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The Desert

This note was originally published at 8am on August 22, 2013 for Hedgeye subscribers.

“What makes the desert beautiful is that somewhere it hides a well.”

-Antoine de Saint-Exupery


Volumes are light, ideas are sparse and the Hamptons are packed.  Welcome to summer on Wall Street!


The desert is the most pertinent geographical analogy to this part of the investing year.   Deserts are defined in a number of different ways, but generally the classification is based on the amount of precipitation that occurs in any year.  Below a certain level of precipitation, the region is considered a desert.  Think of precipitation as the idea generation engine of Wall Street that slows during the summer.


Interestingly, while most of us likely perceive a desert as a vast region of sand and limited plant growth, the reality is that only 20% of deserts have sand.  The largest desert in the world is actually the Antarctic Desert, which is, naturally, in Antarctica and covers more than 5.5 million square miles of ice and snow.  So, no, cold desert is not an oxymoron.


One place you don’t want to go after a long night of cavorting and over indulging is the Atacama Desert, which is the driest place on Earth and virtually devoid of life.  The average rainfall in parts of the Atacama is less than 1mm per year.  Further, evidence suggests that the Atacama may not have had any rainfall for the four hundred year period between 1570 and 1970.  Needless to say, even if you feel your portfolio is devoid of new ideas, there have been worse droughts!


In the Chart of the Day, I’ve attached our current Best Ideas list, which is comprised of the ideas that our research team recommends for three months and beyond (TREND) in our models.  Independent of this list I want to highlight the three ideas that I find most compelling.  They are as follows:


1.   International Game Technology (IGT) – IGT makes gaming machines and is, not to mince words, a free cash flow monster.  Over the course of the past three fiscal years, operating cash flow has outpaced total capital expenditures by over a $1 billion dollars in aggregate.    Compared to the current market capitalization of just under $5BN, this provides IGT ample cash to return to investors via share repurchases or debt pay down.


Speaking of debt pay down and cash flow, one of the more compelling reasons to own this stock is its potential interest to private equity firms and its inherent private market value.   As our Gaming, Lodging & Leisure Sector Head Todd Jordan has oft noted, four private equity firms were interested in IGT’s competitor WMS and one made it to the final round before Scientific Games ultimately won out.


2.   Nationstar Mortgage Holdings (NSM) – The roll up of mortgage servicing is a trillion dollar opportunity and NSM is ideally positioned.  (Translation: this is huge market.) NSM recently put up an EPS number for Q2 of $1.37, which outpaced the consensus estimate by almost 50%.  We think there is continued upside in numbers through 2014.  Currently based on the midpoint of NSM’s 2014 guidance, the stock is trading at less than 7x earnings with upward revisions and continued acquisition catalysts on the horizon.


3.   Fed-Ex (FDX) – FDX is just shy of a 52-week high and has outperformed the SP500 over that period, so is not necessarily a contrarian stock.  On a valuation basis, the stock is cheap trading at less than 6x TTM EV/EBITDA and has net cash on its balance sheet (excluding leases). 

Setting aside the financials, which are bullet proof, we think a key reason for owning the stock is that investors are currently ascribing little value to FedEx Express.  We think this division, once restructured, could have a similar margin to UPS or DHL’s express margin and generate an incremental $1.5BN in additional EBIT per year.   Frankly, if the Germans can make DHL Express profitable, it should be achievable for FDX.  If FDX can’t do it, there is no doubt an activist will consider stepping up.


Speaking of Fed-Ex, its key competitor UPS announced late yesterday that it was going to be dropping 15,000 spouses who are eligible for coverage from their own employer from its health insurance plan due to higher anticipated costs under the Affordable Care Act.  UPS expects to save up to $60MM per year on this “initiative”.


We’ve long extolled the benefits of limiting governments, in large part, due to unintended consequences of policy.   In the UPS instance, it may lead to less or more limited coverage for 15,000 working women.   There has also been ample evidence of workers hours being reduced so employers can avoid the punitive impact of the Affordable Care Act on their bottom line.


On a more macro level, there are potentially long term impacts to the labor market.  As Chicago Economist Casey Mulligan wrote in a recent blog for the New York Times:


“The Affordable Care Act’s explicit taxes on employers, subsidies for layoffs and implicit taxes on employees, together amount to five or six percentage point addition to the marginal tax rate on labor income.”


By Mulligan’s analysis, this may contract the labor pool by 3% in 2015.  At the end of the day, this shouldn’t really surprise any of us for as Milton Friedman said on the topic of government management:


“If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.”




Our immediate-term Risk Ranges are now:


UST10yr 2.74-2.96%

SPX 1631-1669

DAX 8249-8417

USD 80.91-81.81

Yen 96.21-98.56

Gold 1329-1392


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


The Desert - COD


The Desert - vp 8 22






To increase the betting turnover in the mass market, tables with minimum bet of $50, $100 are all replaced by electronic table games, and table limits of gaming tables are raised to $500 or above.  This strategy has proven great success by casino operators.  With the increase of minimum bets of gaming tables to $500 and up to $3,000, the latter mainly for high-end customers, scholars believe mass market business and VIP business will not be overlapped in this case, because low limit VIP tables are unprofitable due to the high operating cost in VIP business.



SJM CEO Ambrose So said its Cotai project will cost HK$25BN, $5BN higher than its previous forecast, due to rising labor and construction costs. 



MGM China CEO and Executive Director, Grant Bowie, said that its new development project is progressing in an orderly manner. He expects to hire 7,000-8,000 employees after completion and stressed that priority will be given to Macau residents. He also added that the company will apply to the Government for 500 gaming tables.



The Meteorological and Geophysical Bureau (SMG) twice issued rainstorm warnings yesterday.  Schools were closed in the morning with flooding witnessed in some areas of Taipa and Coloane.   The Land, Public Works and Transport Bureau has received four reports of landslides in Coloane, one of which took place near residential buildings. 

September 5, 2013

September 5, 2013 - dtr



September 5, 2013 - 10yr

September 5, 2013 - spx

September 5, 2013 - nik

September 5, 2013 - dxy

September 5, 2013 - oil

September 5, 2013 - natgas



September 5, 2013 - eem

September 5, 2013 - VIX

September 5, 2013 - yen

September 5, 2013 - gold
September 5, 2013 - copper


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ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows

Takeaway: Bond fund outflows continue with a substantial $9 billion out of fixed income against a marginal, albeit positive inflow into stocks

Investment Company Institute Mutual Fund Data and ETF Money Flow:


Equity mutual fund inflow slowed to a trickle or just $300 million for the week ending August 28th, down from the $1.3 billion inflow the week prior but remaining positive


Fixed income mutual fund outflows remained substantial with a $9.1 billion withdrawal by investors, a slight decline from the $11.1 billion draw down last week but remaining at out-sized levels


Within ETFs, both equity and fixed income exchange traded fund money flow was negative for the week ending August 28th with just over $1.0 billion coming out of passive equity products and over $900 million coming out of passive bond products although both outflows were improvements from the week prior


ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 1

ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 2



For the week ending August 28th, the Investment Company Institute reported softening equity mutual fund flow trends, albeit positive flow trends, and continuing out sized withdrawals in fixed income mutual funds. Total equity fund flow totaled just a $300 million inflow which broke out to a $1.3 billion inflow into international equity products and a $1.0 billion outflow in domestic stock funds. These trends were a softening from the prior week's total equity fund inflow of $1.3 billion. Despite this deceleration in stock fund flows, the year-to-date weekly average for 2013 now sits at a $2.6 billion inflow for total equity mutual funds, a substantial improvement from the $3.0 billion outflow averaged per week in 2012.


On the fixed income side, outflow trends continued at exaggerated levels for the week ending August 28th with the aggregate of taxable and tax-free bond funds combining to lose $9.1 billion in fund flow, the fourth biggest weekly draw down in 2013 in what now has become the biggest bond withdrawal in the history of the ICI data. The taxable bond category specifically shed $6.2 billion in the most recent period versus the $7.3 billion loss last week. Tax-free or municipal bonds continued their sharp outflow trends losing another $2.9 billion in the week ending August 28th, continuing its trend from last week which experienced a $3.7 billion outflow. Franklin Resources (BEN) continues to have the most exposure in our coverage group to declining Municipal bond trends with over 10% of its assets-under-management in the tax-free category. The 2013 weekly average for fixed income fund flow has now drastically declined from 2012, now averaging a $136 million weekly outflow this year, a far cry from the $5.8 billion weekly inflow averaged last year.


Hybrid funds, or products that combine both fixed income and equity allocation, continue to be the most stable category bringing in another $1.1 billion in the most recent weekly period. The year-to-date weekly average inflow for hybrid products is now $1.6 billion for '13, almost a 100% increase from 2012's $911 million weekly average.



ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 3

ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 4

ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 5

ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 6

ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 7



Passive Products - Slight Outflows Across the Board:



Both categories of exchange traded funds experienced redemptions by investors for the week ending August 28th. Equity ETFs lost $1.0 billion, rebounding from the biggest equity ETF outflow in 5 years of over $12.0 billion last week and only the 10th negative week in the 35 weeks of 2013. Despite this week's outflow, 2013 weekly average equity ETF trends are averaging a $3.0 billion weekly inflow, an improvement from last year's $2.2 billion weekly inflow average.


Bond ETFs also had soft trends in the most recent weekly period losing over $900 million in fund flow. This outflow was a slight improvement from last week's $2.3 billion withdrawal and has now forced the 2013 weekly average to just a $284 million inflow for bond ETFs, much lower than the $1.0 billion average weekly inflow from 2012.



ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 8

ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 9



HEDGEYE Asset Management Thought of the Week - The Shift Change is On:


For investors that are still defiant that an asset allocation rotation has not started need to look no further than the weekly money flow trends since the start of May. While equity mutual fund and ETF inflow on a weekly basis has slowed from the usual seasonally fast start to the year, stock fund flow has remained solidly positive through the most recent week to end the summer. Conversely, fixed income mutual fund and ETF trends on a weekly basis have taken a sharp turn for the worse and are now in massive weekly redemption through the most recent week.


Up until the week ending May 22nd this year, fixed income fund and ETF products were averaging over a $5.9 billion weekly inflow. Since the end of May however, fixed income trends have cascaded down sharply and since the 3rd week of May have averaged a massive $8.5 billion outflow. While the single week of June 26th represented the biggest weekly bond outflow in history of over $31 billion is skewing the weekly average on the margin, fixed income trends have been persistently negative on a weekly basis since the end of May. On the flip side, equity trends have been consistently positive albeit slowing into the summer period. For equity mutual funds and stock ETFs, weekly flow trends have been averaging a $3.2 billion inflow since May 22nd after averaging a $7.3 billion inflow weekly prior to the Fed's "tapering" comments before the week ending May 22nd this year. While all fixed income dollars drawn down are not being replanted one-for-one back into the equity markets, we do estimate that over time the reallocation from fixed income and into cash and money markets will continue to fuel a slow turn from the generational 30 year run in bonds into higher investor asset allocation into stocks.    



ICI Fund Flow Survey - Continued Smoldering in Bond Fund Flows - ICI chart 10



Jonathan Casteleyn, CFA, CMT



Joshua Steiner, CFA



CHART OF THE DAY: What Have You Learned?


CHART OF THE DAY: What Have You Learned? - Chart of the Day

What Have You Learned?

“Wealth actually springs from the expansion of information and learning.”

-George Gilder


And here we were all thinking that innovation, growth, and wealth depended on what the Fed says next. Silly boys and girls of Keynesian academic dogmas we are sometimes…


In Chapter 5 of Knowledge & Power (pg 38), George Gilder nails something my Canadian craw has had a hard time articulating to both my partisan Democrat and Republican friends:


Believing that a weaker dollar is just the thing to spur a sluggish economy… they miss the consequent devaluation of all the assets of the country… abashed by Ivy League expertise, the great peril of establishment Republicans from the time of both Bushes… all cherish the illusion that leading Yale, Harvard, and Princeton economists possess vital wisdom about the economy. They generally don’t. Their preoccupation with static macroeconomic data blinds them to the actual life and dynamics of entrepreneurship.


Back to the Global Macro Grind


To learn (from new information channels) or not to learn, remains the question. Those of us building businesses on the back of our own risk capital actually have no other choice. It’s all about learning.


How quickly can we learn from our mistakes, biases, and dogmas? How flexible are we in implementing the constant change that we need in order to be successful? How readily do we dismiss perceived wisdoms for our visions of that change?


Sounds like the process of economic maestros in the Republican and Democrat parties, no? How about the “economists” of the #OldWall who Bush and Obama lovers cite as having “blue chip estimates” on the economy, markets, and #EOW (end of the world) risks?


On January 1st, 2013 here were #OldWall’s year-end (2013) forecasts for the SP500 and US GDP:

  1. Goldman (David Kostin): SPX 1575 on GDP of 1.9%
  2. Morgan Stanley (Adam Parker): SPX 1434 on GDP of 1.4%
  3. JP Morgan (Tom Lee): SPX 1580 on GDP of 1.8%

Now, to be fair, most buy-siders who get it would call Parker a perma-bear and Lee a perma-bull, so to see their views diverge is no surprise. What was surprising to me was that the most bullish guy on #OldWall (Tom Lee) wasn’t in the area code of what we call Bullish Enough.


Fast forward to this past weekend’s Barron’s forecasts (don’t laugh), here are the “revised” #OldWall forecasts:

  1. Goldman (Kostin): SPX 1750 on GDP of 2.2%
  2. Morgan Stanley (Parker): SPX 1600 on GDP of no one is sure
  3. JP Morgan (Lee): SPX 1775 on GDP of 2.5%



All these Keynesian “certainty” models do is anchor on the most recent SPX high and GDP report. Christie and Clinton better sign all these dudes up to advise them alongside Larry Summers (whose economic forecasting track record rivals Parker’s).


Stop it. I’m not trying to be mean. I’m an ex-athlete who is humbly trying to be one of your coaches. I’m just a little voice of annoyance in your ear so that you don’t get run over (I’ve never had a great coach who didn’t make me want to punch him every once in a while, fyi).


As a country (and a profession), after the mother of all global economics crises, what have we learned? Mr. Market helps us all learn in a hurry. Here are the main lessons of 2013:

  1. Be long growth (US growth stocks)
  2. Be short slow-growth (Gold, Bonds, MLPs, etc)

And that makes sense because, as the score board shows, even the most bullish of perma bulls weren’t Bullish Enough on US GDP Growth at the beginning of the year. Bears have been fighting the #GrowthAccelerating data since December. The best growth data of the 2013 (JUL-AUG) has coincided with the highest 10yr bond yields. That’s not Mucker’s genius. That’s just called an economic cycle.


Now you might say that the sell-side is “too bullish” because:

  1. The average SPX “target” has gone from 1531 to 1708
  2. The average GDP “target” has gone from 1.8% to 2.3%

But, if you are me, you’re saying who cares?


The consensus “forecast” by the sell-side only matters when it’s way outside of what your process says could happen. That’s already happened this year. Old News. The new news is that #OldWall’s latest forecast isn’t a forecast – it’s literally the last report:

  1. SPX closing high for the YTD = 1709
  2. US GDP Growth for Q213 = 2.4%



At the same time:

  1. VIX just failed @Hedgeye TREND resistance of 18.98 (again) = down -11% for SEP to-date
  2. II Bull/Bear Survey just clocked the lowest reading of “Bulls” since November 2012 at 37.1%

And that’s all I have to say about that.


Our immediate-term Risk Ranges are now (you can get all 12 Big Macro ranges in our new Daily Trading Range product):


UST 10yr Yield 2.74-2.94%


Nikkei 139

VIX 14.96-17.81

USD 81.81-82.67

Yen 98.49-100.12


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


What Have You Learned? - Chart of the Day

What Have You Learned? - Virtual Portfolio

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