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River Baptisms

This note was originally published at 8am on October 04, 2012 for Hedgeye subscribers.

“A half-truth is more dangerous than a lie.”

-Saint Thomas Aquinas

 

The aforementioned quote comes by way of Saint Thomas Aquinas, who, to this day, is still considered among the most influential priests in the history of the Catholic Church as a function of his bridging the gap between ancient philosophical works and theology. While this is certainly not the proper forum to discuss religion in any detail, we do think modern-day financial markets could use a scholar of Aquinas’ caliber to help bridge the gap between the prices of many liquid asset classes and the fundamental data underpinning them.

 

Furthermore, the Manic Media outlets tasked with delivering us our economic and financial news could certainly use an army of Aquinas-like editors to help bridge the gap between what has occurred and what is reported.

 

To say that a large portion of the headlines and stories we’ve consumed in recent quarters were delivered in one of the following two formats would be a gross understatement: “ABC Occurred On XYZ Stimulus Speculation” or “[INSERT: Policymaker Name] Signals Further [INSERT: Stimulus Measures; Bailout Funds; etc.]”. In effect, the financial media can be considered guilty of incessantly stoking the broad-based optimism bias of both investors and corporate executives alike in priming news – particularly anything negative – with rumors and expectations for future improvement via “stimulus” or bailouts.

 

For reference, we use quotations around the word “stimulus” because we have shown repeatedly since 2010 that Policies To Inflate do little beyond stoking commodity price inflation that ultimately slows the pace of economic activity. In fact, if we had a burning Bernanke buck for every article in the last three months that anchored on some form of “stimulus”, Hedgeye would have enough capital to create all of the jobs QE3 is allegedly supposed to produce! River baptisms continue to dominate the heavily-biased study of economics in Western academia.

 

Take China, for instance. For much of the year-to-date, just about every occurrence in the Chinese economy was reported on in the context of “stimulus”. Moreover, a great deal of what Chinese policymakers have said publically in the YTD has been interpreted as a general update on the size and scope of China’s pending stimulus package. Alas, the bazooka has yet to be spotted and, perhaps more importantly, we continue see limited scope for and probability of a large-scale Chinese stimulus package over the intermediate term. We have published a compendium of work detailing our thoughts on the subject, analyzing the key data series, political catalysts and rationale(s) of Chinese policymakers pertaining to this topic and are happy email them to you upon request.

 

A couple of the more entertaining rumors emanating from China in recent weeks were centered around actions by the China Securities Regulatory Commission and the National Development and Reform Commission. Last week, it was reported that Chinese stocks rallied over +2% during the last 90 minutes of trading on a rumor that the CSRC was going to hold a press conference to announce measures to boost the stock market after the close. The event turned out to be a previously-scheduled meeting with no major reforms or announcements to speak of. We’re sure you remember the CNY1 trillion of infrastructure initiatives from early SEP that got a large swath of the financial media and international investment community to both celebrate and cheer on further stimulus measures (“globally coordinated easing” was the catch-phrase of the day). Since then, Xu Lin, head of the planning department at the NDRC, has come out and blatantly refuted the consensus interpretation of the event:

 

“The recent accelerated infrastructure project approvals did not mean the government is rolling out more stimulus. These projects are already in our plan... [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

 

Of course, Chinese policymakers could emerge from Golden Week next week or from their 18th Communist Party Congress in the second week of NOV with plans to materially reflate their ailing economy. The desire to pursue social and economic stability – particularly on the inflation and employment fronts – is great among Communist Party officials and, per the latest China Beige Book from CBB International LLC, the percentage of mainland companies reporting net firings increased +700bps QoQ to 20% in 3Q.

 

Despite obvious growing pressure to “do something” (as IMF Director Christine Lagarde would put it), we continue to take the view that Chinese policymakers have a much longer horizon for economic planning than most Westerners are able to comprehend through the prism of democracy. Xi Jinping and Li Keqiang (China’s likely future President and Premier) will be in power for a decade. Do you think it’s in their best interests to perpetuate China’s “unstable, unbalanced, uncoordinated and unsustainable” growth model (per current Premier Wen Jiabao) by reflating the Chinese economy just ahead of or early in their administration? Perhaps, though we’d argue anyone taking a longer-term view would be keen to anticipate the negative impact of a mid-regime property market bust and subsequent financial crisis upon Chinese economic growth and social stability. Unlike most Western financial market participants, the Politburo does not operate in the vacuum of YTD gains or with respect to some year-end bonus pool.

 

All told, the Chinese economy will continue to grow; it probably just won’t grow as fast or necessarily in the same manner as international investors and corporations have become accustomed to. That’s one of the core tenets of prospect theory, specifically in that myopic loss aversion from the status quo occurs not just from present states, but also from future states that were previously assumed to be true.

 

In this light, how will companies like Caterpillar Inc. and Fortescue Metals Group Ltd. react when the Chinese “stimulus” bazooka they’ve all been anticipating to varying degrees does not show up? How will international investors respond to this potential scenario? After accounting for 43.9% of global real GDP growth since 2008, does China even matter anymore? Why can’t everyone just buy the SPDRs and hold on for dear life until the data starts to improve?

 

While we are certain that none of these questions have easy answers, we are convinced that they need to be pondered by anyone managing risk in today’s choppy Global Macro environment. Best of luck out there, everyone.

 

Our immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield and the SP500 are now 1770-1786, 106.78-110.99, 79.60-80.23, 1.27-1.29, 1.58-1.69 and 1437-1462, respectively.

 

Darius Dale

Senior Analyst

 

River Baptisms - Chart of the Day

 

River Baptisms - Virtual Portfolio



Pundit Bias

“Wherever there is human judgment there is potential for bias.”

-Nate Silver

 

That’s a quote from an excellent chapter titled “Are You Smarter Than A Television Pundit” in The Signal and The Noise. Before he moves onto baseball, Silver does a nice job differentiating between quantitative versus qualitative opinions in the partisan media.

 

So you will need to adopt some different habits from the pundits you see in TV. You will need to learn how to express – and quantify – the uncertainty in your predictions. You will need to update your forecast as facts and circumstances change.” (pg 73)

 

If that sounds familiar, it should. This is all encompassing in Hedgeye’s founding principles of establishing Transparency, Accountability, and Trust through independent research. Journalists are not analysts. And only the great analysts in our profession embrace the uncertainty of there being a high probability of being wrong. It’s ok to say it like that. We’re not on TV.

 

Back to the Global Macro Grind

 

China’s 7.4% GDP report for Q3 of 2012 provides a great example of where we were wrong this morning. In our Monday research meeting we discussed what we thought was a heightening probability that Chinese GDP surprised on the upside. It didn’t.

 

Now if you turn on the radio or TV this morning, you’ll probably see something very different than what I just wrote (or what I have been writing on Twitter). Since most of these sources are journalistically driven, they obviously don’t have forecasting models. Instead, they anchor on other people’s content (the sell-side’s), which at times can be even worse than a journalist’s opinion.

 

“China beat”, “China has bottomed”, “China is not Spain” – scanning the Old Media’s headlines will get you spew like that. Whereas I we’ll just show you the data within our analytical framework:

  1. China’s Q3 2012 GDP of 7.4% slowed sequentially (quarter-over-quarter) from 7.6% in Q2
  2. China’s Q3 2012 GDP of 7.4% slowed -19% year-over-year versus 9.1% in Q3 of 2012
  3. China’s Q3 2012 GDP of 7.4% slowed more than the low-end scenario in our forecasting model of 7.6%

In other words, across our risk management durations (TRADE, TREND, and TAIL):

  1. TAIL (3 years or less) – China continues to slow, and surprise both its government and the world on the downside
  2. TREND (3 months or more) – China continues to slow, at an accelerating rate, sequentially
  3. TRADE (3 weeks or less) – China’s stock market just moved to immediate-term TRADE overbought on the news

Maybe China has “bottomed.” But I have no high-probability edge on that and neither do you. Or, let me say that more democratically – if you can send me a model that shows me why and how China just bottomed, I’m happy to look at how you’ve analyzed the Chinese government’s made-up numbers. I’m even happier to change my mind.

 

Made-up, or Madoff? Yes, both American and Chinese guys make up the numbers. And this makes it all the more difficult to make a macro forecast that something has “bottomed” or “topped” with a straight face. It might get you on TV however.

 

Having had to learn from all the mistakes I have made the hard way, the best risk managed opinion I can give you is that both tops and bottoms are processes, not points.

 

In forecasting “Principle #1: Think Probabilistically” –Nate Silver

 

“Instead of spitting out just one number and claiming to know exactly what will happen, I instead articulate a range of possible outcomes.” (page 61)

 

I don’t love everything Silver thinks, but I do love that. That’s the closest thing I have read in the last year to what we call our Risk Range. That’s what you see at the bottom of every Early Look - our immediate-term range of probable upside/downside (risk) – and I think most people would say that’s the most accurate and repeatable forecast we give you every morning.

 

So skip my rants and go to the bottom of the note - save yourself some time.

 

One more point on China - to get Commodities right, we think you need to get the Dollar, Supply, and Demand right. If you think China has “bottomed”, you’re going to have a very different long-term forecast than ours right now. The risks are rising that there’s a decade long-cycle of price and demand topping.

 

Everything that happens in Macro that matters most happens on the margin. And if the new long-term range of Chinese GDP growth is 4-8% instead of what it’s been (8-12% for the last decade), that could matter, big time.

 

If and when we get that wrong, we’ll write about it transparently and accountably that morning.

 

Our immediate-term risk range for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, Shanghai Composite, and the SP500 are now $1, $112.60-115.05, $79.01-79.69, $1.29-1.31, $1.73-1.83%, 2066-2139, and 1, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Pundit Bias - Chart of the Day

 

Pundit Bias - Virtual Portfolio


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IDEA ALERT: SHORT GMCR

Takeaway: We remain bearish on $GMCR

Our recent post, “HOW THE MIGHTY (GMCR) HAS FALLEN”, outlines our current thoughts on Green Mountain.  Today’s news, that the company has appointed Gerard Geoffrion – head of its Canada Division – as President Of International Business Development has led the stock higher.  We remain negative on Green Mountain.  From a quantitative perspective, Keith likes it on the short side at these levels.  He added GMCR to our Real Time Positions on the short side earlier today. 

From a fundamental perspective, the issues facing this company are legion:

  • GMCR’s brand portfolio is – to put it lightly – weak
  • Increasing competitive pressure is compressing already-razor-thin margins
  • The K-Cup patent having expired allows brands such as Starbucks and Dunkin’ Donuts to detach themselves from licensing agreements with Green Mountain
  • We expect Starbucks to part ways with Green Mountain at some point.  They did so with Kraft by reason of wanting to control their brand and consumers’ experience of it.  They will part with Green Mountain for similar reasons.
  • Caribou has expressed reservations about the lack of control it has over its club volumes.  GMCR’s pricing strategy has negatively impacted CBOU’s profitability.  This could harm the relationship going forward and, if typical of other licensees’ experience, could be a negative for GMCR going forward.
  • GAAP EPS may turn negative in FY13 as declining margins, negative cash flow, and competitive pressure comes to bear on financial results.

 IDEA ALERT: SHORT GMCR - GMCR levels

 

Howard Penney

Managing Director

 

Rory Green

Analyst


CRI: Follow The Insiders

Takeaway: Check out how good CRI insiders are in trading the stock. Do you really want to bet against them? Then don't be buying the stock today.

Check out how good CRI insiders are in trading the stock. Do you really want to bet against them? Then don't be buying the stock today.

CRI: Follow The Insiders - cri insider1

Source: Factset


DNKN UNKNOWNS BECOMING KNOWNS

Takeaway: We are pulling back on our bearish stance ahead of $DNKN's 3Q print on 10/25.

We had a candid conversation with the top brass at Dunkin’ Brands yesterday.  Given the timing of the call, and the fact that we have not been positive on the name, we took the call as a bullish sign in and of itself.  The details were reassuring and several grey areas were clarified to our satisfaction.

 

Dunkin’ reaching out to us to schedule a call eight days before the company reports its 3Q earnings was surprising.  If you have kept abreast of our writing on Dunkin’ over the past year, we have been critical of the company’s ability to execute on the long-term domestic growth projections that whipped up such excitement as the company came public.  On top of that, we have been skeptical of actual same-store sales results meeting expectations in the back half of 2012.  Same-store sales are not nearly as important for Dunkin’s profitability as unit growth, given the franchised nature of its business model, but comps do seem important from an investor sentiment standpoint.  Below, we address these two aspects of the Dunkin’ story and update our thoughts.

 

 

Unit Growth

 

We have consistently voiced our concern about what we perceived as a lack of disclosure, on management’s part, around the company’s new store pipeline.  As was explained to us yesterday, in what we thought was a very transparent manner, the company’s future unit growth is partly stemming from existing franchisees.  In 2012, 60% of new unit growth is accounted for by existing franchisees.  Management explained to us the difficulty they have in calculating the backlog because of the undefined nature of existing franchisee commitments.  Many franchisees are seeking to growth their businesses but, given the high level of concentration in existing markets, are looking west for that opportunity.

 

 

Same-Store Sales

 

We have been concerned about 2H12 trends from a headline perspective as expectations are for a V-Bottom in two-year average trends through year end.  We argued that even holding two-year average trends flat was likely overly bullish.  We still believe that a same-store sales miss is possible but see the investments in technology and strong performance of recent food items at Dunkin’ as strong positives.  We have seen with DPZ and SBUX that technology can have a significant impact on through-put, transactions, and both employee and customer-satisfaction.

 

DNKN UNKNOWNS BECOMING KNOWNS - dnkn sss expectations

 

 

Conclusion

 

The overall tone from management was very bullish.  The entire senior management team was on the call to directly convey the message and extend an invitation to us to meet with them in person to dig deeper into store-level returns and the company’s growth outlook.  We will be taking management up on the offer as soon as time permits.

 

For now, ahead of the 3Q print, we are pulling back on our bearish stance on Dunkin’.  Concerns remain, but we believe that the positive aspects of this story are sufficient to warrant the current valuation.

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 

 


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