

At the end of October 2008, Gazprom and Ukraine’s state-controlled Naftogaz Ukrainy signed a long-term agreement for direct gas supplies from Russia to Ukraine with the abolishment of the intermediary company RosUkrEnergo, which is 50% owned by Gazprom. While the agreement did not set out the volumes of gas Ukraine would buy from Gazprom in 2009 and beyond, nor a price or pricing mechanism, the signing of the deal was seen as a positive step in Ukrainian-Russian relations. Yet this relationship has soured in recent months due to Ukraine’s failure (or as some see it inability) to pay off its debt of $2.4 billion in gas back payments to Gazprom on behalf of RosUkrEnergo.

Now that the holiday season and colder temperatures have arrived, observers speculate that Gazprom may have another stand-off with Ukraine, which could have repercussions in European supply.
It is Ukraine’s geographic location that makes it of such political importance for both the European Union (The West) and Russia (The East). Ukraine’s political trend-line has been gradually changing towards a pro-EU orientation, with pro-Western parties and coalitions coming to power, as demonstrated by the victory of President Viktor Yushchenko’s Orange Revolution five years ago. Yet still, observers struggle to qualify the “democratic” nature of the country’s leadership. After entering office, President Yushchenko banned Ukrainian cable companies from showing Russia’s Channel One to limit the Kremlin’s voice, demanded Ukrainian language instruction from kindergarten to university level, and instituted a remembrance holiday to acknowledge the genocide of Ukrainians by Russian commissars during the famines in the 1930s. Such measures didn’t go over so well with all Ukrainians, for a larger percentage of eastern Ukrainians still strongly identify with Russia.

Both the EU and Russia have made attempts to reign in on Ukraine. While Russia has exercised its influence through leveraging its energy price, the EU has made a number of concerted efforts. Just last week NATO foreign ministers met in Brussels to discuss whether Ukraine and Georgia should be allowed into the military alliance. Ultimately Western Europeans, led by Germany and France, blocked US efforts to offer Ukraine and Georgia membership, yet the discussion furthered the debate to recognize Ukraine as a “Western” country.

In another EU gesture to extend its hand to Ukraine, European Commission President Jose Manuel Barroso unveiled an Eastern Partnership package last week to give Ukraine and five other former Soviet states access to €350 million of financial aid, free-trade pacts, and hassle-free visas. In addition Ukraine has already received more than a quarter of the $16.4 billion rescue loan from the IMF. This comes at a time when its currency, the hryvnia, has deeply devalued to historic lows against the dollar.

Russia, on the other hand, has done little to repair its reputation with Ukraine. Ukraine officially denounced Russia’s invasion of Georgia. In fact its aggression further confirmed to many Ukrainians that when it comes to political and economic issues, they trust Europe more. Even the politically significant balance of power between Washington and Moscow over such controversial issues as the US proposed missile defense shield in Poland and the Czech Republic has Ukraine leaning westward.

Yet the icing on the cake to disrupt the political significance of Russia may result solely from its oil-levered economy. Oil prices from a high of $147/barrel in July are down 70% today. Further, the EU is taking steps to limit its dependence on energy imports, including gas. In November, the European Commission convened and came up with The New Energy Policy, a plan by 2020 to reduce carbon dioxide emissions and total demand for energy by 20% and to increase the share of renewable energy sources.

While the plan didn’t explicitly aimed to reduce the EU’s dependence on energy sources from Russia, the implication was understood. Irrespective of the EU’s ability to meet The New Energy Policy, Russia’s bottom line will be affected. Investment is already being made by many European countries in liquefied natural gas (LNG) facilities that would allow gas to be transported via ship. LNG benefits would include the ability to store reserves for times of shortage, and rely on the world’s natural gas reserves rather than solely Russia’s.

While the European Union is not ready to extend membership to Ukraine, it has taken numerous measures to placate the country. With oil’s global demand destruction, Russia’s energy “authority” will be vulnerable, especially if the EU becomes less dependent on Russia for its supply. Ukraine remains an important country that can tip the East-West balance of powers. We’ll be following this global macro event as it plays out.

Matthew Hedrick


The trend remains the friend of the consumer and discretionary stocks…..

Last weekend we highlighted the trend is gas prices as a potential stimulant to consumer spending or at least the trend might be less bad in the coming months……

I guess it should not come as surprise that confidence among U.S. consumers improved this month from the lowest level in 28 years. The University of Michigan index reportedly reflected a record drop in gasoline prices that gave temporary relief to household budgets.

The average price for a gallon of gas now stands at $1.69, 60% below the peak set in July 2008. Next to Financials, Consumer Discretionary stocks are the most heavily shorted stocks in the S&P 500. Next to Energy, Consumer Discretionary stocks are trading at the lowest valuations of any S&P 500 sector. Short covering rally?

I like continue to think there is some tremendous value in the oversold Casual Dining sector – think EAT and DRI.

Eye On Re-Regulation: Where There's Smoke...

Where There’s Smoke… Notes for the Week Ending Friday, December 12, 2008

Auto Da Fe

You’ve got to be very careful if you don’t know where you’re going, because you might not get there.
- Yogi Berra

The discussion in Washington about the automobile bail-out is a watershed moment in America’s economic discourse. Notably absent from the debate has been the affirmation that Government is inherently wasteful, while private industry is by nature ruthlessly efficient. Rather, we are witnessing the spectacle of Big Government excoriating both Big Business and Big Labor for being inexcusably inefficient. As of this writing, it appears that the Paragon of Government Inefficacy is in league with the Poster Boy for Toxic Industrial Wastefulness – President Bush and GM CEO Wagoner are apparently spending quality time on the phone discussing the details of their forthcoming deal.

Congress has shown itself surprisingly resolute in turning down a request that looked to us all quid and very little quo. It appears that President Bush will issue an eleventh hour and fifty-ninth minute Presidential Pardon to Motown. How will We The People pay for this? Will Ben Bernanke file an extraordinary issue of Fed debt and toss the proceeds to the automotive industry? As hinted at by SEC Chairman Cox (“We Need a Bailout Exit Strategy”, WSJ, December 11), bailing out private industry will require a downstream market for the newly-issued paper. Watch out, China, it looks like we may be getting ready to double park in your spot.

Our story so far: the automotive industry has suffered from a national lack of political will, inability to gauge public sentiment, and an ongoing excess of greed that challenges Wall Street. Its labor-management cabal has viciously and systematically dismembered the Goose the Laid the Golden Egg, all while doggedly refusing to structure their operations to fit reality. We do not weep that they have come awfully close to being collectively thrown under a bus of their own manufacture.

While we wait for the next act, it appears that the argument for Capitalist Efficiency versus Government Waste is dead. The most Businesslike player in this story emerges as Republican Senator Bob Corker, who said: I’ll give you quid, you give me quo. This process, as described by economist Nouriel Roubini, entails combining a Bail-Out (government pushing money in) with a Bail-In (creditors, and stakeholders such as the Union, taking payment in kind), all in the common interest of sustaining this major industry. Can it really be that this deal collapsed because special interests refused to admit that they are no longer so special?

Our Big Question: Why have the shareholders of Ford and GM not already paraded their boards of directors through the public square in an Auto Da Fe – barefoot and in hair shirts, wearing signs on their chests with their sins writ large as they march to the scaffold? Boards of Directors of public companies have an obligation not merely to the shareholders, but to the market. Perhaps the argument should be made from orders of magnitude, and we will not suggest where to draw the line, but clearly the Directors of General Motors exercise a public trust vis-à-vis the marketplace.

Underpinning the self image of American Capitalism is the notion of a Meritocracy. Americans believe that people attain success because they are smarter and more diligent than the rest of us. The Horatio Alger hero remains the paradigm of American success. Falling asleep at the switch is the definition of malfeasance by corporate directors. How can it be that there are not already trillions of dollars of lawsuits filed against these failed protectors of the shareholders?

The Wall Street Journal (Friday, December 12, page A2) reports the Bush Administration has redrafted the Endangered-Species regulations “to reduce the input of federal scientists”. Shades of the Creationist Administrator who prohibited NASA scientists from issuing their research conclusions. With the Bush Administration barring scientists from introducing their findings into the debate surrounding regulation on scientific topics, the current disarray in the TARP and Auto Bailout programs should come as no surprise.

It is easier to live within an income than without one.
- Alfred E. Neuman

The Friday print edition of the Financial Times comes with a fat glossy insert titled “Financial Times – How to Spend It”. The magazine urges us to spend large sums of money on luxury goods, to keep the spending engine primed. The rest of the world may be suffering, but we don’t have to suffer along with them. And if we don’t spend it here, the Chinese will get their hands on it. We are not making this up.

This week’s cover features the Indian Motorcycle Company’s new flagship model, the Indian Chief. We salute the ninja marketer that is promoting the ultimate in Ultimate Road-Driving Freedom Machines at the moment when American road-driving culture is in the process of committing ritual suicide – who says Detroit has learned nothing from the Japanese? This whole publication is an exercise in blatant consumption that is not merely conspicuous, but conspicuously excessive. The Prophet Jeremiah might call this Turning Desperately to Pleasures of the Flesh on the Cusp of Doom. Ayn Rand might call this Those Who Have Owe No Apology to Those Who Have Not – Go And Get Some For Yourself. Thucydides might call this: The Powerful Do What They Will, The Weak Do What They Must.

Our advice: spend recklessly, wisely. Life-styles in the mirror are more costly than they appear.

It is a mistake to think businessmen are more immoral than politicians.
- John Maynard Keynes

It appears that Bernard Madoff, head of the financial firm that bears his name, has spent most of his career producing nothing. Like the Old Testament unfortunate Onan, he threshed within, yet winnowed without, and spilled his seed upon the ground. Alas, the Wicked shall not prosper – Selah!

Our recollection of Bernie is of a middle-aged man – avuncular, yet with an edge. Part of his charm was that Madoff & Co. was a family business. Bernie had one heck of a business model, paying us to execute trades through him. The executing broker got paid, Bernie got paid, we got paid – clearly, Bernie was a genius. And Wall Street loves its geniuses. We can only speculate that Bernie could not countenance no longer seeing himself as a genius. Taking losses is financially costly. Being a Loser is unacceptable.

On Black Thursday – October 24, 1929 – Richard Whitney, Vice President of the New York Stock Exchange, made his famous Walk Across the Floor at 1:30 in the afternoon. The Dow Jones Industrials had tumbled from 305 down to 272, and everyone agreed Something Had To Be Done. Stopping at the post where US Steel traded, Whitney announced in a loud voice, “I bid 205 for 10,000 Steel!” Rejoicing was unrestrained, and floods of buying washed across the Floor – though the reprieve lasted only until Monday, when the market reasserted itself, culminating in Black Tuesday and The Crash of ’29.

At the time that the well-dressed Whitney was buoying the hearts of his comrades, no one knew he was personally on the brink of financial disaster. He was running his own business by illicitly pledging his customers’ shares to secure his personal loans. Because there is no worse fate than seeing oneself as a Loser. It all caught up with Richard Whitney, who ended up in prison. Will Bernard Madoff be the Whitney of our age? Those who do not learn from the lessons of history are doomed to do serious time.

Which brings us back to the debate about Government inefficiency, versus Capitalist efficiency. Governor Rod Blagojevich is accused of trying to peddle a Senate seat for one million dollars. (We note that certain public officials may want to practice a little Auto-Rewind and acknowledge that, in America, Governor Blagojevich is innocent until proven guilty.) Governor Blagojevich is 51 years old and may do serious jail time. Bernie Madoff has admitted to massive financial fraud and may end up sharing an executive suite with the Governor. Madoff, though, is 70 years old and, over the course of the decades during which his admitted fraud was in place, enjoyed the adulation of friends, the admiration of business associates, and the love of family. He also may have run through fifty billion dollars. The Madoff-Blagojevich equation argues that Business appears to be orders of magnitude more efficient after all.

The clear upshot of the Madoff scandal is a high-profile overhaul of the oversight of investment advisors. The news programs are full of references to the “Form ADV” – the document a Registered Investment Advisor files with the SEC. Madoff is an SEC-registered firm, and this failure of oversight is sure to be laid at the doorstep of the regulators. Nonetheless, we suspect that this event makes hedge fund regulation a Done Deal, in yet another observance of the ritual of blaming the Private Sector for the failure of Government. The furor surrounding this debate will make for good media, and the nation will generate both advertising revenues and entertainment. The Congressional pillorying of the existing regulatory structure, combined with the moral preaching surrounding the renewed effort to regulate hedge funds, will generate rivers of both Congressional sweat, and journalistic ink. Taken together with the working out of our nation’s terminal case of Auto-Eroticism, this should keep the American public distracted through much of the first year of the Obama Administration, by which time the American attention span will have suffered Crisis Fatigue that we will be glad to move on to new matters, leaving the current issues unresolved.

As the folks who put out “Financial times – How To Spend It” are aware, we always need something to titillate us. The thrill of spending money that we do not have is far preferable to us Americans to the notion of adjusting our life style to match reality. Or of seeing a regulatory process through to implementation and making sure it works. Witness those whose egos won’t allow them to be seen as Not Wealthy, as they rush out to buy $35,000 motorcycles. Witness the man for whom being Governor of the State of Illinois was not enough. Witness the man for whom being a major force on Wall Street and managing a $50 billion hedge fund were not enough.

America has invented a novel form of ritual suicide. The nation appears determined to spend itself to death. Anyone want to give odds?

Moshe Silver
Director of Compliance
Research Edge LLC

Keith R. McCullough
CEO / Chief Investment Officer

Quote Of The Week: Neel Kashkari ((Director of Treasury's Office of Financial Stability)

"We're not day traders, and we're not looking for a return tomorrow"
-Neel Kashkari (Director of Treasury's Office of Financial Stability)

After losing approximately $9B (as in billion), or 1/3 of the value implied in the so called “preferred investments” Neel and his investment banking mentor Hank Paulson made in structurally impaired banking businesses, we should send this guy back to business school. He wasn’t there very long ago – he’ll be cool with it.

Neel is what the real risk managers in this business call a “theoretical guy.” He has never traded a day in his life, and this is no environment for a rookie to be holding the panic button.

You see, Neel didn’t lose this money in one day – he and Hank “The Market Tank” lost it over the course of a month. Managing risk on a monthly basis is presumably a pragmatic strategy for someone in charge of “directing financial stability”; particularly if your boss is the Goldman guy who oversaw the build out of some of the most levered short term prop trading businesses that the world has ever seen.

Per Wikipedia, you’ll notice that Neel being unaware of how market’s trade really isn’t his fault:
“Prior to joining the Treasury Department, Kashkari was a Vice President at Goldman, Sachs & Co. in San Francisco, where he led Goldman's Information Technology Security Investment Banking practice, advising public and private companies on mergers and acquisitions and financial transactions. Kashkari has a Bachelor's and Master's degree in engineering from the University of Illinois at Urbana-Champaign and an MBA in 2002 from the Wharton School at the University of Pennsylvania.[2][1] Before enrolling in Wharton's MBA program, Kashkari worked for the aerospace firm TRW, where, amongst other projects, he worked on the James Webb Space Telescope.”

Neel has never traded a market with real capital. He has never managed real time risk. He wouldn’t know a trading return if he saw the opportunity to earn one tomorrow anyway. After losing $9B’s, his aforementioned quote is right on the money - I can guarantee you he will never be hired to “trade” anything.

This is all so sad and ridiculous all at once. Unfortunately for Mr. Paulson, American history will record his judgment calls for what they were – wrong. Hiring a junior Goldman banker to be his “yes man” when this country needed both perspective and proactive risk management most is what it is. Shame on you Hank.

We are looking forward to The New Reality; we are looking forward to new leadership at the US Treasury; we, like all Americans, are looking forward to earning a return tomorrow.

Keith R. McCullough
CEO / Chief Investment Officer

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