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Chart Of The Week: The Green Monster

That's what this chart is - it's GREEN, and for a someone short selling US Equities into it, it's a MONSTER...

 

Most economists and strategists will have a very hard time convincing me or, more importantly, Mr. Market, that a steepening yield curve isn't a very bullish signal for Equities. Below (see chart) we express this steepening by showing the spread between 10 and 2-year US Treasuries.

 

One of the main reasons why I was running 70-96% cash levels in my Asset Allocation Model in September/October of 2008 was that this spread was compressing. In both December and March/April, you have seen me drop my average position in US Cash down to the 45-65% range, primarily because, on the margin, I have seen this relationship for what it is - a bullish leading indicator.

 

The best question you can ask me from here is why can't this curve begin to flatten again? It definitely could, and I'd argue that a compression of this spread + the strengthening of the US Dollar, were the two governing factors behind the US stock market selloff that we saw in February. The problem with that pattern (for the Depressionistas at least) is that it has not repeated itself here in April.

 

So the point is, beware of the Green Monster - because it can inflict pain on both bulls and bears, depending on its directional move. This morning, despite the manic media's Swine Stress, the yield curve was steepening further. It is now +203 basis points wide, and US Equities have moved to green on the day.
KM

 

Keith R. McCullough
Chief Executive Officer

 

Chart Of The Week: The Green Monster - GM


Oil Inventory At An Almost 20-Year High, But Does It Matter?

Research Edge Postion: Long XLE; Long USO

 

 We had an interesting conversation with a prospective client on Friday.  He has been managing a global macro fund since the early 1990s, has CAGRed 18% in that time period with only one down year (down single digits), and currently manages in the billions.  To say that this gentleman knows what he is doing is, obviously, an understatement.  The one comment he made to us, which we found particularly interesting, was that he thinks he is the only commodity bear left. 

 

In the year-to-date, it has been challenging to be bearish of most commodity classes.  We use price as a primary factor in our models and, admittedly, that discipline has helped us have a positive return in commodities this year, despite clearly negative short to intermediate term fundamentals in many commodity classes.  In particular, oil, at least from a domestic perspective, has flashed consistently bearish fundamentals this year.

 

Specifically, inventory has been piling up in the U.S. This point was highlighted in a Bloomberg news article from Thursday of last week which was entitled, "Oil Rises Fourth Day as Stocks, Dollar Outweigh Demand Concern."  The article went on to highlight that oil inventory in the U.S., as measured by the Department of Energy, had hit the highest level since 1990. 

 

This increase in inventory year-to-date has had a seemingly minimal impact on the price of oil.  We have attached two charts to this point. The first chart highlights a much more interesting point, which is that on a month-over-month basis there has been little correlation between inventory building and the direction of the price of oil over the last three years.  In fact, over the last three years we calculated this correlation at ~0.20.   The second chart highlights the current inventory build, which is at a 19 year high in raw inventories and days of supply.

 

Over time, we would presume that fundamentals will and do matter. That being said, the lesson of the last three years is that looking at supply data from the U.S. is literally irrelevant in trying to predict the direction of the price of oil in the short term.   Recent history is clearly indicating to us that oil is being supported by drivers other than physical supply and demand data from the U.S.  Clearly, a large portion of the driver is financial demand, which may move price, but not have a direct impact on the actually physical supply.  Therefore, incorporating a view of increasing financial demand may be as relevant as having updated physical supply / demand models for oil.

 

We are going to touch more on this in coming notes, but as a frame of reference I wanted to attach an excerpt from Michael Masters' May 20th, 2008 testimony to Congress, which discussed the burgeoning and irrational demand in the financial markets for oil.  No surprise this testimony and congress' rhetoric coincided with the top of the oil market in 2008, but the actual thesis is still relevant today.

 

"Commodities prices have increased more in the aggregate over the last five years than
at any other time in U.S. history. We have seen commodity price spikes occur in the
past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today,
unlike previous episodes, supply is ample: there are no lines at the gas pump and there
is plenty of food on the shelves.

 

If supply is adequate - as has been shown by others who have testified before this
committee - and prices are still rising, then demand must be increasing. But how do
you explain a continuing increase in demand when commodity prices have doubled or
tripled in the last 5 years?

 

What we are experiencing is a demand shock coming from a new category of
participant in the commodities futures markets: Institutional Investors. Specifically,
these are Corporate and Government Pension Funds, Sovereign Wealth Funds,
University Endowments and other Institutional Investors. Collectively, these investors
now account on average for a larger share of outstanding commodities futures contracts
than any other market participant.

 

These parties, who I call Index Speculators, allocate a portion of their portfolios to
"investments" in the commodities futures market, and behave very differently from the
traditional speculators that have always existed in this marketplace. I refer to them as
"Index" Speculators because of their investing strategy: they distribute their allocation of
dollars across the 25 key commodities futures according to the popular indices - the
Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG
Commodity Index."

 

Whether we agree totality with Masters is not the point, but rather the point is to highlight that it is important to not overweight physical supply data points given the financial demand backdrop outlined above.  While oil is down this morning ~5%, the fact that many commodity related stock markets around the globe are up year-to-date, Canada, Saudi Arabia, and Russia as examples, continues to signal to us that there is more risk to being a bear on oil at its current price.

 

Daryl G. Jones
Managing Director


 

Oil Inventory At An Almost 20-Year High, But Does It Matter? - ol1

 

Oil Inventory At An Almost 20-Year High, But Does It Matter? - ol2


Restaurants - The DARK SIDE of the earnings season

Select restaurant companies have crushed the Q1 recession educed estimates and raised guidance from the Armageddon forecast given last December!  Now we need to keep in mind that business is still soft!

 


Restaurant industry valuations are significantly higher in a very short period of time.  Looking at EV/EBITDA valuations across the restaurant landscape, it would appear that some companies may even be factoring in “growth” again! Right now the average casual dining chain is trading at 6.4x EV/EBITDA.  We may have hit a 4 handle in December 2008.

 

With another big week left in the earnings season, I don’t want to fight the tape yet, but this is what I don’t get!  This week we saw massive run ups on cost reductions and “less bad” sales trend.  That is all good!

 

The upside to the “Great recession” is lower commodity prices and less labor pressure.  Believe me, the restaurant industry needs the help but margins will only improve so much in a declining sales environment.  I guess you just lay off everyone but the servers and a cook to keep it going... we need the top line to come back!    

 

The dark side to the massive cost reductions implies zero (or little) growth!  If this is the case going forward, and then company XYZ earns a buck, then another buck next year and a buck after that – you get the picture.   Why does that make a stock go up?  I guess we want to pay more and more for the same dollar?

 

The easy answer is a massive short squeeze on the “stabilization cut the fat” trend – things are bad, but not getting any worse cover the short!  

 

If this is true, then should we expect a big fade?  Usually the advice is to sell restaurants stocks in the spring.  I don’t think this is a bad idea. 

 

Let’s take CAKE for example.  The stock is up 259% from its 52 week low and 76% year-to-date.  On Friday the stock was on up 19% on a “stabilization cut the fat quarter.”  After CAKE reported earnings on February 12, the stock traded as low as $7 and was trading at 4.8x EV/EBITDA.  Today the stock is $18 trading at 9.1X EV/EBITDA.  Remember in 2008 Bain paid roughly 9.5x for Outback Steakhouse in a booming economy!   That was a peak!

 


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Swine Stress

"Fear grows in darkness; if you think there's a bogeyman around, turn on the light."
-Dorothy Thompson
 
In 1939, Dorothy Thompson was called one of the two most influential women in the United States. Eleanor Roosevelt was the other - Thompson was a journalist, and had a proactive and objective research process that remains a far cry from what you see in the manic media today.
 
Much like the houses in American "foreclosure" that the housing bears perpetually moan about and/or the suggestion that one cannot be long China "because they make up the numbers", what you cannot see, is what seems to suck in the short selling community the most. "Fear grows in darkness", indeed...
 
This morning's swine flu "news" will move to where the manic media brings it. On Friday, I titled the Early Look "Glaring Groupthink", and today's US market open will reflect the clear and present danger of that. Some people who are scared of their own performance, should be ... and they'll be the first to be running for the exits.
 
Bertrand Russell said that "collective fear stimulates herd instinct, and tends to produce ferocity toward those who are not regarded as members of the herd." I am certain that the short sellers of everything US Financial Stress Test will be calling me names for NOT agreeing with everyone on CNBC that's telling them that its now the Swine Stress that is going to do us all in for good. Afterall, what else is a short seller of higher lows to do? I guess, just make something up and/or focus on something new...
 
Is swine flu bad? Of course it is... but is it worse than the expectations the media will create? Can the Swine Test end the mother of all US stock market short squeezes? Could it be that the iggy piggy bankers from Merrill are relieved, metaphorically, by the over 2 billion hogs that graze this earth's mud? Ah, shifting the focus away from the human pigs... wouldn't that be a story book ending to a narrative fallacy that continues to have the most inconvenient of truths.
 
The New Reality is that, "With the economy still weak, inflation stubbornly high and valuations no longer so favorable, we do not see further catalysts for upside in the market"... oh wait, that's not America's New Reality - that's UBS's reasoning for downgrading Mexico from their "Top Pick" to "Underweight" this morning...
 
You have to be kidding me right? In a world where even Russia is up +30% for 2009 to-date, the fine folks over at the Swiss Bank that's seeing more money run out their high net wealth barn than Elmer Fudd chasing his pigs had Mexico as their TOP PICK! Better get that recommendation off the sheets boys... and fast! Cuomo cometh!
 
Given their own aforementioned reasoning, the objective mind has to wonder why in God's good name that UBS would be allowed to call this a "Top Pick." Swine in reckless recommendation is probably what you should be really worried about this morning folks - we're playing with live ammo here...
 
But enough about Wall Street's pigs, back to what to do with your money this morning. As we approached my upside SP500 target intraday on Friday, I proactively managed risk and sold down 5% of my US equity exposure. I tend to get a lot of questions about why I am not more invested these days, and while I tend to get those questions after market up moves rather than on down ones, I think those questions are very much fair. My personal reality is that I want to have a positive absolute return for both the 2008 and 2009 investment seasons, so I am ultra conservative with where I invest my cash, and more importantly, when.
 
Understanding that the "when" is where the Street tends to struggle the most, we all know how that narrative fallacy has been built up over the years - the pundits have been potty trained to tell America at large that market timing is impossible.
 
Timing the Swine Stress may be impossible, but understanding the daily risk/reward in the US market place is not. Every morning I wake up to new risks. Every morning I have to re-adjust my positioning for those risks. I may be not always be really right, but in using this proactive investment process I am rarely really wrong.
 
Being really wrong would be running max long exposure to US Equities for this morning's open or on last Tuesday for that matter. Remember that -4.3% bombing out of your book from 4/21? I'll assure you that some of the Depressionista short sellers do - if they pressed those lows, they were also really wrong. My call this morning is that pressing the Swine Stress lows will ultimately result in the same inconvenient outcome.
 
Fully loaded with the pigs, hogs, and swine from Mexico to Bank of America's Board room, this morning my risk/reward setup for the SP500 is as follows: Downside Risk -4% to 829, and Upside Reward +1% to 876. There is an important immediate term momentum line at 852 that will govern how expeditious Glaring Groupthink gets washed into expectations, so if you're looking for line to manage your risk around this morning, use that one.
 
Otherwise, best of luck out there today, and "if you think there's a bogeyman around" out there on a CNBC market open, just "turn on the light."
KM
 

LONG ETFS

XLK - SPDR Technology - Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last six+ weeks.   As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (and the game changing ORCL-JAVA deal). The other big near-term factors to watch will be 1Q09 earnings - which is typically the toughest for tech, along with 2Q09 guide.  There are also preliminary signs that technology spending could be an early beneficiary of the stimulus plan.

EWG - iShares Germany-We bullish German fundamentals, especially as a hedge against financially levered and poorly managed Switzerland. While the automotive industry is ailing, the strength of Germany's labor unions will preserve jobs and maintain a slower rate of sequential acceleration in unemployment. Compared to most of Western Europe, Germany has a positive trade balance and will benefit from Chinese demand, especially if the Euro can stay below $1.32. The ZEW index of investor and analyst expectations for economic activity within six months rose to +13 in April from -3.5 in March, the highest reading since June 2007. We're bullish on Chancellor Merkel's proposed Bad bank plan to clear toxic bank assets and believe the country will benefit from a likely ECB rate cut next month.  

EWZ - iShares Brazil- Brazil continues to look positive on a TREND basis. President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. The Central Bank cut 150bps to 11.25% on 3/11 and likely will cut another 100bps when it next meets on April 29th. Brazil is a major producer of commodities. We believe the country's profile matches up well with our re-flation theme: as the USD breaks down global equities and commodity prices will inflate.

EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months.  With interest rates at 3.00% (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.

TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

USO - Oil Fund-We bought more oil on 4/20 after a 9% intraday downward move. We are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.  

DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold. 

GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.

DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.


SHORT ETFS
 
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- 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.

EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials.  Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.

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 down versus the USD at $1.3150. The USD is down versus the Yen at 96.6000 and up versus the Pound at $1.4558 as of 6am today.

EWJ - iShares Japan -We re-shorted the Japanese equity market via EWJ on 4/22. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-the government cut its forecast for the fiscal year to decline 3.3%, and we see no catalyst for growth to return this year. We believe the BOJ's program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".

XLP - SPDR Consumer Staples- Consumer Staples greatly underperformed the market on 4/24. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.


SWINE FLU: TRADE AND/OR TREND?

I'm not a doctor, nor do I play one on TV, but this swine flu has got me worried.  Remember the Avian Flu?  At the very least, the disease runs a fairly isolated course and the hysteria has already peaked.  At worst, the world has a big problem.  The degree and duration of the uncertainty will ultimately decide what impact this outbreak could have on leisure stocks; it is too early to tell whether a negative trade and/or trend will result.

 

Even under the optimistic scenario, leisure stocks are likely going lower for more than just today.  The Health Commissioner for the EU urged Europeans to forgo travel to the US and Mexico.  Travel will take a big hit.  For traders, it's difficult to make the case that anything leisure related should be owned at this point, especially given the huge two month run we've had in the space.

 

The following sectors within Leisure could be affected:

  • Cruise lines: The thought of being stuck on a ship in close proximity with thousands of other people is likely to strike fear into would-be cruisers. Considering the history of contagious pathogens such as the Norwalk Virus, E. Coli, and Entamoeba Histolytica infiltrating cruise ships, this sector could be the hardest hit.

 

  • Major market gaming: Las Vegas/Macau = lots of people who don't have to be there. One breakout at a hotel casino and that's all she wrote.

 

  • Lodging: Hotels rely on travel. We all know airplanes are flying Petri dishes. At least some travel is necessary (business, family, etc.), but much is leisure related. Even at today's depressed occupancies, there are still too many people at one location for comfort in a flu outbreak.

 

  • Regional gaming - Few people fly to regional gaming destinations but there is still a large, concentrated number of people in a casino at any given time.

US Market Performance: Week Ended 4/24/09

 

Index Performance:

Week Ended 4/24/09: DJ (0.7%), SP500 (0.4%), Nasdaq +1.3%, Russell2000 (0.1%)

April and Q209 To-Date: DJ +6.1%, SP500 +8.6%, Nasdaq +10.8%, Russell2000 +13.2%

2009 Year-To-Date: DJ (8.0%), SP500 (4.1%), Nasdaq +7.4%, Russell2000 (4.2%)

 

 Keith R. McCullough

Chief Executive Officer


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