Island Economics

This note was originally published at 8am on July 29, 2013 for Hedgeye subscribers.

“An island cannot rule a continent.”

-Thomas Paine


I don’t know about you, but I find myself putting most consensus channels of market and “economic” information on mute these days. Life is simpler that way. Markets can be simpler too – if you take big government politics out of them.


Thomas Paine wrote “Common Sense” anonymously in 1776. It was only 48 pages long but one of the most influential writings in US history. As US historian, Joseph Ellis, recently wrote: “both the style and the substance of Common Sense were true to its title… replicating the vocabulary of conversations by ordinary Americans in taverns and coffeehouses…” (Revolutionary Summer, pg 11)


Sometime after filling up my tank with $4.24/gallon gas this weekend, I was reading that book at home. Then I got out of my chair and glazed over Obama’s comments about the next Fed Chairman in the NY Times. He said he wants a “Fed Chairman that can step back and look at that objectively and say, let’s make sure that we are growing the economy.” Then I started laughing.


Back to the Global Macro Grind


The final blow to anyone who is full of it is usually the truth. We see this in every aspect of our lives, so there’s no reason why any of these people who operate under the assumptions of big government Island Economics will be remembered by history any differently.


Although at varying paces, time tends to solve disconnects between fact and fiction. But in between now and then we have to deal with real-time market prices and expectations.


The expectations that the outgoing (and incoming) Fed Chairman is going to try to “grow the economy” with a weak currency are pervasive. Last week’s rumoring of either Larry Summers or Janet Yellen running the Fed had something to do with:

  1. America’s Purchasing Power (US Dollar) dropping -1.1% wk-over-wke
  2. Consensus buying the living daylights out of Gold futures and options contracts
  3. The net long position in Oil futures and options contracts hitting an all-time high

As history buffs like to remind short-term political types, all-time is a long time.


If the President of the United States thinks that having the all-time low (of any US President) in America’s Purchasing Power alongside the all-time high in gas prices is success, that’s just plain funny and sad all at the same time. #Half-BakedClassWarfareIsland


Mr. President, if you are more than just lip servicing people who are on fixed budgets, have Bernanke or Yellen get on 60 Minutes and announce to the world that the USA is raising interest rates next weekend. Both the Gold and Oil price will crash. And The People will like it.


Instead, here’s what futures and options contracts (i.e. our entire profession trying to front-run the Fed) are betting on:

  1. Total CFTC Commodities futures and options contracts were +7.4% wk-over-wk to +615,140 contracts
  2. Crude oil contracts were up another +10% wk-over-wk to +334,094 = all-time high
  3. Gold contracts ripped +26% wk-over-wk to +70,067 (up for 4 weeks in a row)

Yep. So much for the only bull case for Gold that made any short-term sense (that “everyone is short Gold”). Everyone is getting right levered long the Bernanke Bubble again! It’s still crashing YTD (-21.4%), but who cares? Isn’t this just great for the country?


To be clear, the opportunity to replace Bernanke with someone who doesn’t devalue the Dollar, monetize a record amount of US debt, and socialize crony banker losses, is one of the biggest President Obama has had in his career.


But does he get that?


I doubt it – that said, I did take my kids to see Monsters University yesterday, and that movie reminded me that there always is a chance! Meanwhile, Mr. Market is actually begging for a Fed head who gets having a #StrongDollar #RatesRising policy (i.e. a pro-growth policy):

  1. The Russell2000 is = +7.3% for the month-to-date, and +23.4% YTD
  2. Top 25% EPS Growth Stocks = +6.1% for the month-to-date, and +23.7% YTD
  3. Low Yield (growth) Stocks = +5.1% for the month-to-date, and +26.4% YTD

But, if Obama wants to get Summers or Yellen in there, we can always go back to the Island Economics that both he and Bush II had. How does a 0% rate of return on your hard earned savings accounts forever, $2000 Gold, and $160 Oil, sound?


Our immediate-term Risk Ranges are now as follows (*reminder: 12 Global Macro Risk Ranges are in our new Daily Trading Range product as well):


UST 10yr Yield 2.50-2.64%

SPX 1676-1700

Nikkei 13571-14601

USD 81.57-82.38
Brent 106.42-108.01

Gold 1260-1352


Best of luck out there this week,



Keith R. McCullough
Chief Executive Officer


Island Economics - vv. gas


Island Economics - vv. vp 29

Missing Something

“The market is smarter than you will ever be, with its combined knowledge of all participants. Pay attention to the signs. Be quick to admit that you’re wrong. Don’t be afraid to miss something.”

-Yra Harris, Praxis Trading


That quote comes from my “other” favorite book on markets, Inside the House of Money, which is a series of candid interviews with a number of highly-regarded Global Macro Risk Managers (Daniel Kahneman’s Thinking, Fast and Slow forms the other half of my 1A/1B compromise). Harris – a veteran of the trading floor pits at the CME for over three decades – had that to say about the merits of gleaning critical information from market prices.


I make it a point to pay as little attention as humanly possible to the #OldWall’s financial media outlets, so I don’t know much about Mr. Harris’ current views and biases on the markets. I do, however, know that we @Hedgeye subscribe to the same philosophy of recognizing that we’re not smarter than the market. Indeed, having been football or hockey jocks at an institution like Yale has taught us all we needed to learn about not being the “smartest guy in the room”.


Whether you’ve watched us compete in this game for the past five years or you’ve been trialing our research for five days, you’ll quickly arrive at the conclusion that last price tends to dictate our interpretation of the fundamentals. But, obviously, markets oscillate on a day-to-day and week-to-week basis, so we employ a three factor (i.e. price, volume and volatility) quant model to contextualize market trends across three distinct investment durations:

  1. TRADE: 3 weeks or less
  2. TREND: 3 months or more
  3. TAIL: 3 years or less

If a particular security or asset class is Bullish TRADE (i.e. last price is above the TRADE line), we’d argue that the market is in agreement with the positive fundamental view(s) emanating from the bull camp with respect to the most immediate-term of durations. The same can be said of Bullish TREND setups vis-à-vis the intermediate-term duration and Bullish TAIL setups vis-à-vis the long-term duration. The inverse of this interpretation (i.e. Bearish TRADE/TREND/TAIL) holds true as well.


We believe that it is our job as macro analysts to collect and piece together any relevant economic data with the intent of forming a fundamental view on a particular market or asset class. Often times, however, our biases don’t agree with said market’s risk management setup – i.e. the research is bullish when the market setup is bearish, or vice versa.


Prior to putting any risk on, investors generally have the option of dismissing the aforementioned setup as “being early” – at least until they get tapped on the shoulder! When, however, the position is already on the tape and has positive P&L and it starts to trend counter to one’s preexisting and subsequently reconfirmed fundamental view, we’d argue that said investor is late – i.e. he or she is #MissingSomething with respect to the fundamental story.


To better illustrate this lesson in Global Macro Risk Management, let us turn to a discussion of our preexisting bullish bias on the dollar-yen cross with respect to the intermediate-term TREND and long-term TAIL durations and on the Japanese equity market with respect to the intermediate-term TREND duration.


We’ve been out front of consensus making these calls – very loudly in the yen’s case – since SEP and NOV of last year, respectively, but, for those of you who may be new to the thesis, our subsequently reconfirmed fundamental view is as follows:

  1. While enthusiasm for the Abenomics agenda may come and go in the immediate-term, we believe investors are broadly underestimating the structural impact of imposing a +2% inflation target and +3% nominal growth target in Japan. To put that in context, the trailing 10Y averages for these metrics are -0.1% and -0.5%, respectively. Japanese policymakers have a lot of hay to bale on the monetary easing front if they are to even sniff their lofty targets within the proposed 2Y time frame.
  2. Assuming Japanese policy stays the course and our view that the US economy has finally turned the corner from a growth perspective is ultimately proven prescient, a compressing real interest rate differential will also put pressure on Japan’s currency from a capital flows perspective. Consensus expects real 2Y JGB rates to hit -2.5% by EOY 2014 (down meaningfully from -0.4% by EOY 2013); this compares to a forecast of -1.3% for real UST 2Y rates by EOY 2014 (down slightly from -1.1% by EOY 2013). More importantly, this inflection is also being confirmed in the swaps market: 2Y swap rates in Japan are now trading at -1.57% on a real basis (subtracting the 2Y breakeven rate from the swap rate); that compares to -0.88% for the US. As recently as mid-MAR, those metrics were meaningfully inverted at -0.10% and -1.98%, respectively!
  3. In the context of intermittent spikes in volatility in the bond and forex markets, we have maintained that the risk-adjusted outlook for Japanese stocks is decidedly less sanguine than consensus assumes given the reflationary tailwind of currency debasement. The caveat here is that this headwind can be offset via absolute returns that are now likely to be increasingly predicated on economic and fiscal reforms (corporate tax cuts, labor market deregulation, fiscal consolidation, etc.), as well as large-scale portfolio rebalancing by Japanese households. To that tune, only 6.8% of Japanese household financial assets are held in equities vs. 14.4% for the Eurozone and 32.8% for the US.

In spite of what we’ve outlined as arguably the most credible and well-articulated bull case for both the USD/JPY cross and Japanese equities, both are broken from an immediate-term TRADE perspective and flirting with breakdowns on our intermediate-term TREND duration as well. The risk management levels to watch on that front are as follows:

  • USD/JPY (last price = 96.77): Bearish TRADE = 97.72 and Bearish TREND = 97.13 (a few days young; needs to hold below TREND for a few weeks to confirm the move… if confirmed, we would certainly alter our fundamental bias)
  • Nikkei 225 (last price = 13,519): Bearish TRADE = 14,091 and Bullish TREND = 13,336

Profit taking, generally disappointing 2Q earnings and waning international investor sentiment for Abenomics are all credible theses that support a Bearish TRADE setup in both markets. We haven’t come across anything credible that would fundamentally support a confirmed Bearish TREND setup in the USD/JPY cross, which we believe will continue to determine the direction of the Nikkei until it eventually becomes obvious to Japanese equity investors that inflation is not growth (the trailing 1Y and 3Y correlation coefficients between these two markets are +0.96 and +0.97, respectively).


But, as highlighted above, just because we haven’t formed a coherent fundamental story that supports the quantitative risk management setup in both markets does not mean the underlying fundamentals themselves cease to exist.  So either we’re #MissingSomething or this is all just one big head-fake as weak hands are shaken out of the trade.


Let us know what you think.


Our immediate-term Risk Ranges are now as follows:


UST 10yr Yield 2.57-2.73%



VIX 11.72-13.94

Yen 95.91-98.38

Copper 3.17-3.32


Keep your head on a swivel,



Darius Dale

Senior Analyst


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Caesars Entertainment has agreed to sell a golf course in Macau to Pearl Dynasty Investment Ltd for $438 million, effectively giving up obtaining casino operating rights in Macau.  CZR expects net proceeds of about $420 million from the disposal, which it will use to fund capex or buy back debt, it said in a filing.  CZR expects the completion of the sale to Pearl Dynasty to be completed in the fourth quarter.



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The Economic Data calendar for the week of the 12th of August through the 16th 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.



JCP: Does The Market Even Acknowledge A Bull Case?

Takeaway: We’re not professing the validity of the bull case, but are simply pointing out that sub-$13, a bull case does not even appear to exist.

Conclusion: There are more cross-currents swirling around JCP right now than at any time since the story thrust itself into the mainstream back in the summer of 2011. But we think it’s key to draw a dividing line between today’s sheer lack of debate around any potential earnings power – ever – and reigniting a debate around what JCP could become and ultimately earn under a real leader. We’re not professing the validity of the bull case, but are simply pointing out that sub-$13, a bull case does not even appear to exist.



Let’s make one thing absolutely clear. The way that Ackman is going about communicating proposed changes to the management team at JCP is self-serving and irresponsible – at least the way that I (McGough) am looking at it. But the reality is that the end result – that CEO Ullman needs to be replaced with someone that can actually drive this business forward with a transformational vision and an executable plan – is the right one.


We’re on record back in April in saying that the JCP Board was either six months too late in firing Johnson, or six months too early.  It should have acted based on his pricing miscues back in the fall and into holiday (probably not the right move), or based on the outcome of his new shop-in-shop rollout (which wouldn’t have been known until 2H of this year).


So what did we get? We got Ullman. The former CEO – the one that is really really good at discounting below-average product to average Americans. Howard Shultz of SBUX can get on CNBC all he wants and rave about how great a leader Ullman is (he did this last week), but Ullman’s track record for creating value is horrendous. Yes, he made a good move towards stabilizing JCP’s balance sheet, and sales are less horrible under Ullman than they were under Johnson.


But the reality is that Ullman is beginning to behave like he is going to be at the company for a while, which is inconsistent with the purpose for bringing him on as abruptly as the Board did back in April. And that’s just not good. Since he was named CEO the stock is down 18.9% while the S&P is up 7.8% -- and that’s only four months.


There’s one major thing that people need with this story – and that’s someone who can stand up and lead all constituents (customers, employees, vendors, creditors, and investors) to believe what they (at least partially) believed 12-18 months ago – that this is a company that can return to an $18bn sales base at a minimum, and eye something above $2.50 in EPS power.


We’re not saying that it can happen at JCP. But today, no one is even making the argument anymore. The debate isn’t even alive! THAT’s what’s represented in a $12.86 stock price.


Our point here is that one press release can be a big first step toward changing all that. And that’s an announcement that a person with a vision for what JCP ‘could be’ is anointed with the confidence and respect of the Board to step in and get the job done.


Ironically, we think that the right answer is something pretty darn close to what Johnson was trying to accomplish. Is the right number of stores 400 remodels instead of 800? Perhaps. Is the cadence of the roll-outs slower than Johnson planned? Yes. Are certain high-end brands that JCP had planned not appropriate for the JCP customer? Yup. But directionally, the idea was probably the right one.


The bottom line here is that based on the current management team and lack of long-term vision to create value in a rapidly changing retail climate, we have zero confidence that this is a story that has any staying power, and will not otherwise go the way of Sears.


Our gut says that we’ll get a significantly better management team in place (note Perry Capital going as far to note that it wants FL's Ken Hicks in the CEO role when it filed its 7.26% position on Friday). The pressure on a management change seems to be like a balloon under water that is about to burst.  


So as it relates to the stock, if we have to look at it based on what we have today, JCP is as unexciting (and risky) as it gets. But when we think of a new management team coming in and at least firing up a (currently nonexistent) debate on earnings power, the stock looks interesting to us under $13.


JCP: Hedgeye Sentiment Monitor Shows That Investor Sentiment Is About As Bad As It Can Get

JCP: Does The Market Even Acknowledge A Bull Case? - jcpsentiment

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