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Eye on Re-Regulation: Where There's Smoke...

Swiss Cheese
We notice that Swiss banks are suddenly buying US Treasury bonds by the cartful. Could this be a sop to get the US to back off the UBS client list?

Chief Anti Money Laundering Compliance Officers take note: The US authorities pushed for the establishment of offshore relationships for major money center US banks in the 1960’s. The unstated, but very real purpose was to create a captive market for US Treasury debt. Illicit funds that domestic US banks could not take in as deposits, could go to these arms-length relationship banks. Laundered proceeds of arms dealing, drug dealing, and other Dark Arts could safely go to banks in certain Caribbean nations. Those local banks, in turn, through their New York correspondents, would buy up Treasurys for their portfolios.

If you wonder why certain dicey jurisdictions are treated with kid gloves, while the Swiss are suddenly Public enemy Number One, you might look at the Treasury Department’s list of Treasury Bond holdings by country. As of year-end 2008, the Chinese held $727 billion of our debt, the Japanese $626 billion. Third on the list is an entry that reads “Caribbean Banking Centers”, with $197 billion. Switzerland ranks eleventh, after Taiwan, and with half of the Treasury holdings of Russia ($116 billion) or Brazil ($127 billion), clearly, the Swiss can do more.

Switzerland’s holdings of US Treasurys went from under $44 billion in June of 2008, to above $62 billion at year end. This 50% increase is still a rather small percentage of total assets on their books. US authorities appear not to care that the Swiss Franc is itself a reserve currency. With the top ten Swiss banks holding assets on the order of three trillion US dollars, having the entire Swiss banking system hold only $62 billion looks downright… un-American.

The US push to shake loose tens of thousands of confidential account relationships looks like extortion designed to force the Swiss to put more assets at work in our marketplace. After all, we can’t count on the Chinese to do all the heavy lifting. In addition to all the other wonderful financial things our Government is doing, are we now vying to be the Money Launderer of Last Resort?

Swiftian Justice
Laws are like cobwebs, which may catch small flies, but let wasps and hornets break through.
- Jonathan Swift
On March 4, the SEC announced a success in a long-running litigation against 14 specialist firms. The firms in question have collectively agreed to pay $70 million in disgorgement and fines, versus alleged customer harm on the order of $58 million or more.
The SEC’s complaint charges these firms with Trading Ahead – which is filling a customer order from the firm’s proprietary account while holding matchable customer agency orders; Interpositioning – which is filling the outstanding matchable agency order from their own account, after having traded ahead; and Trading Ahead of Unexecuted Orders – which is not filling the customer order and taking the trade for the firms own account.
In addition, the regional specialist firms in the inquiry were alleged to have traded against their customer orders by executing trades on the NYSE that, since they were not recorded in a customer trades blotter, looked like firm proprietary trades. It’s not Bernie Madoff, but it ain’t good.
The activities took place during the period 1, which means that it has taken ten years, since the initial infractions, to build and prosecute this case through to its conclusion. We are not sure whether this qualifies as Swift Justice, but the irony is not lost on us that customers are not being protected by the agency.
But it gets better.
The $70 million that the SEC collects will go into their coffers. Face it, how complicated is it to figure out, customer by customer, trade by trade, who lost what? The firms will pay out, the SEC will add $70 million to its bankroll for the year, and in their year-end report for 2009, they will point to this as a significant achievement.
It is a signal irony of the regulatory process that people never get punished, but only told they must share the wealth. The Consent Decree in the case means that, even though they are paying out millions, the firms in question are neither affirming nor denying their guilt. And their further punishment? An order will be entered saying that, in the future, these firms are not allowed to break the law.
We will bet a very large nickel that, even after paying out on this consent decree, the firms all booked substantial profits on the practices in question.

Regulatory problem – why this happened, and why it will happen again: the exchanges do not share information with each other. We have been given to understand that the SEC will close the matter after taking the Specialists’ money. It should not stop there, because the regulatory mechanism that permitted this to occur has not been remedied.

We do not need to fault the exchanges individually, but we observe that, despite having the same market participants trading across multiple exchanges, the exchanges do not share oversight information. Specialists executing improper trades on the regional exchanges were doing closing, or layoff trades on the NYSE. Since neither exchange saw the entire transaction, these illegitimate transactions looked like proprietary trades. Had the exchanges matched their blotters and the customer orders on the specialist books, many of these illicit practices would have been run down and the firms disciplined.

So far, the SEC has not required the exchanges to share this information. This looks like a typical – and major – lapse on the part of the regulators. Closing this gap would eliminate the loophole that made this abuse possible in the first place.

Are we missing something?

Too Big To Regulate
It is a maxim among these lawyers, that whatever hath been done before, may legally be done again: and therefore they take special care to record all the decisions formerly made against common justice and the general reason of mankind.
- Jonathan Swift

We have been eavesdropping on the global jaw-jaw over introducing a new financial regulatory regime. We would not characterize this as a Dialogue. It is more a cacophony of monologues, with each group, political party, and government telling everyone else why We are Right and You are Wrong.

We do not pretend to have the global solution for the ills that have beset our markets. We are mildly amused at, for example, Senator Schumer – a longtime Wall Street groupie – who is shocked to find rampant greed-fueled speculation driving the financial industry. So far his major overhaul of the system appears to consist of merging the SEC and the CFTC (an awful idea that will leverage the inefficiency of the SEC and extend it to a market they have heretofore not been able to neglect); to adding one hundred junior-level lawyers to the SEC staff (giving the incompetent senior lawyers fresh meat to train in all the tried-and-untrue methods of not following up on leads and tips); and moving the SEC from Washington to New York City (now that DC has a voice in Congress, let’s not let this crisis go to waste).

We will make one fundamental observation, and we hope those who make laws and rules will bear it in mind.

In the 1980’s and 1990’s, large brokerage firms beefed up their compliance departments to keep the regulators at bay. Many of the largest and most successful firms of that era, all household names at the time, no longer exist. Many were absorbed into Citi – itself teetering on the brink of a black hole. Then, there were whole floors in major Manhattan office buildings staffed with lawyers and paralegals. A typical day for a typical mid-level compliance attorney at these firms included multiple Trades Reviews. The reviews would consist of a computer printout being placed on the lawyer’s desk first thing in the morning. These printouts were often a thousand pages or more, each page would have scores of customer trades. The evidence of the review consisted of the attorney signing the cover sheet. The blotter would then be packed up at the end of the day and shoved into a file drawer. After two years, it would be taken from the drawer, packed into a Banker’s Box and sent to a warehouse in Jersey City.

The sheer volume of transactions, by its nature, overwhelmed the human capacity to know what was going on. Permit your correspondent to step out of the Editorial We for a moment and explain a bit about my background.

As a branch manager and compliance officer for retail brokerage firms, my daily routine focused on the blotter. I started my day with the prior day’s trades before me – when I ran compliance for a retail firm with 350 producers, doing over $100 million in commission business a year, I nonetheless made it my business to look at every trade in every account, every day. To be sure, there were things I missed. But it was not for not looking for them.

These hands-on, close to the ground daily reviews are what give supervisors the ability to know when something is wrong. The supervisor gets to know the patterns of trading by broker, by customer, by trading desk, and by security. When the brokerage firms got so large that the reviews were taken off the branch manager’s desk and shifted upstairs to the attorneys, it was the signal that things would never again work properly. You can not tell when something looks wrong if you don’t know what it looks like when it is right.

Today’s failed financial institutions are not Too Big To Supervise. And since the regulatory system runs on a daisy-chain of Reliance, they are Too Big to Regulate. If there were ten times – or fifty times – or a hundred times the supervisory personnel in these institutions, and if they took the trouble to get to know what really went on on their watch, these organizations could be viable. The morphing of the format of business data from individual transactions – be they stock trades, investment banking mergers, or negotiating asset-backed contracts – to computer runs that are checked by upstairs staffers, takes the oversight out of the hands of those who understand how the transaction work. There are very few problems or conflicts that can not be addressed, once you have full information and seasoned managers to process that information. When the ratio of a firm’s information to its managers’ ability to digest that information gets out of whack, the firm is a prime candidate for implosion, regardless of its business mix.

Industries whose major players all grow on this model will collapse sooner or later, as will the societies that stand upon them. There is no substitute for Hands-On oversight.

Of Pots And Kettles
Wall Street indices predicted nine out of the last five recessions.
- Paul A. Samuelson
Latest in the category of Why Are They Reporting On This As Though It Were News? – The Wall Street Journal (11 March, “Obama, Geithner Get Low Grades From Economists”) reports “A majority of the 49 economists polled said they were dissatisfied with the administration's economic policies.”

Showing that even the Wall Street Journal can be fair to Messrs Obama and Geithner, the article also says “The economists, many of whom have been continually surprised by the depth of the downturn, also pushed back yet again their forecasts for when a recovery would begin.” In other words, their predictive acumen has not sharpened measurably since Professor Samuelson made the above observation.

This is a bunch of guys who – like Jim Cramer – get paid not to guess correctly, but just to guess. Forty-nine professional economists criticizing President Obama’s economic policy is like Alice Cooper critiquing Boy George’s wardrobe.

The Wall Street Journal paid someone to write this story, and ran it with a headline that seems to imply a group of experts are telling us we voted for the wrong President. You paid two dollars to buy the paper and spent several minutes of your time reading it. People discussed it all weekend as though it has meaning, and some are now lamenting the day they voted for Barack Obama. The Journal will, no doubt, be able to reference it as it gloats over President Obama’s declining poll figures. None of which has any bearing on whether or not this Administration’s policies will be effective.

With articles like this, the media tread ever closer to the Event Horizon of the Black Hole of meaninglessness. At least they can still sell newspapers. Of such things are public opinion made.

Dollar Down = Stocks Up

In this morning’s Early Look I walked through the quantification of this inverse correlation relative to the week of February 2nd, 2009.

Sometimes, pictures are more powerful than prose. Below we have shown the last 3-weeks of USD vs. SP500. As the USD stopped going up, SP500 stopped going down. As the USD went down, stocks went up.

I don’t want to make this any more complicated than it should be – not very. This macro relationship continues to be a very dominant signal.

Today, we are watching the USD trade down another -50 basis points, and stocks continue their immediate term ascent. My updated math has the USD Index oversold at the 86.71 line (its currently trading 86.86), and the SP500 overbought at the 768 line (currently trading 766).

In the immediate term, if the USD stops going down, stocks should stop going up.

Keith R. McCullough
CEO & Chief Investment Officer

Prices Rule

"Learning without thought is labor lost."

If there is one thing that we think about most here every morning at Research Edge, it's thinking about what we haven't thought about. We trust the process that real-time marked-to-market prices are leading indicators. As prices change, we force ourselves to ask the questions that need to be asked.
Unless they are "marked-to-model", prices in this business don't lie - people do. Sometimes real-time prices can actually tell you that someone either has inside information, or thinks that they do. That isn't the New Reality; the game has always been played this way. However, today's prices are as interconnected across geographies and asset classes as they have ever been. With every new data set of prices, there are macro signals that reveal themselves as having a dominating impact on your portfolio.
As market prices change, the patterns of behavior associated with those changing prices become more or less predictable, within a few standard deviations, on an immediate term basis. As Howard Penney pointed out in Friday's Early Look, one of the most dominant factors in Global Macro in 2009 has been the inverse correlation between the price of the US Dollar Index and US Equities.
As unpatriotic as it has sounded, our recommended investment solution to the US Financial System's crisis has been to "Break The Buck." No, this is not a long term solution. This, like many others that have been tested and tried, is an intermediate term one. Until proven otherwise, it has been one of the few solutions that has worked in 2009. The problem is that it has only worked for 2 separate weeks of this new year!
Last week the US Dollar posted its first week over week decline since the week of February 2nd. In the face of the US Dollar Index dropping -1.4%, the SP500 squeezed the consensus short selling community for a hefty +10.7% move. For the week of 2/2/09, the US$ was down -0.66%, and that was the last week of consequence that the US stock market shot higher, with the SP500 melting up +5.2% in that same week.
This morning, the US Dollar is breaking down further to 86.94, and looky here... the SP500 Futures are indicated UP! There is no irony in this relationship folks. The beauty of being price dependent is that we don't have to get emotional about this or endure some academic and qualitative debate. The New Reality of 2009 is that the only way to get the US stock market to "re-flate" is by breaking the buck's upward price momentum.
This certainly doesn't rhyme with the US government's West Wing consensus, which is all of a sudden choke full of Keynesian Big Government Interventionists. This is much more old school Irving Fisher type pin action, playing out almost to his textbook's form. But where is there room in the Big Rubin ego of one Larry Summers to wrap his head around this? Does Big Leverage Rubinite Junior, Timmy Geithner, understand what's going on here? Is he ALLOWED to learn without thinking?
These are all very critical questions that I hope President Obama inspires his team to ask - what is his economic team NOT thinking about? This objective thinking process was certainly part of Obama's campaign promise, but the man is definitely under fire now to show the country that his inclusive management process includes allowing his financial advisors to learn as they think.
Hope, of course, much like "marked-to-model" investment banking accounting, is not a credible investment process. After listening to both Summers and Christina Romer (Obama financial advisor) on the Sunday morning talk shows yesterday, I was reminded of as much and altogether happy that I took last week's US market strength as an opportunity to book gains. From an Asset Allocation standpoint, I am now back into my crouch, preparing for the US market's next big move.
This morning's US Futures indicate a higher open, but the big move in this market is behind us now. I was in the game on the long side in anticipation of a vicious Bear market TRADE. I have chosen NOT to keep a TRADE a trade in this business enough times to remind me that I shouldn't break my self-imposed rule. Keep a TRADE a trade.
The US Dollar is now broken from an immediate term TRADE perspective. That line of support now becomes resistance at 87.30, and we can breakout above it as fast as we broke down through it. From an intermediate term TREND perspective, the buck has tremendous support down at 85.24. Until that line is broken alongside the US government's long standing and dogmatic "strong Dollar" policy, I don't see the return of a bull market in US stocks any time soon.
My immediate term upside target for the SP500 is now 768. A close above that line would put this market in a bullish immediate term TRADE position. If we continue to close below that line, I'll proactively predict the SP500 has -6% downside from Friday's close to 711.
As prices change, I will. Prices Rule.
Best of luck out there this week,


EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months.  With interest rates at 3.25% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.

 USO - Oil Fund- We bought oil on Friday (3/6) with the US dollar breaking down and the S&P500 rallying to the upside. With declining contango in the futures curve and evidence that OPEC cuts are beginning to work, we believe the oil trade may have fundamental legs from this level.

CAF - Morgan Stanley China fund - The Shanghai Stock Exchange is up +18.2% 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 on a down day. 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%.

DIA -Diamonds Trust-We re-shorted the DJIA on Friday (3/13) on an up move as we believe on a Trade basis, the risk / reward for the market favors the downside.

EWW - iShares Mexico- We're short Mexico due in part to the country's dependence on export revenues from one monopolistic oil company, PEMEX. Mexican oil exports contribute significantly to the country's total export revenue and PEMEX pays a sizable percentage of taxes and royalties to the federal government's budget. This relationship is unstable due to the volatility of oil prices, the inability of PEMEX to pay down its debt, and the fact that PEMEX's crude oil production has been in decline since 2004 and is down 10% YTD.  Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.

IFN -The India Fund- We have had a consistently negative bias on Indian equities since we launched the firm early last year. We believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit. Trade data for February paints a grim picture with exports declining by 15.87% Y/Y and imports sliding by 18.22%.

XLP -SPDR Consumer Staples- 2nd best performing sector on Friday, yet is broken on a trade and trend duration.

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 2/26 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 $1.2972. The USD is up versus the Yen at 98.2400 and down versus the Pound at $1.4173 as of 6am today.

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US Market Performance: Week Ended 3/13/09...

Index Performance:

Week Ended 3/13/09:
DJ +9.0%, SP500 +10.7%, Nasdaq +10.6%, Russell2000 +12.0%

MAR09’ To-Date:
DJ +2.3%, SP500 +2.9%, Nasdaq +3.9%, Russell2000 +1.1%

2009 Year-to-date:
DJ (17.7%), SP500 (16.2%), Nasdaq (9.2%), Russell2000 (21.3%)

Keith R. McCullough
CEO / Chief Investment Officer

Anybody watching cotton?

We’re entering the period where cost comps get easy on a 1 and 2-year basis. Add this to my theme of every other line on the P&L improving on the margin in 2H, and the bullish cocktail gets more powerful.

Front-month cotton futures finished Friday’s session up almost 4% on the NYBOT for the week after data released by the USDA Thursday showed US cotton exports up by 23% for the week ending March 5th from the week prior with a significant increase in Chinese buyers. That data however, is a drop in the bucket after the declines over the past year. We’re literally just entering the period (i.e. today) where compares are getting easy on both a one and two-year basis. And I mean really easy…

All in, let’s not forget that cotton accounts for about $5 in costs for a $100 garment at retail. We can debate up and down where in the supply chain any cost saves would show up – but quite frankly, I really don’t care at this point. We’ve had a 1.5year cost headwind that is starting to ease on the margin. This will help everyone to some degree. It pains me to say this, bc I have zero confidence in management or company strategy, but Gildan would be a disproportionate beneficiary to the reduction in cotton costs given that cotton is 35% of its COGS. If you want to play in that sandbox, then knock yourself out. I’m sticking with the winners like RL, HBI, UA (though it has zero cotton exposure – it competes with those that do), and LULU.

Andrew Barber
Brian McGough

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