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The Great Recession: Why I'm Not Depressed...

This morning’s horrendous 8.1% US unemployment rate is going to wind up being a big positive for the stock market. The only way for this stock market to stop going down is to over-deliver on the misguided apocalyptic expectations that the Great Depression cometh…

Finally, the economic data is terrible enough for the revisionist economic historians (or “economists”) from Washington to Wall Street to absolutely freak-out. As they freak-out, they’ll freak out everyone else… and hopefully break the confidence that global investors have in the US Dollar while doing so…

If the US$ stops going up, you’re going to observe some very itchy trigger fingers in both the short books of wanna be short sellers, and levered long only managers who are sitting on piles of cash. You saw that on today’s market open, and you saw it again when we rallied from down to up again on the day…

Cash? Yes, that stuff that we allocated 96% of our Asset Allocation Model to 6 months ago (September 2008 - before unemployment ripped from 6.2% to 8.1%). Back then, some of Wall Street’s finest savants accused me of “hiding in cash”. Now (after the crash of course) I walk around meeting both existing and prospective clients in NYC and Portfolio Managers are boasting to me how large of a position in cash they have…

You know what this all means - I better start taking down my Cash position from the 70% I was holding prior to this morning’s market opening. I’m doing that more aggressively than I have in a long time, today…

Why? Well, primarily because I am now understanding that what we have here is The Great Recession. While some people on Wall Street are rightly expressing their personal depression, they are wrongly straight-lining that statistically insignificant personal position across a globally interconnected economy. Fortunately, as Dr. Copper, Wal-Mart, and China reminded me this week, Wall Street is no longer going to own the debate as to where this economy is headed next – the clients will. Some of them have blue collars… some of them are Chinese… I know, I know – very weird stuff I am talking about here…

Why I’m Not Depressed: It’s all about the delta. The revisionists are straight-lining the record setting acceleration in unemployment into becoming a repeatable rate of growth – mathematically speaking at least, that’s silly. Whether you want to look at this relative to the mid 1970’s when year-over-year trough to peak unemployment last ramped this quickly (up 300-400 basis points year over year), or in terms of percentage accelerations across different durations, my conclusions are the same – the rate of growth in the US unemployment rate is setting up to SLOW… right as the manic media worries people about it most.

This Is How a Depressionista Can Get To His/Her Numbers: the February 2008 to February 2009 acceleration in the unemployment rate was 330 basis points (from 4.8% to 8.1%, see charts below) – that’s a 69% acceleration of the nominal level of unemployment in this country. If we were to straight line that steep curve (chart) and project the same rate of growth in unemployment to February 2010, you’re looking at a 13.7% US unemployment rate. That would err on the side of a Great Depression type number. Using a shorter duration model, maintaining the current pace of growth in monthly unemployment gets you a 8.6% unemployment rate by the end of March – that too would be depressing, but I don’t think we see that number – if we don’t, the growth rate of unemployment will have SLOWED sequentially.

How Do You Slow The Pace of Growth? Socialize The Country, and Break The Buck: Since The Great Recession began, the USA has lost 4.4M jobs. Obama’s plan is to add back 4M jobs – how convenient is that linear conclusion? In the face of finally adding jobs to the baseline number, can the US unemployment rate continue on this accelerating Trend line? That would be tough math for me to see adding up – and if we get that kind of a Great Depression, I too will join the lines of those who are depressed.

Keith R. McCullough
CEO & Chief Investment Officer


"Today is the tomorrow you worried about yesterday."
- Unknown

It's human nature to lose confidence when you become seriously ill.  You feel worthless and it feels like anything you say is meaningless and everything you do is pointless.   Everything you do is just plain wrong!  Yes, that is ANIXIETY!  Anxiety robs you of your personality, kills your confidence and thus, you lose your identity.  Sound like a typical description of the US stock market!
The good news is your confidence and personality gradually return, building up in layers, until eventually you feel like the person you were before you became ill. In the end, you grow into a stronger person. So today is tomorrow - Nice.
This is a metaphor for how most people feel about the US stock market.  Everywhere you turn and everything you read increases your anxiety level.  "The loss of confidence is pervasive" is one of the headlines on Bloomberg this morning!  "Whether it's GM or C, warnings of possible bankruptcy and concerns about the banking system's fate reinforce the reluctance to take on risk of being a failure" - The Wall Street Journal.  Ok, so GM and C are done, therefore, I need to feel like a failure.  Not going to happen!  
After yesterday's -9.4% decline in the financial sector, the ETF is now down 50% year-to-date.  I get it - Citi and a few others are bankrupt and now owned by the government... but guess what, consumers are still shopping at WMT and a few other "cheep chic" stores.  WMT even said yesterday, ""We believe falling gas prices significantly boosted household disposable income in February and therefore allowed for both more trips and more spending towards discretionary categories."  
Over the past week there are some leading indicators that things might be bottoming, like retail sales, the move in copper prices and the news from the early cycle technology names.
Unfortunately, we are not in control of our own destiny any more.  Without the Chinese, we would likely go down a lot more.  How high does your anxiety level go, knowing that we need the Chinese to fund our deficits and without further stimulus, the global economy suffers?  Talk about a position of strength! The next politician who thinks he can bad mouth the Chinese or push them around needs to be given a "time out", like a child who hasn't learned discipline.  The Chinese own us!
This morning it looks like we are going to get a horrific jobs number with expectations that payrolls could decline by 650,000, the most in a generation.  Since the Chinese control us we need to think more like they do.  Someone in the Labor department needs to "make up" a really horrific number and get all of the bad news on the table so we can move on.  
Anticipating a really bad jobs number, early indication is that the dollar is declining, which will help to stabilize, if not allow the market to rally today.  That's been the US Strategy trade of 2009, US Dollar UP = SP500 DOWN. Reverse that intermediate Trend of US$ strength, and stocks find stability. That's how "re-flation" works.
Last night as I drove home from New Haven, I listened to a debate on Bloomberg Radio about whether Obama is to blame for the decline in the market this year.  He definitely didn't create this mess, but he was elected to fix it... and the market discounting mechanism suggests he's not getting the job done.  
I know my anxiety level increases knowing that we are dependent on the politics of Washington to get us out of this mess.  In the end, pointing fingers is a waste of time, I just want results!
At this point, it is hard to tell which sector is going to lead us out of the doldrums!  There is not a single sector in the S&P that looks good.  The "safe and boring" sectors like Consumer staples are not working in a down tape.  We are dependent on Washington to restore consumer confidence, which will help the discretionary names. Utilities are not going up as interest rates go up.  Healthcare is re-testing the lows and is in a cloud of uncertainty, but a rally from here would be very bullish. The Financials continue to be a toxic waste land. Energy and Materials are not going up unless the Chinese re-flate the global economy.  
That leaves us with Technology....  On a relative basis, Technology is starting to outperform more consistently, but most are closet industrials.  Who wants to own an industrial?
This unemployment report is due out in 30 minutes - it's time to get back on that Wall.
Function in disaster; finish in style...
Howard Penney
Managing Director



  • QQQQ - PowerShares NASDAQ 100 - We bought QQQQ on a down day on Monday.

  • SPY - SPDR S&P500- We bought the etf perhaps a smidgen early with the S&P500 at 715, yet will take it at a discount.  The market is also close to three standard deviations oversold.

  • CAF - Morgan Stanley China fund - The Shanghai Stock Exchange is up +20.4% for 2009 to-date. We're long China as a growth story, especially relative to other large economies. We believe the country's domestic appetite for raw materials will continue throughout 2009 as the country re-flates. From the initial stimulus package to cutting taxes, the Chinese have shown leadership and a proactive response to the credit crisis.

  • GLD - SPDR Gold- We bought gold last Thursday with the S&P500 in the red and gold down. We believe gold will re-find its bullish trend.

  • TIP - iShares TIPS- The U.S. government will have to continue to sell Treasuries at record levels to fund domestic stimulus programs. The Chinese will continue to be the largest buyer of U.S. Treasuries, albeit at a price.  The implication being that terms will have to be more compelling for foreign funders of U.S. debt, which is why long term rates are trending upwards. This is negative for both Treasuries and corporate bonds.

  • DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.

  • VYM - Vanguard High Dividend Yield -VYM yields a healthy 4.31%, and tracks the FTSE/High Dividend Yield Index which is a benchmark of stocks issued by US companies that pay dividends that are higher than average.
  • EWY-iShares South Korea- Despite initial efforts by the Bank of Korea to weaken the Won to spur exports, Korea's new finance minister Yoon Jeung Hyun has proposed strengthening the Won to improve the domestic market. Yet South Korea is export-dependent economy. We see no catalyst in sight to drive external or internal demand to the levels necessary to stimulate recovery, especially with a stronger Won. South Korea's exports fell for a fourth month in February 17.1% Y/Y.

  • LQD -iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.

  • SHY -iShares 1-3 Year Treasury Bonds- On Thursday of last week we witnessed 2-Year Treasuries climb 10 bps to 1.09%. Anywhere north of +0.97% moves the bonds that trade on those yields into a negative intermediate "Trend." If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.

  • UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is up versus the USD at $1.2678. The USD is down versus the Yen at 96.7040 and down versus the Pound at $1.4228 as of 6am today.

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If I’m a retiree then Nevada has to be looking attractive right now. Last I checked it’s still very warm there. Importantly, Las Vegas housing has cracked with pricing down 43% peak-to-trough, much more than the national average, off 19%. By way of example, my new colleague at Research Edge, Todd Enders, points out: rather than finding a job to compensate for the lost value in their house and higher cost of living, his retired parents could just move to Nevada from California.

The first chart shows the peak to trough housing price decline in Las Vegas versus the “snowbird” cities and the national average. The 43% decline in Las Vegas is steeper than any of the cities shown, and by a wide margin with the exception of Cleveland. Las Vegas is suddenly a much more affordable place to live. As long as government doesn’t eliminate the Nevada income tax advantages (there are no income taxes) and the climate stays favorable, the relative appeal of living in Nevada will continue to rise in these difficult economic times. Of course, if you believe the “end of the world” crowd, I suppose we need to worry what global climate change will do the comparative weather advantage.

The second chart details the projected population growth in the retiree age group of 65 and over. The Nevada Small Business Development Center appropriately projects nice long term growth in this segment. However, migration in to Nevada based on the state’s comparative advantages is not reflected in those estimates. We believe migration will push that growth rate higher.

The upshot to this discussion of population growth, demographics, and retirees is that the Las Vegas metro area is likely to sustain population growth (both retirees and workers) at a rate higher than the national average, potentially much higher. This is the primary reason we are bullish (non-consensus) long-term on the locals Las Vegas gaming market, despite the near-term issues. In fact, as we discussed in our 02/05/09 post, “THE LAS VEGAS LOCALS MACRO MODEL”, gaming revenue growth could resume as soon as 2010.

The play on this analysis is clearly Boyd Gaming. Not only would BYD benefit from the market growth, LV locals is its largest, but with the market’s largest player Station Casinos in dire straits, BYD could end up a much bigger player by picking off some or all of Station’s assets. The synergies would be immense in our opinion, and only fractured competition would remain.

I’m Getting Fundamentally Bullish

Improving delta on consumption + controlled inventories + slowing rate of GM % erosion + impact of job and capex cuts = long awaited visibility in cash flow. I really like the risk/reward here on key ideas.

I’m really getting fundamentally Bullish. While it’s tough to admit that when the tape does nothing but go the other way, I think that fundamentals will line up in a way that will call the earnings/cash flow bottom by 3Q. Consider the following…

1) No one is allowed to be bullish on the consumer right now. It’s pretty simple – if you make a call on the consumer and you’re right, then you’re considered ‘lucky’ and don’t get paid for it. If you’re wrong, then you’re ‘stupid’ and still don’t get paid, and perhaps lose your job. I’m not making a sentiment call here. Sentiment calls and valuation calls are ‘unmakable’ in this tape (and it’s also not my job to do so). But the cash flow trajectory in the industry should change meaningfully in 2H09.

2) We’re currently looking at about a 2% EBIT margin for the entire softline retail industry on a consolidated basis (See Ehibit 1). Yes, that’s off by about 600bp vs. last year. I won’t begin to argue for a fleeting second that this is not completely warranted. This industry has over-earned and underinvested for the better part of 8 years. Those peaky margins of ‘05/’06 are history. But I do think that we’re going to bounce back to a 5-6% rate over 12 months. Yes, that’s 2% to 6% after a near-vertical drop in each successive quarter since 1Q07. How do I model this?

3) First, consider that real consumption went negative last quarter for the first time in 64 quarters (Exhibit 2). I’m not a consumption bull by any means, but unless our model’s math is way off, we’re going to see the second derivative in consumption improve meaningfully in 2 quarters (3Q09 – which starts in 4 months). We’ve recently seen a full 3-point-slide in the real consumption rate (from +1 to -2%). In modeling the two-year trend, we’ve got real consumption declining for four sequential quarters – the first time we’ll have seen this since well… ever. Bottom line: we should finally get visibility on top line erosion slowing – and likely improving on the margin.

4) We are 2 quarters into the biggest gross margin (Exhibit 3) hit that this industry will have seen in history. The good news is that inventory levels are being worked down fairly methodically. Days inventory in the channel are hardly healthy, but order levels and production out of China and India are not churning out the quantity of product that would scare me into thinking that there’s a supply-driven Gross Margin shock on its way. I’m not modeling that margins go up, but simply that they stop going down.

5) SG&A (Exhibit 4): Anyone watching these job cuts? Well, by my math that should take down the growth rate in SG&A by 2%, not to mention other discretionary cost-containment initiatives. All in, my math has SG&A growth going from 5-6% over 3Q/4Q down to 2-3% in 1H09.

6) Oh…by the way, Capex is swinging from +10% in ’08 to -5% in 2009. It’s been a while since US retail had a year where cash flow was greater than EBIT. ’09 is shaping up to the year.

7) Names I like. Quality brand, investment base in-tact, co invested through the tough economic cycle even if at the expense of margins, share gainer.
a. Ralph Lauren (RL)
b. Under Armour (UA)
c. Lululemon (LULU)
d. Nike (NKE)
e. Bed, Bath and Beyond (BBBY)
f. Liz Claiborne (LIZ)
g. Crocs (CROX – high risk-reward)

8) Names I’d avoid. Weak brand position. Share loser. Weakening internal investment base. Might show good EPS growth, but have ‘pulled the goalie’ and driven EPS growth the wrong way.
a. VF Corp (VFC)
b. Gap Inc. (GPS)
c. Ross Stores (ROST)
d. TJX Corp (TJX)
e. Jones Apparel Group (JNY)
f. Iconix (ICON)
g. Warnaco (WRC)
h. DSW
i. Brown Shoe (BWS – beware a bounce)

Eye On The Fish: Irving Fisher Revisited...

EYE ON THE FISH: Irving Fisher Revisited

We’ve been discussing Irving Fisher in our morning meetings lately, especially in context of the ever broadening adoption of Keynesians economics. As many of you already know, we are located in New Haven, CT on the fringe of Yale’s Campus, so we have an inherent interest in topics related to Yale, which is where Fisher received his undergraduate degree, PH.D, and taught for many, many years.

Famously before the stock market crash of 1929, Fisher predicted, “Stock prices have what look like a permanently high plateau.” This emphatic call from Fisher, which was incredibly wrong, proved to be the undoing of his reputation, and his personal wealth. The unfortunate side effect of the terrible market call by Fisher was that his debt-deflation analysis of the Great Depression was largely ignored and Keynesian economic ideas began their rise to prominence.

According to a recent Economist article, “Fisher was adamant that ending deflation required abandoning the gold standard, and repeatedly implored Franklin Roosevelt to do so.” The combination of going off the gold standard with FDR’s bank holiday, which stabilized the domestic banking industry, marked the bottom of the Great Depression. As many FDR critics accurately argue, true recovery would come only many years later after many missteps by FDR and his various advisors. Nonetheless, this Fisher idea of devaluing the dollar, or as we like to say, ”Breaking the Buck”, was key to the initial recovery.

Fisher wrote in “The Debt-Deflation Theory of Great Depressions” that there are two dominant factors in great booms and depressions, “namely over-indebtedness to start with and deflation following soon thereafter.” A recent report by the Bank Credit Analyst, suggested that current non-financial institution debt in the U.S. is at 190% of GDP versus 160% just prior to the start of the Great Depression. While we haven’t stress tested the 190% number, we do believe that it is directionally correct. As Fisher goes on to write, while “over-investment and over-speculation are often important; they would have far less serious results were they not conducted with borrowed money.” Thus the high debt level only serves to amplify the typical business cycle.

Many of our clients have asked about our thesis that the US dollar needs to go down for the stock market to go up. Partially this is driven by observations. We use price rule as a primary factor in much of our work and we have observed that the market and the dollar are inversely correlated, or have been for the last 3+ months. The derivative question is obviously, why is this so? In our view, it is that the market understands basic Fisher economics. Specifically, we have an emerging debt asset / imbalance that can only be solved by re-flating assets.

Fisher wrote that it was “always economically possible to stop or prevent such a depression simply by re-flating the price level up to the average level at which outstanding debts were contracted.” Without this re-flation, it is likely the deflation continues to occur such that the debt to asset imbalance becomes even more imbalanced as the price of assets decline and the price of debt, in U.S. dollar terms, stays constant, or increases.

As we have seen over the last two quarters, and as Fisher argued many years ago, fiscal stimulus will likely not be enough to stimulate a recovery in an economic environment where indebtedness is the primary factor. The risk in not re-flating is that the spiral of deflation continues.

As Fisher concluded in “The Debt-Deflation Theory of Great Depressions”, “great depressions are curable and preventable through re-flation and stabilization.” Indeed.

Daryl G. Jones
Managing Director

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