Cat Tails

“A man who carries a cat by the tail learns something that he can learn in no other way.”

-Mark Twain


In money management, like many professions, the act of doing is probably the best training available.  There is nothing like a mistake to change your process or habits, and when you manage money professionally the mistakes come frequently.  The key, of course, is what you do with the mistakes and how you adjust to them.


This is certainly an interesting time in the money management business.  In the last few years, we’ve seen a number of long time and highly successful portfolio managers decide to get out of the game.  In fact, earlier this week Keith and I had coffee with a Hedgeye subscriber who will be converting his highly successful hedge fund into a family office at the end of the year.


This gentleman, like many of his peers, didn’t have one specific reason for returning outside capital, but rather was more generally concerned about the ability to generate returns that justified the fees.  On some level, that is a high class problem.  But the truth of it is, in our view, monetary policy and policy makers have taken us to a place where the risk / reward in many asset classes is simply not all that compelling.  Simply put, if you are going to carry the proverbial cat by the tail, you want to believe that the reward of that action equates to the risk.


Of course, this is not to say that all is necessarily negative.  In fact, this morning is one of the more bullish runs of economic factors that we’ve seen for some time. A few things to consider this morning:


1.   China – The Shanghai Composite was up +4.3% overnight to cap off a two week run of +9.6%.  As a consumer of commodities, China will have its best moves when input prices are deflating, so to see a breakout above our key resistance line of 2,905 on the Shanghai Composite, we will likely need to see Bernanke and Company get out of the way for this rally to be sustainable.  It also doesn’t hurt that the HSBC Flash PMI came in a little better than expected at a stable 50.9, which implies an economic recovery may be taking hold in China.


2.   Germany – As the old adage goes, there is always a bull market somewhere.  Going into yesterday, the DAX was up 29% in the year-to-date, which makes it one of the top ten performing equity markets globally.  This move in Germany equities is supported by the high frequency economic data, such as the services PMI from this morning which came in at 52.1 versus its 49.7 reading in November.


3.   Commodities – Many of the story tellers have suggested that commodity prices go up purely because of supply / demand or tight economies and while at times this is true, the reality remains that monetary policy is a big driver.  To the extent that global central bankers get even marginally more hawkish, it will negatively impact commodity prices.  As we all know, economic recoveries don’t occur at $150 per barrel crude oil and getting oil lower sustainably will be a key factor supporting any sustained economic recovery.


Collectively, this data and these real-time prices are signaling a shift from #SlowingGrowth to #StabilizingGrowth.  This is potentially very positive for equity markets.  The question from here is whether the government can stay out of the way of economic stability.


To dig into this last point in more detail, we are going to be hosting Stanford Economics Professor John Taylor this coming Tuesday at 1pm EST for a conference call (if you are not an institutional macro subscriber and would like information on attending please email ).  Bloomberg Markets recently named Professor Taylor to their 50 Most Influential List and he was on the short list to replace Chairman Bernanke under a Romney administration, but he is probably most known for the creation of the Taylor rule.


The Taylor rule is a monetary-policy rule that stipulates the degree to which central banks should change nominal interest rates in response to measures of economic output, specifically inflation.  The theory behind the Taylor rule is that it increases the credibility of the central bank by reducing uncertainty in monetary policy actions.  In effect, the rule reduces the need for arbitrary decisions by central banks.


Generally speaking, while Taylor believes that government has a role in managing the economy, the role should be limited and predictable.  As such, he has been highly critical of both Democratic economists like Paul Krugman and Republican economists like Alan Greenspan.  In fact, Professor Taylor wrote the following in the Wall Street Journal about the financial crisis in 2008:


“Government actions and interventions, not any inherent failure or instability of the private economy, caused, prolonged, and worsened the crisis."


That’s a statement we couldn’t agree with more.


The big topic we will be discussing with Taylor is the upcoming fiscal cliff and the potential outcomes.  Currently, it seems that a resolution between now and the end of the year is unlikely.   President Obama and Speaker Boehner met for an hour last night and, shockingly, there was apparent movement to a resolution.   So as things stand today, in just over two weeks taxes are set to increase dramatically and government spending is set to decline.


As we’ve stated, this will have an impact on economic growth in the short run, though the positive implication may well be dollar strength as the United States takes some fiscal medicine.  The other looming issue, which we highlight in the Chart of the Day, is that in Q1 2013 the federal government is likely to hit another debt ceiling.  


So, it seems our politicians have a few cats by their tails . . . it will be interesting to see what they learn.


Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1, $105.61-108.98, $3.63-3.71, $79.51-80.31, $1.29-1.31, 1.66-1.74%, and 1, respectively.


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


Cat Tails - Chart of the Day


Cat Tails - Virtual Portfolio

America Reborn?

This note was originally published at 8am on November 30, 2012 for Hedgeye subscribers.

“America is the only country that is constantly being reborn.”

-William Knudsen, 1945


I’ll be turning my attention to a fresh new history book this weekend. I’m looking forward to that. I always do. It’s the only way I learn how to proactively manage for future risks – by contextualizing history’s behavioral patterns and economic cycles.


The aforementioned quote comes from the conclusion of the book I have been reviewing as of late – Freedom’s Forge. It’s an interesting quote. It probably makes an American feel good. As much as I respect Bill Knudsen, it’s completely inaccurate too.


How do you think the Chinese and Germans feel about that? If you’ve studied the last 400-500 years of economic history, you’ll recall that global economic hegemons are slowly, but constantly, changing. Before its war with Britain began in 1839, China had almost 1/3 of Global GDP. In the last 3 years, the USA has fallen from 23% to 21% of Global GDP. Where will it go from here?


Back to the Global Macro Grind


Now that the bull case for US stocks has gone from “growth is back” (Q112) to “but earnings are great” (Q212) to the government is going to save us from themselves (Q3/Q4 2012, Qe and #Keynesian Cliff), is America Reborn? As what?


If we really are asking to be reborn, maybe we should consider birth rates. Looking at America’s birth rates (officially released this morning), as US GDP as a % of Global GDP has fallen in the last 3 years, the USA’s birth rate has fallen -8% to a record low.


Sound familiar?


Japan has a negative population growth rate. And while the Keynesian Quacks who have been perpetuating unlimited Quantatitive Easing, Currency Devaluation, and Debt Financed Government Spending in Japan for the last 20 years doubt they’ve had a causal impact on the correlation between Japan’s economic decline and societal despair, to me at least, gravity is readily apparent.


So, let’s “get a deal”, kick the can, print some more money, and do more of that…


It’s sad to watch. And while I think I am doing my own part in being the change we need to see in our profession, my hope for an America “Reborn” on the principles of equality, liberty, and “free” markets is fleeting.


My hope for a Strong Dollar isn’t a risk management process either – and risk, of course, works both ways – so the best I can do is attempt to risk manage a tape that’s begging for more of what will ultimately make America look more like a European Social Democracy.


In terms of US Equity performance chasing, where is American risk trading into month-end?

  1. SP500 has rallied back from the thralls of its Q4 lows (on no volume) to down -4% from its Bernanke Top
  2. US Equity Volatility has been stamped right back down to its long-term TAIL risk zone of 14-15
  3. SP500 close > 1419 (TREND resistance) = bullish; a close below 1419 = bearish

All the while, despite the Dollar Debauchery (Cliff can kicking and Qe4 rumors have the US Dollar down for 2 weeks in a row), the US Treasury Bond market doesn’t care:

  1. UST 10yr Bond Yields down 7 basis points on the week, from 1.69% to 1.62%
  2. Treasury Bond Yields remain in a Bearish Formation, reflecting Global #GrowthSlowing expectations
  3. Yield Spread (10yr minus 2yr Yields) has compressed another 5 basis points wk-over-wk to +137bps wide

Now some still think the US stock market is the global economy, so just a reminder on our answer to that:

  1. CHINA – Shanghai Composite hit a fresh 3yr low this week; no China “stimulus” in sight
  2. COPPER – lower-highs continue since March (we shorted Copper yesterday)
  3. BOND YIELDS  - Treasuries are going to beat Corporate Bonds in November (Corporate #EarningsSlowing)

But, again – if you are more concerned about what the government can do for your year-end bonus in December, all we need to see are 2 things:

  1. Japanese Style Can Kicking on the #KeynesianCliff
  2. Rumors from Hilsenrath (WSJ) into the close on Bernanke doubling (heck, tripling) his monthly printing

Who would have thunk? The great American Republic of “free-market liberties” reborn as a casino of market expectations driven by what Pelosi and Boehner might say next. Think about it in historical context before you beg for more of it – then think about it again.


Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1704-1732, $109.88-111.49, $3.43-3.62, $79.94-80.58, $1.29-1.31, 1.57-1.67%, and 1406-1419, respectively.


Best of luck out there today and enjoy your weekend,



Keith R. McCullough
Chief Executive Officer


America Reborn? - 55.household


America Reborn? - 55. vp

Bullish TREND: S&P 500 Levels, Refreshed

Takeaway: This US stock market is back in a Bullish Formation for the right fundamental economic reasons.

This note was originally published December 13, 2012 at 11:11 in Macro

POSITION: Short Commodities, Long Consumer


This US stock market is back in a Bullish Formation for the right fundamental economic reasons. Deflating commodity inflation is one of the very few policies the government has tried yet. That, of course, is because it would require them to get out of the way.


Across our core risk management durations, here are the lines that matter to me most:


  1. Immediate-term TRADE resistance = 1435
  2. Intermediate-term TREND support = 1419
  3. Long-term TAIL support = 1366


In other words, bullish is as bullish does until it doesn’t. The volume signals in this market are beyond alarming at this point. I get that, but also get that consensus hedge funds tend to capitulate and cover at no-volume lower-highs when the VIX hits 14.


So there’s plenty to consider as you risk manage this very manageable Risk Range (1419-1435). What was TREND resistance (1419) is still confirming itself as newfound support.


If it doesn’t hold, we’ll change our position.



Keith R. McCullough
Chief Executive Officer


Bullish TREND: S&P 500 Levels, Refreshed - SPX

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FL/FINL: Buy on Weakness

The athletic footwear sales trends out this week have investors nervous. At first glance the deceleration is notable, but a closer look at recent trends suggest that the turn is in areas that are significantly under-represented at FL/FINL.  Our interpretation of the data is that trends remain strong where it matters. We think this is a solid buying opportunity for both FL and FINL on perceived weakness in trends.

There are multiple ways to parse the weekly/monthly footwear sales results to gauge underlying trends at footwear retailers like FL and FINL. The two that have proven most indicative of underlying trends that we track most closely are:

  1. Looking at the monthly data by channel which separates Athletic Specialty sales from the Department Store (KSS, JCP, etc) and Shoe Chain (BWS, DSW, etc.) channels that have been underperforming, and…
  2. Tracking our own Performance vs. Non-Performance footwear index. This analysis has yielded the more notable callout.

Simply put, performance categories (Running, Cross Training, and Basketball) which account for ~75% of athletic footwear sales and where FL and FINL are over-indexed are materially outperforming non-performance categories (Boots, Casual, Hiking, etc.).


Recall on the FL’s 3Q earnings call in mid-November, the company reported month-to-date comps up +MSD despite industry sales down -6% according to the weekly data. Over the past two years, the spread between Performance footwear vs. Total Athletic footwear has been somewhere between 5-to-10pts and currently stands at the upper end of that range. This spread can be clearly seen in the following charts below. As our proprietary index suggests, underlying Performance footwear sales are still running up +HSD (high-single-digit). What’s accounting for the industry sales deterioration is the Non-Performance index, which is largely sold through the Department/National Chain channel.


The bigger question for us is whether weakness in these non-core categories can be so sustained and pervasive such that they can carry through to the Foot Lockers of the world. We think we’d need to see months of that type of trend to pose this risk. We simply not there, but the market is starting to discount that it will come to fruition.

The bottom-line is that we think weakness in both FL and FINL reflect investor concerns based on underwhelming industry sales data without accounting for the critical distinction between Performance and Non-Performance categories. As such, we think this recent weakness is an great buying opportunity for both FL and FINL.

Our estimates remain above the Street for both names. On FL, we’re 6% above consensus EPS for 4Q with a +8% comp, and are looking at $3 in earnings power next year approaching $3.50 in F14. We still think this one is in the early stages of its turnaround and see more opportunity for upside earnings performance over the intermediate-term.


On FINL, we are in-line with Street expectations in the upcoming quarter and year where we think upside in earnings is limited due to current investment spending, but are shaking out +5% and +8% ahead of consensus in 2013 and 2014. At 9.5x our 2013 estimate, we think setup for earnings growth next year is not reflected at current levels.

Both FL and FINL are among our top long ideas behind NKE, FNP and RH.



FL/FINL: Buy on Weakness - FW App Table Trends


FL/FINL: Buy on Weakness - FW Weekly PerfvNonPerf


FL/FINL: Buy on Weakness - FW Weekly PerfvIndustry Spread


FL/FINL: Buy on Weakness - FW Weekly Cat


FL/FINL: Buy on Weakness - FW Mo Chan


FL/FINL: Buy on Weakness - FW Mo PerfvNonPerf


FL/FINL: Buy on Weakness - FW Mo Cat


FL/FINL: Buy on Weakness - FW App 1Yr


FL/FINL: Buy on Weakness - FINL Comps


FL/FINL: Buy on Weakness - FL Comps



Sector Analysis

Over the last six months, the market has shifted greatly with events like the fiscal cliff and Federal Reserve announcements shifting the performance of stocks. If we look at sectors, financials (XLF) have been outperforming the broader market (S&P 500) greatly while technology (XLK) has struggled to play catch up. With Apple (AAPL) heading lower week-after-week, it's going to be rough for people who bought into technology at peak levels.


Sector Analysis - image001

JCP: Reasons To Reconsider Your Short

Takeaway: While we're not pounding the table on $JCP, we think there's serious risk to being short headed into 2013. Don't ignore them.

We’ve thought from Day 1 that there’s no shortage of reasons to be bearish on JCP. Structurally, we still think that’s the case. But stocks don’t trade in a vacuum, and on the short side, we would not touch this one with a 20-foot pole in the high teens. Our purpose here is not to convince anyone to buy JCP. But rather to explore as many factors as possible that could prove a short position painfully wrong.



We recently spent two weeks on the road, and JCP name was a topic of discussion in 8 out of 10 meetings. The only one that rivals it in terms of controversy is Nike. The irony here is that despite the overwhelming bearishness – 40% of float short and bulls capitulating with less than 30% recommending JCP as a Buy – the topic we encountered most on the road was “why not buy JCP here, as it seemingly has all the bad news we’re likely to see in the stock, and is discounting zero positive developments?”. Out of all the people who raised that question, we could find maybe one who followed through and actually bought the stock here.


We think the reason is that if you buy it here and you’re wrong, it’s an offense that probably poses career risk for some. Buying JCP here is really taking a flier on Johnson getting ANYTHING right next year – even if by accident. Let’s face it, after so many self inflicted black eyes, the guy is due for a win. That blind assumption is hardly a sound investment process in our book.  But if you want  to stay bearish in the high teens, you should remember the following.


1)      The ‘JCP is a Zero’ argument has been made about SHLD since that marriage was formed in the fall of 2004. And since then, the stock has underperformed with a -10% CAGR, but it has been flat for the better part of five years, and has been far from insolvent. We could make a good TAIL call about how JCP will prove to be a failure in 8 years – even sooner than that. But it has no bearing on how the stock trades next year. Initially we feel short sighted in saying that, but the facts are what they are, and we won’t ignore them.


2)      Let’s look at the specific stock trading patterns from the week before the Sears/K-Mart deal was announced vs the week before Ron Johnson’s appointment as JCP CEO. They’re different types of events, but we put them both in the ‘hail Mary’ category and therefore comparable. For 10 months, the stocks followed almost the same EXACT trading pattern, until JCP’s egregiously low comp level pushed it down to new cyclical lows. JCP is now down 45% from the announcement, while SHLD was UP 45% at the same corresponding point in time (ie 1.5 yrs after announcement). The point is that there was ‘reason to believe’ 2-3 years into the SHLD story. It turned out to be unjustified, as SHLD is sitting at a mere $42 today, down 56% from the announcement of the deal. But if you were a ‘perma-short’ throughout the past 8 years, the early part of it was probably less than comforting. The chart below is self explanatory.


JCP: Reasons To Reconsider Your Short - jcp1


3)      Why does this ultra-long duration matter? Because that’s how Ron Johnson gets paid. Keep in mind that his warrants don’t vest until 2017. We can’t imagine that he did not get the Board’s full support before accepting the job to live through major jolts to the company’s financial nerve center. Without that, there’s no way he’d have taken the risk. Currently, his 50mm warrants are worthless. Above $29, he starts to see the fruits of his labor. His big mistake was not in trying to radically change the store. It was bowing to storytellers in the investment community and issuing near-term guidance around a story that would not play out until the intermediate-term had long passed.


4)      One thing to keep in mind is that Johnson is not afraid to miss near-term targets for long-term value creation. That’s painfully apparent to the bulls who suffered through the past three quarters of financial results. But his investments ultimately paid off. We’re the first to highlight how his toolbox at JCP pales in comparison to what he had at Apple. But the guy is not used to losing, and likely won’t go another year wearing that tattoo.  Check out his performance at Apple.  The retail business missed its guidance to hit break-even target twice in the early days. We’re currently seeing the miss, though obviously on a much greater scale. But he will likely tweak the equation in whatever way he needs in order to keep morale heading higher and fend off share loss.

JCP: Reasons To Reconsider Your Short - jcp2


5)      Speaking of share loss, we don’t think its clear exactly how much share JCP has hemorrhaged in year 1. For the first three quarters of this year we’re talking over $2.7bn in share. When 4Q – the seasonally strongest quarter – comes out, we’ll be looking at something closer to $4bn in annual share. This is coming off a base of only $17bn in revenue.  Our sense is that the M’s, GPS’, KSS’ and TJX’s of the world are underestimating how much share JCP is handing them. This is not a permanent share shift by any stretch. And given that these other retailers pretty much don’t have a clue as to how much share they are gaining, it’s tough for them to have a clear plan as to how to avoid giving it back.

JCP: Reasons To Reconsider Your Short - jcp3


6)      The argument for comp improvement is tough to refute mathematically. Not only is JCP coming off –mid20% comp declines, but it is happening at the same time that an incremental 2-3% of its store base is being remodeled every month. With current sales per square foot sitting at a paltry $112 – yes, you read that right, $112 – and the new stores likely to clock in 30-40% above that level, it is tough for us to not get to a 20%+ positive swing in comps next year. One may wonder (as we do) how much the comp will cost them in terms of higher technology and deferred maintenance costs, we think that it will trade with the comp, not necessarily with profitability. We don’t think that’s appropriate, but we think it’s reality.

JCP: Reasons To Reconsider Your Short - jcp4


7)      We think that the big risk here on the long side is simply cash flow. In other words, to be short the stock here, we think that you have to prove the company will run out of cash to fund its growth. That might happen, but not until 2-3 years down the road at the earliest. Before that, we’ll see the comp delta improve.

In the event that cash runs dry the company can follow in the footsteps of Dillards and most recently Loblaw, a Canadian food retailer that is spinning-out 80% its of its property assets and reinvesting the $7bn into its operating business. Yes, JCP would have to pay market rent on this property that is currently largely fully amortized. But again, for the first few years this would not matter. It would have the liquidity for Johnson to evolve the store base according to his plan.

With cash flow from operations YTD down -$655mm and net debt-to-equity at historical highs at 0.67x, the probability of JCP pursuing this option is still low, but increasing on the margin, and most importantly, the optionality is there.  

JCP currently owns approximately 39% of its real estate, or 44.6 million sq. ft. Based on current rent and cap rates, we estimate JCP’s potential REIT value at $1.85Bn-$2.55Bn, or $8.25-$11.50 per share. Since the formation of a REIT provides the greatest benefit for retailers that own a substantial percent of their real estate, we’ve looked at the likely candidates (see chart below).  Both Macy’s (55%) and Nordstrom (46%) own a greater portion of their store base compared to JCP, but even with 39% of its real estate owned, this is an option for Penney’s to consider. 

While forming a REIT is not likely, one thing to keep in mind that Steven Roth is on JCP’s board. While Loblaw’s announcement may have roused speculation in the start of a potential trend, recall that Roth was one of the first to execute such a strategy when he bought Alexander’s out of bankruptcy in 1993 and converted it to a REIT. Roth has “been there and done that” before.

JCP: Reasons To Reconsider Your Short - jcp5


JCP: Reasons To Reconsider Your Short - jcp6


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