“Socialism would make our society comparable to that of the white ant.”
After the market close last night I was excited to crack open the biggest brick in my reading pile – The Last Lion: Defender of The Realm (1). This puppy is 1182 pages long; could take awhile – so prepare for plenty from the Old Man on 10 Downing St.
Comparing Britain’s rise and fall from global economic (and currency) power of the early 20th century is very appropriate when considering what the United States of America is doing under Bush/Obama in the 21st. Churchill has always resonated with me, not because I am like him, but because he wasn’t liked by the burgeoning British #PoliticalClass.
“Churchill had a natural sympathy for simple people because he himself took a simple view of what was required… That was no doubt why the man-in-the-street loved him and the intellectuals did not… For that reason, Churchill had “dislike and contempt”, of a kind that transcended politics.” (Preamble, page 6)
Back to the Global Macro Grind…
Reading the preamble to Churchill after watching the gong show that became Ben Bernanke’s rock-star presser yesterday may very well have done the unthinkable to me last night – it made me think.
How conflicted, constrained, and compromised are we in America at this point to even consider some of the un-qualified spew that comes out of an un-elected and un-accountable professor who is literally making it up at this point on the fly?
Educating yourself to contextualize this moment in economic history is one thing – having common sense is entirely another. Bernanke admitted yesterday that his entire policy framework is based on forecasts that you should have no confidence in.
Finally, I think global markets actually took his word for it on that.
To review Bernanke’s 2012 experimentations (actually he called them “innovations” yesterday, and smirked):
1. January 25th, 2012 – right when Global Growth was accelerating (I was as bullish as anyone in the world on the prospects for US and Global Consumption growth on JAN24), he arbitrarily decided to move his 0% interest rate Policy To Inflate out to 2014 from 2013. Stocks and Commodities ripped for the next month, then topped.
2. September 13th, 2012 – after whispering sweet bailout promises to whoever got the memo (other than me) from Jackson Hole, Bernanke pushes his 0% interest rate Policy To Inflate out to 2015 and beyond. Stocks and Commodities continued to rip for another day, then topped.
3. December 12th, 2012 – whoever was front-running the Fed’s latest “innovation” (knowing he’d move to “targeting” an unemployment rate that you may not see until 2017-2020) didn’t even stick around for the full press conference. Stocks and Commodities topped, intraday!
After perpetuating all-time highs in Housing, Education, Oil, Gold, and Food prices (2006-2012), he pushed out 0% rates 3x in 10 months, from 2013 to 2017 and beyond. Each time, the market rallied less (for less time) on less volume. Atta boy Ben!
And people wonder why the commodity/stock market casino of front-running whatever Bernanke makes up next doesn’t reflect the underlying fundamentals of A) the economy and/or B) corporate revenue/earnings growth? Wonder no more. His explanation of what he is doing and why yesterday was so scary that even Gold wouldn’t keep going up.
And boom! Gold and Silver fall another -1.2% to 2.4%, respectively, this morning. To me at least, it’s like watching White Ants marching over their own expectations cliff. If you’re really long this stuff (say, for example, you own 21% of the Gold ETF), what, precisely, is your next catalyst? 2050?
As Churchill said, “Never, ever, give up!” And I won’t in contextualizing the moment markets are in within the lessons of history learned. Gold has been up (year-over-year) for 12 consecutive years. One might assume that the market has sufficiently discounted:
- Japan cutting to zero (and now setting the Yen on fire)
- USA cutting to zero (and then re-defining zero)
- Europe readying itself to create the fiscal/debt union to accomplish Japanese/American Style Zero
Zero. Think about what zero means. If the risk-free rate is zero, going forward it’s going to be increasingly difficult to beat zero.
I think most people who run money get that. And if you’re being honest with yourself (all you have to do is look at the balances in your equity market accounts versus where they were in December 2007 to get the point), you’d be happy to get back to zero (break-even). Like the Nikkei post its real-estate/asset 1980s price bubble, the SP500 keeps making lower long-term highs.
As I’ve written multiple times since stocks bottomed at higher-lows in November, there will be a great economic opportunity born out of food and energy price deflation if we allow Bernanke’s Bubbles (Commodities) to pop.
Deflating The Inflation Expectations out there will definitely take time – but at this point you don’t even have to have faith. You don’t have to believe the Keynesian intellectuals who are failing all-over themselves anymore either.
Just be a simpleton, like me. Think mean reversion, gravity, and White Ants.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, Shanghai Composite, and the SP500 are now $1, $105.43-109.65, $3.61-3.71, $1.29-1.31, 1.66-1.72%, 2035-2095, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on November 29, 2012 for Hedgeye subscribers.
“You want a prediction about the weather? You’re asking the wrong Phil. I’ll give you a winter prediction: It’s gonna be cold, it’s gonna be grey, and it’s gonna last you for the rest of your life.”
-From the film Groundhog Day
I used the quote from Groundhog Day because as an analyst covering Europe the political and economic developments of the region continue to repeat and there appears no simple solution to solving its ails – headline risk is here to stay.
If Greece headlined the film by taking its first bailout in May of 2010, it was quickly joined by the peripheral actors of Portugal, Spain, Italy, and Ireland – and each and every time the scene repeated: a crisis deepened, Eurocrats (European politicians) responded by calling a summit, announced a solution, the solution did not have “teeth” or didn’t work, and risk expectations shifted as the movie played on.
Monday’s Greek aid deal is part of the same film. The main tenants of the “deal” include a payment of its next bailout tranches (€43.7B); approval to reduce its debt as a percentage of GDP to 124% by 2020 (versus estimates of 190% in 2013); both a reduction in interest rates on loans and extension in loan maturities and interest payments (by as much as 15 years!); a pass-along of €7B from profits on ECB Greek debt holdings to Greece; and a potential (undetermined) debt-buyback scheme.
Yet what’s most unsettling is that market participants recognize this deal for what it is: a shell game. After all there’s no prospect of this being the last bailout or concession thrown Greece’s way.
But can Eurocrats get away with playing the game? And where is the region politically and economically going now that it officially slipped into recession, with Eurozone GDP declining -0.1% in Q3 quarter-over-quarter following a -0.2% contraction in Q2? Here are some assumptions we’re working under:
- Eurocrats will do everything in their power to maintain their own job security and therefore will continue to support the region monetarily
- There’s nothing in the main constitutional treaties to allow a member state to exit the Eurozone or be expelled. Therefore we do not expect Greece et al to leave or be forced out over the next 1-3 years
- When it comes to ‘hard’ decisions or impasses, Eurocrats will chose the path of least resistance (a strong argument for keeping the region together remains the fear of a breakup), which should prolong a return to growth
- Fiscal consolidation (austerity) is needed across much of the periphery; governments have recently taken the flawed stance that they need to take their foot of the gas. Instead what’s needed is more manageable consolidation expectations and strategy to reform labor markets to improve growth prospects
- A Eurozone governed only by monetary policy is not feasible for long-term sustainability
- The path to a Fiscal Union is littered with challenges given the inability of states to relinquish their sovereignty to a European commission
- Fellow member states represent the largest trading partners for most states, therefore no one state will see a major inflection in growth until the region collectively improves
- France, the second largest economy in the Eurozone, and once a close political ally to Germany via Merkozy, has inflected alongside the election of the Socialist President Hollande. His 75% tax policy on the rich, among others, will be a headwind as the country’s sovereign debt tips past 90% of GDP and France loses its AAA status. All this bodes poorly for Eurozone bailout structures built around the credit rating of the larger economies and given that France is the second largest contributor behind Germany.
Despite the region’s challenges, one cannot forget ECB President Mario Draghi’s September announcement that “the ECB is ready to do whatever it takes to preserve the euro” via the Outright Monetary Transactions (OMT) program to buy sovereign bonds.
To date the facility has not been triggered, however sadly market operators are left to manage risk around the bubble of Big Government and Central Bank Intervention. It’s this market reality that solidifies our thinking that Eurocrats will do all that is necessary to maintain the Union; has kept the EUR/USD trading in a relatively tight band and eliminated the euro parity crowd; and caused sovereign bond yields to moderate in recent months and new issuance to be priced at lower yields versus previous auctions.
This is all positive but hinges on Draghi suspending economic reality over the long term, and is a mismatch with Eurozone fundamental indicators that continue to move in the wrong direction: PMI Services and Manufacturing figures remain grounded below 50 representing contraction; economic, business, and consumer confidence figures have been down for 7-8 straight months; Retail Sales and Industrial Production remain challenged in the core and bombed out in much of the periphery; and inflation is sticky and above the ECB’s target.
On the downside we’d caution that there is measurable risk still imbedded in Spain (the sovereign) needing a bailout, which could accompany a need for assistance in Italy. Further, a rise in foot power, namely strikes and riots, especially given outsized unemployment rates across the periphery, and push back on austerity could turn both the political and economic tide in the Eurozone.
Remember, just two weeks ago there was the first ever coordinated strike against austerity of 40 unions across 23 countries. In addition, a recent Greek popular poll showed that the anti-bailout Syriza party leading, and regional elections in Catalonia, Spain over the weekend voted in a majority of secessionist parties, all suggesting that there’s risk in reaching a tipping point should we see more concentrated popular push back on government policy and Eurozone membership.
While we don’t expect to see borders shifting in the Eurozone anytime soon, citizens have a way of viewing shell games for what they are: deception.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1704-1731, $107.94-111.49, $3.45-3.58, $79.95-80.61, $1.28-1.30, 1.56-1.68%, and 1406-1419, respectively.
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Takeaway: Good debut for $RH. The growth/margin improvement story is very much intact, and in fact, is slightly ahead of our aggressive expectations.
This story is still full steam ahead, which is notable given that investor interest around the name has been paltry at best since the day after IPO. Comps are crushing it at +29%, the new Design Gallery in Scottsdale opened at or ahead of plan, and the company announced two new catalog businesses to launch this Spring – RH Tableware and RH Objects of Curiosity. It also announced RH Fine Art, which is likely an ASP-lifter. There’s usually not this much new info out of a recent IPO, but we definitely liked what we heard. There's noise around 4Q-to-date trends given the port stroke and lingering impact of Sandy, but that's hardly a sign of real underlying trends.
We’re taking up our Direct Numbers my next year about 4k catalogs without any degradation in revenue per page. This takes up our total Direct revs by about 800-900bp, and total RH sales by about 400bp.
There seemed to be some concern on the call about the Gross Margin. That shouldn’t be the case. The company went up against up a +450bp gross margin in this quarter last year. On a 2-year run rate, the gross margin was up 200bp despite an incremental shift to furniture which is lower GM (COGS includes shipping costs). This not a Gross Margin story on a longer term basis. It is about sheer top-line growth leveraging SG&A (which only grew 12.9% vs 22% sales growth).
We still like this one a lot. The key rationale is that…
1) We think that the company can leverage mid single digit square footage growth into double digit growth, and 20% top line. The company can then leverage fixed costs and grow EBIT by 30%, and EPS approaching 40% while it pays down debt. It is not without its volatility – especially on a quarter to quarter basis, but the growth algorithm works.
2) Scale is critical in this business. That’s not a problem for RH if you measure by number of stores given that it has 73 locations as it can leverage a national distribution platform. Unfortunately, store count is a pretty useless metric when your average store is so small that it can only show 25% of the assortment. Categories like apparel might be ok in showing a prospective customer an item in an iPad 'lookbook' in hopes of placing an order. But when buying a sofa, desk, or bunk beds, people need to touch and feel. The shift to the company’s Design Galleries allow the ENTIRE assortment to be visible in the appropriate places.
3) With the larger (25,000 square foot) Galleries, the company can also get into new categories like we’re seeing it do in the Spring of 2013. These will allow the company to cherry pick the best and most appropriate mix of product in each region and for each store to maximize sales productivity.
4) While it opens Design Galleries, the existing base of stores allows the company to backfill existing markets with the new categories that are being tested in its new concepts.
5) It has only scratched the surface with its design services offering. Ever try to furnish a home with the help of a designer? Plan on spending 2x your budget.
6) In the end, the Home category is one of the most fragmented in retail. Though people are quick to complain that prices are too high, we'd be quick to answer that there's a difference between high price and expensive. RH’s existing prices on like-for-like items are very competitive, and there are no other retailers that are doing what RH is trying to do with the same scale. It has had ‘defacto SKU proliferation’ in the past that held back profitability – which was only the case because it did not have the real estate to show 75% of its product in the way it needs to be presented to consumers.
RH remains one of our top picks for those with a higher risk tolerance.
Today we bought Walmart at $69.03 a share at 3:44 PM EDT in our Real-Time Alerts. The stock is oversold on our immediate-term TRADE durations but continues to hold our long-term TAIL support as oil makes another lower Bernanke high.
Takeaway: We think the downside here is minimal and there’s a big call option on WMT to the extent oil continues to make lower highs.
We added WMT to the long-side of our Real-Time Positions yet again. The stock signaled that it was immediate-term TRADE oversold according to Keith’s quantitative model today while holding its long-term TAIL support. We think the downside here is minimal and there’s a big call option on WMT to the extent oil continues to make lower highs.
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