Conclusion: Looking to recent history, VIX ~15 has been an explicit signal to get hedged; thus, we are doing so in our Virtual Portfolio.
Position: Long the iPath S&P 500 VIX Short-term Futures ETN (VXX)
In this morning’s Early Look, Keith used a very appropriate quote from Daniel Kahneman that we feel describes the appropriate state of our industry:
“The illusion of skill is not only an aberration, it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions – and thereby threaten people’s livelihood and self-esteem – are simply not absorbed.” (Kahneman, page 217)
Regarding the first part of the quote, perhaps the reason the VIX has a coincident relationship with the S&P 500 instead of a leading one is that it’s simply human nature to not want to buy downside protection when the market feels like it wants to trend higher. Everyone’s best ideas are working on the long side and both sell-side consensus and legacy financial media sources cheer on gains instead of focusing on the catalysts which could bring about mean reversion. While it’s not always an appropriate time to position for mean reversion, we’ve been consistently making calls to hedge for meaningful downside risk in U.S. equities when the VIX is trading with a 15-handle on it – just as it is today.
That brings us the second point Kahneman makes, which is that “facts that challenge such basic assumptions” (like combining top-down fundamentals with a quant overlay to make an explicit call not to chase “Dow 15,000”) and are threatening to the “livelihood and self-esteem” of market operators “are simply not absorbed”. Often times, they are, in fact, refuted with great vigor as we have seen in our inboxes from making similar calls in years past.
That said, however, our number #1 goal as an outsourced Macro Team remains to help our clients preserve and grow capital across economic cycles and all types of market environments; thus, making contrarian calls is not something we shy away from.
Today, that call is to get hedged, no matter how counterintuitive it feels at current prices. Our quantitative levels on the VIX are included in the chart below.
Conclusion: Just as Chinese officials intended, both supply and demand trends are going the wrong direction as it relates to the price of real estate in China. While we don’t think the PBOC will cut its benchmark interest rates in the immediate-term, we do think these data points are supportive of continued consensus speculation around monetary easing in China and could lead to additional RRR cuts over the next quarter or so. Even still, domestic monetary easing will have a highly disappointing effect on stimulating Chinese growth absent a removal of the curbs on real estate activity.
In JAN, Chinese residential real estate prices posted their worst performance in at least a year, with 48 of 70 cities declining MoM and 22 cities holding flat. For commercial buildings, the number of cities posting MoM price gains came in at 5; 11 held flat and 54 cities declined MoM.
JAN ‘12 marked the start of the second year of China’s discombobulated official national price reporting due to the National Development and Reform Commission’s nation-wide index terminating in DEC ’10. Since then, investors have had to rely largely upon the sale price data from the transactions of large developers – entities who may or may not be incentivized to “put their best foot forward”, so to speak (akin to data from our own National Association of Realtors).
So in the absence of what we’d deem as totally reliable data, we’ve taken advantage of the latest supply & demand data points to form an educated view of China’s property market, which, as we have shown in previous notes, is the largest driver of Chinese, and, by extension, global growth.
In the JAN-FEB period, the growth rate of completed supply accelerated to an all-time high of +45.2% YoY as seen in the Floor Space of Buildings Completed series. From a pending supply perspective, growth in Floor Space of Buildings Under Construction accelerated to +35.5% YoY in the JAN-FEB period – good for the second-highest rate on record. The State Council’s goal of building 36 million units of affordable housing from 2011-2015 is a key policy initiative affecting the underlying trends in supply.
From a demand perspective, growth in Total Sales of Buildings slowed in JAN-FEB to an all-time low rate of -20.9% YoY. Moreover, growth in Floor Space of Buildings Sold and Purchases of Land have each slowed to multi-year lows of -16% YoY and -0.5% YoY, respectively.
Looking at the investment climate, the one positive data point we’d highlight is that growth in domestic financing for real estate investment accelerated to +16.3% YoY in JAN-FEB, which is the fastest rate of growth since NOV ’10. That said, however, China Economic Network’s Real Estate Climate Index ticked down to a 32-month low of 97.89 in the JAN-FEB period; the index’s YoY growth rate of -4.9% is the slowest rate since JUN ’09.
With supply increasing at much higher rate than any measure of demand, continued price declines seem likely and, in fact, may be poised to accelerate. Our financials team, led by Josh Steiner, has shown that demand leads U.S. housing prices by one full year. While certainly not an apples-to-apples case study, one would expect Chinese property prices to continue trending lower throughout 2012 given the current supply and demand setup.
From a policy perspective, we believe the current trends will prove supportive for continued speculation around monetary easing in China. While we certainly don’t see any reason for the PBOC to suddenly abandon ship and cut rates aggressively in response to this data (the State Council and PBOC have been explicitly trying to deflate housing prices and slow real estate speculation for two full years), it does lend credence to the view that conditions on the ground in China are, in fact, threatening enough to support near-consensus expectations of a full-scale rate cutting cycle.
Again, given the stated and oft-reiterated policy objectives, it remains our view that China isn’t as close to lowering its benchmark policy rates as a great many investors would like; that said, however, we would expect continued action on the RRR front ahead of any material easing. Most importantly, we continue to hold the belief that, until Chinese policymakers actually lift the property market curbs, domestic monetary easing will have a highly disappointing effect on stimulating Chinese growth.
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Short interest data released on Friday, in conjunction with sell-side sentiment, show that for the two weeks ended 2/29 most restaurant stocks saw gains or no change in their sentiment scores versus the prior period’s reading. Only CMG, RRGB, PZZA, KKD, and BAGL saw their sentiment scores decline. We expect much more movement in the sentiment scores when the next release comes out on the 26thof March.
Sentiment Scorecard Callouts
MCD: Continues to lead the pack but, following disappointing February sales and the emerging reality that austerity is impacting the company’s sales in Europe, there is room for sentiment to come down. That said, we would expect that the sell-side will be reluctant to lead the charge given the 21 Buys, 9 Holds, and 0 sell ratings currently held on MCD by the street and historically bullish consensus on this name.
DNKN: This stock is trading well today and, the latest data point aside, short interest has been coming down over the last couple of months. The stock was recently initiated “Buy” at Citigroup also, which boosted sentiment. Coffee prices coming down are a benefit to DNKN franchisees but, in terms of the company’s EPS, this factor is less relevant for DNKN than it is for PEET and SBUX, for example.
CMG: Chipotle’s sentiment score came down for the second reading in succession despite the stock price continuing to grind higher. While the valuation implied by the stock price is egregious, we are waiting to see the company’s return on investment metrics flash negative in the Hedgeye Sustainability Model before looking at this stock on the short side. With the returns that the company has generated from new stores over the past couple of years, CMG is unlikely to fall off a cliff.
CBRL: Cracker Barrel’s sentiment score ticked up as shorts covered their positions during the two weeks ended 2/29. The stock had spiked on earnings guidance for 2012 being raised on 2/21 but gave back much of its gains over the next couple of weeks. Gas prices are the obvious threat to Cracker Barrel but, with many casual dining executives recently stressing that they were not noticing any impacting from gas prices. The consumer's pain threshold can be breached quickly with prices moving higher as quickly as they are, however, and we think that political polls released over the weekend highlighting gas prices as a particular problem for Obama’s approval rating could be an indication that we are approaching that threshold.
PFCB: P.F. Chang’s remains an untouchable for investors in the restaurant space. As longer-term bulls on the name, we like this as we believe that the turnaround is in motion. The road ahead is certainly not without difficulty but we believe the company has a distinct advantage over other casual dining chains that are also faced with serious issues; namely, a management team that has acknowledged the reality of the situation and has the acumen to remedy it. One risk for all of casual dining, P.F. Chang's included, is that the seasonal adjustment distortion in jobless claims turning into a headwind from May through July leads to employment headline numbers disappointing versus investor expectations. Initial jobless claims data heavily impact the casual dining space.
Greek Eggs And Ham
As an ignorant investor, my main question is if there is truth in investment.
- Ted Rees, Professor of Ignorance, Retirement University of Hard Knocks
This is a true story.
Back in “the day” – around the late 1980’s – early 1990’s – when the wave of truly nasty people flooding into the brokerage industry was topping what turned out to be a very long-lasting crest – one highly successful retail brokerage firm trained its new recruits by having them stand in military ranks every morning shouting the dialogue from Dr. Seuss’ Green Eggs And Ham. If you were ever a child – or if you have one – you know the book. The story is something of a literary oddment as the narrative is enfolded within its own telling. Unlike other children’s books, there is no reference to an outside world (parents, school, sibling, dog). Dr. Seuss has created a self contained reality whose curious focal dish – a unique reality within a unique reality – lies doubly hidden, or doubly absurd, at the heart of the book.
Sort of like the Greek CDS.
While PhD theses are likely not being written about literary structure in the works of Theodore Geisel (Dr. Seuss’ alter ego) this volume was seized upon by stockbrokers in the late 1980’s as a training manual for persuasive argument. At the height of the depth of the financial profession – when barely-literate kids were being summoned to the boardrooms of seedy brokerage operations in lower Manhattan – the give and take between Sam and his unnamed prospect became a template for how to handle a phone conversation with a potential stock buyer.
I would not eat them on a plane!
But, Mr. Jones – (for some reason the universal prospect was always called “Mr. Jones” in stockbroker training scripts) – if I could show you how eating them on a plane would benefit you, then wouldn’t you agree that it might be something you should eat?
I would not eat them in a box!
But, Mr. Jones, if I could show you that the smartest money in the world eats them in a box, then wouldn’t you agree that maybe you should eat them in a box?
This was the rigorous training through which myriad new stockbrokers were put before being unleashed on the public. In other words, the degree of information they were trained to absorb about the investments they were flogging was minimal. And they were explicitly told that giving prospective buyers too much information about a stock would result in them losing the sale. If you give people stuff to think about, they are going to think about it.
Today we have an argument that investors should be informed – that much of the carnage in the investment markets is the fault of Emptors who failed to sufficiently Caveat. One problem with this refined form of Blaming the Victim is that it presupposes that a person of average intelligence and education can, by a bit of regular diligence, learn enough about their investment portfolio to make informed decisions about whether to buy, or stay away from, an investment. This completely overlooks the fact that investment vehicles are being created by people with PhD’s from MIT who were trained to design rocket engines, create the next generation of atom bombs, and enhance the range and efficiency of military spy satellite communications. With Wall Street beckoning, and with government funding for basic scientific research at historically low levels, high-frequency trading systems are clearly a greater societal priority than missile defense or the manned Mars mission.
Which means the default setting is for the individual investor to get screwed. Actually, we maintain it is not “collateral damage,” but conscious policy – which brings us to the SEC’s current Financial Literacy Study. Mandated under Dodd-Frankenstein, the Commission must submit its findings “of retail investors’ financial literacy” to Congress by 21 July. In January the Commission began accepting “public comment on financial literacy and investor disclosure issues.”
We have sampled a few of the comments – far less voluminous than those submitted regarding the Volcker Rule (see our Screed of 24 February, “Mr. Volcker Goes To Washington.) We suspect this is primarily because retail investors remain at a monumental informational disadvantage: most of them probably do not know the SEC wants to hear their opinion.
A number of the comments touched on the bizarre fact that, in a nation that considers itself the flagship of Capitalism’s fleet, there is no economic education for our young – and certainly no practical guidance on structuring an investment portfolio, how to select between stocks and bonds, how to assess the differences in ratings for government and corporate debt, how to hedge using listed options, currency arbitrage and its inherent risks – or even how to open a bank account and balance a checkbook. A sixteen year-old cannot get behind the wheel of a car without passing a written test that at least demonstrates some basic awareness of the fundamentals of good driving, but a 21 year-old can blow his patrimony with options trading. What does it say about a society that activities for which no education or training are required include handling the finances of your family (or your company), and purchasing a gun?
Mr. Ted Rees – about whom we know only what he posted on the SEC’s website – asks: “I guess the banking collapse is another type of deception, where the banks disguised bad investment as good investments. Perhaps in translation, this means what can you put into your documents to cover truthfulness?”
What can issuers or brokers say, under current regulation, that is so misleading as to effectively constitute fraud, even while legally permitted? That’s a great question, Mr. Rees. Today’s securities markets are not fundamentally different from the 1980’s and 90’s, the roaring, cocaine-fueled days when – as one banker disdainfully said at the time – “they turned the business over to the bridge-and-tunnel crowd.” In those days having a college degree was seen as laughable, and an MBA was a liability. The business was all about selling. You won’t eat green eggs and ham with a fox? How’s about you eat them on a box? You don’t want to eat them in the rain? No problem! You can eat them on a train! All I know, Mr. Jones – you gotta eat them.
It is abundantly clear that neither the individual investor nor Congress learned anything from the misdeeds of the retail stock market in its Wild West days. But Wall Street learned its lesson as many Bad Actors saw in the great implosion an epochal ratification of the dictum that crime does pay. In fact, on Wall Street crime generally not only pays, but even after one is caught the net take is likely to remain near-astronomical. The punishment is routinely light – the fine is a small fraction of the money made from the illicit behavior; the Bad Actors must affirmatively neither affirm nor deny that they ever did anything wrong (if you are a lawyer, you understand that clause – if not, find a lawyer and get them to translate for you) and solemnly promise that they will not in future do the things they anyway never admitted doing in the past.
We do not have global figures to hand, but the loss of personal wealth surrounding the demise of edgy brokers was pretty astounding. Federal prosecutors charged in 1996 that the demise of A.R. Baron – which they branded a “criminal enterprise” – left customers with losses of $75 million – in 1996 dollars. This includes losses taken by investors on both sides of the Atlantic. Indeed, it seems Baron singlehandedly forced a change in the regulatory relationship between the UK and the US because of the number of wealthy British investors who had lost tens of millions of dollars in their brokerage accounts.
The A.R. Baron failure also led to the downfall of Richard Harriton, president of Bear Stearns Clearing, and to Bear paying a $38.5 million settlement to the SEC. According to an article written at the time (Gretchen Morgenson in Forbes, February 1997, “Sleazy Doings On Wall Street”) Bear Stearns Clearing was handling 12% of the NYSE’s daily volume through its more than 2,100 clearing customers, among whom were a large number of small brokerage firms – including a number of outfits that the SEC had in their crosshairs. Over the years, Bear had cleared for Rooney Pace and D Blech & Co, to name but two brokerage companies whose failures likewise left tens of millions in losses in their wake.
It was decidedly suspicious that Bear kept these firms on as clearing clients, even as problems grew with the firms’ customer base, and with their trading positions. Clearing is the sensitive nerve center of the brokerage business. Clearing firms are first to get wind of potential problems with their correspondents (customer firms) and famously ruthless in self preservation –Lehman is still suing JPMorgan, its main clearing broker, for “siphoning $8.6 billion of critical assets in the last few days prior to its September 15, 2008, bankruptcy” (Reuters, 1 February, “JPMorgan Slashes $710 Million Lehman Bankruptcy Claim”). Indeed, the SEC said Bear Clearing “took extraordinary steps to keep Baron in business,” including allowing millions of dollars in unauthorized trades to remain in Baron customer accounts. Harriton, charged personally with fraud, ended up settling with the SEC. He paid one million dollars and – without admitting or denying the Commission’s charges – agreed to be barred for life from the securities industry, with the odd qualification that he was to be permitted to reapply for regulatory clearance after two years. A brief hunt on line reveals Harriton is now president of an entity called Park Avenue Consulting, of which we were not able to find anything other than a LinkedIn listing.
The quote that best sums up Wall Street’s attitude comes from the Morgenson article. “Bear Stearns spokesperson Hannah Burns says: ‘Clearing is a very, very proprietary business for us, and we don’t want the public knowing about it.’”
Which bears directly on the SEC’s mandate to report on financial literacy and investor disclosure issues as they relate to the private investor. After the Bear Clearing case, the Commission made moves to substantially overhaul the clearing business. Some of this resulted in tighter controls governing counterparty risks, and some attempted to tighten controls on illegal short selling, an activity that often takes advantage of slippage in clearing processes. But none of it has resulted in the investing public being made any wiser about what happens once they hang up the phone after giving their broker an order.
“Professor” Rees’ terse comment to the SEC says it all. Still, we thought to read some of the lengthier submissions. One comes from the Association of Independent Investors, a newly-formed entity based in Vermont and headed by a former Wall Street executive who was active in the industry from 1 and was a senior executive at Merrill Lynch (they invite you to visit them at www.aiinvestors.org). The Association makes several salient points. One is the blurring of the regulatory line between brokers and advisers, and an attendant confusion over the professional’s duty to the customer. “With commission rates at or near zero, broker-dealers have been pushing into the fee-based, or advisory account business.” The Association says brokers, who are held only to a Suitability Standard (the customer was smart enough to know the risk they were taking, and they could afford the loss, so it’s not my fault the Emptor failed to sufficiently Caveat) “have been offering fee-based advisory accounts for years by taking advantage of regulatory loopholes and by lobbying for special rules,” including registering as both stockbrokers and investment advisor representatives.
Dual registration brings the professional under the jurisdiction of both the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. Where dual registration would logically lead to a professional having two intertwining sets of obligations to their customer, the practice is often to wear the hat of the ’34 Act (the stockbroker’s suitability standard) while marketing a product that comes under the fiduciary standard of the ’40 Advisers Act. “Regulators have bent over backwards to accommodate the brokerage industry in this,” says the Association, calling for an end to dual registrations. The letter stops short of championing Chairman Schapiro’s efforts to apply the fiduciary standard across the board, saying rather than brokers should be either fish or fowl, but not a cross between both.
The letter quotes an Investment Company Institute report that “the average expense ratio for an equity mutual fund was 1.45% in 2010.” In their disclosures (this one’s for you, Professor Rees – a lie permitted under the rules) investment managers are permitted to “dismiss their fees as not material. But when asset-based fees are put into the proper perspective, it becomes obvious how they destroy investor value.” Using an example a sixth grader could replicate, the Association says that an investment manager who generates an annual return of 10% actually charges 15% of that return in annual fees. “Or more realistically,” they write – because if you are generating 10% a year, you are leaving the mutual fund and starting your own hedge fund – “if your return was 5% with the same fee and expense assumptions, you paid a whopping 30% of your return in fees.”
The Association does not push for changes in fee structures. Instead they recommend that worst of all Wall Street bugaboos: full transparency, including “an annual accounting of all fees and expenses (in absolute dollars) that investors incur in connection with the management of their accounts.”
Regulators routinely allow the industry to define what constitutes “material charges.” In a zero-interest rate world, we think even an SEC examiner would agree that 1.45% is “material,” yet Congress addresses this, not in terms of fair treatment for the investor, but in terms of Caveat Emptor. Just some of the green eggs and ham the industry gets to peddle to the public. We wonder whether there might not also be an element of cartel-like collusive behavior in an industry where every hedge fund manager charges 2 / 20 (two per cent management fee, twenty percent of profits) and where mutual fund management charges run in a tight band. Of course, industry participants will tell you it’s a “standard,” and it is, of course, sanctioned by the SEC. Oh, and OPEC uses a “benchmark.”
But investors typically do not get to question concepts like the materiality of management fees. This is largely due to Regulatory Capture – the SEC allows Wall Street to tell them how to regulate, what to regulate, and how much to regulate. The industry does not have to do an exceptional amount of haranguing to shove the green eggs and ham down the investors’ throats, as the bulk of the heavy lifting has already been done by Congress and the regulators. All a broker has to say is “Fund Family One, or Fund Family Two? – ‘Moderate Risk,’ or ‘Average Exposure’ – unless of course you prefer the ‘Not-Too-Risky-But-Not-Too-Risk-Averse Fund.’”
Just as Aristotle says all literature can be reduced to six basic dramatic elements, the staggering majority of investment products are clones of a small handful of basic ideas and are differentiated almost exclusively by their packaging, not by behavior or performance. The SEC might start by asking individual investors whether they are aware of that. In fact, the recent paucity of retail activity in the markets may indicate that even the public can only be fooled so far – Abe Lincoln may yet be proved right, that you can not fool all the people all the time.
We think the most useful comment comes from Muriel Siebert, CEO of Muriel Siebert & Co and holder of a number of Firsts, including first woman to hold a seat on the NYSE, and first woman New York State Superintendent of Banks, in which capacity she used to refer to herself as the “New York SOB.”
Siebert – who knows as much about the industry as anyone – says “the playing field has become far from level” for retail investors, “with computerized trading accounting for an estimated 50%-80% of trading, with complex products they cannot understand and with venues offering prices they cannot access, I believe retail investors are justified in having lost confidence in a system that places them at a decided disadvantage.”
Siebert makes the point we made earlier: “stock brokers are mandated to ‘know their customer,’ but investors are not mandated, other than by the principle of caveat emptor, to know their stock brokers.” Siebert makes a number of administrative recommendations that we find reasonable, including a standardized and transparent process around product disclosures, and she proposes that new account paperwork include a basic investor quiz to determine whether the customer has even the vaguest of notions of what they are doing. And she points out that, unless securities and markets regulation is made global, there will always be a refuge for scoundrels.
Several years ago Siebert decided there was a crying need for investor education and, through her foundation, created the “Personal Financial Program,” a basic curriculum that is now used in hundreds of high schools in ten states, including New York and Florida. In New Jersey, Siebert writes, “by 2014 high school students will be required to demonstrate proficiency in financial literacy in order to graduate.” This is a huge step from the world we live in today, where financial knowledge and investment methods are actually kept secret, revealed only to a chosen few. Even the undergraduate business major is not likely to have more than a rudimentary knowledge of what goes on on Wall Street.
The New York Times reported last year (14 April, 2011, “The Default Major: Skating Through B-School”) that “business” is the most popular undergraduate field, accounting for over 20% of majors, with more than 325,000 bachelors degrees awarded annually. But, cautions the report, business majors “spend fewer than 11 hours a week studying outside of class,” the least of any broad major. Business majors also “had the weakest gains during the first two years of college on a national test of writing and reasoning skills.” Finally, business majors “score lower than students in every other major” on the GMAT, the entry exam required for MBA programs. Whatever it is we’re teaching our youth, it is neither entrepreneurship, nor how to think for themselves.
As another comment letter says, “when I went to school I learned everything from finger painting to Fibonacci numbers, but I was rarely taught important practical topics.” If Einstein famously (though perhaps apocryphally) believed Compound Interest to be the single greatest human mathematical discovery, then why is it not taught in school?
The long and the short of it is: unless you have worked on Wall Street for ten years – been through market cycles, economic cycles and electoral cycles – you stand an exceptionally slim chance of understanding even a basic financial product such as a long-only mutual fund. Meanwhile all around us we are being offered heaping plates full of green eggs and ham. The sellers do not care whether it is what we like – nor even if it is good for us. All they know is they have a quota to fill, and must get us to eat as much of the stuff as possible.
We acknowledge that not all outcomes of transparency are pretty. Hedgeye loyalists know we are fixated on the notion that a strong dollar is the only thing that will make America strong. Everything else is kowtowing and temporizing. A transparent marketplace, coupled with a strong dollar, would have consequences for the stock market, for the commodities markets, for the financial firms that make their fortunes in those rigged markets, and for the politicians whose campaigns are paid for by those firms, and who return the favor by keeping the markets rigged.
Does anyone really believe Congress wants investors to understand how this actually works? Still, we think it’s worth a try.
Managing Director / Chief Compliance Officer
This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.