Hell or High Water

This note was originally published at 8am on July 12, 2013 for Hedgeye subscribers.

“Life is not easy for any of us. But what of that? We must have perseverance and above all confidence in ourselves. We must believe that we are gifted for something and that this thing must be attained.”

-Marie Curie


For those that haven’t been following the news reports from Alberta over the past month, the province and in particular its largest city Calgary, have been devastated by floods.  I’ve been up in Calgary, Alberta over the last couple of days meeting with clients and companies and the perseverance to rebuild and recover has been nothing short of amazing.


The most significant tourist and cultural event in Calgary every year is the Calgary Stampede.  It is a combination of an outdoor fair and championship rodeo, and attracts many hundreds of thousands of visitors.  Fittingly, the slogan of this year’s Stampede is “Come Hell or High Water”, which is an acknowledgement to what the city has gone through to begin the recovery from devastating flooding.


Once a century floods are what we in the risk management business call tail risk events.  They are low probability events that occur rarely but have an outsized relative impact.  The reality of tail risks, or black swans as Nassim Taleb calls them, is that they actually occur much more often than normally distributed risk model would project.


Back to the Global Macro grind . . .


Yesterday we hosted a call with George Friedman, the CEO and founder of Stratfor, a veritable private CIA.  With an army of global contacts and human intelligence collectors, they are rightfully considered among the best and most accurate assessors of global geo-political risks.  As a result, their clients include major government organizations, corporations and global asset allocators.


One of the key ideas that Friedman raised on his call was that despite the recent complacency in European equity and debt markets, things may not end well in Europe.  From his perspective, which we would agree with, the key political issue in Europe is that the grand experiment of the Euro has really only benefitted Germany.   The value of the Euro has supported the 40%+ of exports that drive German GDP, but has failed the rest of Europe.  Friedman thinks we may be in the early days of mass popular unrest in Europe across economically disadvantaged European nations outside of Germany.


Next week we will be releasing our quarterly themes, which is how we quantify the most important factors that are, and will be, driving markets and asset returns over the next couple of quarters.  Our Q2 themes were growth accelerating, strong dollar, and emerging outflows.   These largely played out in spades, particularly emerging market outflows, the extent of which surprised many market participants in Q2.  We added the etf EEM, which is a proxy for the emerging markets equities, as a short idea to our Best Ideas product on April 23rd. Since then the EEM is down more than 10%.


On Monday at 1pm eastern we will be hosting our Q3 Themes call, and while I don’t want to want to steal all of the thunder of that call, our Q3 Themes are as follows:


1.   #DebtDeflation – This theme analyzes the massive build up of debt globally and then looks at debt by sector to assess the outlook over the coming months.  Broadly speaking, you don’t want to be long bonds in the TREND duration.  Even if gentlemen prefer bonds, we don’t.


2.   #AsianContagion – Our Senior Asia Analyst Darius “Sunny D” Dale has done an outstanding job parsing through the Asian economies over the last eighteen months.  This theme primarily looks at the intermediate impact of Japan and China across Asian economies more broadly.  By and large, as Chinese economic growth goes, so goes growth across Asia.


3.   #RatesRising – This theme has been and will likely continue to have the most meaningful impact on U.S. markets as we’ve seen over the past six weeks with rates breaking out to the upside and devastating the bond markets.


In the Chart of the Day, we’ve borrowed a chart from the Q3 Themes presentation of the high yield index and the potential impact of a reversion to the mean in bonds.  As the chart shows, high yield is well below its 10-year average yield of 9.6%.  Even if we exclude the anomalous period of 2008 – 2009, in which rates spiked, that average is at 8.6% and well above current levels.


Our research shows that rates reverting to more normal levels won’t actually impede growth, and thus equity market returns.  In fact, the best U.S. economic growth rates often occur when the 10-year yield is in the 4 – 6% range.  The bond and gold markets, of course, fare much, much worse in a rising rate environment. 


In particular, gold has surprised people to the downside this year.  Many gold bugs have argued to us that with the recent correction in gold, now is no time to sell.  In reality, the facts tell a different story.  Gold will continue to underperform in an environment of rising rates and a strong dollar.


Our correlation analysis tells us that the other key factor driving gold is the size of the Federal Reserve balance sheet.  In fact, the correlation is over 0.90 on an r-squared basis (so very high).  To the extent that the rate of change in the Federal Reserve balance slows, or god forbid declines, it could well be the death knell for gold and gold bugs.


We hope you can join us for our theme call on Monday.


Our immediate-term Risk Ranges are now as follows:


UST 10yr 2.42-2.77%

SPX 1634-1681

VIX 13.15-15.92

USD 82.52-83.93

Oil 105.84-110.73

Gold 1210-1312


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


Hell or High Water - HY EL


Hell or High Water - Virtual Portfolio

CHART OF THE DAY: Cheating Opportunities


CHART OF THE DAY: Cheating Opportunities - Chart of the Day

Cheating Opportunities

“Forces might make it easy for group-based processes to turn collaborations into cheating opportunities.”

-Dan Ariely


There’s some serious irony that I’m finishing up my behavioral economics review of Dan Ariely’s The (Honest) Truth About Dishonesty while our profession gets its reputation tarred and feathered by the fun cops.


I call it our profession, because it is. We are all responsible for self-policing this Street. For too long we have allowed our compensation structures to cloud our definition of grey. Leadership principles are black and white. It’s time to champion transparency and accountability.


No, it’s not easy to write about this. I think we all have former friends who have lied to us. Accepting that isn’t easy either. Social groups affect us in many ways that we are too human to understand.


Ariely reminds us that “when cheaters are part of our social group, we identify with that person and, as a consequence, feel that cheating is more socially acceptable. But when the person cheating is an outsider, it is harder to justify the misbehavior, and we become more ethical in our desire to distance ourselves from that immoral person and from that other out-group.”


“… results show how crucial other people are in defining acceptable boundaries for our own behavior, including cheating. As long as we see other members of our own social groups behaving in ways that are outside the acceptable range, it’s likely that we too will recalibrate our own internal moral compass and adopt their behavior…” (pages 206-207).


Leadership isn’t how much money you make; it’s your opportunity to make a difference.


Back to the Global Macro Grind


The Russell 2000 clocked another all-time closing high yesterday of 1054 (+24.1% YTD) as mostly every growth stock that beats toned down expectations rips to new YTD highs. Slow growth investor T-Bonds were down (again). This remains a growth investor’s market.


Growth, growth, growth – if you can find it, buy it – that’s not just a progressive message that stands in stark contrast to the fear-mongering one that is getting pummeled (VIX -29% YTD), it’s a good way to live your life. In order to grow, you need to embrace change.


What’s interesting about being long growth is that not all “growth” investors have actually agreed with it, yet. That said, it’s important to remember that we’re all storytellers – and the market doesn’t care about our own individual versions of the story.


Here’s the non-fictional account of what we call growth “Style Factors” for 2013 YTD:

  1. Top 25% EPS Growth Stocks (SP500) = +23.8% YTD
  2. Low Dividend Yield (growth) Stocks = +26.4% YTD
  3. High Short Interest Stocks = +22.6% YTD

In other words, if you are long high-beta stocks that A) look “expensive” B) have high short interest and C) deliver better than “expected” growth results – boom! Non-cheater alpha is yours to keep.


Not only are non-obvious growth Style Factors beating the SP500’s YTD return of +18.5%, so is growth as a sector-style within the SP500:

  1. Consumer Discretionary Sector ETF (XLY) = +25.1% YTD
  2. Utilities Sector ETF (XLU) = +12.3% YTD

That’s a massive (and widening) performance spread that looks a lot like being long US Stocks vs US Treasury Bonds.


And there’s more alpha where that came from. Whether it was Visa (V), Facebook (FB), or long-time Hedgeye favorite Starbucks (SBUX) this week, Mr. Market is telling you that you don’t need to cheat to win in this business. You need to pay up for the growth that you can find.


While this doesn’t always make sense to people until they make the amount of mistakes I have, the other side of being long this growth rip is shorting “value” stocks that look “cheap” (if you use the wrong numbers).


That’s CAT.


So all in, what we have here is an opportunity to separate the pretenders from the pros. This is the new old school - roll up your sleeves and do your own work. No need for insider information. Just have the confidence and humility to let Mr. Market tell you all you need to know.


Math is our edge. It’s black and white. The opportunity to capitalize on leadership principles and a repeatable process has never been so bright.


Our immediate-term Risk Ranges are now:


10yr Yield 2.47-2.65%


VIX 11.82-13.37

USD 81.54-82.57

Yen 98.41-100.78

Gold 1


Best of luck out there today and enjoy your weekend,



Keith R. McCullough
Chief Executive Officer


Cheating Opportunities - Chart of the Day


Cheating Opportunities - Virtual Portfolio

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According to the Marine and Water Bureau, the revamp of the Outer Harbour Ferry Terminal aimed at improving its passenger facilities will begin as soon as July 29.  The project, which will cost the government 80 million patacas (US$10 million), will add a baggage carousel on the east wing of the ground floor, and more counters on the second floor for tourism agencies and banks, as well as ferry ticketing counters and check-in counters for Hong Kong airport ferries. The one-year Outer Harbour revamp will proceed in five phases, said Sam Ip Va Hung, chief of the bureau’s Port Control Department. 



Macau's unemployment rate for April-June 2013 held stable at 1.8%.  Hmm, I wonder in what part of the underground economy the 1.8% work?



Colgate reported a top-line miss, but met EPS expectations of $0.70, for 2Q13 this morning and revised earnings guidance lower by 1% to 4.5-5.5% for the year. There were some reservations ahead of the quarter, on our part, about the difficult sales growth compare but strong volume growth, offset by FX headwinds, impressed versus expectations. Despite strong organic growth and operational performance, we would not own the stock at 21x forward earnings. Importantly, #RatesRising, one of Hedgeye’s 3Q Macro Theme, is a key risk for the broader Staples sector and we believe that the associated strength in the USD would be a negative for CL.



North America: The North America division delivered 5% organic sales growth (6% volume, -1% price) as Colgate continues to grow its dominant share of the oral care category. A strong new product pipeline is continuing to support robust revenue growth in this division, which represents roughly 18% of company sales.  EBIT margins in North America grew 2.8% year-over-year to 29.8%. This may be unsustainable, but a “benign cost environment” and continuing sales growth implies additional strong EBIT margin results going forward.



Europe South Pacific: Management cited sluggish economic growth as a headwind to sales growth after announcing organic sales declines of -2% versus 2Q12 (1% volume, -3% price). Despite the slowing environment, the company is growing its share in toothpaste, toothbrushes, mouthwash, and fabric softener.



LatAm: The Company’s largest region, by revenue, delivered 7% organic growth in the second quarter (2.5% volume, 4.5% price) and grew market share in many categories and markets. FX was an 8% drag on the top line, driving the entire -1.5% decline in net sales growth. EBIT margins contracted in Latin America for the third successive quarter although, again in 2Q if the impact of Venezuela’s currency devaluation were excluded, LatAm margins would have been up year-over-year.



Greater Asia/Africa: GAA delivered 9.5% organic sales growth (0% price) as toothpaste market share increases in India, China, Russia, and other markets. China and India are growing at double-digit organic growth rates. Growth potential remains promising in this segment as the company improves its distribution into new cities and rural areas.



Hill’s Pet Nutrition: Hill’s net sales surprised to the upside, with unit volume of 2.5% and pricing of 3% resulting in 5.5% of organic sales growth. While the volume growth was unexpected, “one quarter ahead of schedule”, according to management, it seems to have come at the expense of some margin. In 2Q, Hill’s EBIT margin contracted by 250 basis points to 24.8%.




  • Management revised FY13 EPS guidance to +4.5-5.5% growth versus +5.5-6.5% prior. This downward revision was entirely due to
  • Reaffirmed organic growth rate guidance of 6-7% for FY13
  • Reaffirmed gross margin expansion guidance of 30-70 bps



What we liked

  • EPS met consensus expectations
  • Consolidated organic sales growth came in at 5.5% vs. a difficult comp (comps ease over 2H13)
  • Gross margin expansion accelerated in 2Q13 despite sequentially tougher comparison (chart below)
  • EBIT margin year-over-year growth was 3.1% versus sales growth of 1.9%
  • FCF flat vs. year ago despite 57% ramp in capex
  • Easing comparisons in 2H12
  • FY13 gross margin guidance likely to be met


What we didn’t like

  • FX continues to be a big drag
  • Earnings multiple implied by the stock price seems full at 21x
  • Margin weakness in Latin America


CL ORGANIC GROWTH IMPRESSIVE - cl gross margin chart 7.25.13png


Rory Green

Senior Analyst


When Will Ben Raise Rates?

(Editor's note: Earlier this morning, Hedgeye CEO Keith McCullough was asked what his estimate was for when the Bernanke Central Planners Fed will finally begin increasing the Fed Funds rate. Here's his response.)


When Will Ben Raise Rates? - bern4


KM: Well, my estimate and when the Fed will actually do what I would estimate they should do are two completely different things. The difference between the two is that one is math and the other is politics. That’s unfortunate.


I would never dare say that I have a forecast on when the Fed’s going to do anything. Because the best forecast you can have is having Bernanke, or one of the boys in his Crony Network, telling you.  That’s why people pay so much money for that—the people that are still willing to pay for that kind of information. That’s the real answer.


When Will Ben Raise Rates? - bern7


When should he taper? He should be tapering right now. I mean, he should have tapered at the last meeting. He should be tapering through September. But that doesn’t mean that he will. So it’s kind of a tough one to answer.


Because what he should do, and what he will do, are two very different things.


Look, this is the first Federal Reserve chief in U.S. history to never raise interest rates. Never. He won’t even taper! Never mind raise interest rates. It’s sad, and it’s pathetic. But we just have to deal with the game that’s in front of us. 


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