Chart Of The Week: Unemployment's Peak Pessimism?

While the propensity for emotional over reactions in markets never cease to amaze me, this one was rather predictable – that’s why we sold down a lot of our invested exposure early in the week as the market was making its new 3 month-cycle highs at SP500 941.

Plenty of money managers and the manic media alike basically aren’t allowed to be bullish anymore – with the SP500 already down -1.4% for 2009 to date, the trigger fingers associated with chasing short term performance are already shaking.

I don’t think it’s the actual level of unemployment that’s freaking revisionist historians out in this country as much as it is the steepness of its acceleration. As always, in order to frame up yesterday’s news we must look back and consider where The New Reality fits within the context of economic history.

This 7.2% unemployment rate, of course, is last year’s number. Markets move on expectations of tomorrow, and this week’s -4.5% drop in the SP500 implies that the masses genuinely expect US unemployment to worsen – and I agree that it will – but NOT at an accelerating 6 month rate…

That’s why I am getting bullish for another “Trade” higher in both commodities and stocks. Everything that matters in my macro model occurs on the margin. If the unemployment rate starts to go up at a decelerating rate, the US stock market is going to continue to make higher lows.

Look at the chart below – is it steep? You bet your Madoff it is! This is the steepest 6 month sequential acceleration that the USA has seen in unemployment in 33 years. You have to go back to 1 to see this kind of 6 month delta and, on a 6-month basis, I don’t think it will re-accelerate from here.

On the contrary, I think there is a much higher probability than current expectations bake in that, come one month from now, we will not be looking back on peak pessimism for what it was – at the peak of a sequential acceleration. Yes, I think the unemployment rate will test 8%, but I do not think that we’ll be testing 9% or higher 6 months from now (7.2% +180 basis points of continued acceleration = 9%, which I believe is Goldman’s estimate).

1. US jobless claims have improved, materially, in the last 2 weeks
2. Obama’s “shovel ready” plan of 3M jobs has basic math implied that provides a cushion to my estimate
3. Unless either points 1 and 2 change, I won’t need to change my view.

I realize this is not consensus, but when I was calling for a 6-7% unemployment report by 2008 end at this time last year, at least as many people disagreed with my bear case. This is what makes a market. Lets strap the accountability pants on - put me in print at less than 9% unemployment 6 months from now.

Keith R. McCullough
CEO / Chief Investment Officer

US Market Performance: Week Ended 1/9/09...

Index Performance:

Week Ended 1/9/09:
DJ (4.8%), SP500 (4.5%), Nasdaq (3.7%), Russell2000 (4.9%)

2009 Year To Date:
DJ (2.0%), SP500 (1.4%), Nasdaq (0.3%), Russell2000 (3.6%)

Keith R. McCullough
CEO / Chief Investment Officer


I’ve thought the two most compelling acquisitions for PENN were buying PNK or an MGM Strip asset. The pendulum appears to be swinging west all the way to Vegas.

The deal absolutely makes sense strategically. PENN would gain a high quality, well maintained, upper mid property in the premier gaming destination in the country. The Mirage brand is powerful and would bring a destination property into PENN’s portfolio. The cross marketing benefits are potentially huge. PENN’s current properties are widely dispersed with millions of customers in its database. Many of these players are already going to Las Vegas anyway and now they can be incentivized to stay at The Mirage. Harrah’s Entertainment has been very successful with this strategy and is the only company with the geographic diversity to pursue it, until now (maybe).

While we don’t know the price, an acquisition of The Mirage probably works economically. How many gaming companies can borrow over a billion dollars at 1.25% above LIBOR right now? None. We believe PENN would pay between 7.5x and 9x forward EBITDA for The Mirage. Of course, forward EBITDA is a very depressed number so the timing is probably right. We calculate The Mirage will generate $155 million in 2009. At those multiples the deal could be accretive to EPS by 20-25% to a run rate EPS number of $1.50. More importantly, the acquisition would add over 10% to free cash flow.

The previous assumptions assume PENN borrows the full purchase price from its credit facility. There is another, potentially more value added approach PENN could take. As we wrote about in our 7/25/08 post, “PENN: ‘BASSET’ SWAPS AND VALUE CREATION”, PENN may have bought/buying MGM bonds at a steep discount in order to trade them back to MGM in exchange for The Mirage. The transaction would be a “win-win” because PENN takes ownership of the property for less than 7.5x-9x discussed above while MGM retires debt at par. In effect, PENN pays a lower price than MGM is receiving. Thanks to a very lenient credit facility that allows MGM to use proceeds from asset sales to retire subordinated debt, this transaction is feasible.

Either way, the purchase of The Mirage for 9x EBITDA or below looks attractive for PENN shareholders.

Economics likely attractive

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Eye On European Bond Yields

On Wednesday German 10-year bonds failed to attract enough bids to place the full €6 Billion the German government had sought, amounting to the second worst auction on record in terms of demand. In contrast France and Spain successful sold a total of around €11.4 Billion of bonds yesterday.

French 10-year bond yields traded at about 50 basis points above Germany, while Spanish 10-year bond yield came in a level over 80 basis points higher, with higher demand. This suggests that investor appetite for higher yield outweighs concerns over relative credit risk.

In the coming weeks, global markets will continue to be flooded with bond offerings as governments around the globe raise money for their respective stimulus packages. It seem likely, therefore, that we will see yields start to inch upwards as supply swoons.

Global equities, particularly those we purchased today (USA and Brazil), should outperform bonds as this perpetually bullish Trend in the Bond market comes under fire.

Matthew Hedrick

Korea Cut - No One cared!

The Koreans cut interest rates to their lowest level ever today – yes, even in The New Reality, “EVER” is a long time.

Both the South Korean Won and the KOSPI (Korea’s stock market Index) reacted negatively to this news. This is an immediate term “Trade” development, but it seems that Asian countries are starting to go through the withdrawal symptoms of any addict – you can only do so much, for so long. An addiction to easy money rate cutting has unintended consequences. Remember, America had this same addiction problem from September to November… not until the USA cut to zero, rate cuts were met with anxieties rather than optimism.

The KOSPI closed down another -2.1% on the day at 1180. From a quantitative perspective this country’s chart (see below) remains broken. Qualitatively, you’ll recall that not everything Asia is China. That’s why we have our long position in China, FXI, paired off with a short position in the Korean etf, EWY.

Keith R. McCullough
CEO & Chief Investment Officer


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