“The American people do not think the system is fair, or on the level.”
Forget #BigBird. The world’s tweeters will shift to whose political chicken gets fried tonight in Danville, Kentucky. It’s a good thing there’s no bubble in partisan US politics.
In terms of political ironies, the aforementioned quote is a beauty. It’s how MSNBC’s Chris Hayes kicks off Chapter 3, “Moral Hazards”, in the most recent book I have been reviewing, “Twilight of The Elites.”
While I’d love to debate Hayes and/or my boy Biden on their respective concepts of “fairness”, here’s something Hayes wrote that I completely agree with: “ … we cannot have a just society that applies the principle of accountability to the powerless and the principle of forgiveness to the powerful. This is the America in which we currently reside” (page 102).
Back to the Global Macro Grind …
With the SP500 down for the 4th consecutive day, we got longer yesterday, for a trade. To be clear TRADEs (3 weeks or less) in our model are not to be confused with TRENDs (3 months or more). TRADEs get overbought and oversold. TRENDs (like #EarningsSlowing) last longer.
Some people don’t like the whole Duration Agnostic thing. Some people love it. I don’t wake-up every morning looking for love or loathing. I focus on doing what I can do to make our risk management process more dynamic and repeatable, across durations.
From an immediate-term TRADE perspective, at $630 AAPL was evidently oversold on Tuesday. What was oversold on Wednesday?
1. Tech (XLK) – First, understand that this S&P Sector ETF is 1/5 AAPL, so buying XLK yesterday gets me more of what I really want - in a slowing growth scenario, I want to buy the cheap growth that I can find.
2. Utilities (XLU) – If I am going to buy what’s getting smoked in October (Tech), I also want some asymmetry on the long side in owning something that works if Tech doesn’t. Utilities are one of the top performing S&P Sectors since The Bernanke Top.
3. Gold (GLD) – Hedgeye Playbook long, for a trade, here as the US Dollar Index moves to immediate-term TRADE overbought. Remember, get the US Dollar right, and you’ll get a lot of other things right.
Yes, one of our intermediate-term TREND Themes for Q4 is Bubble #3 (Commodities), but that doesn’t mean I can’t fully embrace understanding what people do with bubbles (they chase them when they are green), and trade the risk of the position both ways.
Gold’s long-term TAIL risk (3 years or less in duration) is much more daunting than its intermediate-term TREND risk. Why?
- TAIL risk = lower long-term highs from the $1900/oz zone (2011 all-time highs) make a bubble look like a bubble; look backwards
- TREND support = Gold has recently proven to test its YTD highs established in February ($1794); that keeps mo mo bulls in it
- TRADE range = $1; you don’t have to be bullish or bearish to understand that; it’s just math
Agreed. It’s a lot harder to keep countervailing thoughts, across durations, in your head than being perma – but that’s precisely why I think about risk that way. The market doesn’t care about your politics or your positioning.
So, if I sell Gold at $1792, it will probably be because it’s immediate-term TRADE overbought, the USD is immediate-term TRADE oversold, and Romney’s momentum in the polls keeps firing Bernanke in play (no Bernanke is not good for Gold).
Back to Tech…
I’m not a techie, but I have built a #WallSt2.0 firm that’s been able to monetize Twitter. So you can just call me social. Risk managing Tech (XLK) is not for the faint of heart, but where it closed yesterday illustrates the Duration Mismatch of price momentum quite well:
- Tech (XLK) = down -2.5% for the month of October is the worst performing Sector of the 9 in the S&P Sector Model we track
- Tech (XLK) = up +18.1% YTD is the 3rd best performing Sector in the S&P for 2012
- Tech (XLK) = has a heavy weight in AAPL (20.73% of the ETF) and AAPL is up +58.25% YTD
So, if you want to get Tech (XLK) right, you probably have to get AAPL right. That’s why timing and factoring your position risk matters.
Now some people pay a lot of attention to what is up for the YTD. I personally couldn’t care less. My net wealth (and most people who don’t measure it on Old Wall’s calendar bonus schedule) compounds or is drawn-down, daily.
If AAPL is up +58.25% YTD, but down 10% in a straight line (from The Bernanke Top in September) from where your money manager bought it for you, you need to be up +11.1% (from the down 10%) to get your money back to break-even. That’s not Kentucky Fried Politics. That’s just risk management math.
My immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, Tech (XLK), and the SP500 are now $1, $112.54-115.05, $79.43-80.03, $1.28-1.30, 1.68-1.76%, $30.02-30.69, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Takeaway: Our view on $KMTUY is similar to our $CAT thesis: Mining Capex is slowing, mostly because of reduced Chinese construction activity.
Keith shorted KMTUY in Real Time Alerts
TRADE resistance = 19.91
TREND = 21.63
Komatsu Exposed To Declines in Mining Equipment & Chinese Construction Investment
- KMTUY Like CAT…: Komatsu is heavily exposed to mining equipment capital spending, which appears to be slowing significantly. For a detailed review of our views on the mining capital investment cycle, please see CAT’s Deep Cycle.
- …But More China: Construction equipment sales have been in free fall in China, with CAT reporting that the market is off 40% yoy. Komatsu’s percentage of sales in China has dropped from over 20% to around 10%. The Chinese domestic market has become increasingly competitive and local inventories have been elevated.
- Valuation: Komatsu has a strong franchise, but remains overvalued from a cyclically-adjusted standpoint. We see the ADR fair value in the mid-teens with the potential for an overshoot if mining capital investment continues to weaken.
- Improved Data: Recent disconfirming evidence has been a sharp rebound in iron ore and Chinese steel prices. However, real Chinese rebar prices have only bounced to their 2009 lows. Coal prices, another key mining equipment end-market, have not rebounded. Commodity prices in China are an important indicator for mining investment, in our view.
Real Chinese rebar prices have bounced to the 2009 lows….
…but coal prices have not bounced.
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Takeaway: Short $MCD was added to our Real-Time Positions this morning. The positive $MCD reaction to $YUM's EPS was not warranted.
We don’t think the time is right to buy MCD – yet. The stock reacted favorably to the YUM 3Q earnings results. These are two well-run, global companies in the same industry but we think there are some important caveats to bear in mind when comparing their respective outlooks.
This morning, we added MCD on the short side to our Real Time Positions as the stock was overbought from an immediate-term TRADE perspective. Our fundamental outlook matches Hedgeye CEO Keith McCullough’s quantitative setup.
We took a step back from our positive stance on the stock in April and we think it will be at least another couple of months before we become constructive on the name again. While downside in the stock is likely not substantial, we think that the positive reaction in McDonald’s stock today is overdone for two reasons:
- As our note following McDonald’s November sales release, “MCD SALES HUNKERING DOWN FOR WINTER” described, compares ramp up dramatically through February for the company’s US division. Yum! Brands’ US business is also bumping up against a difficult compare in 4Q but the domestic business, for YUM, is far less important than it is for MCD.
- The YUM results were initially viewed as a positive for MCD and SBUX in that they could imply a diminished risk of disappointing 3Q results in China for those two companies. While YUM’s China results were strong, it was largely margin-driven. Comparable sales decelerated sequentially in 3Q and are expected to continue to do so in 4Q. An additional important caveat is that YUM’s fiscal 3Q ended on 9/8; the full third calendar quarter may not look so positive in China, especially given some of the recent disappointing macroeconomic data for September.
McDonald’s faces plenty of risks over the next few months as the euro-crisis continues to drag on, and Growth Slowing in the US and Asia drags on consumer spending. We are waiting for the right time to get behind this stock, especially given the company’s resilient performance in prior periods of poor economic growth, but believe that to do so now would be premature.
Per Keith’s quantitative models, immediate-term TRADE support for MCD is at $90.18. Long-term TAIL resistance is at $93.35
Takeaway: Broader economic growth suffers when corporate executives broadly shift their focus to managing earnings expectations.
- As we have stressed in recent weeks, the 3Q12 earnings season will likely be the most dour since the Global Financial Crisis and, perhaps more importantly, consensus estimates for NTM EPS growth are simply too rich – particularly in light of aggressive margin assumptions embedded in consensus expectations.
- As such, the direction and tone of corporate guidance will likely be as important to stock performance as it has ever been in the post-crisis period. In this regard, the next few months will definitely be a stock-picker’s environment for those seeking to meet year-end performance targets.
- As we highlighted in recent notes, a key risk that could equate to an incremental drag on global growth over the intermediate term is an acceleration of corporate cost-cutting initiatives across both domestic and international corporations. Moreover, recent company commentary suggests this trend is already underway.
#EARNINGS SLOWING UPDATE
On our 4Q12 Macro Themes Call Monday afternoon (email us for the replay materials if you missed it live), we detailed our thesis which suggests: A) the 3Q12 earnings season will be the most dour since the Global Financial Crisis and, perhaps more importantly, B) consensus estimates for NTM EPS growth are simply too rich – particularly in light of aggressive margin assumptions amid a backdrop of global economic data that has been tepid at best/nasty at worst in recent months.
Bombed-out 3Q12 expectations provide room for short-squeezes across a number of names when they report the quarter, but we believe the broader takeaway here is just that: “where do we go from here?”. As such, the direction and tone of corporate guidance will likely be as important to stock performance as it has ever been in the post-crisis period.
We discuss the implications of “B” later in this note; for now, here’s an update on very recent developments with respect to “A”:
- The Rio Tinto CEO says the company will defer large capital programs, as it has become more cautious about its outlook for the next few quarters, partly because of anticipated delays in Chinese stimulus efforts. The company now sees its $14B CapEx forecast for next year as a ceiling that could be reduced; moreover, it is expecting to materially reduce spending over the next few years.
- Alcoa revised down its global aluminum growth forecast to +6%, down from +7% prior, citing a slowdown in China as a negative drag on the 2H outlook. They also updated end-market growth forecasts – most notably the Heavy Truck and Trailer segment, which is now seen coming in at -7% to -9%, which is down from a prior forecast of -3% to +1%. The company anticipates a slowdown across all major regions, particularly Europe and China.
- FedEx announced programs aimed to increase profits by $1.7B annually by end of FY16; a significant portion of the profitability improvement will come from cost reductions at FedEx Express and FedEx Services.
- Cummins guides FY12 revenue to come in around $17B vs. a prior forecast of $18B. They cited demand in China that has weakened in most end markets and they have also lowered their forecast for global mining-related revenues. Additionally, they guided EBIT margins to come in below previous guidance primarily due to the sharp reduction in revenues. The company is taking actions including a number of measures to reduce costs, including planned work week reductions, shutdowns at some manufacturing facilities, and some targeted workforce reductions.
While it may seem like we’re cherry-picking negative commentary (there’s always some degree of negative commentary to be found every earnings season), one would be remiss to ignore that these four companies represent a combined $147 billion in market cap. Moreover, when analyzed with respect to prior warnings given by companies like CAT, HPQ, NSC, IHS and SPLS, it’s easy to spot a trend developing here. This is a classic case of “ignore the data at your own risk”.
GLOBAL GROWTH UPDATE
Each month as a small part of our rigorous Global Macro research process, we amalgamate a broad sample of global PMI readings to get a data-driven sense of how global growth is trending on a sequential basis. The analysis includes 23 readings from 14 countries and/or economic blocs and we measure the absolute level of the indices and the sequential deltas on a median basis to produce a top-down look upon trends across the global economy.
In this light, it would appear that global economic growth slowed at a slightly slower rate in SEP vs. AUG (49.7 from 49.2); the metric does, however, remain below the 50 line, which economists use to delineate expansion vs. contraction readings. To the extent global growth continues to hang out in contraction territory on a sequential (i.e. MoM; QoQ) basis, we expect YoY growth readings to come under incremental pressure to the downside. On the flip side, the +50bps sequential uptick reminds bears that the global economy is unlikely to slow in a perpetual straight line. There is obviously room for improvement from bombed-out levels of global economic data, but the broader callout is that any gains will be limited and the trend is likely to continue south.
WHEN MACRO MEETS MICRO
As we highlighted earlier, the key risk that could reaccelerate the rate(s) of sequential contraction across various metrics of global growth readings is an acceleration of corporate cost cutting – both domestically and globally. As was vividly demonstrated across the last corporate earnings slowdown cycle (2007-09), broader economic growth suffers when corporate executives shift their focus to managing earnings expectations (as opposed to their businesses) en masse.
S&P 500 NTM EPS growth expectations are fairly robust – as are forecasts for operating margin growth. As we highlighted on our aforementioned conference call, corporate margins are asymmetrically stretched relative to prior cycles and as a share of the economy – suggesting limited room for upside to corporate operating efficiency. In that light, where will the revenue growth needed to meet such aggressive out-year margin expansion expectations come from if a large contingent of international corporations engage in reducing SG&A and CapEx at roughly the same time?
That’s a question we aren’t sure anyone has an answer to at the current juncture. What we do know is that corporate executives know full well what is being asked of them with respect to NTM forecasts. That will put a tremendous amount of pressure on companies to A) cut guidance (CMI); B) cut costs (FDX); C) do both (RIO); or D) pretend everything is generally fine and hope for a resurgence in demand (AA).
At any rate, the next few months will definitely be a stock-picker’s environment for those seeking to meet year-end performance targets.
Takeaway: We like $YUM for a longer-term TAIL investment but are concerned by China macro picture and difficult 4Q compares in the immediate term
Yum! Brands reported $0.99 in EPS versus consensus expectations of $0.97. The China division drove almost three-quarters of the EBIT growth as lower COGS helped profitability in YUM’s most important market.
3Q Report Card
YUM is trading up 8.5% as, during the earnings call, management provided bullish commentary on China and the growth opportunity that market presents for the company’s brands. With that said, we view China’s volatile economy as the greatest risk in the stock. Management acknowledged this reality but came across as confident that China would continue to perform profitably. Historically, buying this stock on “China scares” has proved profitable, particularly over longer durations.
However, given difficult 4Q compares for YUM’s business in China and the persistence of concerning economic data from the region, we remain on the sidelines for the immediate-term TRADE. It is worth bearing in mind that YUM’s 3Q ended September 8th; the macro data for September, so far, pertaining to China were, generally, sub-consensus. Longer-term, this remains one of the best growth companies in the industry. From a fundamental perspective, depending on the macro backdrop, we would likely become more positive on the stock on an immediate-term basis at $65 per share.
Press Release & Earnings Call Details
The China Division drove almost 75% of the consolidated EBIT growth of the company as unit count grew 18%, same-restaurant sales grew 6%, and restaurant level margins improved year-over-year on lower than expected food costs. Management expects China comps to be in the flat-to-low-single-digit range in the fourth quarter.
- Transactions declined 1% versus 27% growth in 3Q11
- Opening 750 restaurants in China this year (18% growth) versus initial expectation of 600
- Difficult to know how much of sequential slowdown in comps is due to economy
- Pizza Hut comps gained 8% in 3Q
- KFC comps gained 6% in 3Q
- 3Q labor inflation was 8%, commodity inflation was 2%
- 4Q is toughest SSS compare…expecting flat-to-LSD comps with 5% price (negative LSD transactions)
- Expecting slight y/y improvement in 4Q restaurant operating margins in China due to deflation in commodity prices
- Development focus is shifting from Tier 1 cities to lower tier (better returns, margins)
- Continuing 20% margins “over the long run”
- Current development rate is 18% which lowers SRS required in FY13 to hit earnings growth target
Potential Issues for the China Division
NEAR-TERM: Price cycling off the menu and sequential economic deterioration
INTERMEDIATE-TERM: Economic deterioration in excess of what management is anticipating
INTERMEDIATE-TERM: Management growing too fast. Currently, returns imply that “over-growth” is not yet a problem
The United States Division has gone from abysmal to impressive in little over a year. Whether or not this performance can be sustained remains to be seen. The US generated 6% in same-restaurant sales growth and management highlighted the completion of the KFC and Pizza hut refranchising as a positive.
- Doritos Locos Tacos and Cantina Bell have been key product introductions – should drive sales in FY13
- KFC sales and profits benefitting from new items and advertising
- Pizza Hut business in the US is stabilizing – added stores in 2011 after 10 years of unit decline
- Commodity costs were flat (below industry) in the U.S. due to supply chain initiatives
- 4Q will be weaker than YTD for US
- Overlap of 53rd week
- Lapping toughest comps of last year
- YTD refranchising of 340 restaurants in US will be profit dilutive in 4Q
- Ongoing growth model for the US calls for same-restaurant sale growth of 2-3%
The YRI Division delivered same-restaurant sales growth of 2%, including 5% in emerging markets. Ramadan negatively impacted comps by 1%. The division drives roughly 8-9% of the company’s overall EBIT growth.
- Building 900 new units this year
- Opportunities in developed countries like France, Germany, Russia where YUM underpenetrated
- KFC Russia business improving dramatically, AUV’s at $1.8m from $1.2m two years ago
- 4Q comps should benefit by 1% due to Ramadan timing
- Positive earnings growth for YRI in 4Q offset by impact of lapping 53rd week in 2011
- Ongoing growth model for YRI calls for unit growth of 3-4% and SRS of 2-3%
- 45% of YRI units are in emerging markets
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