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US HOUSING - BULLISH BOTTOM FORMING PART II

Earlier this week we learned that this month’s existing home sales came in +6.5% higher than last month’s number (see post US Housing: Bullish Bottom Forming? - 1/26/09), and more importantly, inventories declined significantly. The supply of homes came down to 9.3 months, down significantly from the peak and the 11.2 months recorded in November 2008.

The second positive data point came yesterday. It was reported that the S&P/Case-Shiller 20-city index fell 18.2% year-over-year, the biggest drop since it began 2001. Less attention was paid to the fact that the October decline was 18.1%. Yes, it was the worst month on record, but the rate of deceleration continues to slow. On the margin, this is a positive. As we noted in our MEGA note, we believe that as we reach the spring, we will have reached the peak in declining home prices. Home prices will continue to decline but at a much lesser rate.

The bears point to the fact that home values will continue to decline contributing to what’s already been the biggest destruction of American household wealth in many generations. Consequently, the decline in home prices makes banks even more reluctant to offer mortgages. We know all this!

How many times have you heard everything has its price? Clearly, the decline in home prices is now leading buyers back into the market. At the same time, we are seeing a zero percent Fed funds rate, and an Obama administration focused on getting banks to lend to those seeking new lows in 30-year mortgage rates. The combination of significantly lower home prices and lower mortgage rates will have a positive impact on the US real estate market in 2009!

Howard Penney
Managing Director

MCD - DECELERATING

MCD’s U.S. same-store sales growth remained surprisingly strong throughout 2008 despite the tough economic environment. The company states that half of this comparable sales growth has been driven by traffic with the remainder coming from increases in average check. The growth in average check in 2008 was driven solely by MCD’s 3%-4% price increase, which was partially offset by negative mix contribution in each quarter. Please refer to the charts below, which assume 50% of MCD’s quarterly U.S. comparable sales growth is driven by traffic and 3.5% pricing for each quarter in 2008. One obvious explanation for MCD’s negative mix in the U.S. is that customers are trading down to the Dollar Menu, which has also helped to support traffic growth. Management has said, however, that the Dollar Menu has remained within its historical range of 13%-14% of sales.

Instead, management commented on this negative mix issue on its 3Q08 earnings call, saying, “I wouldn’t call it negative mix. The problem with an average check is you have a lot of different transactions in there. So our breakfast business, as we have said, in the U.S. continues to grow faster than the rest of the day and breakfast is a lower average check but a higher margin transaction. The same way with drinks. We were strong in our drink promotions through the summer, as we have talked about. Coffee is up more than 30% and a lot of those end up being transactions that are during off-peaks which are also smaller average checks, or they are only individual versus family purchases.”

When asked earlier this week about its pricing plans for 2009, management said in reference to Europe that MCD will most likely not be taking the level of pricing in the first half of the year that it normally would because “you’ve got to consider how the consumer is feeling and during these times the consumer is looking for deals and we want to make sure that we’re out there.” Although the company did not make any specific comments about pricing in the U.S., I believe the same line of thinking must hold for the U.S. as consumers are under increased pressure. I do not think the company will reduce its pricing but it may be become more difficult going forward to maintain its 3%-4% price increases. In 2008, MCD relied on these price increases to offset its negative mix and support same-store sales growth.

Also hurting average check in 2009 will be the increased contribution from specialty coffee sales. I continue to believe that MCD is launching its specialty coffee platform at exactly the wrong time (with people cutting back on these more discretionary purchases) and that it will not provide the expected sales lift. The bulls on MCD continue to believe that the company will be able to flawlessly execute on the launch of this new beverage platform, but specialty beverages are just that for MCD; a new platform. The company is not maintaining its strict focus on its core products, and I think these beverages will add complexity to a system that in the recent past has consistently improved its operations. That being said, increased coffee sales have resulted in lower average checks in the past so I would expect any incremental off-peak specialty coffee sales to put further pressure on average check growth.

Going forward, MCD’s ability to maintain its same-store sales momentum in the U.S. may be at risk as it becomes more difficult for the company to raise prices and as its average check is hurt by increased Dollar Menu, breakfast and coffee sales. Although increased breakfast and beverage sales would be good for margins, investors have become accustomed to consistently superior same-store sales results. Additionally, it should not go unnoticed that some of MCD’s biggest competitors, Wendy’s and Sonic in particular, are increasingly focused on their value offerings, and based on its recent success, MCD has the most to lose should these companies experience improved traffic growth. Remember, the restaurant industry is a zero sum game!

EYE ON THE YIELD CURVE

With issues of historic size for 2 & 5 year paper driving yields higher on the short end and market anticipation of a “bad bank”, the curve is starting to show declining steepness -a data point that could be negative on the margin if the trend were to continue.

With a spread of over 170 basis between the twos and tens it would be premature to call this out as a sea change but it is worth taking note of and we will keep it in our line of sight.


Andrew Barber
Director

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EYE ON LEVERAGE: ULTRASHORT

We have recently fielded several questions about ETF structures with enhanced leverage features.

The matter of ultrashort ETFs pricing has been a hot topic of conversation for the past two or three months as investors who purchased and held them realized returns that diverged significantly from the results they had anticipated. The common issue that many investors encountered was a misunderstanding of the actual mechanics of the products.

Ultrashort ETFs, such as TBT -the ProShares Long-Term Lehman Bond Index product that is used for the charts below, replicate a short position that is recalibrated daily rather than a static leveraged position in the underlying (which would not be possible to duplicate in this type of structure mathematically). As such, investors that have purchased the shares and held them have often been very disappointed as illustrated by the first chart below which illustrates the divergence in returns realized by a long term holder of the ETF vs. a static short in the underlying index. The increasing number of shareholders holding the ETF over multiple trading sessions has increased with volume since inception (see "OVERHANG" in the second chart on the first illustration panel).

The confusion over these structures has been compounded by the existence of active options for many, which has led some retail investors that regularly engage in buy-write strategies to buy ultrashort ETFs and sell call options against the position without fully understanding what they were buying and selling.

For intraday traders who are utilizing the ETF as it was intended, the returns have come in with a very close correlation to a leveraged short intra-day position in the underlying, as illustrated in the second illustration panel below. Since the trading-leverage drought started last year the ultrashort class of ETF has become a magnet for hedge funds employing short term strategies who have found leverage to be difficult to extract from their prime brokers.

Ultimately, it seems unlikely that an ETF will be introduced that can truly approximate the economic exposure of a static 2-to-1 leveraged short position given the inherent credit exposure assumed by the issuer of any such product in the event that the underlying investment declined by an amount greater than the value of the actual ETF. As such I would expect that sophisticated speculators looking for multi session exposures will probably prefer futures and options markets whenever available.


Andrew Barber
Director

EYE ON GERMANY: SENTIMENT CHECK

IFO Sentiment data for Januray released today registered better than anticipated with the Business Climate sentiment index at 83, up from a revised 82.7 in December. Current Assessment was down 2 to 86.8 (still significantly higher than anticipated) and Expectations were at 79.4, up from a revised 76.9 reading for December and much better than economists had forecasted.

The slight uptick in sentiment indicates a less-than-toxic outlook for Germany. Chancellor Angela Merkel agreed this month to spend €80 Billion ($105 Billion) over two years to overturn the country’s worst recession since WWII.

We are currently neutral on Germany’s Equity market.

Andrew Barber
Director

Matthew Hedrick
Analyst

The Liquidator

The Liquidator - asset allocation012809

“What is a committee? A group of the unwilling, picked from the unfit, to do the unnecessary.”
-Richard Harkness
 
I haven’t had to ‘You Tube’ CNBC for a while now, but I guess all it takes is the first 3-day rally in the US stock market since November to remind us all how reckless some of these entertainers on our nation’s manic financial media network can be.  After all, most of the “traders” on Dillon Radigan’s “Fast Money” have never seen a bullish tape that they didn’t chase.
 
Unfortunately, this tape isn’t bullish, yet. Clearly, Dillon Radigan doesn’t proactively manage the process by which his “committee” of Fast Money group thinkers gets excited at immediate term tops and freak-out at immediate term lows, well… because… the man doesn’t have an investment process.
 
A wise man who taught me a great deal in this business once told me that it is better to be an idiot in this profession and remain silent, than to open your mouth in a meeting and remove all doubt. Last night, Fast Money’s Joe Terranova – the man they call “The Liquidator” – reminded me of as much. After (not before) this 3-day rally, this momentum trader of everything that goes up was firing his mouth off on being bullish on everything from Brystol Myers (thanks, we just sold into that), to energy stocks. Then he proclaimed his mystery of faith by asserting himself as a resident expert on what this “Bad Bank” proposal means – it was truly a professional embarrassment.
 
When someone who has no idea what they are talking about looks into one of these cameras and gives you that ridiculously serious stare that the producers of Fast Money order their performers to deliver, please watch your step. The only thing worse than an idiot giving you financial advice is an idiot who always has conviction.
 
The real “Liquidator” that you should be focused on this morning is the US Government. In a perverse way, the anteing up of larger and larger socialist stimulus plans and government bailout expeditions is going to be good for the stock market, at a price, in the very short term. Why is that? Well, quite simply because this has disastrous implications for both America’s balance sheet and her long standing leadership in having the world’s currency reserve standard. The more we show the world that we are willing to capitalize individual gains on Wall Street, and socialize the losses, the less the US Dollar will be worth.
 
There is a penalty for malfeasance, and yes the US Dollar can go down, a lot, as a result. In the immediate term, if the US Dollar breaks down and closes below the levels that I issued in yesterday’s missive, the stock market should continue to work higher. No, I am not saying this is good – and neither is General Electric’s AAA rating when you consider that they support the class action law suits waiting to happen with their said professional “traders”… it all ends very badly. But again, everything has a time and a price.
 
For generations, mismanaged countries have had to de-value their currency in order to dissuade their citizens to save. This, of course, encourages people to take on additional risk in order to find a relative return. Is it bad? You bet your Madoff it is… but try ramping the US Dollar up another +3-6% from here, and let me know how that feels in your stock portfolios.
 
The fact of the matter is that the US stock market’s only up month (December) since the Crisis of Credibility went into full swing, came in a month where the US Dollar broke down. If you’re more into the Fast Money thing, the first 3-day consecutive rally in US stocks came on the heels of a US Dollar decline as well. For the week to date, the SP500 is +1.6% and the US Dollar is down -1.7%. That’s as tight an inverse correlation as you are going to find. That’s just the math.
 
The worst part about this reactive government intervention is that it is being run by committee. Then we have the manic media interpret the reactive decision making with some of the most reckless advice I have ever heard. This is bad.
 
I ‘You Tubed’ the output of that new Obama committee via Larry Summers Meet the Press interview in a note to our macro clients earlier this week. The bottom line is that the stimulus package is going to be much larger than that $825B number, and Summers knows it. Page One of the WSJ this morning finally addresses my point, so Joey T will get that memo for his slapstick punditry on tonight’s show. He’ll only be 3 days late.
 
Joe, sorry to steal your high conviction thunder, but your stage name, “The Liquidator” is owned by one Resolution and Trust Corporation. This “Bad Bank” idea is somewhat similar in scope to what the US government implemented during the Savings & Loan Crisis. Don’t forget that between 1, this US government owned asset management company, closed/dissolved 747 thrifts (banks) with assets of almost $400B – yes that’s beelions – and no, it didn’t end well for shareholders of last resort. That’s a “Liquidator”!
 
The politicized US Federal Reserve will be front center later today with an FOMC decision that has been compromised. When you cut rates to zero, the only thing left to do is implement emergency bailout plans, and get Fast Money traders in heat trading the futures. With the US futures spiking higher last night, and CNBC promoting it with a live chart, I sat there in wonderment trying to think of how many times the American public has to see this hope-fest of entertainment better suited for the E! channel before she finally understands that this network has virtually been wrong in leading you to buy into these bailout plans at every turn…
 
GE’s stock goes down for a lot of reasons, but why is the obvious fact of liability in their media portfolio so deceptive? Don’t ask Radigan’s “committee” – this is a group “picked from the unfit, to do the unnecessary.”
 
In the immediate term, the SP500 range of 861 to 873 will be very much overbought. Unless the US Dollar breaks down, you are best served liquidating longs today into strength, rather than listening to the man formerly known as “The Liquidator.”
 
Best of luck out there today.

The Liquidator - etfs012809


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