“The downside to thinking statements are more complicated than plainly stated, is that what is plainly stated is more often than not the truth when arrived at the long way around.”
Rob Shewchuk is a long time friend of Hedgeye and also many moons ago played junior hockey with our CEO Keith McCullough for the Pembroke Lumber Kings. If the moniker Big Alberta fits me, I think it is fair to say that Big Ontario fits the 6’3”, cowboy boot wearing Rob Shewchuk. Rob grew up in the mining town of Red Lake, Ontario and has parlayed his natural business instincts into becoming one of the top brokers in Canada, with a special focus on undervalued mining assets and emerging growth companies.
Rob and I were texting each other about a common business situation and he put on his Red Lake philosopher’s hat and sent me the above quote. As a bachelor who is still in full dating mode, I’ll be the first to tell you that text messages can lead to confusion, but I think the message Rob was sending was pretty clear: keep it simple.
In investing, complexity negatively infiltrates the investment process in a number of ways. One way is analysis paralysis. Undoubtedly, we’ve all worked with analysts that are guilty of this crime of complexity. The guilty analyst will have a 75 page spreadsheet analyzing a company down to the return on capital of the administrative assistant to the head janitor, but won’t be able to make a call on whether the stock is going up or down. The analyst knows so much, he or she is in fact paralyzed and unable to make a decision.
The other crime of investing complexity, which is more to Rob’s point, is when an analyst complicates simple things, like say valuation. A friend of mine from home says that when it is – 40 degrees Celsius out, you don’t need to ask how cold it is, you just know it is *expletive* cold. The same could be said for valuation. If a stock or asset is cheap, you shouldn’t have to argue it’s cheap, or justify that it is cheap. The valuation will be plainly obvious.
Yesterday, to the last point, I wrote a research note on the valuation of the SP500. Many stock market pundits are making the case that the SP500 is cheap based on future consensus earnings. Unfortunately, that analysis is not really all that simple, for the basic reason that consensus estimates are usually wrong. In fact, according to a McKinsey study from 1985 to 2009, SP500 earnings estimates were higher than the actual reported number 92% of the time.
So, obviously when making the simple valuation call, it depends on the complexity of the underlying estimates. When looking at the valuation of the SP500, we prefer to use CAPE, or cyclically adjusted price to earnings. CAPE is a metric popularized by Yale Professor Robert Shiller that looks at a market P/E that is adjusted for inflation and normalized for cycles. Currently, CAPE is showing that the SP500 is trading 21.9x, which is the highest level since July 2011 and in the top quintile of market valuations going back to 1880 (before even I was born).
CAPE hit a 35-year low in March of 2009 at 13.4x. This also coincided with a low in other stock market valuation metrics and the bottoming of the market. Stocks were, simply, and obviously, cheap. As for now, it is neither simple, nor obvious.
As of late, we’ve been flagging and harping on another simple indicator of the equity markets peaking, which is the VIX. The Chart of the Day today goes back exactly three years to the bottom in March 2009 and compares the SP500 to the VIX over that period. As the chart shows, a VIX level of 15-ish has coincided consistently with a short term top. To the simpletons at Hedgeye, that is a red flag worth emphasizing. More simply, the VIX at this level signals that complacency is setting in.
Over the last 24 hours, we’ve made a couple of simple moves in the Virtual Portfolio that should inform you on our current positioning:
1. Shorted Greece via the etf GREK – With “positive” catalyst of the Greek debt restructuring in the rear view mirror, Greek equities now have to deal with austerity headwinds and a population that is leaving Greece en masse.
2. Shorted SP500 via the etf SPY – Selling the SP500 at our overbought line has a high historical batting average and at 1,401, the SP500 is overbought. Yes, it can be that simple.
3. Shorted consumer discretionary via the etf XLY – With oil prices and inflation accelerating, this isn’t good for growth or discretionary spending. Historically, growth slows when oil reaches 5.5% of GDP. Simplistically, a Brent oil price of $116 equates to 5.5% GDP and Brent is currently at $123.
Henry Wadsworth Longfellow also had a great quote about simplicity (although he didn’t text it to me), which was: "In character, in manner, in style, in all things, the supreme excellence is simplicity."
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
TODAY’S S&P 500 SET-UP – March 16, 2012
As we look at today’s set up for the S&P 500, the range is 30 points or -2.11% downside to 1373 and 0.03% upside to 1403.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: 579 (2015)
- VOLUME: NYSE 844.45 (-1.03%)
- VIX: 15.42 0.72% YTD PERFORMANCE: -34.10%
- SPX PUT/CALL RATIO: 1.06 from 1.01 (4.95%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 39.74
- 3-MONTH T-BILL YIELD: 0.08%
- 10-Year: 2.34 from 2.28
- YIELD CURVE: 2.00 from 1.92
MACRO DATA POINTS (Bloomberg Estimates):
- 8:30am: CPI (M/m), Feb., est. 0.4% (prior 0.2%)
- 9:15am: Industrial Production, Feb., est. 0.4% (prior 0.0%)
- 9:15am: Capacity Utilization, Feb., est. 78.8% (prior 78.5%)
- 9:55am: U. Michigan Consumer, Mar P, est. 76.0 (prior 75.3)
- 10am: API Monthly report
- 1pm: Baker Hughes rig count
- 3pm: Fed’s Evans speaks in Frankfurt, Germany
- President Obama attends fundraisers in Chicago, Atlanta
- House meets in pro forma session. 10am
- Mitt Romney, Rick Santorum campaign in Illinois ahead of state’s Republican primary March 20
- Supreme Court not in session
WHAT TO WATCH:
- Apple iPad goes on sale in 10 countries, betting on sharper screen, faster chip to extend lead over Google, Amazon.com in market for tablet computers
- Consumer-price index probably increased 0.4%, most in 10 months, as gasoline prices climbed, economists’ est.
- Google said to be investigated by regulators in U.S., Europe for bypassing privacy settings of users of Apple’s Safari Web browser: WSJ
- UPS says takeover talks extended with TNT Express after TNT rebuffed initial EU4.89b offer received on Feb. 11
- U.S., U.K. haven’t reached any agreement on releasing strategic petroleum reserves or set timetable for action, White House press secretary Jay Carney said yesterday
- Italy said to pay Morgan Stanley $3.4b to unwind derivative contracts from 1990s that had backfired
- Johnson & Johnson’s Incivo won backing of U.K.’s health-cost regulator in draft recommendation for treatment of hepatitis C
- SAP seeks to become “major provider” of database software, will disclose plans at April 10 news conference in CA: Reuters
- U.S. ITC may decide on review of judge’s finding that cleared Motorola Mobility of infringing three Apple patents, 5pm
- Cheniere Energy confident of winning U.S. approval to build two natgas export terminals on Gulf Coast, even as opponents seek to block shipments
- National Public Finance Guarantee said to participate in mediated talks with Stockton, Calif., under new state law intended to forestall bankruptcy filing
- Sears plans to close 53 specialty stores in 1H 2012: LA Times
- Port of Dampier, used by Rio Tinto, shutting down in anticipation of large swells, co. spokesman says, as Tropical Cyclone Lua strengthened into severe storm off Australia
- No U.S. IPOs expected to price
- SATURDAY: Missouri Republican presidential caucuses
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
OIL – after attempting to SPR global Consumers yesterday while they were watching some hoops, the Administration of Central Planning denied they’d ever politicize what the DOE defines (govt website next to the slide deck on Obama’s opinion on oil supply/demand) as “the last line of defense against a supply disruption." We bought oil on that as all 3 of our durations of support held like the rock of Gibraltar.
- India Raises Gold-Import Tax for Second Time; Prices Drop
- Gold Bulls Weakest in Two Months as Economy Gains: Commodities
- Oil Halts Weekly Decline Before U.S. Consumer Confidence Data
- Wheat Drops as Canadian Production May Increase; Soybeans Fall
- Copper Heads for Weekly Advance as U.S. Rebound May Spur Demand
- Sugar Climbs to 4-Month High as EU May Import; Cocoa Retreats
- Gold May Decline in London on Improving U.S. Economic Outlook
- Stalemate Hits $10 Billion Czech Nuclear Plan on Funding: Energy
- Deripaska’s Vision For Rusal Leads to Losses for Li Ka-Shing
- McDonald’s, Carrefour Targets of China Consumer Rights Campaign
- Vale, Newmont Retain Appetite for Indonesia Mines Amid Stake Cut
- YPF Bonds Fall as Provinces Pull Field Permits: Argentina Credit
- Bullish Oil Bet Drop Seen as Peak in Iran Rally: Energy Markets
- Soybeans Gain to Six-Month High on Exports
- Corn in Dalian Rises to Record on Speculation of Smaller Supply
- Viterra Sales Process Underway After Getting Buyer Interest
- Japan May Ship More Copper to Make Up for Dwindling Local Demand
USD – this is easily the most bullish development we’ve seen since Bernanke’s attempts to debauch the dollar (Jan 25th) – gravity. US Dollar Index should close up for the 3rd consecutive week – while it may not have been for Apple and BAC, this has been a huge headwind for anything Bonds, Gold, Foreign Currency, etc. this week. Yes, anyone who is diversified across Global Macro got tagged by this Correlation Risk.
INDIA – the Indians told the world they got off the Greenspan-put drugs (no rate cut), so the world sold their equity market down another -1% overnight (down -2.6% in 2 days). India is a net importer of inflation (oil) and has seen their yield curve go flat.
The Hedgeye Macro Team
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This note was originally published at 8am on March 02, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“Europe does not just face a debt crisis, Europe also faces a growth crisis.”
Growth Slows As Inflation Accelerates. I wrote that in every other Early Look note between February-April of 2008 and 2011 and, unless the US Dollar doesn’t catch a credibility bid soon, I’ll write it again from February-April of 2012.
Why is it that people in our profession didn’t believe me then? Why is it that they don’t believe me now? Do less people believe me less? I really have no idea on what the answers to these questions are. The only thing I am certain of is that my process for intermediate-term economic forecasting using the US Dollar as my lead indicator for Growth and Inflation has not changed.
Sadly, neither has the broken processes of those who had both the 2008 and 2011 Growth Slowdowns wrong.
Back to the Global Macro Grind…
Britain’s Prime Minister David Cameron gets this. The Chinese, Indians, and Brazilians get this. So why is it that the Crack Keynesian economists, who got the USA, Japan, and Italy into this mess to begin with, don’t?
That’s pretty simple. It would mean they’d have to hold themselves accountable for structurally impairing the long-term economic growth prospects of Global GDP via Keynesian/Fiat Policies to Inflate.
Got data to support these attacks on the aristocracy of our academic elite?
Let’s look at yesterday’s American Institute of Supply Management Report (ISM) for February (see Chart of The Day):
- GROWTH: Slowed -3.1% sequentially (month-over-month) to 52.4 from 54.1
- INFLATION: Accelerated +10.9% (month-over-month) to 61.5 from 55.5 (Prices Paid)
- POLICY: Dollar Debauchery began January 25th after Ben Bernanke push his Policy to Inflate to 2014
So why didn’t markets go straight down on that yesterday?
I have no idea – they didn’t until May of last year either. Markets will do what they do, until they don’t. The German hyper-inflation of the 1920s saw its stock and commodity markets rise as real (inflation adjusted) German Growth Slowed to all-time lows too.
No worries. According to the Chairman of The US Federal Reserve’s CYA Career Risk Management campaign:
- GROWTH: Qe2 (ended Q2 of 2011) was supposed to get us a US Growth acceleration to 3.5-4% (it was 0.36% in Q1 2011)
- INFLATION: never – at all-time highs in food and energy prices, you’ll never see it, ever (it ramped to 4-6% in 2011)
- POLICY RESULTS? Bernanke said this yesterday and I almost fell out of my chair:
“We’ve had about 2.5 million jobs added … and we’ve seen big gains in stock prices…”
Oh. Ok. Now that the stock market is up, we need to do more of what we did from an inflation policy perspective last year – because, uh, it actually worked? This is the kind of groupthink, dogma, and confirmation bias that almost every behavioral psychologist of the modern Millennium shuns. Enough of the Great Depression fear-mongering thing already.
It’s ok to admit it.
We have a pending Growth Crisis in Japan, Western Europe, and the United States of America. Like an AA meeting, we might have to all say it together: “we are addicted to easy money, inflation, and debt – they structurally impair growth.”
Got math to support these plainly visible claims? Let’s look at how US Growth (GDP) did as the US Dollar Strengthened in Q4 of 2011:
- US Dollar Index and American Purchasing Power rose +6.7% from mid October to the end of December 2011
- US GDP Growth Accelerated from +1.34% in Q2 2011 (highest inflation quarter of 2011) to +2.98% Q4 2011
- US Consumption Growth Accelerated from +0.38% in Q2 2011 (lowest since Q1 of 2009) to +1.17% Q4 2011
The math is so trivial that only an un-elected Central Planner can obfuscate it to the Muppets in Congress at this point.
Facts about US Economic Growth:
- US Consumption represents 71% of US GDP – get that right, you’ll get mostly everything else right
- Export Manufacturing won’t move anything but the political dial – debauching the Dollar for “export” growth has not worked
- Strong Dollar Deflates The Inflation = Higher Real-Inflation Adjusted Consumption = Higher US Growth
Setting aside the accounting irregularities of the US Government on silly things like birth/death adjustments to the US Employment report and using a GDP “Deflator” that’s usually understating US inflation anywhere between 50-1000% (GDP Deflator for Q4 was 0.86%, when CPI and PPI blended averages for Q4 were approximately 500% higher), you should feel better now.
You shouldn’t feel better about America’s long-term Growth Crisis. You should just feel better because I am telling you the truth.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1697-1735, $123.29-126.41, $78.11-79.22, and 1363-1375, respectively.
We’ll be hosting our Sovereign Debt and Demographic Reckoning Conference Call on Japan at 11AM EST. Please email Sales@Hedgeye.com if you are interested in participating.
Best of luck out there today and Happy Birthday to my beautiful little girl, Callie.
Keith R. McCullough
Chief Executive Officer
The reality is a spin may only be a split/sale which could benefit enterprise value but not necessarily shareholder value.
Despite the fact that roughly 95% of CZR’s EBITDA comes from its core casino operations, most of the focus remains on the company’s interactive division. This division currently comprises online gaming operations in the UK and social gaming through Playtika’s platforms. Speculation (dare we say “spin”?) is that CZR’s unencumbered interactive assets will be spun off to shareholders. Under this scenario shareholders would hold stock in 2 companies – “bad company” consisting of highly leveraged core gaming operations and “good company”, essentially an option on a huge growth business comprised of online and social gaming. Sounds good, but doesn’t really mesh with reality.
As we wrote about in “SPIN-OFF OF CAESARS INTERACTIVE? NOT SO FAST….” on 2/28, a spin-off of CZR’s interactive assets presents several challenges:
- A spin-off poses material tax consequences for both Caesars Entertainment and its shareholders unless they can effect a tax-free spin under Section 355
- While it is true that Caesar’s Interactive has no debt, that doesn’t mean that it is truly “unencumbered.” CZR’s secured lenders at the operating company and CMBS entity have upstream guarantees secured by stock in Caesar’s Entertainment Corporation (CEC) and thereby an indirect claim to anything that CEC owns. If a spin-off occurs and debt holders don’t receive consideration for their stake, they have a strong case of fraudulent conveyance should CZRs eventually file. Even if no filing occurs, there are likely to be lawsuits brought by debt holders to either prevent a spin or get a piece of the proceeds.
- Federal legislation now looks a lot less likely than a few months ago since the “Barton Bill” did not get tacked on to payroll tax extension as many hoped. There is still hope that HR 2366 will get tacked onto a piece of must pass legislation this year (e.g. Highway Bill), but the odds look slim. An online gaming market developed through the State route will take longer to develop and be smaller in size.
- Without the exciting growth opportunity of social gaming and the option on US online gaming legalization, the core business is a collection of a over-leveraged Regional/ Las Vegas/AC assets with a lot of deferred cap ex and a sky high interest expense bill where every cent of FCF will go towards interest service for the foreseeable future.
We recently obtained some clarification to some of these issues. The company confirmed to us that if they decide to monetize CZR’s interactive assets in a separate entity it would likely have to be in form of a split-off or sale where the proceeds would go back to Caesar’s Entertainment. While this may seem like a subtle clarification, for an entity that is over 11x leveraged, an accrual of proceeds from any sale back to the enterprise vs. shareholders makes huge difference. Essentially, with a monetization of Caesars Interactive, shareholders would be left holding the bag of a highly leveraged portfolio of Caesar’s casino holdings where proceeds of any sale would likely go towards debt reduction. This is not necessarily a bad thing but on a $22BN pile of debt, it’s hard to move the needle enough to create material equity value.
CZR’s also needs to consider the synergies of keeping the company intact:
- State by state legislation will likely require having physical assets in each state in order to get a license. This means keeping CZR Interactive in-house maybe a necessary reality for the foreseeable future
- Co-branding opportunities for the social gaming site
- Question of whether a split-off of the assets would create value in excess of what investors are currently assigning to the interactive business. A split-off of the interactive company would also introduce a second set of reporting and public company expenses as well as a fee payable CZR’s would also diminish the standalone entities’ value.
We believe that the vast majority of CZR’s $1.6BN equity cap largely reflects the value of the Interactive division and an option value of a major recovery on the core. Without a tax free spin, the equity value of the Interactive division may be less than investors perceive.
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