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Commodity Gap

“Icy with anger, warm with satisfaction, sharp with concern”

-Emmet Hughes


Allegedly, that’s how President Eisenhower reacted to Russian intelligence briefings in July of 1956. While he didn’t sign off on the depth of the American U2 spy plane mission to begin with, “the President’s skepticism (about Russia) had been confirmed by just five days of aerial reconnaissance. The Bomber Gap was a myth.” (Ike’s Bluff, pg 215) The Russians didn’t have anything real.


Like the “missile gap” concerns that came thereafter, the Bomber Gap was part of the political fear-mongering that kept the American People on edge, building home bunkers, and buying canned foods – essentially preparing to be attacked. But freaking people out with a false story that’s based on logical premise isn’t new in this country. That’s how the #PoliticalClass gets paid.


Ultimately, knowing the truth (but keeping it to himself) became Dwight Eisenhower’s advantage in a world that was perpetually on the brink of war. When I see the emerging advantages of sequestration (Strong Dollar born out of fiscal spending sobriety), but hear politicians trying to scare people (when they should just get out of the way), I think about leadership. I also think about Ike.


Back to the Global Macro Grind


Does President Obama get what a Strong Dollar does for the US Economy? Did George Bush? Nixon and Carter didn’t. Reagan and Clinton did. A pervasively Strong Dollar gave the US Down Oil prices in the two most impressive growth decades since Eisenhower.


Last week, the US Dollar Index was up another full +1%. That was the 4th consecutive up week for the US Dollar. At the same time (and not ironically), Commodities (19 component CRB Index) were down for the 4th straight week. Commodity Deflation has been absolute (CRB Index -4.9% in 4 weeks), and now prices are finally scaring expectations.


To expect or not to expect Commodity Inflation, remains the question. Let’s look at last week’s CFTC futures and options net long positioning (hedge funds speculating on money printing, Bernanke Policies to Inflate, etc.) for some clues:


  1. The net long position in all of commodities collapsed another -16% last wk to 447,106 contracts
  2. Oil’s net long position dropped another -16% wk-over-wk to 175,211 contracts
  3. Farm Goods (think food) net long position crashed (again) another -24% to 145,564 contracts


Oh yeah, baby. Strong Dollar – we people who put gas in car, and food in mouth – we love you long time. But what, in this manic market, is a long time?


  1. March 2009? Yep. This is the lowest speculative net long position in CFTC contracts (commodity inflation) since 2009
  2. Corn contracts (down -20% last wk) are perpetuating the lowest food inflation expectations since, again, March 2009


For those of you still long the consumption related assets you bought after the March 2009 lows (we bought Starbucks, SBUX, at $11.52 in April of 2009, and still have it on #RealTimeAlerts; not a typo!), you are probably quite happy.


Freaking-out about the Commodity Gap now isn’t much different than freaking out about it then. I remember then almost like it was yesterday. People were pinging me with live quotes of “Dr. Copper crashing” saying the world was going to end. It didn’t. People who were long of Copper did.


Since the #PoliticalClass always asks for “solutions.” Why not try something no US President (under their Keynesian Economics regimes) has tried since the 1990s.  Why doesn’t the President of the United States hold a press conference today saying something like:


“Today, folks, is a great day in America. We finally cut spending and we are about to get this Bernanke character out the way on your savings accounts. Your currency is strengthening and your purchasing power is being restored. God Bless a free-market America.”


Anyone think that might happen? Bueller? Or does he really get this (and he’s just keeping it to himself)?

In the meantime, all I can tell you is this:


  1. WTIC Oil prices snapped our TREND line of $93.41/barrel support last week (-7% in the last month)
  2. Russian Stocks (which trade off oil expectations) snapped TREND of 1566 on the RTSI (-8% in the last month)
  3. Our immediate-term TRADE correlation between WTIC Oil and the US Dollar is now -0.99!


Enough of the #ClassWarfare speeches already. Mr. President, if you really want to help people who drive to work every day, tell the truth about Strong Dollar (+4% in the last month) and all its benefits as a real-time Tax Cut! Long live the Commodity Gap (down).


Our immediate-term Risk Ranges for Gold, Oil (WTIC), Copper, US Dollar, USD/YEN, UST10yr Yield, VIX, Russell2000, and the SP500 are now $1, $89.72-92.93, $3.48-3.57, $81.44-82.65, 91.85-94.68, 1.81-1.94%, 11.96-17.18, 901-930, and 1, respectively.


Best of luck out there this week,



Keith R. McCullough
Chief Executive Officer


Commodity Gap - Chart of the Day


Commodity Gap - Virtual Portfolio

A Look Back at the Month in Consumer Staples

February saw 4/7 sectors in our universe outperform the broader market (non-alcoholic beverages just underperformed the S&P 500 during the month).  Tobacco lagged on regulatory concerns and the protein sector suffered when TSN suggested that trends in the current quarter were weaker than originally anticipated.


A Look Back at the Month in Consumer Staples - Sector performance YTD


This month we added something new - we took a look at the sector’s performance by P/E quartile – unsurprisingly, the 3rd quartile (P/E ratios between 16-20.7xs) had the strongest monthly performance (HNZ was in this quartile).  The HNZ transaction drove multiples broadly higher in large cap staples name, several of which traded in the same P/E range – CL, CLX, PEP.  MDLZ was the weakest performer during the month and the only negative performance within that P/E quartile.


A Look Back at the Month in Consumer Staples - Monthly PE by Quartile


Similarly, within the 2nd P/E quartile (P/E ratios between 13.3 and 16.0x), HNZ appeared to have been the primary driver of monthly performance – CPB was the best performer in that quartile (+12.1%).  The quartile’s performance also benefitted from KMB (+5.3%) and GIS (+10.3%).


The 1st P/E quartile (P/E ratios less than 13.3xs) was all about STZ (+36.7%) – the quartile would have been up 1.7% but for STZ.  A second of our preferred names, (STZ, at the time, being the first) ADM, was a significant contributor to the quartile’s performance, +12.4% on the month.


Higher multiple names in the sector had a good month was well, with SAM (+10.8%) and BNNY (+17.0%) the best performers.  Multiples expanded across all quartiles as prices continued to move higher and estimates for 2013 were lower to unchanged coming out of Q4 earnings season for most sectors (protein being the notable exception).


A Look Back at the Month in Consumer Staples - Beginning End of Month PE by Quartile


A Look Back at the Month in Consumer Staples - EPS Revision Chart


Consistent with a broad-based rally in the consumer staples sector, there hasn't been a significant divergence between high and low beta names.  If anything, lower beta names have outperformed in the wake of the HNZ acquisition, likely setting the stage for some mean reversion in lower beta names as the takeout speculation wanes.


A Look Back at the Month in Consumer Staples - Beta Chase 3.3.13


This is a familiar chart for those of you who have been following our work - it is also the chart that keeps us broadly cautious across the sector.


A Look Back at the Month in Consumer Staples - Staples Forward PE 3.3.13 


The anomalous relationship between the XLP and the 10 year that has existed since 2009 persists...


A Look Back at the Month in Consumer Staples - XLP vs. 10 year 3.3.13


...despite the fact that the yield of the XLP has become marginally less attractive (combination of the yield on the 10 year creeping up and the price performance of the XLP).


A Look Back at the Month in Consumer Staples - Yield spread


Some clients have suggested to us that the move up in the group post-HNZ has been short-covering - the data doesn't appear to bear that out.


A Look Back at the Month in Consumer Staples - Short Interest February


Finally, our "XLP vs. Economic Surprise" chart suggests that continued strength in the economic surprise index could signal a pause for the staples sector.


A Look Back at the Month in Consumer Staples - XLP and Economic Surprises 3.3.13


Where does that leave us?


We are going to focus on three charts - overall sector valuation, "beta chase" and economic surprise.  These suggest to us that we could see a pause in the staples sector as sentiment surrounding the broader economy improves, valuation becomes more relevant and takeover speculation recedes.  We would look for relative underperformance in the lower quality, lower beta names that have seen a move up in the wake of HNZ (TAP, GIS, CPB).  Our most/least preferred list remains relatively unchanged:


Most preferred

  1. ADM - play on upcoming crop year (BG should work as well)
  2. BUD - least expensive large cap staples name (replaces STZ on our preferred list due to unfavorable risk/reward)
  3. CAG - valuation remains compelling, estimates remain too low
  4. NWL - valuation + stealth housing play

Least preferred


  1. KMB - robust valuation plus deteriorating earnings quality (CL works here as well)
  2. TAP - valuation support but zero business momentum
  3. GIS - run up post-HNZ is unwarranted (CPB eventually, but not yet).

Call with questions,



Robert  Campagnino

Managing Director





Matt Hedrick

Senior Analyst 



Early Look

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Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.


The Economic Data calendar for the week of the 4th of March through the 8th of March is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.



Pensions: The Funding Pit & The Pendulum

Takeaway: Pensions are in dire need of proper reform. Time will tell if America's pension systems can fix themselves before a massive crisis erupts.

Hedgeye’s Industrials Sector Head Jay Van Sciver hosted an expert call yesterday with David R. Godofsky, head of the employee benefits practice at the law firm of Alston & Bird.  A Fellow of the Society of Actuaries, Mr. Godofsky has decades of experience in all areas of corporate benefits and compensation.  His talk yesterday was titled “Pension Funding and Accounting: The Pension Pendulum.” 


Mr. Godofsky’s analysis demonstrates how the nation’s pension plans have been yanked back and forth as Congress repeatedly tries to fix what is wrong with pension funding requirements – then rushes to fix what they got wrong the last time.  Companies struggle to keep their balance while adjusting their pension funding practices to conform to the latest changes.

The Employee Retirement Income Security Act (ERISA) took effect in 1976, creating federal funding requirements and government insurance for private sector pensions.  This first swing of the pendulum set funding requirements, giving companies 30 years to meet unfunded liabilities and setting rates for contributions.


ERISA was put under IRS jurisdiction, and the agency pressed companies not to fund their plans quickly, in order to maintain tax revenues.  The convergence of a long time horizon, unrealistically low funding requirements, and IRS pressure to keep contributions low, led to low balances backing very large pension liabilities.  


This was compounded by moral hazard with the introduction of federal pension insurance.  Even today there is very little restriction on what companies can promise in terms of pension benefits – and federal insurance is on the hook.  Godofsky says the vast majority of insurance claims come from collectively bargained plans, where both management and the union know the government will backstop whatever they agree to.


After ERISA was in place, Congress introduced funding caps and a 50% excise tax on withdrawals from overfunded plans, and Congress has kept the pendulum swinging ever since.  Successive new rules keep trying to strike a balance between beefing up contributions to protect employees, and avoiding excessive corporate tax deductions. 


One change, adopted in 1987, was to use actual bond rates as the investment return assumption.  Companies realized they could issue their own bonds at rates below the assumed rate of return.  They used the proceeds to buy stock in the pension plans, and booked the difference in interest rate payments as a profit.  Through the “magic” of this paradigm, companies could consider their pensions fully funded when there was actually a significant asset shortfall.


So Congress changed the assumptions again, requiring contributions to be calculated on the assumption that all investment assets are equivalent.  Except, as Godofsky points out, they are only equivalent today.  Their values will diverge in 30 years.  Or in ten years.  Or by tomorrow.  Companies could no longer create assets using borrowed cash.


Even though funding assumptions were now based on bond rates, between 40%-60% of all pension money is invested in stocks, which did what they were supposed to do: outperform bonds.  This created a large number of overfunded plans.  The companies can’t just withdraw the excess, because of the 50% tax hit.  But they can get creative.  


Some companies deal with excess pension assets by offering extra pension payments in lieu of current compensation.  Or a company with an overfunded pension can sell a division to a company with an underfunded plan.  The buyer also takes on a piece of the seller’s excess funding, paying for it in an inflated purchase price for the operating unit.  There are also legal ways to give special pension bonuses to a select group of senior management employees without having to grant equal treatment to others.


The bottom line, says Godofsky, is that the 50% excise tax is never actually paid, and these measures also reduce payroll and other tax revenues.  And all this still doesn’t prevent companies going out of business and defaulting on plans, increasing the burden on an already distressed pension insurance program.


Congress whipped the pendulum back the other way with the 2006 Pension Protection Act which exacerbates economic cycles by requiring companies to maintain funding levels.  Companies are forced to pump cash into plans in down markets, taking away resources they could use for business expansion or job creation.


What’s The Next Swing?

Godofsky believes funding assumptions will continue to be a source of tension.  Accountants believe pensions should invest in fixed income, because pension liabilities look like fixed income.  Meanwhile, pension managers will continue to be about 50% in equities, because portfolio theory says stocks outperform bonds over the long term.  This tension is not likely to be resolved.


Godofsky sees crises brewing in multi-employer plans, and in public sector plans, especially at the municipal level.  

One thing that appears certain is that Congress will continue to meddle.  It’s what they’re good at.  As Godofsky’s Rule states: the pendulum never stops in the middle. 


BKW remains a short in the Hedgeye Restaurants Position monitory.


Two areas continue to concern us within the Burger King business:

  1. Same-restaurant sales trends
  2. The remodel program


Same-Restaurant Sales


The bullish thesis hinges on 2012 same-restaurant sales demonstrating that the strategies BKW has been pursuing are effective.  We disagree.   A slowdown in early 2013, that we believe is underway at BKW, will shake the prevalent belief that the Burger King turnaround is a done deal.



  • Challenging competitive environment, esp with MCD spending on marketing
  • Weather comparisons
  • Payroll tax hike
  • Gas prices
  • Tough comparisons
  • Brand association with horsemeat scandal

Carrols Restaurant Group (TAST), a franchisee of Burger King and is seeing February SRS tracking -4% to -5%, including average check of 3-4%, implying traffic down between 7% and 9%.  TAST management is still guiding to a 2-4% comp for FY13.  We do not expect this guidance to be achieved.



Remodel Program


Longer-term, we are skeptical that management’s goal of having 40% of the system remodeled over the next three years will be met.  The current sales lift from remodeled stores within the Carrols system is running at 8-10%, below what BKW has guided to: 10-20%. This disappointing sales lift should increase skepticism in the long-term viability of the remodel program.


Don’t take our word for it, Carrols management said the following:  “We would hope to remodel at an aggressive pace, but recognize that we may need to temper this, based on how the year progresses.”



Howard Penney

Managing Director


Rory Green

Senior Analyst

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