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Flattening The Curve...

For those investors looking to borrow short and lend long, this is one of the most negative 3 week charts that has developed in American Capitalism.

This morning’s narrowing between 10s and 2s has resulted in a +126 basis point spread. This is well off the higher levels that we saw in both late October and early November when I started to get more constructive on US Equities (see chart). In “The New Reality” of American Capitalism, we need to be able to see an expedited wealth transfer from the levered long to the liquid long investor. Steepening the curve is the best way to ensure that process takes hold. It’s the only way to incentivize those with real savings to lend.

It’s not only 2 month Treasury yields that increased on a week over week basis last week (from 0.74% to 0.88%), short rates like 3 month Treasuries went from 0.00 (ZERO) to +0.06%. I have long maintained the most basic of arithmetic thesis’ that once you cut to zero, the only way to move next is UP. Now, albeit slowly, that’s starting to happen… and this development should be monitored very closely on a day to day basis. This is why the XLF (Financials) continue to underperform.
KM

Re-Flate!

Re-Flate! - asset allocation122908

"To be wronged is nothing unless you continue to remember it."
-Confucius

For many, it has been a long hard year. Being a record setting 0-16 Detroit Lions, or being down as much as the SP500 year to date (-41%) is actually nothing now, "unless you continue to remember it." In t-minus 3 trading days, both levered long Portfolio Managers and NFL coaches missing the post season get to move out of the way. For many of their investors and fans, it can only get better from here. Don't forget, everything that matters in markets happens on the margin!

Rather than pointing fingers and getting bogged down by the rear view mirror, this is a great moment in American history to look forward. This is quickly developing into one of the greatest opportunities that American Capitalists who proactively prepared will ever see. US Equities are on track to lock in their best sale prices since 1931, oil prices have dropped -76% in the last 6 months, and interest rates around the world are going to zero. Can you imagine what the "it's global this time" bulls would have done with a fact-based economic narrative like that? Actually, we don't want to go there... we might find a whole band of Bernie's.

Fortunately for him, Bernie didn't quite find his way to Russian or Asian coffers. Rather than bouncing reporters on Park Avenue, he would have had himself quite the situation to deal with. The best news about the moral-less Madoff story is that it too will find its way out of the mass media in the New Year. That, on the margin, is also a bullish catalyst for markets.

Israel raining down on a region where there are 1.5 million Palestinian civilians has not been able to shake the boots of The New Reality investor. Neither has Pakistan deploying tens of thousands of troops to the Indian border. Weekend at Bernie's New York apartment looks tame compared these geopolitical risk sirens, but markets find a way of discounting news before it happens. You don't need an SEC that actually looks for insider trading anymore - if you watch markets and stocks closely enough, you'll see plenty of it revealed before the mass media rehashes it.

Thankfully, we bought oil into its vortex of year-end dismantling. This isn't about "year-end selling" - that's over with. This is about dismantling... and now, as a result, you can find plenty a "prop energy trading desk" being sold on EBay. Like the Lions NFL season, thank God it's over. Having to deal with the "he said, she said" nonsense of some of these vaunted institutional jungle gyms was making me nauseous. Now, volatility is coming down as fast as employment in this segment of the financial services sector. The VIX was down another -3.4% last week, taking its cumulative cliff diving score to -46% from its manic peak.

My asset allocation model went to 14% in Commodities last week. I was thankful for the blessings of family at Christmas, and many of the tidings that came alongside Wall Street's cycle crashing. Buying oil under $40/barrel was something that doesn't make sense until it does. This morning, like many other mornings on the interconnected planet called Earth, those who sell oil low are reminded that the price of oil has a geopolitical risk premium. Some mornings it is more obvious than others - but wherever you wake up in this world, there it is.

I have dropped my asset allocation to Cash down to 44%, and that's very close to its lowest level of 2008. With only three trading days left, I had to splurge on some of these holiday deals. The "shop till you drop" mantra of many moons past is really quite cool, particularly when there are no lines. The US Dollar continues to get hammered, because ... well, the US Government has decided to devalue it. This decision by our politicized Federal Reserve is not unlike the one that Nationalist hero Vlady Putin has made. When in doubt, devalue - and "Re-flate."

With the US Dollar index trading down another -1.5% this morning to 79.53, our decision to short it on Friday is making our clients smile. This exercise isn't that complicated. "Re-flation" is what you get after everything has deflated!  With all of the bubble watchers on CNBC reminding you that things can pop, you have to be a little confused now that all of the bull market parties balloons are dead flat laying all over the floor.

We remain long Gold via the GLD etf, and that asset class had another fantastic week, closing up another +4.1% at $871/oz, outperforming the SP500 by almost 600 basis points. With the Russian Ruble hitting all time lows against the Euro this morning, the Chinese Yuan hitting its lowest price since December 10th, and the greenback feeling the ills of a nasty Hank "the Market Tank" 2008 hangover, gold continues to "re-flate."

Whether you are an exec at Rohm & Haas this morning who is seeing his/her stock price deflate due to the Kuwaitis not having the cash to supply Dow Chemical for the acquisition, or your one of them poor fire engine chasing "activist" people who chased Bill Ackman all the way to "Tar-g-eh"... it's all one and the same. 2008 was a year that everything from the madness of petrodollars to those "Made-up" Madoffs has all deflated. The only thing that gets air back in the tires of global finance is to "re-flate" them. Don't worry about the long term implications - this country hasn't worried about them for decades now. "To be wronged is nothing, unless you continue to remember it."

Best of luck this week.

Re-Flate! - etfs122908


SENTIMENTAL EXPECTATIONS

Sentiment is far better in softlines retail than many might think. Combined with earnings expectations that are way too high, the only saving grace here is valuation. If there is one theme that is clear it is that there is massive lack of conviction out there – both long and short. Look for earnings outliers in this space. I’ve got plenty.

We can’t always predict the facts, but we can always manage the process around them. A friend of mine who runs a $1bn+ non-Wall Street business once told me that “when things become ‘unmanageable’ it is when the facts spiral out of control faster than I can adjust my own expectations.” I like that…especially given that so much in this market is driven by changes in expectations on the margin. In looking at anything retail-related, all one needs to do is look at the ‘75% off’ signs in retailers’ windows, ‘winter clearance’ blast emails, or gloom and doom news reports about how unmanageable this holiday appears to have been. These facts beg the question as to whether this is the bottom for retail. I am absolutely far less bearish than I have been over the past two years. But my colleagues at Research Edge are getting incrementally bullish on their respective groups. Trust me, I want to be part of that club. But the facts continue to lead me down a different path.

Why? Sentiment and expectations.

Sentiment: Many people might not realize this, but short interest as a % of float in this group is now 10% -- down from 15% in late summer. It has come down at an extremely consistent clip, and has given back all the interest accumulated since the ‘The Consumer Is Doomed’ call became en vogue back in late 2007.

Is the short interest ratio still high at 10%? Yes, it probably is when combined with how Underweight long-only funds are in this group right now. But you should definitely not look at the SIR for the group 5 years back and use the 3-5% range as a benchmark. The overcapacity that has built in the hedge fund community has driven this higher. That is flushing out now, but despite the carnage, I’d challenge anybody to show me a statistic saying that there are fewer funds out there today than 5-years ago. My point here is that anything in the 10% range does not seem grossly out of whack for me as it relates to short interest – suggesting to me that the group is not particularly over-shorted right now.

Expectations: My beef is still that Analyst estimates suggest that there will be only a 50bp margin hit next year on top of the 150bp hit we’ll have seen in ’08. That’s a 200bp margin decline after a 7 year run where margins were up 6.5 points. That’s simply not realistic in a severe consumer-led recession with such meaningful industry-specific headwinds. The Street is looking for EBIT growth to bottom in 4Q08, sharply recover to a point where it is flat by 3Q09, and then revert to high single-digit growth by 4Q. My math suggests that 4Q/1Q EBIT growth expectations will prove aggressive to the tune of 10-15 points.

So what do we have? Sentiment is no longer flat-out bearish. Earnings expectations are still meaningfully too high. A saving grace is valuation, which sits at about 5x EBITDA. What’s interesting to me is that short interest is down, but so are multiples. What does this tell me? There’s lack of conviction on both sides of the trade – long and short.

I still think that this will be the year for Winners vs. Losers – as defined by earnings momentum. I like Under Armour, Columbia Sportswear, Bed Bath and Beyond, Hibbett Sports, Lululemon, Liz Claiborne, Kohl’s, Hanesbrands, Payless and Chico’s. I’d avoid, TJX Cos, DSW Inc, VF Corp, Gap, Philips-Van Heusen, Brown Shoe, Carter’s, Wolverine Worldwide, Ross Stores, Sears and JC Penney.


Brian McGough
Casey Flavin
Short interest is far less than most people probably think it is...
This year’s SIR has been far different from seasonal trends of old.
Once margin degradation flattened out, short interest started to decline meaningfully.
The market thinks that earnings revisions are done. I think not.

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Eye On Re-Regulation

O Come, All Ye Faithful

Do you believe in fairies? Say quick that you believe. If you believe, clap your hands!
- James M. Barrie

Page one of the Christmas Eve edition of the Financial Times features a Christmas pilgrim, praying at the Grotto in Bethlehem. The article announces what must surely be considered good local economic news: “An estimated 1.25m tourists are expected to visit Bethlehem by this year’s end – a near doubling on last year’s numbers.” In these trying economic times, there is still someone experiencing year-over-year growth.

The cover of the holiday issue of the Economist features an angel strumming what appears to be a Gibson Les Paul model electric guitar. As the world teeters on the brink of the Great Beyond, Sex and Drugs pale before our yearning for the Life Eternal – though Rock ‘n Roll is holding on.

If you no longer believe in Capitalism after the past year and a half, there are still the comforts of our ministering angels. The principle of No Atheists in Foxholes applies to the walking wounded of the financial world, no less than any other field of battle.

Then there are those of us still working through the unreality of the visible world. Truth is not only stranger than fiction, it also has a warped sense of humor. Al D’Amato – Pothole Al, the man who used to refer to himself proudly as “the poorest man in the Senate” – says Bernie Madoff’s scam appears to have been so broad and complex that it is inconceivable that he could have acted alone. Senator D’Amato – who knows a thing or two about how Wall Street works – said “you would have to believe in the tooth fairy” to believe that Bernard Madoff pulled off this entire elaborate scam without the ongoing involvement of his family.

Indeed.

Speaking of the inadequacy of the regulatory process – we were intrigued by the lead article in the Financial Times of Tuesday, December 23, headlined, “Madoff Investor Warned Its Clients”. Kingate Global Fund Ltd., run by FIM Advisers in London, handed Madoff $2.75 billion, while explicitly warning its investors that their outside manager “could abscond with those assets.” We have not seen the actual documents from which this quote is lifted, so we cannot tell whether this was pointed out to investors as a specified risk, or was merely buried in a litany of boilerplate. Either way, we bet the Fund’s solicitors have already drawn up a brief arguing that Kingsgate Global provided full and fair disclosure. How much more explicit could they have been? the lawyers will ask. Even if it is deemed a technicality, it is a rather large one, against which the courts may be hard pressed to argue, leaving the losers to decry the inadequacy of human justice. “Vengeance is mine, saith the Lord.” Unfortunately, the Lord is no longer taking clients.

In light of the angels around us, let us reflect that ours is a world of Faith, rather than scrutiny. Wall Street is fueled by our propensity to operate on a wing and a prayer, and not on due diligence. The greatest failing of the SEC is that it has never told investors that government regulation of industry does not mean that consumers are safe. We test drive cars before buying. We try on dozens of shoes before settling on a purchase. Yet people wire a hundred thousand dollars to a complete stranger on the strength of a ten-minute telephone conversation. The American public believes fervently in the Angel of Market Success, followed closely by the Tooth Fairy of Regulation. And when the Regulators lost all the teeth they had, we didn’t even find a quarter under the pillow.

So please, if you believe in market forces, don’t bother to clap your hands. Let Tinker Bell die, by all means. And let those who were willing to throw their money at smiling gentlemen in expensive suits finally learn how things work. The nice man in the expensive suit, his job is to throw your money out the window and hope it bounces. The lawyers with their expensive bulging briefcases, their job is to write up contracts with all the pages and pages of small print that will shackle you to your losses. And you? Your job is to read that fine print before you act. All of it.

Christians around the world are celebrating the Birth of the Redeemer. But it is a Lord who redeems only the eternal soul. Those of us fighting the hand-to-hand combat of financial trench warfare know that, come Christmastime, the window for redemptions has long been shut. As Above, so not so very often Here Below.


Of Shoes and Ships and Ceiling Wax

Sometimes a hard look at nonsense yields a surprise.

Page one of the Financial Times of December 23 has a photo of Viktor Bout, alleged Russian arms dealer. (Alleged to be an arms dealer, that is. He really is Russian.) Viktor Bout, described as the Merchant of Death, inexplicably left the safety of Russia, the only country that would never have extradited him to the US, and flew to Bangkok in search of a transaction, leaving behind a wife, a family, and a personal net worth of some six billion dollars.

He is now in a Thai jail fighting extradition to the United States.

What could possibly induce a man in his position to leave the safety of the only haven that will protect him? Even after a Presidential pardon, Marc Rich has barely been seen outside of Switzerland.

We remember the bewildered face of Mikhail Khodorkovsky, multi-billionaire chief of the Russian energy giant Yukos, staring through his glasses and the bars of a prison cell. The interlocking relationship between Russian government corruption and Russian private-sector corruption should not be lost on Western commentators when Putin appears to trash the capitalist values that his own government endorsed. Not every land is America, where capitalists are permitted to be profligate nincompoops, and where the government rushes to their aid when they scrape their knee. There are lands where the government made the transition to a market economy by dishing out favors – creating capitalists by fiat, and for a price. Woe to the capitalist who serves at the pleasure of the government, when he believes his cash puts him beyond the reach of that government.

Our guess is that Viktor Bout incurred the displeasure of the Kremlin and decided that spending his life in an American prison was preferable to having it cut short in a Russian one. Not to mention, in America you get time off for good behavior. Whereas in Russia, as the old joke goes, they shoot all four-legged creatures on sight. But, you ask, surely Viktor Bout is two-legged? Yes. But as everyone knows, they count after the fact.

Russia, down on their luck because of the crash in the price of oil, is trying to create a Gas-PEC – an international consortium of natural gas-producing and exporting nations. Let it not be overlooked that Iran is right at their side. So much for putting a halt to Ahmedinejad’s nuclear wet dream. And that Russia is now strong-arming Ukraine – ditto for the US defensive system in Russia’s vestibule.

But how to pay for all this? Perhaps by nationalizing one of the few remaining highly lucrative businesses left within their borders: arms trafficking.

We wonder who will play Viktor in the movie.


Payment for Order Flow

Woulds’t thou have a serpent sting thee twice?
- Merchant of Venice (Act IV, scene I)

It is a shame we cannot drive using only the rear-view mirror, when in retrospect it is all so very clear. The Financial Times (Wednesday, December 24, page 13) reported on the business that first put Bernard Madoff on the map. In the 1980’s and ‘90’s Bernie was sending checks out every month to brokerage firms who were routing their orders through him. Bernie created what came to be known as the Third Market, at one point draining off some 10% of the total NYSE business.

The article reports that Bernard Madoff, by far the largest practitioner of payment for order flow, was on the commission set up in the 1990’s to look into that practice – the Ruder Committee, led by former SEC Chairman David Ruder.

Madoff typically paid brokerage firms a penny a share for their order flow, then matched orders internally, essentially setting the price on both sides of the trade. He traded his matched executions against the market, often pocketing the lion’s share of the spread on the stocks he bought and sold. One bit the article does not mention is that, as the NYSE’s biggest competitor, Madoff could also influence the market spread, thus paying himself more if he felt he was not getting enough on a trade.

Should we be shocked that Bernard Madoff was named to the panel convened to study his own business?

How do we determine which activities need to be regulated? First the Government asks the people who claim to have been harmed by the activity. Then, to be fair, they hear from those who are about to be regulated. And who knows more about the Third Market than the man who created it? And so Bernie Madoff gained a seat on the Ruder Committee. This is a classic case of Keep Your Enemies Closer – and we don’t mean the Committee keeping an eye on Bernie.

Wall Street has always been the leading indicator for new regulation. It is definitional to its business. Bernie Madoff made his fortune by exploiting an unregulated gap in the market and riding it for as long as he could. It was a gap that even Arthur Levitt failed to plug, and fortunes were made over the years in compensation, from cash payments, to all manner of soft dollars. In common parlance these are called Kickbacks.

Here at Research Edge, our philosophy is driven by our CEO’s dictum that everything important happens at the margins. The fat part of the bell curve poses no threat to the Norm. It is the norm. In the world of Regulation this means that, as laws are passed and rules introduced, the creative minds of Wall Street seek the loopholes. And they find them – because legislators and regulators do not come from the industries they regulate, and so are forever passing laws and making rules to prevent folks doing what they already did. Rules are implemented when, after years of a certain activity going unregulated, it becomes so widespread it is seen as abusive.

We hope the Obama Administration will see the wisdom of bringing real market professionals into the regulatory process, of setting people’s interests against one another as a way of ferreting out the truth of what goes on in the business. For regulation to work it must be forward looking. It is all but pointless to pass laws to prevent the next Madoff scandal. We guarantee that, even now – even as you read these words – somewhere, somebody is working on a multi-billion dollar scam using instruments and strategies and mechanisms none of us has ever heard of. That’s the person we want to catch.


The Random Swim

An article titled “Here Is The Market’s Water Forecast” in the magazine New Scientist (December 13-19, page 10, “) describes a program set up by the Australian Knowledge Exchange. Participants in a virtual marketplace are given a stake of $100,000 play money, and 1000 virtual shares in each of the reservoirs in New South Wales. The stocks pay a monthly dividend tied to the level of water, up to a maximum of $100 for a full dam, and market participants buy and sell one another’s shares, depending on their own analysis of trends in water levels. The government hopes to use the market consensus as a predictor of actual water levels in the drought-endangered country. The theory behind this program is that a market, even a play one, is a better predictor of reality than any academic computer model.

The Australian government plans a proliferation of on-line markets to “help manage other environmental issues such as animal extinctions and brushfires.” These on-line markets are to serve as a touchstone for Australia’s environmental policy.

The Efficient Market Hypothesis, developed as an academic tool by Eugene Fama at the University of Chicago in the 1960’s, was taught to generations of B-Schoolers, thereby becoming gospel from Wall Street to the halls of Congress. The EMH is based on the notion that prices in markets contain all information relative to their instruments. Even now, after EMH theory has been largely nudged aside by new and robust theories, academics agree that significant information content resides structurally in markets. The challenge is to devise mechanisms to mine it usefully.

Enter Nate Silver, (no relation) who gained media stardom by correctly predicting the Obama victory. Silver’s blog, FiveThirtyEight.com, not only picked Obama as the winner; the statistical analysis was stunningly correct, with a high degree of what quants call “granularity”. This means: he got it right down to the Nth decimal place.

Silver was lauded in the press, garnering such accolades as “Genius of the Year” (blogger Al Giordano), being listed as one of the top “40 under 40” (Crain’s Chicago Business) and featured in the Huffington Post’s list of “Ten Things That managed Not To Suck In 2008”.

Heads up, Team Obama. The greatest benefit of the current global Carbon Emissions Trading programs may be not as an actual control on the level of greenhouse gases, but as a laboratory for studying the phenomenon to create workable policy. It might be more useful to chart the arguments in the next go-round of global environmental negotiations, than to try to actually win them. Robust statistical theories demonstrate that large numbers of people, all busy analyzing the same phenomenon, have great predictive power. It may be more useful to create a bunch of virtual marketplaces than to commission Government studies. Australia thinks so.

Picture an on-line market where people can bet on the level of automobile sales over the next twelve months, the likelihood of war with Iran, the identity of the next Bernard Madoff, or the actual drop-dead date to reverse global warming.

Add to this the stunning productive power of Capitalism – that in short order, people will figure out a way to make these virtual trades pay off in real money. There will be abuses, but not before the predictive power of the market mechanism has become stunningly robust. Anyone have any statistics on the lag between market participants coming up with new money-making concepts, and the upsurge of market abuses to the point where the market loses its predictive power? Looks like there should be a prominent spot on the Obama team for Mr. Silver. Maybe Big Government can actually get something accomplished.


Follow The Money

The Wall Street Journal editorial page (December 23, page A12) was aglow with Capitalist congratulations at the news that Judge Colombo, in Wayne County, Michigan, has thrown out the medical evidence proffered by Dr. Michael Kelly. The Free Press (freep.com, November 20, “Wane County Judge’s Ruling Jeopardizes Asbestos Cases”) reports that Dr. Kelly, who received $500 apiece for his expert testimony, has declared 75 patients as suffering from asbestos-related illness. According to the article, “About 1,000 doctors looked at these same 75 plaintiffs and none of them saw what Dr. Kelly saw…” The litany of alleged failures and possible malpractice on the part of Dr. Kelly is succinctly summed up in the Journal’s congratulatory piece.

What this makes us think of is a phenomenon with a similar profile. It struck the attorneys for the asbestos companies as odd that Dr. Kelly’s diagnoses appeared to all follow the same pattern. They looked at the regularity with which Dr. Kelly identified the same maladies, and the high frequency of “hits” – positive diagnoses of asbestos-related illness – versus No’s or Maybe’s. Too good to be true, they thought, and so they investigated.

The charts we have seen depicting Bernard Madoff’s returns to his investors are a market professional’s nightmare. The fact that the line goes up is not the problem. At issue, rather, is the steady, regular slope of the line. Bull market or bear, melt-down or melt-up, Bernard Madoff was returning the same percentage to his investors.

Assuming that he really could beat the market, the only possible explanation was that he was trimming his returns in good times, and husbanding them to pay out in bad times. Or, that he was scalping his good returns and pocketing everything above the rate of return his investors expected.

Or that the whole thing rested on as sound a footing as Judge Colombo found underpinning Dr. Kelly’s expert testimony. It appears the only thing the Doctor may have been “expert” at was bilking insurance companies. Over 2,000 pending asbestos litigation have been called into question.

The corollary to the dictum “Follow the money” – If it goes in a straight line, something is wrong.
Moshe Silver
Director of Compliance
Research Edge LLC

Keith R. McCullough
CEO / Chief Investment Officer


US Market Performance: Week Ended 12/26/08...

Index Performance:

Week Ended 12/26/08:
DJ (0.7%), SP500 (1.7%), Nasdaq (2.2%), Russell2000 (2.0%)

December 08’ To Date:
DJ (3.6%), SP500 (2.6%), Nasdaq (0.40%), Russell2000 +0.80%

Q408’ To Date:
DJ (21.5%), SP500 (25.2%), Nasdaq (26.9%), Russell2000 (29.8%)

2008 Year To Date:
DJ (35.8%), SP500 (40.6%), Nasdaq (42.3%), Russell2000 (37.8%)

Keith R. McCullough
CEO / Chief Investment Officer

NOVEMBER LV AIRPORT DATA

McCarran Airport reported that the number of enplaned/deplaned passengers fell 14.7% in November. The decline was the worst since the months following the 9/11/01 terrorist attacks, and the third straight monthly double digit drop. Hopefully, the follow through to Strip revenues will fare better than October when a 12.8% passenger decline translated into 23.2% revenue hit. I believe it will.

My model projects a 12% Strip revenue decline for November assuming normal hold percentages. The decline should be better than the airport data would otherwise suggest for two reasons. First, Strip slot machines held abnormally low in November of 2007. Second, low gas prices probably enticed a higher percentage of drive-in visitors than in recent months, which are obviously not captured by the McCarran data. Nevada gaming revenues should be released in a couple of weeks.

Less bad is hardly a long-term investment thesis and we remain very negative on Las Vegas.

November data was worst since the 9/11 months
I project Strip revenues will fall less than the passenger decline

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