This note was originally published at 8am on June 26, 2013 for Hedgeye subscribers.
“Nothing is certain but the unforeseen.”
No stranger to intellectual debate, British author James Anthony Froude (1818-1894) was well-known for stirring the pot – perhaps even more so than @HedgeyeDJ (Daryl Jones, our no-holds-barred DoR) and @HedgeyeENERGY (Kevin Kaiser, our oft-controversial senior energy analyst).
Froude’s generally polemic works were often met with fierce debate and rejection among the British intellectual elite – perhaps none more so than his seminal work The Nemesis of Faith (1849), which was carefully crafted to call into question blind acceptance of the popular Christian doctrine of the time. Widespread public backlash in response to the novel ultimately cost Froude his fellowship at Oxford University.
Eventually Froude’s avoidance of institutionalized groupthink won out. Froude and his wildly contentious ideas ultimately found a permanent home when he was appointed Regius Professor of Modern History at Oxford (i.e. a really big deal) in 1892 – the very institution he was driven away from nearly a half-century prior. During his regrettably brief stint at Oxford (he died in 1894), Froude quickly earned a reputation for being among the most popular lecturers of his time.
If nothing else, Froude’s journey from the top to the bottom and back again is a lesson for analysts young and old to avoid the safety and comfort of groupthink. Never is this advice more important than when a time-tested, comprehensive and repeatable research process leads one to hold a counter-consensus view. Hold the LINE [short], Kaiser!
Back to the Global Macro Grind…
Incorporating another one of Froude’s lessons, we call attention to the aforementioned quote in the context of China’s banking system woes – which, thanks to the recent spate of legacy media coverage, are now as obviously present as a 6’3”, 325lb left tackle in one of Froude’s 19th century lectures.
Specifically, anyone even tangentially following recent press will arrive at the conclusion that a growing consensus among analysts across both the buy and sell sides believes with a fair amount of certainty that China’s credit binge and alleged housing bubble are sure to cause a Western-style financial crisis.
We aren’t so sure. With less than 2% of all financial assets held by foreigners, strict capital controls have, thus far, prevented a mass exodus of liquidity through the capital account. Domestically speaking, the PBoC’s own words from yesterday should douse any hopes of a crisis:
“Financial institutions’ cash reserves stood at about 1.5 trillion yuan ($244 billion) as of June 21, compared with the 600 billion yuan or 700 billion yuan sufficient under normal circumstances to cover payment and clearing needs. The present liquidity is not insufficient.”
Indeed, by comparing China’s present-day banking woes to the early tremors of Bears Sterns or juxtaposing China’s property market – rife with “ghost cities” – with our own pre-crisis froth, consensus has undeniably fallen victim to the availability heuristic. We don’t think that’s a prudent call to make at the current juncture; the Chinese sovereign has the resources, political will and mobility to prevent any Western-style financial crisis.
We’ve become a broken record on this, but it’s critical to remember that China’s present day economic woes are actually a function of very deliberate macroprudential policies. While highly unlikely, at any given time, Chinese officials can reverse course and keep the credit bubble inflating longer than any of us short-sellers can remain solvent.
On the contrary [to consensus], we think the outlook for China’s banking sector is likely to resemble that of a slow bleed, rather than sudden cardiac death. We’ve published a ton of work recently backing our conclusions with detailed analyses, but for those of you who weren’t able to tune in until now, we’ll take this opportunity to rehash our views:
Please email us if you’re interested in reviewing the full compendium presentation materials and research notes backing these conclusions, and we’ll get them right over to you. We also have a list of ancillary securities and asset classes to underweight/sell/short if you’re interested in those as well.
At any rate, we urge you to embrace the uncertainty of this situation by running full speed away from anyone who tells you they know how this all ends.
In fact, the only certainly anyone can promise you regarding these risks is that the outcome is presently unforeseen and, quite possibly, hidden deep within the “shadows” of China’s financial sector.
Our immediate-term TRADE Risk Ranges are now (TREND bullish or bearish in brackets):
UST 10yr Yield 2.35-2.69% (bullish)
SPX 1560-1614 (bearish)
DAX 7619-8108 (bearish)
Nikkei 12,406-13,449 (bearish)
VIX 16.59-20.98 (bullish)
USD 82.21-83.39 (bullish)
Euro 1.30-1.32 (neutral)
Yen 96.25-99.17 (bearish)
Oil 99.18-103.39 (bearish)
NatGas 3.64-3.82 (bearish)
Gold 1226-1324 (bearish)
Copper 2.98-3.12 (bearish)
Keep your head on a swivel,
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“The one who engages in conversation should not debar others from participating in it.”
That’s one of the many quotes from Stephen Greenblatt’s The Swerve (page 70) that gets the juices flowing. Whether you’re tapping into the minds of the early Greeks (Epicurus = 341-270 BCE) or the arena of debate in the Roman Republic (Cicero = 106-43 BCE), it’s all there.
If you work within an investment culture that demands both constant questioning and collaboration, it’s all there too. Is there any other way to find the truth? Those who put their political pride over the market’s truths have never made good Portfolio Managers, fyi.
Sadly, politicians have provided the Fed, ECB, and BOJ closed forums where un-elected bureaucrats call the shots. While that may have been normal in Stalin’s Russia, it’s not in the area code of what America’s Founding Fathers envisioned. Who really cares about today’s Fed “minutes”? Until the Fed opens itself up to the Dalios and Druckenmillers of the world, they’re not even having a conversation.
Back to the Global Macro Grind…
China’s economic data was horrendous overnight. So let’s not talk about the implications of Asian #GrowthSlowing, copper demand collapsing, mining capex bubbles, etc. Let’s start begging for a Bernanke-style bailout for the Chinese economy!
Yeah baby, that’ll do it – look at how well things turned out for every other Asian government that levered itself up since the Ming dynasty. I am hearing the Chinese are really into the whole Krugmanomics idea of turning China’s balance sheet into Japan’s too. Shhh.
To be crystal clear on this, we do not think China will “stimulate” you. Here are Darius Dale’s Top 3 reasons why:
1. Property Bubble – they are trying to pop it before they get popped like we did (imagine that, learning from US history); property price growth continues to accelerate (+7.4% YoY in JUN; 13 consecutive months of sequential gains)
2. Rebalancing, Not Levered Growth - Politburo's economic rebalancing agenda (quality of growth now more important than quantity of growth), which they've supported with recent rhetoric and (in)action during the recent credit crunch
3. Psychology – despite the intermediate-term TREND slowing Chinese growth is still trending in-line to above long-term targets; if growth doesn’t fall off a cliff, new leaders will be reluctant to appear weak in the context of their long-term plan
Unlike team Obama, Geithner, and Bernanke (or Abe, Aso, and Kuroda in Japan), Xi and Li will be in charge for another 10 years. Why on earth would they implement short-term Western-style “stimulation”, when their ultimate goal is for history to respect them long-time?
I know, I know – whatever you do, do not engage in rational discussions about this when you can always defer to trading on the latest Chinese, Eurocrat, of Fed horse whispering rumor. That’s where the vig is at, bros.
Yeah, you know – “also known as the juice, the cut or the take…” (Wikipedia definition). Or the amount a Washington “consultant” gets paid for his super secret inside info on what the Fed Minutes are actually going to say today (or what Bernanke is going to whisper next).
Just like Jefferson envisioned, for sure.
In other #StrongDollar, Strong America news, US stocks closed up for the 4th day in a row yesterday, taking the Russell 2000 to yet another all-time closing high of 1,018. For those of you who are still into keeping score for the 2013 bears, that’s +20% YTD.
All-time is also a very long-time, so why not sell some up here? You know, lather yourself up with some booked gains. As our Financials guru (and birthday boy), Josh Steiner, always reminds me, ‘no one ever went broke booking a profit.’
From our process’ perspective, making some sales up here in US Equities is your short-term, high probability, bet because:
What goes up on no-volume can come down on no-volume. So, as consensus is forced to chase price again, and again, and again in 2013, just take a deep breath and focus on proactively managing the risk of a very trade-able range (SPY range = 1, for now).
Despite the “rumors” of being “stimulated” by some Chinese dudes, both the Shanghai Composite and the Hang Seng closed well below their bearish TREND lines of 2,190 and 21,991, respectively overnight.
Oh, and Oil is testing a breakout above our long-term TAIL risk line of $108.36/barrel this morning too. So, Bernanke, before you think about devaluing the Dollar again with a closed network “communication tool”, think about the rest of us who are engaged in open discussions about you while we’re taking your Policy To Inflate in the pump.
Our immediate-term Risk Ranges are now (we have 12 Macro Ranges in our new Daily Trading Range product too, fyi):
UST 10yr 2.56-2.73%
Hang Seng 20,124-20,991
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – July 10, 2013
As we look at today's setup for the S&P 500, the range is 37 points or 1.90% downside to 1621 and 0.34% upside to 1658.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: Sensing the Chinese water torture of S1s could hurt, RH upped guidance a lot closer to what we think it will earn (but still not enough).
RH got some good advice on this one and averted what could have been a multiple-killer.
When the company announced yet another follow-on offering on July 5, the story immediately lost some momentum. The underlying fundamentals were still solid, but anyone with a shred of analytical integrity had to step back and wonder if it was going to be like a 'Chinese water torture' of additional stock sales.
That was particularly the case with the size of the deal growing to 12mm shares from 10mm after the close tonight, and with officers and Directors participating instead of just Home Holdings (the three firms that took it private -- whose ownership will be down to 15.9% post offering ).
But alas, RH came out and issued new long-term growth targets that are nothing short of parabolic. It made the following changes…
Note that the revenue growth guidance is a bit closer to our model, but our much more aggressive top-line forecast of 30%+ is the base of our roadmap for RH to achieve triple-digit status (see our research below). We should also note that we think that the company is being conservative with the leverage to the EPS line of a company in this business that is growing its top line in excess of 20%. In three years' time we get to $3.36 in EPS vs the Street at $2.22. Ultimately, in 5-years we're over $5.
HERE'S OUR RECENT NOTE POST 1Q THAT WE THINK BEST HIGHLIGHTS OUR CALL
RH: CAN EBIT GO UP BY 10X?
Takeaway: RH is expensive and it's built to stay that way. It continues to meet or beat our lofty expectations. The consensus is low by 60%.
Conclusion: Still one of our favorites. The company overdelivered on a heck of a lot more than the EPS line. It took up sales and EPS guidance well ahead of what the 1Q beat would imply. It accelerated square footage, announced yet another two businesses, two new catalogs for Fall, and made a major hire in luring away the President of the Williams-Sonoma brand to be CMO for its RH Kitchens and Tableware business (where current share is near zero). RH continues to meet or beat our expectations in almost every area. The biggest question for us here revolves around how much higher the stock can go. After all, the stock is up 82% in six months, and is flat out expensive. But it was also expensive 82% ago. In addition, if our model is right, we're looking at an earnings CAGR of about 50% for each of the next three years. Then it eases to something in the mid/high 20s. So what's a fair multiple for that? 30x? 40x? It's tough to say. But what we can say is that we're 60% ahead of the Consensus in the outer years, and until the Street realizes that there's $5.00+ in EPS over 5-years, then we're comfortable owning it even if it's expensive.
RH was one of our favorites headed into the quarter, and it remains so after the quarter. But aside from a solid beat, we did not expect much in the line of new disclose or thesis-changing information with this print given that the company just executed on its secondary on May 15th (which in itself was just weeks after a delayed 4Q earnings print and subsequent positive preannouncement). We were wrong -- they gave the thesis some more positive go-juice.
Here's what changed on the margin:
A REMINDER ON WHY WE LIKE RH
We think that RH is to home furnishings what Ralph Lauren is to Apparel and what Nike is to Athletic Shoes. It's the preeminent brand in the space, and sets/leads consumer style trends/wants/needs but with very little fashion risk. From a maturity perspective, we think that RH is 8-10 years behind RL, and 15-20 years behind NKE. Its got the runway. And even though it has such minimal market share across its categories, the competitive set is actually not very strong.
One thing that makes the RH model stand out is the growth algorithm over the next 5-years. Specifically…
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