My Christmas Question... And Best Wishes!

If the SP500 can hold and close above 864 next week… I think I’ll be as bullish as I was bearish, exactly one year ago…

I am not doing this for the sake of making a call. I make calls when I think I am going to be right.

THE QUESTION is, do more people disagree with my bullishness now than they did my bearishness then?

Here are 6 bullish macro levels for you to keep front center on your screens – they need to hold for us to “Re-flate”:

1. SP500 864
2. Nasdaq 1498
3. Russell 454
4. VIX 52.06
5. Gold 802.11
6. US$ 82.67

Have a wonderful Christmas with your families and friends.

Keith R. McCullough
Research Edge LLC

Putin Power's rise and fall trades on black...

This morning, the Russian ruble was down another -1% against a US Dollar that is also falling. Since August (see chart) Putin’s currency has lost -18% of its value. Importantly, now he is proactively the one making a concentrated effort to devalue it!

This morning’s Russian “devaluation” was the 3rd this week, and alongside oil prices looking to lock in their bottom, Putin looks to be trying to perpetuate and expedite that process.

Devaluation of any currency leads to inflation. That’s not KGB mandate; that’s just math.

Do not miss the 1H09’ “Re-flation” trade. From the USA to Asia to Russia, governments are going “all in” to ensure it has a shot. After all, that’s the only way out of a deflationary spiral.

Crisis In Credibility Remains: MS Quarterly Conference Call...

MS Quarterly Conference Call: Where was Mack? It seems planning for his next capital raise . . .

Even though they told us that they don’t have a liquidity problem, Morgan Stanley late yesterday filed a mixed shelf to raise another undisclosed amount of money "to buy back stock, repay debt or use as working capital".

Outlined below is a post that we wrote after reviewing Morgan Stanley's earnings call late last week. We were wondering why John Mack wasn’t leading the call… and it seems we now know, planning for his next capital raise.

We’ve been negative on Investment Banking, Inc for quite some time and, obviously, this has now morphed into consensus. That doesn’t mean, though, that these stocks are no longer shorts. At a minimum, they are valuation traps. As Keith noted on our Morning Call today, the negative intermediate "Trend" for federal government financials fully intact. “The Investment Banking Inc model of old will go by the way of the horse and buggy whip… BAC is down -29% in the last 2 weeks vs. the SP500 down -5%... they are underperforming miserably in a US tape that continues to shape up bullishly, making higher lows.”
We listened to Morgan Stanley’s earnings call yesterday and reviewed the transcript. Curiously, John Mack wasn’t on the call, which we would have thought would be a logical show of leadership in these trying times, but undoubtedly he has a busy schedule.

The most alarming issue with Morgan Stanley continues to be its high level of Level 3 assets (no pun intended). For those of you who don’t follow financials and don’t know what Level 3 assets are, you are not alone, as by definition no one knows what they are or worth.

A financial blog that we follow gave the following summary of Level 3 assets and partially borrows directly from FASB’s definition:

“Level 3 values are based on "unobservable" inputs reflecting companies' "own assumptions" about the way assets should be priced. In other words, Level 3 assets are based on effectively best guess, or in many situations what firms want to value these items for in order to improve the situation in the books. The majority of derivative instruments carried on the books of brokerages are Level 3 assets.”

In essence, these assets are worth whatever the firm decides they are worth, which is not exactly comforting.

According to Morgan Stanley’s CFO as it relates to Level 3 assets on their recent call:

“Now we are expecting the absolute value of Level 3 assets to increase this quarter and they represent approximately 13% total assets. The increase in the value is primarily due to the volatility seen in the derivatives market, especially given the widening of credit spreads. The dramatic reduction in our total assets this quarter exacerbated the ratio of Level 3 assets to the balance sheet. As we have previously said, there were offsetting hedges to these positions in the other levels of the fair value hierarchy.”

So, these assets that can’t be valued by outside parties are expected to go up as a % of assets on a gross dollar basis. That is more than a little concerning.

We found a few more comments on the call interesting. As it relates to the Prime Brokerage business:

“We remain committed to maintaining a premier Prime Brokerage franchise. While this business is smaller it will benefit from the repricing of services.”

Come again? To us that sounds like Morgan Stanley is taking pricing up on the their prime brokerage customers, which is an interesting way to grow a business when the customer base is losing money. We no longer run hedge funds, but if we were and our prime broker just publicly stated they were going to grow their business by price, we may be looking around for alternatives.

On the proprietary side of the business, MS lost more than $700MM in the quarter, so not surprisingly an analyst on the call asked the following question:

“Can you just talk about the balance between pulling back in proprietary trading and taking risk where you see some upside?”

The CFO’s response was as follows:

“What we're doing is we're reallocating businesses on a risk adjusted basis to where we think we can generate alpha. So these (losses) were not unexpected insofar as the market away from what the market did itself.”

I definitely didn’t quite follow that one, but I guess in summary they are searching for alpha.

The CFO was then asked:

“I guess in listening to your commentary about risk positioning and appetite for principal investing going forward, how do you think about your approach to markets once they -- when we get to this eventual point where credit markets stabilize and we see increasing asset values again.”

To which he answered:

“Well, I mean, it is clear that we are very negative on these markets at the moment and have been for some time, Roger, as you know, right?”

Find that confusing? That makes two of us. They are searching for alpha and are now negative on the markets after a 40% decline in most assets classes.

Keith’s chart and levels are below. We covered this name a lot lower, and we will be re-shorting MS on strength.

Daryl Jones
Managing Director

Early Look

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Bush's Merry Christmas Chart!

If there's one "Trend" that's held its head above water for all of 2008 it's that your liquid long American capitalist has started to wear the pants again. Gone are the investment days of Wall Street’s transparent-less gospels.

Now with 3 of the top 5 investment banks gone, and the other 2 becoming bank holding companies ... that same American capitalist is taking matters into his/her own hands. If you want something done right in this world, do it at the right price, and do it yourself.

This week's MBA mortgage applications index jumped so far off of my page that I had to look at it 3 separate times. Mortgage apps were +11% week over week, which is better than bad but, more importantly, refis surged by 63% week over week!

Your local federal bankers know that they shouldn’t be taking a bonus this year, but your Main Street American capitalist is taking theirs, both at the pump and on their credit line (30 year mortgage rates have dropped to 5.04%!).

US Consumer Discretionary stocks (XLY) continue to trade very well today for a growing list of reasons. We just added the XLY etf to our portfolio. Both gas and stocks are cheap; the stock market is down -41% YTD; 3-mont Treasuries are FREE; and the shorts are in trouble with their consensus short the consumer narrative.

Keith R. McCullough
CEO & Chief Investment Officer


"The winters of my childhood were long, long seasons. We lived in three places - the school, the church and the skating rink - but our real life was on the skating rink." - Rich Carrier ("The Hockey Sweater")

Keith is back in his hometown of Thunder Bay, Ontario this week and I am in mine, Bassano, Alberta. If there is a quote that describes life growing up in a small rural Canadian town it is the one above. After I finished editing the Early Look with Brian and Keith yesterday morning and was enjoying breakfast with my parents, I was reminded of the long cold Canadian winters as I stared at the thermostat outside that was flashing -34 degrees celsius.

My hometown of Bassano is a quiet prairie outpost of 1,345 people located about 80 miles south of Calgary.  The town was incorporated in 1911 and was an agricultural center originally founded in conjunction with the building of the Bassano Dam, which was, at the time, the largest man-made dam in the world.  Yet in the last few decades agriculture has been far surpassed by the Oil and Gas industry as the life blood of the local economy.  The context of growing up within the Oil and Gas industry has given me a great foundation to do fundamental research on it.

Bassano is located above the Western Canadian Sedimentary Basin, which is one of the largest oil and gas reservoirs in the world, and a short flight from the tar sands in northern Alberta.   In total, Canada ranks second largest in terms of global proven crude oil reserves (15% of world reserves), after Saudi Arabia. The majority of these reserves are found in Alberta's tar sands – over 173 billion barrels.

While I've taken a slighly different path in life than many of my friends from Bassano (thanks to an apptitude on standardized tests and a decent slapshot) it is always a pleasure to come home.  Most of my friends from growing up now work in the Oil and Gas industry in jobs which are popularly known as "Roughnecks". These guys are the lifeblood of the industry and operate the massive CAT tractors in the Oil Sands up north, service the Oil batteries spread across the prairie in the dead of winter, and travel with their drilling crews around the country, and world, in search of the next gusher.

Most Roughnecks probably don't own a suit and will never have a seat in a boardroom. Despite their lack of "sophistication", they forget more about the energy industry in a day than most of us will ever know in a lifetime, so being back home and sharing a few Labbat's Blues at the local watering hole (there is actually only one!) gives me a great opportunity to do some real due diligence.

These conversations, along with work the Macro team has been doing on the Oil industry recently, have helped me cement a few energy related macro themes heading into 2009.

First, geopolitical power will shift in 2009 with the massive year-over-year decline in energy prices.  In particular, this is important as it relates to Russia.  We emphasized "Putin Power" repeatedly in 2008 and saw witness to it with the Russian incursion into Georgia.  With Oil in the $40/$50 range, Putin's power both domestically and abroad will be reigned in dramatically. Amplified “Putin Power” was a key global macro tail risk for the last 3 years – now it’s no longer in the tail.

Second, there is liklihood that a major oil producing nation encounters serious internal budgetary difficulties in 2009 and potentially defaults on sovereign debt.  At the top of our list of countries that may ecounter serious economic difficulties in 2009 due to this dramatic year-over-year price decline in Oil is Mexico. The combination of lower prices and production declining at -10% year-over-year (driven by the peaked Cantarell field) is concering as more than 40% of the state's budget is funded by PEMEX, the national oil company.

Finally, the long term supply constraint issue remains. While Oil has crashed for a -74% move from its manic July 11, 2008 high due to demand declines and deleveraging, longer term supply constraints are real and will likely re-emerge in late 2009 and beyond.  According to the BP Statistical Review of Energy from June 2008, world oil production in 2004 was 80.3MM barrels per day and, despite massive investment, had only grown to 81.5 barrels per day, or 1.4%, by 2007.  Because of oil’s expedited crash this year, investment will slow to a level that will only eventually exacerbate the problem.  The long term supply issues will eventually remerge  as a major investable theme. Every asset class has a price.

In the short term, we like Oil as a reflation “Trade” based on a declining U.S. dollar combined with nominal interest rates in the U.S. being as low as they have ever been, and interest rates going lower globally.  With Oil in the low $40s/high $30s per barrel, we do need much inflation to have a highly profitable “Trade” on our hands.  And if the “Trade” turns out to be profitable, maybe we'll even celebrate. Or as the well known Alberta country singer Corb Lund sings, maybe "we'll shine up our boots and head into town, scrape up twenty dollars and throw it around."

I hope you are all enjoying being home and visiting with your friends and family. (If I could only figure out how to put these fancy degrees of mine to work and beat my Mom in our nightly Jeopardy competition, I'd be really happy. . .)

Happy Holidays from Big Alberta,

Daryl G. Jones
Managing Director

Long ETFs

SPY-S&P 500 Depository Receipts – Front Month CME S&P 500 contracts opened down slightly, trading in a range of 857.1 to 861.3 before 6:30AM.

USO - U.S. OIL FUND – Front month NYMEX Light Sweet crude contracts traded as low as 38.04 before 6:30AM as surveyed refiners anticipated that today’s EIA report will show further inventory increases.

GLD -SPDR Gold Shares – Spot Gold declined 0.5% to $836 an ounce in LME trading this morning.
VYM – Vanguard High Dividend Yield- General Electric (VYM 5.2%) announced an agreement to sell their Australian mortgage lending unit including a portfolio of $2.7B  in residential mortgages. letter of warning from the FDA criticized Coca Cola’s (VYM: 2.51%) nutritional claims on the packaging for their new “Diet Coke Plus” beverage.

DIA –DIAMONDS Trust Series – Front Month CBOT DJIA contracts opened down slightly trading in a range of 8,370 to 8,417 before 6:30AM.

EWT – iShares Taiwan —Export orders declined a record 29% year-over-year in November, according to a government report released late yesterday.

EWZ – iShares Brazil —In a televised address last night, Brazilian President Luiz Inacio Lula da Silva encouraged increased consumer spending to help the national economy overcome the global slump, noting that inflation levels appear under control.

EWH –iShares Hong Kong –The Hang Seng declined 0.3% to close at 14,184.14 in a shortened holiday session today.

FXI –iShares China —The CSI 300 fell by 1.7 % to close at  1,887.07 at the close today while the yuan strengthened 0.13% to 6.8397USD.

Short ETFs

FXY – CurrencyShares Japanese Yen Trust - The yen rose to 126.50 EUR and 90.45 USD this morning


We all know that October was a bad month for the casual dining group. Same-store sales were down 6% and traffic was down 8.1%. We learned yesterday that November’s numbers, although still negative, improved sequentially from October (please see yesterday’s post titled “Casual Dining – November Was Less Bad”). On a regional basis, October’s results showed more of the same with Texas continuing to post the best numbers and Florida continuing to trail the rest of the country, according to Knapp Track data (holds true on a year-to-date basis as well). In October, Texas was the only region of the 11 (listed below in the chart) that both improved sequentially from September and did not experience a same-store sales decline (was flat). In October, the spread between the best and worst performing regions (in this case, Texas and Florida) on a comparable sales basis reached 10.1%, its highest level since January 2007 and a nearly 400 bps increase since September.

So from a regional exposure standpoint, this widening of the range of performance among regions reaffirms that it is still a positive if a company has a significant proportion of its restaurants located in Texas (PFCB, EAT’s Chili’s, TXRH and DRI are among the highest). And, on the flipside, it is less than positive if a casual dining operator/concept has a lot of geographic exposure to Florida (LongHorn Steakhouse, SNS, Capital Grille and RUTH). We will have to monitor whether casual dining trends in Texas continue to outperform, however, as DRI commented last week on its earnings call that it is seeing weakness across the country and that some of the regions that had been strong, Texas in particular, did soften up in the second quarter.

The charts attached below show casual dining restaurants’ exposure to the better and worse performing regions of the U.S. relative to the national average from a comparable sales growth perspective in September and October 2008. As of October, CPKI has the most exposure to the underperforming regions of the country, primarily as a result of it having 40% of its restaurant base located in California while 74% of SNS’s restaurants are located in the better performing parts of the country, despite its large presence in Florida. The only region of the country that moved from performing below the national same-store sales average to better than or equal to the average in October was the East and part West South Central region. If these relatively better trends hold up, CHUX will be the biggest beneficiary as 26% of its restaurants are located in this region of the country.

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