“The skin of the bear must not be distributed until the bear has been killed.”
-Sir Winston Churchill
That’s what Churchill said after the Allies invaded Italy at Salerno in late 1943. If you’ve ever thought about trying to skin a bear yourself, locals from my neck of the woods would suggest you make sure it’s dead first too.
Risk management lessons in markets and in life tend to rhyme – if you practice common sense, that is. Some people get all religious about this stuff. Others practice some “technical” form of voodoo. I’m more into Churchillian-style strategic thinking myself.
During WWII, Churchill’s strategy was “to assign a larger importance to opportunism and improvisation, seeking rather to live and conquer in accordance with the unfolding event than to aspire to dominate often by fundamental decisions.” (The Last Lion, page 708)
Back to the Global Macro Grind…
If your risk management strategy is to A) Embrace Uncertainty and B) react to changing probabilities based on time and price, you’ll be satisfied doing a whole lot of nothing sometimes. Waiting and watching is a risk managed choice.
That’s what we did heading into Apple’s (AAPL) earnings event. Since we didn’t have any fundamental “edge” on the quarter, and our risk management signal (Bearish Formation, TAIL RISK $561) said to stay away, any other decision would have been a gamble.
That doesn’t mean today’s reactions to AAPL (down -8%) or Netflix (up +30%) don’t present opportunities. And that’s the point. The great goals in my life have been scored when preparation meets opportunity. Patience is a virtue.
With the SP500 up for 6 consecutive days (up +4.8% YTD and +10.4% from its mid-November 2012 fiscal cliff freak-out closing low), plenty a stock market bear’s bum has been skinned – but has The Bear been killed?
If your answer to that is yes, you and I (and the T Bay locals) need to have a little chat about wild animals.
To review, there are 2 core components to what we do:
- Quantitative Risk Management (Signals, Factoring, etc.)
- Fundamental Research
On both, there are a few chinks in the bull’s growth horns this morning.
- KOSPI (-3.3% correction now from its YTD high) broke TRADE line support of 1985
- CHINA (Shanghai Comp), down -0.8% overnight, broke its immediate-term TRADE line of 2308
- JAPAN (Yen vs USD) failed to overcome 87.71 resistance again and is trading down hard, -1.2%
- Implied volatility in both the Yen and Japanese Equities is rising, fast
- Overbought signals across European Equities are being confirmed by lower immediate-term highs
- CRB Commodities Index failed at its long-term TAIL risk line of 306 (should snap 300 again today)
- Gold failed fast at intermediate-term TREND resistance of $1692
- Oil remains sticky, testing a TAIL duration breakout in both Brent and WTIC
- Copper, immediate-term TRADE overbought at $3.72/lb is making a series of lower long-term highs
- SPX overbought at 1496 and VIX oversold at 12.16 are what they are until they aren’t
- Spain’s unemployment hits a higher-high at 26.02% (#PoliticalClass gets paid before The People)
- Japanese Exports fall another -5.8% y/y in DEC, despite setting their currency on fire!
- France printed a nasty Manufacturing PMI report for JAN, 42.9 (vs 44.9 in DEC)
Of course there are bullish Fundamental Research data points in this morning’s macro grind as well (imagine there wasn’t?). Chinese PMI of 51.9 in JAN was a little better than 51.5 in DEC; Germany’s Manufacturing PMI for JAN came in at 49.8 vs 46 last month, and the US economic data that’s pending (jobless claims today; New Home Sales tomorrow) continues to be bullish.
There’s always bulls and bears somewhere. Our daily service isn’t to be either – it’s to be objective and opportunistic when risk/reward changes (in any market or security) on the margin.
On the margin, was the Russell2000 making a lower-high yesterday a signal or was it noise? How about the US stock market’s breadth (advancers 46% vs decliners 50%) being negative on an up SP500 day? Why was there no volume (down 9% vs my TREND avg)? Channeling my inner-Churchill, inquiring risk management minds should never, ever, ever, give up asking questions.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, USD/YEN, UST 10yr Yield, AAPL, and the SP500 are now $1, $110.23-112.27, $3.65-3.71 $79.79-80.14 (USD bullish, Yen bearish), 80.71-90.41, 1.81-1.87%, $464-506 (Apple = immediate-term TRADE oversold in the post), and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on January 10, 2013 for Hedgeye subscribers.
"He who ate the chick must also eat the rooster, or pay for it."
-Francisco de Almeida, first viceroy of the Portuguese State of India, circa 1508
Dom Francisco de Almeida (1450-1510) was a distinguished Portuguese solider and explorer. Also of noble background as a counselor to King John II of Portugal, he is widely credited with establishing Portuguese hegemony in the India Ocean – paving the way for nearly a century of Portuguese dominance in the Indian Ocean trade.
Before Almeida’s arrival as commander of Portugal’s fourth seaborne voyage to India, the Portuguese Empire had been struggling mightily to establish a stronghold in this globally omnipotent trading hub, failing to cultivate key trading relationships in addition to being denied a meaningful presence at key ports.
The first voyage was commanded by Vasco da Gama (1460-1524), who is credited with captaining the first ships to ever sail directly from Europe to India (1498), rounding the Cape of Good Hope into what was previously believed to be a landlocked Indian Ocean.
Beyond his discovery – which is arguably the most important geographic discovery in the history of globalization – his first voyage was a broad failure, losing roughly half his men and two of his four ships.
The second voyage of eight ships was commanded by Alvarez Cabral, which set sail for India’s port cities in 1500. After an inadvertent detour to the coast of Brazil, Cabral and his depleted crew finally docked in Calicut six months later.
Cabral’s brief stay in the region was highlighted by two violent skirmishes with established parties within the region, which perpetuated more largely unsuccessful trading exploits. He hastily retreated to Lisbon with just five men and one ship.
The third voyage was once again commanded by Vasco da Gama. Setting sail in 1502 with a 15-vessel fleet, da Gama’s primary objective was to uproot the Egyptian power preventing Portugal’s establishment of trading dominance in the region.
To some degree, da Gama found a fair amount of “success” – particularly in combat. His fleet is credited with burning alive 250 men, women and children on a ship, as well as slaughtering 800 fishermen in Calicut. Shortly after his ruthless exploits, he traveled to neighboring Cochin where he defied local wishes and set up a well-forfeited trading factory.
A costly tactical error would have cost the Portuguese all of their progress in India when Cochin was overran by Calicut forces, had it not been for the timely arrival of our “hero” Francisco de Almeida.
Under several years of the viceroy’s leadership, Portugal was able to make solid headway into Indian Ocean trade. His eventual victory over a joint fleet of Gujarat, Egyptian, Calicut, Ottoman, Venetian, and Ragusa forces in the Battle of Diu (1509) cemented Portugal’s dominance within the region and ultimately allowed the empire’s trading and transport strategies to flourish.
It is believed that had Almeida’s son Lourenco de Almeida not been murdered by a joint Gujarat-Egyptian fleet in the First Battle of Chaul, the decisive Portuguese victory mere months later at the Battle of Diu would have eluded the history books. The battle itself was pursued as a personal outlet for Almeida to avenge the death of his son, which is the origin of the highlighted quote above.
Motivated by the pain of a lost child, Almeida’s hasty foray into battle helped the Portuguese Empire finally overcome the headwinds to Portuguese dominance of the world’s most important trading route at the time.
If this colorful story of persistent failures preceding ultimate triumph reminds us of anything, it’s modern-day Japan. Plagued by persistent deflation (10YR average annual CPI = -0.2%) and nonexistent growth (10YR average annual nominal GDP growth = -0.7%), the Japanese economy has long been failing to establish itself as anything remotely resembling vibrant, dynamic or just plain healthy.
If Japan is the modern-day version of the Portuguese Empire – oft seeking, but not finding – then Japanese policymakers have undoubtedly been reincarnated versions of Vasco da Gama and Alvarez Cabral, multiplied many times over.
For over ten years now, Japanese policymakers have implemented a variety of “counter-structural” strategies (i.e. there’s absolutely nothing cyclical about Japan’s economic malaise) designed to overcome deflation and perpetuate nominal GDP growth: perpetual ZIRP, quantitative easing, comprehensive monetary easing, bloated sovereign deficits, etc.
All have failed to deliver the Japanese economy the inflation and nominal growth it has so desperately sought.
Enter recently-elected prime minster Shinzo Abe, who we think has a chance to be Japan’s modern-day version of Francisco de Almeida. Abe, head of the ruling Liberal Democratic Party (LDP), can indeed be said to be motivated by the “blood of a son”.
The LDP has long been the dominant political party in Japan. With the exception of a brief 11-month period between 1993 and 1994, the LDP was in power from 1995 through 2009, when it was flat-out dominated by rival Democratic Party of Japan (DPJ) in the AUG ’09 general election (308 to 119 seats).
On the strength of party leader Shinzo Abe’s pledge to proactively pursue a nominal growth target of +3% and an inflation target of +2%, the LDP was able to take back control of the Lower House to the tune of 294 seats vs. only 57 for the DPJ in the DEC ’12 general election.
Focused intently on the previous failures of Japanese policymakers (particularly the central bank) to deliver the goods, Abe has adopted a very open and aggressive anti-deflation stance in the media. His appointment of Taro Aso as Finance Minster is yet another signal that he is prepared to do what it takes to win Japan’s version of the Battle of Diu.
As outlined in our 12/26 note titled: “JAPAN TO LOOSEN FISCAL POLICY AS WELL”, the following is a list of the strategies we think Abe will purse to emulate Almeida’s success in the 1509 version of the battle – which the latter won by leading off with a massive naval bombardment that was followed up by the larger Portuguese ships pelting enemy vessels from afar with technically-advanced weaponry that was far superior to that of their opponents:
- A +2-3% joint Diet-BOJ INFLATION target (likely at the JAN 21-22 BOJ board meeting);
- A meaningful expansion of public expenditures and “large scale” stimulus package (additional details in the coming weeks);
- A VAT hike delay (discussions to begin in late 2013);
- The LDP wins a majority in the Upper House pending elections late-JUL/early-AUG, paving the way for a full-fledged assault on Japan’s public finances;
- An erosion of BOJ independence, with the BOJ governorship and two deputy governorships eventually assumed by politicized puppets (late-MAR/early-APR); and
- Experimental monetary POLICY – particularly a foreign asset purchase program (likely several weeks after the previous catalyst materializes).
All told, we are of the view that a true phase change in the Japanese economy is definitely underway. While some may still be viewing Abe through the same lens as previous Japanese policymakers, we think it will continue to pay to be short the Japanese yen with respect to the intermediate-term TREND and long-term TAIL.
And while we continue to view incremental monetary Policies To Inflate and expansionary fiscal POLICY as reflationary for Japanese equities and supportive of regional sentiment in the near term, we continue to flag material risk of Japanese currency and sovereign debt crises borne out of those same policies with respect to the long-term TAIL.
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, VIX, and the SP500 are now $1642-1671, $110.28-112.82, $80.26-80.81, $1.29-1.31, 1.84-1.96%, 13.34-16.03, and 1446-1491, respectively.
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Takeaway: Industry sales decelerated for 2 weeks running, driven by weakness in discretionary categories. Does not bode well for department stores.
Here’s an interesting call out with some of today’s Retail Sector data. Specifically, sales decelerated for the second week in a row, and the underlying trends suggest that discount stores are holding steady while department stores continue to decelerate. It's probably too little and too soon to use that as a broad statement about the consumer, but on a day where Coach compounded its company-specific issues with statements about department store promotional activity, the data can definitely not be overlooked. It’s surprising that Macy’s actually traded up on these datapoints today. It remains one of our top short ideas.
1) The Johnson Redbook and ICSC Same Store Sales Indexes, which tracks 70 and 80 general merchandise and apparel retailers, respectively, are both decelerating on the margin.
2) Redbook’s breakout of Discount Stores versus Department Stores suggests that the more discretionary categories are lagging.
3) The spread between spending at Discount Stores versus Department stores remains on a general upswing…
4) …which on the whole is not a bullish statement about the consumer or the economy.
“If you’re going through hell, keep going” – Sir Winston Churchill
It’s been a long, downward spiral for IGT and its gaming ops business – a five year peak to trough slide of 24% in revenues. Ouch. While we’re not sure that that road has turned north, IGT does seem to be making the best of the situation. We could even go so far as to say that there is actually some definitive positives in the business. Market share in gaming ops has held steady for 2 years and the continued trend of right-sizing capital expenditures has contributed to growing operating cash flow in the segment.
IGT’s gaming operations revenues have declined in 17 of the last 19 quarters and in the 2 that were positive, the YoY increase was less than 1%. Gaming operations gross margin dollars have similarly seen declines in 15 of the last 20 quarters. Given this backdrop, we are encouraged to see IGT investing less money to produce these lackluster results. Gaming operations capital expenditures have seen 9 consecutive quarters of decline.
The bear may say that lower capex spending portends even worse results going forward. However, based on our rigorous statistical analysis, we have found a surprisingly small and statistically insignificant relationship between gaming operations spend and revenues. The fact is, IGT has been able to reduce the cost of maintaining its existing footprint. Maintenance declines are driven by:
- Game performance - The longer the games perform well, the lower the need is to refresh them
- Cost of a refresh
- It’s become a lot cheaper over the years to refresh titles (just a conversion kit and signage)
- The ability to efficiently refurbish and deploy older boxes
The chart below illustrates that as a result of right-sizing their capital expenditures, IGT has been able to grow their cash flow from gaming operations and increase the productivity of their install base despite the pressure on revenues.
IGT’s gaming ops performance has been a focus of investors, especially the bears. However, despite the strong headwinds, IGT has grown EPS YoY 6 out of the last 8 quarters, with 27% growth over the past 4 quarters. For fiscal 2013, we’re projecting 26% growth. The second leg of our positive thesis is IGT’s ability to generate strong cash flow and distribute that cash to shareholders. As evidenced by the chart above, IGT has been very successful turning a declining top line business into a growing cash flow generator. With the stock trading at just 11x, these factors should continue to move the stock higher as 2013 unfolds.