2007 Redo

“This book isn’t based on academic theories. It’s based on our experience.”

-David Heinemeir Hansson


What a difference the last 5 years makes. Or did it? The aforementioned quote comes from the introduction of one of my favorite leadership and innovation books. Some of you already have it on your bookshelf. I’ve cited it often since founding the firm – REWORK, by Jason Fried and Victor Heinemeier Hansson.


If you are jammed for time into summer’s end, I read this book in 12 minutes to our team at a workshop meeting – lots of pictures. We like pictures. We’ll show you one of our risk management favorites in today’s Chart of The Day.


Re-work, Re-think, Re-do. Sadly, when it comes to Old Wall Street’s forecasting and risk management processes, there hasn’t been much of that going on in the last 5 years. Instead, broken sources keep re-cycling the same old stuff that sucked people in during Q3 of 2007.


Back to the Global Macro Grind


2007? Pardon? Weren’t we talking about Q308 similarities? Or was it the 1930s? 1987?


Here are 3 Big Macro things that are precisely like 2007:

  1. SALES: GDP Growth led Corporate Revenue Growth Slowing; by Q307, companies were right confused
  2. MARGINS/EARNINGS: stocks were “cheap” if you used peak margins and peak earnings assumptions for 2008
  3. VOLATILITY: US Equity market Volatility got slammed by “rumors” of Bernanke bailouts, rate cuts, etc.

Fast forward to Q3 of 2012:

  1. SALES: Same pattern – but Global GDP growth slowing faster now than it did then (China especially)
  2. MARGINS/EARNINGS: perma-bulls are still using peak margins and prior 2007 all-time high in EPS to justify “cheap”
  3. VOLATILITY: yesterday marked the 1st time since 2007 since the VIX dropped below 14

Since the VIX dropped below 14 eighty nine (89) times throughout 2007, the good news is that you probably have plenty of time to get out of stocks before everyone else has to. There are only 30,000 funds chasing beta at this point.


One question on that: after the shorts have all covered how, precisely, is that going to happen without volume? Probably just a silly risk management question; NYSE volume was only down -42% versus my intermediate-term TREND duration average yesterday. That’s gotta be bullish for someone. Just not Tommy Joyce.


Enough about price, volume, and volatility already – who cares about 3-factor risk when simple 1-factor Fisher Price point and click 50-day moving averages tell us all we need to know in the rear-view mirror?


Let’s deal with my personal baggage instead…


Not that I took it personally, but since I got fired for being “too bearish” in October 2007, I do remember the proceeding birth of my 1st son and the vision for Hedgeye quite vividly. So do the perma-bulls. The SP500 dropped -4.4% in November 2007.


And, that was it.


That was it for the storytelling. That was it for the “world is awash with liquidity” thing. That was it for the academic theory that “shock and awe” rate cuts to zero were going to free we centrally planned beasts from the shackles of our own thoughts.


Where to next?


The only thing I can predict, with 100% certainty, from here is that this is not 2007. This is 2012. And next year will be 2013.


What will get #GrowthSlowing to stop slowing? Will it be a bird or a plane? Or will Keynesian Economics finally provide the long lasting elixir of life that its group-thinkers have so often promised (growth) but never delivered?


I don’t know.


What I do know is that if you are buying US stocks at lower long-term highs (-10.3% versus October 2007 and -1.1% versus April 2012) at anything < 14 VIX, you either think 1990s growth is coming back and/or that this all ends well.


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Spain’s IBEX, and the SP500 are now $1, $110.36-115.42, $81.76-82.59, $1.23-1.24, 6, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


2007 Redo - Chart of the Day


2007 Redo - Virtual Portfolio

President Obama's Reelection Chances

President Obama is undeterred by the likes of Paul Ryan. His chances of being reelected increased by 80 basis points (0.8%) to 59%, the highest reading since May according to the Hedgeye Election Indicator. That could soon change as Paul Ryan and Mitt Romney begin to pounce on undecided voters in battleground states.


Hedgeye developed the HEI to understand the relationship between key market and economic data and the US Presidential Election. After rigorous back testing, Hedgeye has determined that there are a short list of real time market-based indicators, that move ahead of President Obama’s position in conventional polls or other measures of sentiment.


Based on our analysis, market prices will adjust in real-time ahead of economic conditions, which will ultimately shape voters’ perception of the Obama Presidency, the Republican candidates and influence the probability of an Obama reelection.  The model assumes that the Presidential election would be held today against any Republican candidate. Our model is indifferent toward who the Republican candidate is as the sentiment for Obama and for any Republican opponent is imputed in the market prices that determine the HEI. The HEI is based on a scale of 0 – 200, with 100 equating to a 50% probability that President Obama would win or lose if the election were held today.


President Obama’s reelection chances reached a peak of 62.3% on March 26, according to the HEI. Hedgeye will release the HEI every Tuesday at 7am ET until election day November 6.



President Obama's Reelection Chances - HEI


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Daryl Jones, Director of Research at Hedgeye, appeared on CNBC this afternoon to discuss what’s going on with stocks. He talked about recent market gains Groupon (GRPN) earnings. He discussed the company’s business model and low barrier to entry. 

PETM (Correction): Mind the Commodity Exposure

Takeaway: $PETM's commodity inputs on its food biz (53% of revs) are ripping due to the drought. That's not helping its intermediate-term mgn outlook.

Conclusion: The last time PETM had a big increase in food as a percent of mix, margins were off by 110bps. It has diversified into services since, but the run in relevant commodities is a strong consideration at peak profitability and productivity levels. Not an outright short. But keep an eye on these risk factors if you have exposure.



While PETM might not be an obvious company to watch as it relates to input price exposure, history shows that we need to keep tabs.  About 53% of PETM’s business is in the food category, which is the primary traffic driver and is significantly impacted by corn, chicken and beef prices.  The company can pass through some of this, as people obviously still have to (and want to) feed their pets.


But the last time there was a meaningful increase in food as a percent of mix (from 53% to 57% in ’06-08) EBIT margins came down from 8.0% to 6.9%. That might not seem like a lot, but PETM took comps higher by relying on categories other than food (services such as grooming, adoptions, training, vet services), has since recovered that margin loss by a factor of 2x, and is now sitting at peak margins.


With relevant commodities up 20%+ yy – which is not being helped by the drought – we need to be mindful of the sustainability of PETM’s current comp level at its existing margin trajectory.


The Street has generally not taken a stand on PETM in either direction headed into Wednesday’s print. The consensus is at the high end of management’s $0.61-$0.65 guidance, short interest is around 7-8% of the float (reasonable), and there’s a fairly even dispersion between Buy and Neutral ratings.


In the grand scheme of big box retail, this is actually a decent-enough business that is managed well. The category is one where sales are fairly predictable, it is not difficult to differentiate from the Wal-Marts of the world, inventory is easier to manage ( fish, parakeets and hamsters die at a lesser rate than apparel inventory goes out of fashion). Furthermore, compares don’t get tough on the top line for another two quarters. So PETM hardly screens as a great short here.


But given current productivity and profitability levels, we need to keep in mind any margin headwinds that are building in its cost base.



Figure 1: There's little evidence that PETM can pass through enough commodity exposure to consumers to preserve margins.

PETM (Correction): Mind the Commodity Exposure - petm1


Figure 2: Food as a Percent of mix has fluctuated.

PETM (Correction): Mind the Commodity Exposure - petm2


Bad(ger) Choice or Good Choice?

Takeaway: Paul Ryan won’t help with Electoral College math, but could help Romney regain an edge in the debate on the deficit and economy.

After months of speculation, presumptive Republican presidential nominee Mitt Romney selected Wisconsin Congressman Paul Ryan to be his Vice Presidential running mate this weekend.  Now that the punditry has reacted and the partisan attacks have begun, we’ll give you our perspective.


In our view, this is likely a wise choice for Romney.  This election will be about two key issues: the national debt and the economy.  Ryan is one of the most well versed politicians on both of these topics and will be able to articulate a strong case against the Obama administration.   In fact, Ryan already has a well established history of challenging the President head-to-head, in particular on the budget deficit, as emphasized in this video:


Another key advantage stemming from this choice, may relate to the law of low expectations.  In hindsight, Sarah Palin was considered a weak choice for Senator McCain.  Initially, though, Palin was received very favorably.  In fact, according to Fox News polls right before the election McCain was at 39%, Obama was at 42%, and 19% was other/don’t know.  In the same poll, shortly after Palin was announced as McCain’s running mate, McCain jumped to 45% and Obama remained at 42%.


The real time reaction from Intrade was tepid at best as the Intrade market for a Romney Presidency actually moved down initially on the Ryan announcement, though it has since moved back up.  The key critique of the Ryan selection is that he doesn’t have the ability to deliver a key state like Ohio (Portman) or Florida (Rubio).  Admittedly Wisconsin does help at 10 electoral votes, but both Ohio and Florida are more critical at 18 and 29, respectively.   Clearly Romney was thinking more about elevating the key debates rather than solving for electoral math.  Indeed, Ryan’s ability to own these debates may be critical heading into the fall.


Longer term, we think that Ryan is potentially an intriguing Vice Presidential choice to the extent his voice gets heard.  More than a year ago, we published the note below about Ryan’s proposed budget plan.  It is worth a reread as a quick refresher on his fundamental economic policies and views.  In effect, he is very focused on shrinking the federal government and narrowing the deficit.   If and when the market views these policies as realistic, they will be very dollar bullish.


Daryl G. Jones

Director of Research



 Bad(ger) Choice or Good Choice?  - chart1a


Conclusion:  Simply put, the Ryan budget dramatically reduces the size of the federal government over the long run and thus reallocates capital back to the private sector, which could be incredible bullish for economic growth in the United States.


The current budget debate in Washington is amongst the most heated and partisan we’ve seen since the beginning of the Obama administration.  On the conservative side of the equation is, of course, the Ryan budget, which was introduced two days ago by Representative Paul Ryan the Republican from Wisconsin.   Philosophically, the basis of the budget is simple; it both reduces taxes and dramatically reduces the size of the government over ten years, with a focus on restructuring the cost of healthcare.


The Congressional Budget Office, at the request of Representative Ryan, presented their analysis of his budget yesterday.   In the introductory section of the analysis, the CBO stated:


“To prevent debt from becoming unsupportable, policy makers will have to substantially restrain the growth of spending, raise revenues significantly above their historical share of GDP, or pursue some combination of those two approaches.”


In theory, the budget situation is actually that simple:  either raise taxes or cut costs, or both.  Politically, and practically of course, the solution is far from simple, but the outcome of the Ryan budget, albeit at the expense of restructuring healthcare, may provide some real long term economic advantages for the United States versus the fiscal status quo.


The key components of the Ryan budget are as follows: 

  • Healthcare – The Ryan budget would convert the current Medicare system to a system of premium support payments and would increase the age of eligibility of Medicare.  On Medicaid, the federal share of Medicaid would be converted to block grants to the states, which would grow with population and CPI-U.  The Ryan budget would repeal all components of the 2010 Patient Protection and Affordable Care Act (more commonly known as Obamacare). Finally, several limitations of punitive damages in medical malpractice would be implemented; 
  • Other spending – Under the Ryan budget, mandatory and discretionary spending, other than that for mandatory healthcare (outlined above) and social security, are cut from 12% of GDP in 2010 to 6% of GDP in 2022 (this is below pre-WW2 levels); and 
  • Revenue – Under the Ryan budget, federal government revenues grow from 15% of GDP in 2010 to 19% of GDP in 2028, and remain at that level thereafter.  For comparative purposes the long run average of federal government revenue as a percentage of GDP from 1960 – 2011 is 17.6%.   So, in essence tax receipts in Ryan’s proposed budget are slightly above the long run percentage of taxes as share of the U.S. economy and ~27% above current levels. 

Unfortunately the CBO analysis didn’t offer a comparison of the Obama budget versus the Ryan budget, but they did offer a comparison of the Ryan Budget versus their Extended-Baseline Scenario (normal scenario) and Alternative Fiscal Scenario (draconian scenario).  In the table below, we’ve also included the CBO’s most recent estimates of the Obama budget, albeit the ten year budget ends in 2021 and not 2022.  The clear take away from the ten year budget comparison below is that the Ryan budget effectively outpaces both the federal government’s current fiscal path and the proposed Obama budget in reducing the budget deficit over the next decade.


 Bad(ger) Choice or Good Choice?  - chart2


The longer term fiscal benefits of the Ryan budget are even more compelling according to the CBO.  By 2050, the federal government would be running a 4.25% budget surplus (as a percentage of GDP) under the Ryan plan versus -4% in the CBO’s normal scenario and -26% in the more draconian scenario.  


In evaluating the long term benefits of the Ryan budget from an economic perspective, we think three key factors are most relevant, which are as follows:


Long term structural debt – The most thorough analysis of the impact of long term debt is This Time is Different by Carmen Reinhart and Kenneth Rogoff.  The key take away from their analysis is that as sovereign debt balances accelerate and eventually reach the 90% debt-to-GDP level, which we have coined the Rubicon of Sovereign Debt, growth slows dramatically. 


In fact, their analysis of 2,317 observations has a statistically significant 352 observations at, or above, 90% debt as a percentage of GDP.  Collectively these observations show us that GDP growth averages at 1.7% beyond the Rubicon of Sovereign Debt, which is almost three standard deviations below the collective growth rates at lower debt levels.  The Ryan budget by 2050 has debt-as-percentage of GDP at 10% according to the CBO, while the CBO’s baseline and draconian scenario take debt-as-percentage of GDP to 90% and 344%, respectively.


Declining government spending – For starters, government spending is a large percentage of GDP (between 29% and 35% in recent years), so, in theory, cutting government spending dramatically could be a drag on the economy.  Further, and as the argument of Keynesians, higher levels of government spending or stimulus are required in periods of below average GDP growth.


To test the impact of declining government spending introduced by the Ryan budget, we analyzed real GDP change from 1960 to 2009, and year-over-year government spending changes in the same years.   Interestingly, in the five years with the slowest year-over-year growth in government spending, GDP in those years grew on average 4.74%.  Conversely, in the five years with the largest year-over-year change in government spending, GDP grew 1.10%.  The average of real GDP growth over the entire period was 3.2%.  


Now, admittedly, this is a somewhat simplistic analysis, which we will be refining further.  A key pushback is obviously that as GDP growth slows, certain entitlements naturally kick in, and vice versa.  Interestingly, if we look at one year out after the five most dramatic ramp ups in government spending, GDP growth does reaccelerate to 3.3% on average, which is just above the long run average.  While this is encouraging for Keynesians no doubt, it is still somewhat anemic growth given easy comparables.  So, while this analysis needs refinement, it does appear to lend credence to the idea that government spending does not have a comparable return to the same capital allocated to the private sector.


Long term low taxation levels - Under the Ryan budget, federal government revenues grow from 15% of GDP in 2010 to 19% of GDP in 2028, and remain at that level thereafter.  For comparative purposes, the long run average of federal government revenue as a percentage of GDP from 1960 – 2011 is 17.6%.   So, in essence, tax receipts in Ryan’s proposed budget are slightly above the long run percentage of taxes as share of the U.S. economy. While this may seem less conservative, in reality, it’s quite conservative when compared to the current alternatives. For example, by 2022 the CBO baseline estimate has government taxes at 21% of GDP, and President Obama’s budget has government revenues as a percentage of GDP at 19.3% by 2021, while Ryan has this statistic at 18.5% by 2022. 


So, the long run debate continues, are lower taxes better or worse for the economic growth?  We know where we stand on that, but if you don’t believe us, take the CBO’s word for it, which in their analysis of Representative Ryan’s budget wrote:


“To the extent that marginal tax rates on labor and capital income would be lower as a result, future output and income would be greater in the long term, all else being equal.”


To many, the Ryan budget is scary.  It dramatically attacks the long term expenditures and structural deficits of the U.S. federal governments by cutting costs to unprecedented levels.  The reality is, though, based on the fiscal history of the modern United States, this plan could be wildly bullish for the U.S. economy in the long run as it dramatically allocates capital away from the government and into private hands where it will potentially be much more efficiently allocated.


Daryl G. Jones

Managing Director 



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