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Re-Shorting Japan: Industrial Production & Employment Charts

After seeing the EWJ (Japan etf) rally +17% from its November lows, I am thankful this Christmas for having covered it. Next Christmas, I want to be thankful that I re-shorted this political and economic mess. This morning’s macro economic reports out of Japan are charted below.

Now that the Yen is appreciating alongside a depreciating US Dollar, it’s next to impossible to see how Q1 exports in Japan can turn out to be nothing but terrible. While the Japanese export print of -27% y/y for November was the worst number they have ever reported, there is no economic leadership in this compromised socialist story that gets me anywhere other than back on the short side of my longstanding bearish view of Japan.

There is huge “Trend” line resistance in the EWJ etf up at $9.38. We re-shorted it this morning.


Many hedge funds were burned playing the January effect in early 2008. Stocks got creamed, particularly consumer discretionary, and especially gaming. Gaming stocks were pounded to the tune of down 22% in the first two weeks of 2008. See the first chart.

Here is why January 2009 could bring more holiday cheer for the gaming bulls than 2008:

• Short interest is sky high now (2nd chart)
• Investors are much more bearish this time per the BBI (2nd chart)
• Consumer discretionary looks good technically
• Low gas prices bring some optimism
• Real interest rates near zero
• Fire sale valuations

Gaming stocks have had a decent run lately but are still down 70-80% on the year. The industry faces a myriad of issues in 2009 but bearishness is unprecedented, valuations are low, and some markets appear to be stabilizing. The macro croupier may have dealt the pessimists a bad hand, if only temporarily, through the unprecedented use of short term monetary (near zero interest rates) and fiscal stimuli.

A January rally may indeed be in the cards. What a difference a year makes.

"January effect" was not effective in 2008
Investors are much more bearish heading into 2009

Bush and Billy's Boxing Day

"The only blind person at Christmas time is he who has not Christmas in his heart."
-Hellen Keller

Like most countries in the Commonwealth, Canada has her own “Boxing Day” traditions. I would be remiss not to call out the most obvious, which is Day 1 of the World Junior Hockey Championships. This is the jersey that all little boys growing up in this country aspire to wear in front of their families on the day after Christmas.

“Boxing day”, of course, does not allude to athletics. Its origins date back hundreds of years to when the wealthy would take the day and seize it as an opportunity to give back to both their employees and people of their respective communities who were less fortunate. Rather than chasing CNBC for the “latest” holiday shopping stat this morning, one has to wonder where and when the Street went wrong over the course of time. Christmas is about giving, not taking.

Perhaps it takes a blind woman’s genius to boil this point down to its deepest simplicity. The aforementioned one by Hellen Keller certainly gets me there. This morning’s #1 Bloomberg news headline is “Holiday sales tumble…”, and I can’t help but take the other side of this building consensus of negativity.

Over a year ago, the US Consumer Discretionary stocks were trading 50% higher, and hopes were abound that the “activists hedgies” who bought over valued wares like “Tar-g-eh” were going to warm the hearts of the levered long community with cashmere sweater sets. Now that the real hedge funds (one’s that actually hedge), are starting to take market share, I for one, am thankful for that. Most of our clients stayed long Wal-Mart (WMT), and short Target (TGT) in 2008.

If you look at Target’s stock price as a proxy for all of last year’s “holiday sales” and “activist investing” punditry, the metaphor rhymes. I remember sitting here at my desk on Boxing Day of 2007, listening to the entertainers talk about “Target taking share in a different demographic”. The stock price, meanwhile, has lost -37% of its value since December 26, 2007.

“Activist”, Billy Ackman, either forgot or was unaware that the US Consumer spending cycle is cyclical. Ostensibly, if you thought 64 consecutive quarters of positive consumer spending in this country was an economic “Trend” that you could straight line out to forever, you probably felt pretty good about telling all of your friends to buy into these candy canes dancing in your head too. Don’t blame Billy – he has been You Tubed as one of the many who “don’t do macro.”

I bought the US Consumer Discretionary Index (XLY) in our virtual Portfolio on Christmas Eve. Not because I had Christmas in my heart – rather because proactively predicting the Street’s Boxing Day narrative is about as simple as “making a call” gets. When there is a lack of a narrative, the Street will make one up… and now that the US Consumer stocks are outperforming nearly every one of the 9 sector indices we follow, we think they’ll ultimately change the #1 headline to something more positive.

Stocks discount expectations of the future. They don’t really care about the past. While Target miserably underperforming the sector since its early December rally isn’t our problem (since December 10th, TGT is down -17%), we have to be asking ourselves why it is that a large population of investors being “short the consumer”, after the group has lost ∏ of its value, still makes sense.

George Bush has a few weeks left in office, and before he moves back to Texas, he may very well leave US Consumers with the most wonderful gift of all. With oil trading at $36/barrel, interest rates at ZERO, and a stock market that’s on track to have one of its best sale prices in the last 150 years, we have to tip our hat to the man who may be the world’s most misunderstood.

You see, rather than getting all caught up in his approval ratings, and that he’s still lookin’ to get that there credit thing “unstuck”, contrarians may be best served to be focused on the good intentioned Texan having had this master plan in his back pocket for the last 8 years. Remember, Bush has taken the Presidency as an opportunity to read books and stuff – maybe he is signaling a return to a Boxing Day of giving. If Americans were ever ready for that change, now is the time.

Enjoy the rest of your weekend with your loved ones,

Long ETFs

SPY-S&P 500 Depository Receipts – Front Month CME S&P 500 contracts opened up slightly, trading as high as 866.5 before 7AM this morning.

XLY Consumer Discretionary SPDR - ShopperTrak estimates visits to U.S. retail stores declined 5.3% -a 24% percent Y/Y drop, during the weekend of Dec 19-21.

USO - U.S. OIL FUND – Front month NYMEX Light Sweet crude contracts traded as high as 36.9 before 7AM this morning as the market focused on reports of OPEC member production cuts in compliance with last week’s decision.

GLD -SPDR Gold Shares – Spot gold traded up slightly to $848.50 an ounce this morning on the Tokyo Commodity Exchange.

VYM – Vanguard High Dividend Yield- Commerce Department data shows consumer spending fell by 0.6% in November - less than forecast as cheaper gasoline helped fuel more spending.

DIA –DIAMONDS Trust Series – Front Month CBOT DJIA contracts opened up slightly at 8,430 this morning.

EWT – iShares Taiwan —The Taiex index closed up 0.3% at 4,425.08 this morning, a decline of 5.7% for the week.  

EWZ – iShares Brazil — Central Bank foreign currency inflow estimates showed a net of +$29 million in the first 19 days of December vs. $3.1 billion in all of November.

EWH –iShares Hong Kong – From the South China Morning Post: Hong Kong retailers experienced increased traffic over the holiday due to more visiting mainland shoppers than last year with some malls reporting more than 10% increases in shoppers Y/Y.

FXI –iShares China — The CSI 300 declined 0.5% percent to close at 1,862.10, down 9.3% for the week. The yuan declined 0.15% to 6.8414 this morning as NBS data showed Chinese industrial companies’ net income increased 4.9% in the first 11 months of 2008, the slowest pace of growth since the agency first began reporting the data.

Short ETFs

FXY – CurrencyShares Japanese Yen Trust - The yen traded down to 90.47 USD/127.19 EUR this morning as Trade Ministry data showed  factory output for November decreased -8.1% over the prior month.

Keith R. McCullough
CEO & Chief Investment Officer

Early Look

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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

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