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DEBUNKING THE STRUCTURAL BULL CASE

CONCLUSION: We see downside risk in the US equity market over the intermediate term as the structural bull thesis is riddled with shortcomings.

 

According to Dr. Richard Peterson, renowned behavioral psychologist and author of the highly-acclaimed book, Inside The Investor’s Brain, an asset class needs to two features to be correctly identified as a bubble: 

  1. A good story; and
  2. Price confirmation. 

While we don’t care enough to argue whether the US equity market is or is not a bubble at the current juncture, we can confirm that this market does indeed satisfy the previous criteria. In reverse order, the S&P 500 remains in a Bullish Formation on our quantitative factoring – albeit amid some of the most worrisome volume and volatility signals in years.

 

DEBUNKING THE STRUCTURAL BULL CASE - 1

 

In line with Keith’s remarks on our Morning Call yesterday, we continue to be unsurprised to see prices jammed higher due to the sheer level of performance chasing and “short low/cover high” strategies being employed across the oversupplied asset management industry. In spite of this, we continue to side with our proprietary Global Macro GROWTH/INFLATION/POLICY fundamental research process that continues to auger bearishly for global equity markets (including domestic stocks) with respect to the TREND duration.

 

To address the former of the aforementioned criteria, below we debunk what we see as three of the most deeply ingrained arguments in the structural bull thesis on US equities:

 

“Investors are massively underweight equities, therefore the market should continue to trend higher as both investors and fund managers chase performance.”

On a variety of measures, there is a bit of truth to this statement. At the fund manager level (excluding money market mutual funds), investors ended 2011 with a 61.5% allocation to equities (per the 2012 ICI Factbook), which is -0.2 standard deviations from the long-term average (yearly data starting in 1990). At the broader mutual fund investor level, which has been shown to be even more sensitive to forward-looking economic variables than the asset allocation strategies of fund managers (many of whom may be constrained from a mandate perspective), equities represented 44.8% of total net assets of the mutual fund industry. That is 0.2 standard deviations from the long-term average (yearly data starting in 1975). Net-net, at -0.2x and 0.2x standard deviations from their respective historical means, we’d argue that neither fund managers nor mutual fund investors are grossly underexposed to equities.

 

 

DEBUNKING THE STRUCTURAL BULL CASE - 2

 

DEBUNKING THE STRUCTURAL BULL CASE - 3

 

Given the understanding of the aggregated prescience of mutual fund investors as indicated in the previously hyperlinked article, we decided to run the analysis a bit deeper. We regressed the broad allocation to money market funds against the broad allocation to equity funds, finding exactly what we expected to find: an obvious and statistically tight negative relationship (i.e. “risk on/risk off”). Furthermore, we looked at the residual of the latest data point (2011) to see if A) it implied whether equities were over/under allocated to with respect to the model and B) by how much. In short, this analysis suggests that according to the weight of mutual fund investors’ allocations to money market funds (i.e. cash), they are underweight equities by -730bps in their portfolios – a fair amount (-0.9 standard deviations to be exact), but not nearly as underweight as they were in the late ‘80s/early ‘90s ahead of that bull market in US stocks.

 

DEBUNKING THE STRUCTURAL BULL CASE - 4

 

DEBUNKING THE STRUCTURAL BULL CASE - 5

 

All told, while there is certainly room to return to prior peaks in equity allocations, the notion that investors and fund managers are massively underweight equities and, thus, are poised to materially ramp up their exposure to this asset class is more than likely a gross overstatement.

 

“The US is not headed for a Japanese-like financial market outcome(s), largely because we continue to have favorable demographics, whereas Japan does not.”

***We attribute much credit for the following analysis to our Healthcare team, led by Managing Director, Tom Tobin. To the extent you like what you see below and would like to trial their research, please email .

 

While perhaps not as acute as the gaping bi-partisan leadership void in Washington D.C., the US’s demographic headwinds can be considered equally as problematic as it relates to the long-term health of the US economy. To arrive at this conclusion, we initially source a 2007 paper from The Review of Economics and Statistics that strongly demonstrates a consistent pattern of consumption throughout the human life cycle – specifically the presence of a steep hump with peak consumption typically occurring in the mid-to-late 40s due to changes in household size and makeup. Not surprisingly, we were able to document similar humps in the latest US census data, from both an income and expenditures perspective.

 

DEBUNKING THE STRUCTURAL BULL CASE - 6

 

DEBUNKING THE STRUCTURAL BULL CASE - 7

 

As it pertains to the most economically important cohort (i.e. people at/near peak earnings and peak consumption), YoY growth rates in this segment of the US population are set to remain negative through 2019 – after having turned negative for the first time since 1975 in 2008 (coincidence?). Needless to say, contraction here will continue to weigh on the US and global economy for quite some time. Specifically, by applying a demographic overlay (i.e. # of people per age bucket) to the income and expenditure data from the two charts above, we have created metrics that project total after-tax income and total consumer expenditures; YoY growth rates in both series are set to continue slowing though 2022.

 

DEBUNKING THE STRUCTURAL BULL CASE - 8

 

DEBUNKING THE STRUCTURAL BULL CASE - 9

 

In summary, we would agree with the view that the US does not have as negative a demographic outlook as has been repeatedly documented in Japan. That said, however, the US economy does have its own demographic challenges to contend with over the next 5-10 years, making a return to persistent rates of +2-3% real GDP growth an unlikely scenario over the long-term. Perhaps the trailing 10yr average of +1.6% is just about right. If that is, in fact, the most probable scenario, we’d argue that investors are NOT missing a generational opportunity to allocate funds to the equity market, as many perma-bull marketers would have you believe.

 

“Corporate profits – which have been outstanding of late – will ascend to even greater heights when the economy bounces back, rendering US equities substantially undervalued on a broad basis.”

This is arguably the easiest tenet of the long-term bull thesis to debunk and we’ve already completed a compendium of thoughtful work on the topic. In short, we certainly do commend the efforts of US corporates for being able to consistently generate margins at/near peak during such a challenging economic environment. Inclusive of this tipping of the hat, we’ve walked though the steps they’ve taken to achieve such lofty results in great detail and, needless to say, we are not completely impressed. Specifically, the broad-based trend of cost-cutting and negligible investment sets US corporate revenue growth to remain sluggish for the foreseeable future.

 

This is on top of incessant capital misallocation out of central planners across the globe, which is likely to perpetuate muted top line (i.e. GDP) expansion from a macroeconomic perspective for the foreseeable future.

 

In short, we find it unreasonable for investors to expect anything but weak sales growth, given that instead of investing in their businesses, companies are using capital to buy back stock with the hopes of juicing earnings. We don’t see how that is sustainable from a long-term perspective. By all means, email us if you disagree.

 

The following research notes provide the analyses upon which we have formulated these conclusions: 

  • HAVE US CORPORATE EARNINGS GONE TOO FAR? (JUL 20): “When analyzed outside the vacuum of short-termism associated with quarterly reporting, US corporate profit margins appear particularly overstretched – from both an operational and a social perspective. This has potentially dire implications for corporate earnings growth over the long term.”
  • ARE  US EQUITIES SUFFERING FROM COGNITIVE DISSONANCE? (AUG 8): “We see a similar see a similar pattern in consensus storytelling and a similarly-asymmetric price setup as we did in the previous occurrences of our being bearish at cyclical tops in the US equity market and “risky assets” broadly (1Q08, 1Q10, 1Q11, 1Q12).”
  • THINKING OUT LOUD RE: GLOBAL GROWTH (AUG 10): “New data points, including negative revisions to the official growth forecasts out of Singapore and Hong Kong, affirm our bearish conviction on the slope of global growth with respect the intermediate-term TREND duration. Applying a longer-term lens, would argue that the incessant policy responses out of the global central planning cartel over the last ~5yrs have set us up for broadly weak economic fundamentals for the foreseeable future.” 

All told, while you may not agree with our ultimate conclusion that the US and other global equity markets are likely to head south over the intermediate term, we do think it’s important to help you contextualize the key top-down economic debates as you ponder the bottom-up exposures in your portfolios. In that regard, we find that three of the most central tenets of the structural bull thesis on US equities are substantially weaker than they are likely being perceived by popular consensus.

 

Darius Dale

Senior Analyst


DRI: IDEA ALERT

Takeaway: If $DRI breaks $51.56, look out below. Industry data are not hinting at any sales recovery in casual dining.

Keith added a short position in Darden Restaurants (DRI) to the Hedgeye Virtual Portfolio today.  As we discuss below, our fundamental view on the stock, along with recent industry data, corroborates with his quantitative view of the stock.  For our recent Darden Black Book, please email us.

 

Quantitative Setup

 

Darden is immediate-term TRADE overbought with TREND support at $51.56.  If that line does not hold, the stock will likely drop to the low $40’s in short order.

 

DRI: IDEA ALERT - DRI levels

 

 

Fundamental Perspective


Our view on Darden is predicated on the company’s focus on growth at a time when its two most important revenue drivers (Olive Garden and Red Lobster) are producing sustained traffic declines.  Multi-brand restaurant companies typically historically encounter difficulty when attempting to grow brands with weak fundamentals.  The company is using its balance sheet to grow what are currently poorly performing concepts.  Should the dividend come under threat, we believe that could force an entire constituency of shareholders to reconsider their positions.  Below are some of the concerns we have about Darden from a fundamental perspective:

  • Anemic sales trends at Olive Garden, Red Lobster
  • Focusing on growth rather than remedying issues at OG & RL
  • Capex growth outstripping sales growth
  • The company is burning cash
  • Maintaining the dividend, growth profile, and operating margins not possible with current fundamentals
  • Difficult macro outlook is not encouraging
  • Absent a resurrection in sales trends, we believe downside in stock is significant (to $43)

 

Industry Data Shows No Resurrection in Sales

 

We are non-believers in an Olive Garden or Red Lobster sales resurrection.  Industry data is indicating that no such sales recovery is happening. 

 

Malcolm Knapp released his estimates for July's Knapp Track Casual Dining Same-Restaurant Sales Index. Comparable sales grew 0.6% versus July '11 while traffic declined -1.8%.  On a sequential basis from June, July’s estimates imply a sequential deceleration in two year average trends of -80bps and -45bps for comps and guest counts, respectively.  This is not encouraging for Olive Garden or Red Lobster, both of which have had difficulty growing guest counts versus the industry over the last few years.

 

The Black Box Intelligence casual dining same-store sales data also implied a slowdown, on a sequential basis, in growth from June to July.  Comparable sales growth in July was 0.8% while traffic declined -1% year-over-year compared to the -0.6% slowdown in June.  

 

Our takeaway from the Knapp Track data is that a sales pick up at Olive Garden and Red Lobster is unlikely.  The Black Box data seems to be confirming this, from an industry standpoint, and we remain bearish on Darden at this price.

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 


Idea Alert: UA

Takeaway: Recent bearish developments won't impact UA's numbers near-term. We still like it long.

 

Keith added UA to the long side of the Hedgeye Virtual Portfolio as a TRADE. The resignation of UA’s SVP of sourcing and the developments at JJB are not bullish, but they will not impact UA’s numbers near-term, nor do they pose enough of a challenge to offset the company’s ability to capture the long-term opportunity before it. We’ll buy on red. Though this is one of our favorite TAIL ideas, look for us to keep a TRADE a TRADE on this one.

 

Idea Alert: UA - UA TTT

 


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KORS: The Unshortable Stock

Takeaway: KORS is having a fantastic year and growth is through the roof. The company is expanding in both the US and in Europe which is no easy task.

Hedgeye's Retail teamhas been agnostic on Michael Kors (KORS) since we issued a Blackbook on the stock back in March. However, based on yesterday’s +16.4% rip in the stock, we can no longer stand on the sidelines. We are deeming KORS an unshortable stock. This company is golden.

 

At $49 a share, some might call KORS expensive. We call that poppycock. This company is on fire. Strong numbers all around, P&L is on fire, and the company is ripping market share from competitors, including Coach (COH), which we continue to remain bearish on. Check out the growth in KORS versus COH below:

 

 

KORS: The Unshortable Stock  - KORSCOH

 

 

The story for 2013 remains positive for KORS. This is one of the few companies that has strong European growth on top of US growth – a rarity in this day and age. While we like KORS, we’d still rather buy Fifth & Pacific (FNP).

 

 


CPI DATA SHOWS TOUGH PRICE ENVIRONMENT

Takeaway: Price elasticity of demand at QSR is likely higher this year as grocery inflation slows. $MCD and others have little room for further hikes

Inflation in the grocery aisle is decelerating rapidly.  We continue to see this as an impediment for restaurant companies seeking to protect margins via raising prices.  The Bureau of Labor Statistics released CPI data for the month of July this morning.  The negative spread between CPI for Food Away from Home and Food at Home continues to grow.

 

In 2011, grocers were forced to raise prices in line with inflation to protect margins.  We believe that the restaurant industry benefitted greatly from the relatively benign level of inflation for Food Away From Home versus Food at Home. 

 

Looking ahead, we believe that several companies in the restaurant industry will find it increasingly difficult to lap difficult compares over the summer months if the “food value spread” continues to widen.  Management teams at McDonald’s and Jack in the Box, among others, have highlighted this metric as being instrumental in their pricing strategies.  MCD, for instance, is running price in the U.S. at roughly 3%.  With Food at Home CPI decelerating, we believe the consumer may be less willing this year, as compared to 2011, to absorb additional price increases.

 

CPI DATA SHOWS TOUGH PRICE ENVIRONMENT - food at home vs food away from home cpi

 

Howard Penney

Managing Director

 

Rory Green

Analyst


Golf Claps For Mao

GOLF CLAPS FOR MAO

 

 

CLIENT TALKING POINTS

 

GOLF CLAPS FOR MAO

China gets us thinking. It is a country that truly puts the brain to work. While getting coffee with a friend this morning, we pondered just what makes China tick. The provincial governments, the “second” balance sheets – can you trust ANYTHING coming out of this country? The consensus in the West is that China will cut rates! It will provide stimulus! Then the People’s Bank of China comes out and says no, they’re not going to do any of that nonsense. They don’t need Keynesian economics driving up food and fuel prices any further. Oh. Well then that would explain why China stocks continue to crash, down -2% this week.

 

 

MY DEAR MERCUTIO

Shakespeare was a man of tragedy. Come to think of it, the guy was just downright depressing. Hamlet? Macbeth? Romeo and Juliet? Death all around! Kind of reminds us of the stock market. Yeah, it’s cool to be a bull these days with the levels the SPX and Dow are at, but is this sustainable? We don’t think so. Economic numbers and news are going to get worse, not better. This coincides with our #GrowthSlowing theme that we’ve been pushing for some time now. Bailouts and higher commodity prices are certainly not the answer to our woes – everyone can agree with that.

 

 

GET THE DOLLAR RIGHT…

…and you get a lot of other things right. We’ve said this before. And after a nice multi-week fall, the US dollar is now heading to the upside. As a result, the SPX hasn’t gone up in two days. Europeans are playing the quiet game, so what are you going to do for a catalyst? Not even Hilsenrath can spin this one. Instead, let’s see what Romney and Ryan can do to shake up the market over the weekend. Who knows what these two are capable of? It’s certainly better than a President who goes around buying Bud Lights for everyone (and by everyone, he meant the first ten people to bumrush the beer booth). $25,000 down the hole.

 

More info on ‘Bama Beers here: http://www.indystar.com/article/20120815/NEWS01/120815013/Owner-complains-Obama-s-beer-tent-stop-cost-him-25-000

 

_______________________________________________________

 

ASSET ALLOCATION

 

Cash:                  Flat

 

U.S. Equities:   Flat

 

Int'l Equities:   Flat   

 

Commodities: Flat

 

Fixed Income:  Flat

 

Int'l Currencies: Flat   

 

 

_______________________________________________________

 

TOP LONG IDEAS

 

JACK IN THE BOX (JACK)

This company is transitioning from cash burn to $75mm annual free cash flow generation thanks to completion of a reimaging program and refranchising of JIB units. Qdoba is the leverage; a maturing and growing store base will bring higher margins. We see 8.5% upside over the next 6-9 months.

  • TRADE:  LONG
  • TREND:  LONG
  • TAIL:      LONG            

 

FIFTH & PACIFIC COMPANIES (FNP)

The former Liz Claiborne (LIZ) is on the path to prosperity. There’s a fantastic growth story with FNP. The Kate Spade brand is growing at an almost unprecedented clip. Save for Juicy Couture, the company has brands performing strongly throughout its entire portfolio. We’re bullish on FNP for all three durations: TRADE, TREND and TAIL.

  • TRADE:  LONG
  • TREND:  LONG
  • TAIL:      LONG

 

LAS VEGAS SANDS (LVS)

LVS finally reached and has maintained its 20% Macau gaming share, thanks to Sands Cotai Central (SCC). With SCC continuing to ramp up, we expect that level to hold and maybe, even improve. Macau sentiment has reached a yearly low but we see improvement ahead.

  • TRADE:  LONG
  • TREND:  NEUTRAL
  • TAIL:      NEUTRAL

  

_______________________________________________________

 

THREE FOR THE ROAD

 

TWEET OF THE DAY

“rhetoric is QE” -@fearlicious

 

 

QUOTE OF THE DAY

“Why be a man when you can be a success?” – Bertolt Brecht

 

 

STAT OF THE DAY

The Carlyle Group is looking to buy Getty Images for $3.3 billion.

 

 

 


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