Shock Me

“Shocks create change.”

-Myron Scholes


Ex the Nobel Prize thing, Mr. Scholes and I have a few things in common. We’re both Canadian-American economists. We’re both from Northern Ontario (he’s from the home of the Timmins’ Benjamin Bears). We’re both ex-hedge fund managers!


Admittedly, Scholes’ 1998 blow up of Long-Term Capital Management was more shocking than ours at Carlyle in 2007. His team got a bailout. Ours didn’t. But we’ve both had an opportunity to learn from our mistakes.


In one of the most timely chapters of The 4% Solution, “Not All Growth Is Good”, Scholes made some of the simplest but relevant risk management points I have read in a while: “We have to encourage success (and allow for failure), because that is how we grow… we need to remain flexible… adapt to changing circumstances… let’s not let a good shock go to waste.” (page 115)


Back to the Global Macro Grind…


I was on the road this week in both Denver, Colorado and Kansas City, Missouri. I love the road. It’s where I became both an athlete and an investor. As a risk manager, the road is where I get a non-groupthink pulse in this country.


Every cab I got into in Kansas City yesterday was blaring Rush Limbaugh. Every cabbie was all fired up about the debate. No matter what your politics, Mitt Romney shocked the country yesterday. That’s what this country (and market) needed.


Bobby Valentine got a little shock of his own last night too. I’m guessing Red Sox fans probably appreciate the accountability assigned to wins, losses, and leadership.  That’s the America I immigrated to in the 1990s. I think it’s the one we all love too.


Shocks create change


Or at least, in free-market economy, they should. Could a change in overall US Growth Expectations shock the country? You tell me. If my macro model gets as much as a whiff of a +3% US GDP Growth probability that’s greater than 33%, I may have to dress up as a bull for Halloween.


That’s scary.


And so was the Old Wall’s March 2012 consensus that the USA would see +3-4% GDP growth with all this debt and uncertainty. While I have had no problem leaning longer in the last 3 weeks, I’ve had even less of a problem selling on green.


Why? Because #EarningsSlowing is going to continue to shock the bulls in certain stocks throughout earnings season. That starts next week. So, no matter where we go on a made-up and politically massaged government number today, there we will be.


What if Romney’s Rally wasn’t a one off?

  1. Financials (XLF) could continue to shock you to the upside (Financials lead the market in October at +3.0%)
  2. Energy stocks (XLE) could continue to shock you to the downside (Energy lead losers in October at -0.4%)
  3. Strong Dollar, Strong America (higher long-term lows for the USD) could surprise the world

What if Romney continues to build momentum, but Earnings Season is worse than I expect?

  1. I don’t know
  2. But the bond market could continue to be right in 2012, with bond yields making lower-lows
  3. And, on mean reversion risk alone, the SP500 could drop to 1419 (-3%) in a day

A 3% down day? Never. It’s different this time. Right?


Right. Right. Until it isn’t, I guess. India’s stock market (the Nifty) dropped -16% this morning on “erroneous orders” and they had to halt trading for 15 minutes. Imagine that happened here? It has. So you don’t have to imagine too hard.


This market is as laden with both risk and opportunity right now as I can remember. I like to be shocked the right way. But I fully expect to be shocked, at any given moment of my centrally planned day, the wrong way.


And that’s all I can say about that.


My immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr UST Yield, and the SP500 are now $1, $108.41-111.89, $79.29-80.13, $1.29-1.31, 1.59-1.73%, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Shock Me - Chart of the Day


Shock Me - Virtual Portfolio


Takeaway: Dairy prices rising is a negative for $CAKE, $TXRH, $CMG, $SBUX, $DPZ, and $PZZA

A weak dollar over the last week was partly behind the higher commodity prices, generally, on a week-over-week basis.  Coffee prices remain favorable year-over-year, while grains, proteins, and dairy costs are likely to squeeze un-hedged restaurant operators over the next couple of quarters.  On the short side, we are targeting stocks like BLMN and TXRH where we think commodity inflation will be difficult to mitigate from a top-line perspective should our stance that, for each company, top line growth should come in below expectations.


Summary View

Dairy prices are up ~20% versus a year ago as concerns mount over shrinking herd sizes in the United States.   A CME report released this week indicated that the percentage of dairy cows being moved to slaughter is growing and some estimate that a new record high could be achieved when the January 1 inventory report is released by the USDA.  We see this as a negative for CAKE, TXRH, CMG, and SBUX (SBUX has guided to dairy headwind in FY13).  PZZA have their cheese costs hedged but to the extent that dairy prices continue higher, the company’s commodity costs could rise from here.   


Beef prices were flat over the last week as weak economic data and a decline in year-over-year slaughter numbers for cattle YTD.  This article explains that this lesser rate of slaughter is not as bearish a sign as it may seem, given the longer term context and extreme slaughter rates in 2011. 


Longer-term, our view is that beef prices are likely to remain at elevated levels.  Higher feed costs are reducing the number of cattle on feedlots versus a year ago and herd sizes remain depleted after the last two years of drought.  It seems that supplies of beef are set to remain tight for at least a couple of years.  This is a negative for BLMN, TXRH, CMG, JACK, and WEN, among others.


Grains were mixed over the past week largely as a result of the details within the USDA Grain Stocks report released last Friday.  Corn and wheat futures traded sharply higher on the report, which indicated that ending stocks for 2011/12 were below and at the low end of estimates for corn and wheat, respectively.   Soybean stocks were above estimates and the September WASDE projection; soybean prices have declined -1.2% over the last week.  Overall, grain prices remain elevated and, along with energy prices, are squeezing food processor margins.  Ultimately, this is leading to higher costs for food retailers, restaurants, and consumers. 





Refinery and pipeline shutdowns are increasing concern that supplies are not adequate to meet demand.  Gasoline and other commodity-based expenses are squeezing the American consumer.  As we have written in recent posts, we view this inflation as having a negative impact on growth in consumer spending and believe that consensus expectations for same-restaurant sales growth are – in many cases – overly optimistic.  Gas prices are up 11% year-over-year.












COMMODITY CHARTBOOK - crb foodstuffs










COMMODITY CHARTBOOK - chicken whole breast


COMMODITY CHARTBOOK - chicken broilers












Howard Penney

Managing Director


Rory Green




Takeaway: We still think the industry will fall below the low end of MAR’s Q4 RevPAR guidance of 5-7%.

  • RevPAR trends are softening
  • We are projecting 4-5% Q4 RevPAR growth in the US for the Upper Upscale segment
  • The Street and company guidance looks too high for 2013 – MAR guided to +5-7%.  We don’t share their optimism.



Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.


Takeaway: The Chinese property market is likely to remain under pressure, portending negatively for both Chinese and global economic growth.



  • The Chinese property market is likely to remain under pressure over the intermediate term, which, as a result of fixed capital formation equating to just under half of Chinese GDP, portends negatively for both Chinese and global economic growth.
  • Illiquidity on Chinese property developer balance sheets is accelerating, a phenomenon reflected in their recent actions (accelerating debt issuance), market prices for their equity and throughout broader sector data. This could spell an incremental leg down in Chinese property prices if they are broadly forced to slash prices to help clear the market.
  • Additionally, we believe the resolve of Chinese policymakers to continue combating “overly high prices” and speculative demand warrants further caution with regards to any expectations for both prices and transactions in the Chinese property market over the intermediate term.
  • We’re not currently in the camp that China is careening towards a banking crisis; we are, however, flagging the risk that a potential broad-based deterioration of credit quality across the Chinese financial system is likely to keep Chinese policymakers focused on quashing any signs of a property price bubble in a proactive,  not Western-style reactive, manner.
  • Rather than reflate now and risk an epic economic and financial market collapse at some point in not-too-distant future, Chinese policymakers are likely attempting to engineer a soft landing/smooth transition to a more sustainable growth model.


In continuing with the themes of today’s Early Look (i.e. the Manic Media and the Chinese economy), we highlight the following headline from yesterday morning:


“Chinese developers led junk bond sales in Asia to a five-month high in September as speculation the world’s second-biggest economy will ease housing curbs and boost stimulus measures caused yields to drop to a record low.” (Bloomberg)


The articles goes on to describe the recent surge in Chinese property developer international debt issuance (10x MoM to $1.15 billion) is an indication of Chinese property developers front-running a relaxation of the existing policies designed to curb speculation in China’s property market, citing Premier Jiabao’s recent statement that the curbs have achieved “obvious” results as an indication that Vice Premier Li Keqiang will be inclined to ease the measures shortly after taking control of the premiership early next year.


We couldn’t disagree more with this interpretation. From our vantage point, we view the recent acceleration of debt issuance by Chinese property developers as a function of increasing illiquidity on their balance sheets amid a slowing sales and declining price environment. Furthermore, if Chinese property developers were, in fact, gearing up for a meaningful acceleration in demand, it is unlikely that growth in Building Starts and Land Purchases would be contracting in the YTD as they are currently (i.e. they are not accelerating investments).


YTD growth in sales of buildings and floor space is trending at multi-year lows through AUG (+2.3% and -4.1% YoY, respectively):






On our 20-City Nominal Properly Price Index, Chinese property prices came in at -4.7% YoY in AUG – the second-lowest reading in the YTD (refer to the bottom of this note for our index methodology):




YTD growth in starts and land purchases is also trending at multi-year lows though AUG (-6.8% and -16.2% YoY, respectively):






Growth in total funds in the Chinese financial system available for property development is also trending at multi-year lows in the YTD through AUG (+9.1% YoY):




Rising illiquidity on Chinese property developer balance sheets could potentially lead to declining prices if they are broadly forced to slash prices to help clear the market. It’s worth noting that floor space under construction and floor space completed are trending up +15.6% and +20.2% in the YTD through AUG. Growth in incremental supply – both present and future – is far outpacing the growth in demand in the YTD.







As it relates to the slope of future demand in the Chinese property market, we continue to take our cues from Chinese policymakers and the unilateral nature of China’s command economy generally means what they say goes with regards to the ebb and flow of economic activity. While front running any changes on the margin in their policy stance can be helpful from a speculative perspective, we wouldn’t recommend doing so at the expense of ignoring their repeated attempts to temper market sentiment:


  • JUL 19:  China has told its local governments to keep a firm grip on the housing market to prevent property prices from rebounding, state media reported Friday, citing an urgent government notice. "Local authorities must strictly implement the property-control policies. Don't relax the control without authorization. Those that have loosened controls must rectify the policies right away," the state-run China Securities Journal cited the notice as saying. The notice was jointly issued Thursday by the Ministry of Land Resources and the Ministry of Housing and Urban-Rural Development, according to the China Securities Journal, Shanghai Securities News and other state-run newspapers. (WSJ)
  • AUG 23: China’s government is studying further measures to strengthen its control of the property market, the official Xinhua News Agency reported yesterday, citing an official with the housing ministry. The government is “closely monitoring” changes in the real estate market and has ordered local governments not to relax property controls, the unidentified official with China’s Ministry of Housing and Urban-Rural Development was quoted as saying in the Xinhua report. Easing policies by some local authorities were among problems that need “particular attention,” Xinhua reported on Aug. 17, citing findings from an inspection ordered by the State Council. China’s property market is expected to stay stable, the housing ministry official said in the Xinhua report. Most buyers in recent months are first-time home owners, according to the official. (Bloomberg Businessweek)
  • SEP 7: A senior official on Wednesday vowed to prevent rebounds in property prices in the second half of the year. “We will stabilize control measures to curb speculation and increase housing supplies, especially small- and mid-sized housing,” said Zhang Ping, head of the National Development and Reform Commission, in a report delivered at an ongoing bimonthly session of the national legislature. Xie pledged to promote property tax reforms on a trial basis and strictly implement differentiated taxation policies for property transactions. Chinese Premier Wen Jiabao has reiterated the country still needs to resolutely curb speculative property investment as controls on the real estate sector are still in a "critical period." Wen said that smooth progress in the affordable housing projects will provide important support in stabilizing property prices and consolidating the government's efforts to tame overly high home prices. (Xinhua)
  • SEP 23: Real estate prices in China are in no condition to rebound with the government firmly set to continue its regulation on the property market, said the Ministry of Housing and Urban-Rural Development (MOHURD). But the official also notes that negative factors do exists against a stable property market and that regulation over the sector is still at a crucial stage… Next, the government will continue to carry out its regulative policies to ensure implementation, said the official. Differential credit and taxation policies will continue to be implemented to curb speculative buying. More work will be done to enhance taxation over unsold properties and there will be an expansion of property tax pilot schemes, the official added. The Chinese government will also work to increase land supply and the stock of small and medium commercial properties. It will also improve market monitoring to make full preparations for a future price rebound, said the officials. (China Daily)


Net-net, it’s pretty easy to see where Chinese policymakers stand with regards to the future demand in China’s property market. Moreover, we think their resolve to continue combating “overly high prices” and speculative demand warrants further caution with regards to any expectations for both prices and transactions in the Chinese property market over the intermediate term. Additionally, QE3-inspired commodity price inflation has caused monetary easing expectations to be priced completely out of the Chinese interest rate market from a NTM perspective.




As an aside, we were keen to point out the undeniable negative impact of QE3 on global GROWTH (via accelerating INFLATION and decelerating POLICY easing) in the following two notes (hyperlinked for your reviewing ease):



The diminishing outlook for “stimulus” in China – particularly on the monetary easing and property market regulation fronts – led to a proactively-predictable selloff across property developer stocks in recent months. Notably, this chart does not rhyme with the pollyannaish expectations for the impact of QE3 in the US equity market:




With Chinese real GDP growth trending so weak in the YTD (+7.6% YoY in 2Q was the lowest since 1Q09) and expectations for future growth making lower-highs in the YTD (Bloomberg Consensus 2013 estimate at +8.1% YoY currently, down from a peak of +8.6% in MAR), it’s natural to ponder why Chinese policymakers appear so content to let their economy slow to a relative crawl.


The most logical answer that comes to mind is official fear of social unrest. As such, keeping a lid on inflation and maintaining economic stability are two of the primary goals of the Communist Party agenda. In on the inflation front, it’s easy to see why they would be concerned with prices in China’s residential market (~80% of total supply; ~90% of sales) that 74.3% of polled Chinese households find “too high to accept” (per the PBOC’s latest quarterly monetary policy report). Furthermore, the intense government focus on increasing the supply of affordable housing also lends credence to this view.


On the economic stability front, we think Chinese policymakers have been keen to recognize the lessons learned from the US housing bubble and its subsequent bust, which led to the 2008-09 Global Financial Crisis. US employment remains structurally impaired as a result and we think Chinese policymakers are carefully seeking to avoid this fate.


While we certainly aren’t calling for a Chinese banking crisis (nor do we think their property market is a bubble in the traditional sense), we do find it worth noting that the total amount of loans on Chinese bank balance sheets have more than doubled since end of 2008, creating ample room for adverse selection as well as a future upswing in non-performing loans, which are at historic lows as a percentage of total loans. Additionally, the memories of shelling out a total of $650 billion (44.7% of 2002 GDP) to bail out the country’s fragile banking system during the years of the late ‘90s/early ‘00s may still be potent in the minds of Chinese policymakers (the top brass has been in power for a decade).






Broadly speaking, bank credit is just shy of historic peaks as a ratio of the Chinese economy and the 2,000-plus basis point upswing from 2008 to 2009 lends credence to the view that the Chinese policymakers (via state-directed lending at policy banks) may have levered the economy too quickly in an attempt to reflate growth in the wake of the GFC – an event which led to an acceleration of inflation as well as rising risk of an NPL cycle over the long term. It is our understanding that this is a view increasingly shared by Chinese policymakers atop the central planning hierarchy (and perhaps one of the primary reasons they have been reluctant to implement a commensurate stimulus package in the YTD):


[The] 4-trillion yuan package of state spending and tax cuts announced in 2008 stoked inflation and sparked concern local governments took on more debt than they can afford.”

– Xu Lin speaking to reporters at Peking University on SEP 17, 2012




Again, we’re not currently in the camp that China is careening towards a banking crisis; we are, however, flagging the risk that a potential broad-based deterioration of credit quality across the Chinese financial system is likely to keep Chinese policymakers focused on quashing any signs of a property price bubble in a proactive,  not Western-style reactive, manner. Furthermore, the credit risk embedded in a [potential] severe property price bust is not well diversified across the Chinese financial system – meaning the Chinese government would ultimately be on the hook for any damages (net corporate bond issuance was a mere 15.4% of the aggregate net bank loan and trust financing extended in 1H12 – a similar ratio to full-year 2011).


With fixed capital formation at 46.2% of Chinese GDP, we would be remiss to single out property developers as the only industry at risk; there are a handful of other industries such as steelmaking (Baoshan Iron & Steel Co.?) and construction equipment manufacturing (Sany Heavy Industry?) that may also experience a structural erosion in credit quality. A chart of Chinese steel products prices agrees with this view:




Perhaps that’s why Chinese policymakers were keen to focus their 12th Five-Year Plan on rebalancing the country’s economic growth model, calling for a structurally-slower pace in the process. Rather than reflate now and risk an epic economic and financial market collapse at some point in not-too-distant future, Chinese policymakers are likely attempting to engineer a soft landing/smooth transition to a more sustainable growth model (i.e. the Politburo ≠ the Fed). Even though they explicitly told us that’s precisely what they were going to do, it’s just now all starting to make sense in the context of the “missing stimulus bazooka”.


Darius Dale

Senior Analyst



As you probably are aware, the National Bureau of Statistics pulled the plug on its monthly nominal property price data back at the end of 2010, leaving analysts and investors alike searching for clues to the severity of China’s policy-induced property market downturn. Until now, we had been content with analyzing the monthly 70-city MoM data, but the need to contextualize those sequential changes became too great to ignore. As such, we’ve combined price per sq.m² data from China Real Estate Information Corp. (one of China’s top real estate data providers) to formulate an average market price of 20 of China’s busiest property markets.


The caveat here is that their data series start in JAN ’11, making historic context hard to come by. To solve for this constraint, we indexed our new series to China Economic Information Network price indices going back to 1998 (though 2010). Our methods aren’t perfect, as both data sets aren’t necessarily apples-to-apples, but it’s as good a long-term read on the nominal price level of the Chinese property market as any we have access to at the current juncture.


Our chart below showcases the performance of the EUR/USD currency pair over the past year. You can easily spot some of the big events that occurred in 2012: the turmoil of Spain and Italy over the summer, the late July "whatever it takes" comments by Mario Draghi and of course, the "unlimited' buying remark made on September 6 that really kicked the Euro into high gear.


It reminds us of charts we've displayed in the past showing Bernanke's effects on various markets. This is just the European version.


ECB Meets The EUR/USD - eurusd

Idea Alert: Shorting FXE

Takeaway: Fundamentals and the challenges inherent in the Union of uneven states suggest our $1.31 EUR/USD resistance level will hold.

Positions in Europe: Short EUR/USD (FXE); Long German Bonds (BUNL)


Keith added FXE to our Real-Time Positions at $129.13. FXE’s TRADE range is $127 – 129 with a TAIL resistance of $131.


With regard to the trade Keith said: “Europe didn't cut rates today. But they will, again, eventually. This is the Currency War. Immediate-term TRADE overbought within a bearish long-term TAIL.”


Idea Alert: Shorting FXE - bb. eur


We’ve written a number of notes on Europe this week. Certainly at any moment the EUR/USD can be influenced by numerous factors, however below are the larger forces we think are acting on the cross:



There is great political uncertainty in Europe right now, which lends support that the EUR/USD will not cross our quantitative long term TAIL line of resistance at $1.31. The market consternation centers around:

  • If and when Spain will seek a sovereign bailout
  • The extent to which the ESM can directly recapitalize troubled banks, and
  • The terms around setting up a fiscal and banking union

On a banking union we’ve already seen push back from stronger nations like Germany to “blindly” accept this risk (ie without conditions to benefit itself and/or limit reduction in its credit rating) and coordination to set up the logistics of a fiscal union inducing a protracted drag in this decision. 


To the point on timing, ECB Executive Board member Joerg Asmussen said on Monday that the ECB will not rush through “half-baked” plans for a new pan-European supervisor.


Also, remember that German Chancellor Merkel and Bundesbank President Jens Weidmann continue to butt heads on many fiscal issues. Eurobonds is one topic that Weidmann remains vehemently against while Merkel has not ruled out their use. However, if the Eurozone is to move to a fiscal union, Eurobonds are simply a natural extension of a fiscally united union. This is one hot topic to monitor as we move through the calendar year.



Interestingly, this week, Jin Liqun, chairman of the supervisory board of the China Investment Corporation (China’s $480B sovereign wealth fund), said that CIC will not buy bonds issued by debt-ridden Eurozone countries until their fundamental problems are solved. This point is of note because some over the last 12 months have suggested there’s a reduction in “risk” across Europe given the willingness of the Chinese to step in and support the region. Further, Jin said:


“The mass demonstrations in Greece and in Spain against fiscal tightening do not bode well for attracting investment into their debt… It's not realistic to expect any Chinese investor, CIC included, to buy the bonds, which are not safe…If the euro zone would issue a Eurobond backed by all of the countries - it is more attractive to international investors. Backed by all of the countries means backed by the core members."



European Manufacturing and Services PMIs for September (released on Monday and Wednesday, respectively) have shown little to no improvement over the last 7-8 straight months, stuck below the 50 line indicating contraction (see chart below).


Idea Alert: Shorting FXE - bb. pmis


The next immediate political catalyst for the cross is the Eurogroup being held next week in Luxembourg on October 8-9, however we do not expect any definitive action to be agreed upon. Taken together, we are fully aware of the powers of Central Bankers to drive the EUR/USD. That said, the fundamental data from Europe keeps us grounded in our opinion that despite best efforts from Eurocrats to craft rescue programs, we think slowing growth, rising inflation, and the structural flaws inherent in creating a Eurozone will continue to present challenges that should prevent appreciation of the EUR/USD above our TAIL line of resistance at $1.31.  


Matthew Hedrick

Senior Analyst

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