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Takeaway: Current Investing Ideas: BNNY, BYD, FDX, HCA, HOLX, MD, NKE, RH, SBUX, TROW and WWW


Editor's note: Below are the latest comments from Hedgeye Sector Heads on their high-conviction stock ideas. Please note that Financials Sector Head Josh Steiner has removed Nationstar Mortgage (NSM) from his Best Ideas list. Josh provides his full rationale below.


In related news, we have added a new stock to Investing Ideas this week. Hedgeye Gaming, Lodging & Leisure Sector Head Todd Jordan has added Boyd Gaming (BYD) as a high-conviction stock idea. We have included Todd's note sent to our Institutional Clients below as well.


* * * * * * *


BNNY - Consumer Staples analyst Matthew Hedrick writes, "There was no real news flow in Annie's since last week. BNNY remains a buy." Hedrick adds that, "Annie's is making higher highs, and was up over 2% this week, despite a tough week overall in the US stock market where the S&P 500 was down 1%."


BYD - Please see below Gaming, Lodging & Leisure Sector Head Todd Jordan's latest Institutional Note on Boyd Gaming.


FDX - As he wrote in his Investing Ideas update earlier this week, Industrials Sector Head Jay Van Sciver remains bullish on FedEx. However, he says, “We would lighten up on our FDX long here – like sell half - for a few key reasons.


First, the shares have moved significantly higher within our fair value range. Second, the details of the most recent quarter lead us to expect an opportunity to buy the shares back lower around FY2Q results. Finally, we had expected capacity and inventory trends to turn more supportive than they have.


We are not dropping our long-term thesis and remain positive on the name, but acknowledge that no long-term thesis plays out without disruptions and trading opportunities.” Taking a magnifying glass to the company’s financials, Van Sciver notes “several unusual items that helped the Express margin, potentially introducing ‘choppiness’ to FY2Q.”


HCA - Hedgeye Healthcare Sector Head Tom Tobin is paying close attention to October 1st. That is the open date for the Exchanges created under the Affordable Care Act, better known as Obamacare.  This week the monthly premiums were released and in general were described as better than expected. 


There remains much to learn about how well Obamacare will do in reducing the number of uninsured.  The biggest question is how many of the healthy uninsured will pay for a plan.  With the government subsidy to cover the cost of insurance, many people with low incomes will pay nothing, but if you make anything over $35,000, the cost is close to $300 per month. 


Of course, having insurance is only the first step.  Obamacare sets a maximum out of pocket expense of close to $2000 per year, so co-pays and deductibles will still be a cost for the uninsured to consider.  While it’s a big problem for the health insurance industry if healthy uninsured people don’t sign up, for the hospital industry is in a little better position. 


We’re assuming those in need will gladly take on a policy and let their insurance company pay the bulk of their expenses.  For the healthy uninsured, they probably weren’t coming in anyway.


HOLX - Hedgeye Healthcare Sector Head Tom Tobin has no update on Hologic this week.


MD - Hedgeye Healthcare Sector Head Tom Tobin says there is still much to like about Mednax, but the recent absolute and relative performance is giving us pause.  Short interest continues to fall, although remains elevated, which we view positively. 


Our biggest concern is the recent survey results from our OB/GYN Tracking Survey. Births continue to look like they are running negative.  We’re still waiting for the deferred births of the last 5 years to return.  On the positive side, Medicaid rates will be heading higher in the coming quarters (ACA Rate Parity) and the company has yet to complete their acquisition goals for the year. 


NKE - Please see below Retail Sector Head Brian McGough's latest Institutional Note on Nike.


RH - Retail Sector Head Brian McGough reiterates his long-term, high-conviction thesis on shares of Restoration Hardware. McGough would like to remind subscribers that the company's recently reported numbers were excellent. In addition, he says the cadence of strategic change to achieve the long-term earnings growth we’re looking for was there.


According to McGough, 2H square footage is accelerating, comp is improving, and gross margins are on the rebound. And all of this is in the context of what we think is an extremely favorable 5-year growth trajectory. 


SBUX Hedgeye Sector head Howard Penney's message on Starbucks shares is basically, "If ain't broke, don't fix it." In other words, Starbucks remains the single best growth stock in the restaurant space that he covers.  He likes Starbucks on both an intermediate-term TREND and a long-term TAIL basis.


Penney says SBUX will show above-trend revenue growth over the next few months, due in large part to U.S. and international growth, as well as ongoing expansion in the Consumer Products Group.  CPG refers to Starbucks’ business of selling products through grocery stores and warehouse clubs, in addition to selling other branded SBUX products worldwide.


Penney also believes SBUX is poised to achieve impressive long-term growth as long as it continues to focus on its core business.  


TROW - Hedgeye Director of Financials Research Jonathan Casteleyn says that T Rowe Price is the best positioned asset manager to capitalize on the emerging trend of a reallocation out of bond funds and a replanting into equity funds. 


According to his calculations, if the current asset allocation of 68% in bonds and 32% in stocks normalizes to longer term averages, that a $2 trillion shift between the asset classes can occur.  With the industry’s best stock fund performance, T Rowe Price would disproportionately benefit by incrementally picking up a large amount of new investor funds into equities. 


WWW - Retail Sector Head Brian McGough says there's not much to report on the news front this week. With the quarter closing in less than a week, Wolverine's quiet period is just about to begin.  WWW reports in the first half of October. McGough is coming in at $1.20 vs. the Street at $1.02. It goes without saying that we think it will have a terrific quarter. 


* * * * * * *


Financials Sector Head Josh Steiner thinks it’s time to walk away from Nationstar Mortgage on the long side as the pressures they’re likely to face on the originations business in the third quarter don’t appear to be fully understood. Much of the good news on the servicing side now seems well understood.


In light of the confluence of recent positive news and sell-side coverage, the positive recent performance in the stock and our growing concern about potential 3Q13 earnings weakness, we think it no longer makes sense to be long Nationstar. We expect some further positive catalysts in the short-term such as potential MSR deal announcements. These should help support the stock in the short-term and may push it higher. It’s 3Q earnings results that have us concerned. The company is scheduled to report earnings on November 5.


TRADE: In the short-term we expect positive MSR deal announcements.


TREND: Over the intermediate term, we are concerned about the potential for weaker-than-expected 3Q13 earnings results.


TAIL: In the long-term, there is still a tremendous opportunity for non-bank servicers like Nationstar to roll-up the servicing business. NSM is well positioned to be a prime beneficiary. Once the market has reset expectations on the gain-on-sale business we may well revisit this name on the long side.


* * * * * * *


(Editor's note: Hedgeye Gaming, Lodging & Leisure Sector Head Todd Jordan issued this note to Hedgeye Institutional clients earlier this week.)


It's been awhile since we've seen so many positive catalysts for this sell side whipping boy.


I’m in Las Vegas for meetings and wanted to relay one important highlight.  I have come away very positive on Boyd Gaming (BYD). We will expound on our thesis points in upcoming posts, but since some of the catalysts are fresh, time is of the essence.


We still worry about the regional markets and the declining base of slot players.  However, BYD maintains significant exposure to the Las Vegas locals market, an incremental positive in our opinion given the positive macro offset to tough nationwide casino demographics.  


Even in the regional markets where we are less sanguine, BYD seems to have significant room for cost cutting and thus, margin improvement.  In New Jersey, Borgata is spending less and gaining market share.  And speaking of New Jersey, we cannot forget the future, which is in online gaming.  Only a handful of companies can boast of first mover advantages - and they are huge - in the future of federal or multi-state internet poker.  BYD is one of them.


So with a return to revenue growth in the LV Locals market and likely margin improvement everywhere, we actually could see earnings upside for the first time in a long time for BYD.  Investment ratings are mostly neutral, leaving plenty of room for upgrades, especially with potentially a positive earnings surprise and higher guidance combined with the reactive nature of many on the sell side.


Here are some upcoming catalysts:



  • New Jersey tax court ruling should occur this month
    • It’s not in the numbers or guidance but a favorable property tax adjustment could result in $10m+ in annual EBITDA at Borgata.  Moreover, the last 4 years are being challenged so Borgata could also receive a $40-50m tax rebate.
  • G2E and DB/UBS investor conference in Vegas starting on 9/23
    • We expect BYD to show well and exude optimism
  • Earnings release in late October
    • We believe BYD is on track to beat consensus and provide solid guidance and commentary.
  • November approval for online gaming in New Jersey
    • New Jersey online gaming is a positive for Borgata and a marginal positive for BYD.  More importantly, BYD should have a great head start if and when online gaming rolls out nationally.  Online is the future people.

* * * * * * *


(Editor's note: We are pleased to feature Retail Sector Head Brian McGough's bullish note sent to Hedgeye's Institutional Clients Thursday evening. As you will see below, McGough remains uber-bullish on shares of Nike.)


Takeaway: Nike is making ailing US retailers as well as its global competitors (aka Adidas) look downright silly.

What’s there to say about Nike’s quarter? We’re surrounded left and right by weakness in US retail, and yet Nike comes out and prints a quarter of Champions. 


NKE printed top line growth of 8%, and an acceleration in futures to +10%, with a nice balance of 7% growth in units, and 3% increase in price. We saw +120bp improvement in gross margins, which was far ahead of our above-consensus estimate – as pricing initiatives are being met with very little resistance, and raw materials costs are coming in below plan. SG&A was flat for the quarter, which is largely due to comparisons against event spending vs last year. But still, the growth algorithm is inarguable…sales +8%, gross profit +11%, and EBIT +40%. EPS came in at $0.86, well ahead of our estimate of $0.82 and the Street at $0.78. Inventory looked great as well, growing 6% -- below the rate of sales for the 5th quarter in a row.


You might say that Nike naturally sidesteps the US retail malaise due to the fact that it is a global company. But then why did Adidas – its closest global competitor that has a nearly identical scope, reach and mix outside of the United States – put out an announcement on September 20 taking down expectations for the quarter and the year due to weak sales globally, particularly Russia (which Nike highlighted as a strength this quarter), and golf (this was also weak for Nike, to be fair). This juxtaposition simply highlights how well Nike is managed relative to its peers.


We’re taking up our estimate to $3.25 for the year (20% EPS growth). We think that Nike is being conservative with its expectation for only 50bps of improvement in gross margins for the year, and although we’ll start to see more normalized levels of SG&A spending, the reality is that a high-single-digit growth rate in sales with 100bp+ in gross margin improvement is nothing to shake a stick at. Mid-high teens EPS growth on top of 25% ROIC makes Nike every bit worthy of its 20 forward multiple (and then some). Nike’s still a core holding any way we cut it.


We’ll return with a more thorough deep dive after Nike’s analyst meeting in two weeks. 

[VIDEO] McCullough Talks Markets on T3 Live



Hedgeye CEO Keith McCullough speaks with T3 Live Chief Strategic Officer Scott Redler about recent market action, the Fed's recent "no taper" decision, and trends to look for over the next 6-12 months.


They also discuss the current landscape on Wall Street and how newer companies like T3 Live and Hedgeye are working to level the playing field for average investors through education, transparency and discipline.

Get Involved

This note was originally published September 27, 2013 at 07:48 in Morning Newsletter

Editor's note: Please enjoy this complimentary "Morning Newsletter" from Senior Analyst Darius Dale. While Hedgeye CEO Keith McCullough typically writes this newsletter, periodically, other members of the team jump in for guest appearances.


“What people fail to realize is that we spend ~70% of the time at record highs in the equity market.” Anonymous Seasoned Investor

The big picture

Keith and I picked up that gem in a recent meeting with a client out in San Francisco. Truly a savvy investor, this gentleman belongs to the increasingly rare camp of investors that has managed market risk across multiple decades and economic cycles.


Regarding the aforementioned quote, he dropped that line in a discussion about the pervasive lack of enthusiasm for 2013’s non-consensus equity market rally, specifically in response to our conjecture that baggage from the hard times of 2008-09 is broadly preventing investors from buying into the sustainability of said rally.


While I believe he was merely throwing a number out there to make a [wise] point, the reality is that he’s actually not that far off as it relates to the assertion he was trying to make:

  • Being worried about allocating capital to the equity market at/near its all-time high is hardly as big of a deal as the average investor – fully loaded with 2000-02 and 2008-09 baggage – would have you believe.
  • Over the past 30Y, the S&P 500 has traded within 5% of its [then] all-time high 43.8% of the time.
  • Over that same duration, only 26% of the time has the index traded 20% below its [then] all-time high.

Oddly enough, when looking at aggregated fund flow and securities market allocation trends, it seems that investors are still positioned for yet another blow-up in the equity market, when, in reality, it’s the inevitable unwinding of Bernanke’s bond bubble they should be most concerned about.


Per Jonathan Casteleyn, the newest member of our highly-regarded financials team:

  • Per the most recent data (2008-11 period), pension fund allocations to stocks is at an all-time low of 44%, while their allocations to bonds is at an all-time high of 37%. That ratio was 52% to 33% in the 1984-94 period, 64% to 27% in the 1995-00 period and 60% to 28% in the 2001-07 period.
  • From the start of 2008 through the most recent data (JUL ’13), bond mutual funds have seen a cumulative $1.09T of inflows, or 17% of starting AUM. This compares to a -$441B outflow from equity mutual funds, or -7% of starting AUM.
  • At $38T outstanding across the various categories, bonds represent 68% of the total US securities market (equities and debt). That compares to a 20Y average of 64% and a balanced ratio of 50/50 in 1999. Reversion to the mean implies a greater than $2T outflow from bonds into stocks over the long term.

Regarding that last point, we get a lot of pushback from fixed income managers that bonds funds don’t necessarily need to see outflows for the equity funds to receive inflows, citing record “cash on the sidelines”.


Indeed, un-invested cash in money market mutual funds, credit balances in margin accounts and deposit and currency assets on household balance sheets currently totals ~$12.4T, which is just off of all-time highs. As a percentage of the securities market, however, it hovers just above all-time lows (23% vs. a record low of 22% in 1999 and a record high of 32% in 2009).


If in 1999 someone thought the aggregate investment community was going to take its liquidity ratio down to new all-time lows in order to continue financing a bubble in stocks or even to take up its gross exposure by simply increasing its allocations to bonds, boy, were they sorely mistaken. Making that argument in defense of fixed income right now is equally off base, in our opinion.

Macro grind

In summary, we continue to believe there is a compelling, long-term fund flow case to be made in favor of the equity market in lieu of the bond market. 


Not from every price, however…


We need to see the US Dollar Index recapture its TREND line of $81.35 for us to believe that tapering is an intermediate-term event, rather than one that is far off in the distant realm of “potentially never”.


Simply put, as long as a collection of fear-mongering doves dominate the domestic monetary policy debate, the probability of a Japan-like, no-growth economic scenario will remain heightened.


Besides a natural monetary policy response to economic gravity, what else would get investors excited about investing for growth in lieu of safety?


Corporate America would be a good place to start. My, how they have been conspicuously absent from this recovery!



  • Record cash on their balance sheets ($1.8T per the latest data);
  • A near-record ratio of liquid assets to short-term liabilities (47.3%; 1.8 standard deviations above the 30Y mean);
  • An effective tax rate of 19.9% that is near all-time lows (-1.6 standard deviations below the 30Y mean);
  • An estimated $700B in interest savings since 2009 that can be specifically attributed to QE*; and
  • Profits that have grown +34.7% since 2007…

… Corporations have reduced employee headcount by -2.9% since 2007 and grown nominal CapEx by a measly +0.6% on a trailing 5Y CAGR basis – a growth rate that is just above a generational low.


Regarding the former point on corporate, QE-derived interest savings, $700B is enough to employ 9.6M workers for 1Y, assuming a $51k median income (per the Census Bureau) that represents 70% of all-in employee compensation costs (per the BLS), effectively taking up the median annual comp to $72.9k. To put that in context, there have been only 6.8M net hires since 2009 per the seasonally-adjusted nonfarm payrolls numbers.


Obviously that’s nothing more than a hypothetical analysis meant to draw attention to the fact that QE to-date has been little more than an overt transfer of wealth to Corporate America and the rest of the top-10% that owns the lion’s share of financial wealth in the this country.


It’s time both parties said, “thank you” by putting capital to work (corporations) and allocating capital back to pro-growth assets (investors).

  • CASH: 49

Our levels

Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 2.57-2.74%

SPX 1684-1705

VIX 12.95-14.98

USD 79.99-81.35

Yen 98.02-99.17

Brent 107.40-110.61


Keep your head on a swivel,


Darius Dale

Senior Analyst


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Household Wealth Up, Income...Not So Much

Takeaway: Higher Highs in Household Net Wealth. Personal income and spending improved in august but growth should remain constrained near-term.

We’re not big into “maintenance” research at Hedgeye but, at the same time, contextualizing marginal macro changes (i.e. the ones that matter) requires continually grinding through the incremental big picture data points. 


This morning’s Consumer Spending and Income data and Tuesday’s 2Q13 Flow of Funds data from the Fed aren’t  particularly actionable from an investment perspective, but they are worth a quick highlight. 


Below is an updated snapshot of the U.S. Household Balance Sheet from the latest Flow of Funds report from the Federal Reserve.   The continued improvement in Household Net wealth shouldn’t come as a surprise given the lack of aggregate household credit growth and the ongoing re-flation in real estate and financial asset prices. 


As of the end of 2Q13, Household Net Wealth is well above the prior 2007 peak on a nominal basis, flat on an inflation adjusted basis and -3.4% vs prior highs after adjusting for both inflation and the number of households (ie. inflation adjusted net worth per household).   


Household real estate values, currently at $18.6T (21% of total assets), grew at a rate of +11.9% YoY and remained a primary driver of net wealth gains in 2Q13.  We continue to expect positive growth in property values, albeit a slower rate of improvement than we’ve observed over the TTM,  to support further balance sheet improvement over the intermediate and longer-term. 


Putting aside the disproportionate benefit and wealth equality implications stemming from financial asset price inflation, ongoing strengthening in the aggregate household balance sheet remains an obvious positive as we continue to emerge on the other side of a long-term, domestic credit cycle.    


Household Wealth Up, Income...Not So Much - HH BS 2Q13



Consumer Income & Spending:  Upside Still Constrained


Today’s preliminary estimates from the BEA showed Personal Income grew 0.4% MoM  in August while Consumer Spending advanced +0.3% alongside a tick higher in the Savings Rate to 4.6% from 4.5% in July.   


On the income side, personal and disposable income growth accelerated on both a MoM and YoY basis while Government sourced income (~17% of the Workforce) remained a discrete drag on DPI growth.    


On the spending side, consumption of Non-durables decelerated on both a MoM and YoY basis (after accelerating last month) while spending on Services and Durables both accelerated sequentially (after decelerating last month).


From a multi-month Trend perspective, accelerating spending on goods has helped offset a modest deceleration in consumption of services. (see table below for a detailed breakdown).   


Inflation remained muted with core PCE – the key measure for the Fed – mired at 1.2% growth. 


Summarily, Personal Income accelerated sequentially but with the savings rate rising and compensation of government employees still growing negatively (due to ongoing job loss and the negative income effects from furloughs – see Here for a fuller discussion) consumer spending growth remained middling. 


The confluence of smallish credit growth, a static savings rate and a fiscal policy related drag on (already muted) income growth should serve to constrain the upside in consumption growth nearer term.  


Enjoy the weekend.  


Household Wealth Up, Income...Not So Much - Income   Spending 092613 


Christian B. Drake

Senior Analyst


Takeaway: We are removing NSM from the Hedgeye Best Ideas list as a long.

We Think It Makes Sense to Step Aside For Now

We have been consistently bullish on Nationstar Mortgage since adding it to Hedgeye's Best Ideas list back on February 27, 2013 at a price of $38-39. The stock has had a good run since then, recently trading in the $56-57 range, but today many of the themes and catalysts we thought were misunderstood earlier in the year have either come to pass or are now far better understood and priced in. Consequently, we think most of the good news is now reflected in the valuation. Consider that in just the last few weeks there have been at least two positive initiation reports and one upgrade of the stock from the sell side. In fact, there are currently 8 buy ratings on the stock, more than at any other point in the company's history.


We expect there will likely be near-term positive catalysts in the form of deal announcements. Inside Mortgage Finance has written that sizeable MSR transactions are to be expected in the near-term from Wells Fargo ($40 Bn), JPMorgan ($70 Bn) and, most recently, Citi ($61 Bn). Recall that in their second quarter earnings release, Nationstar bumped up its guided pipeline for bulk deals by $100bn, or roughly in line with the sum of the reported WFC & JPM deals. Clearly, there is high probability, but also high expectations, that NSM will win a large share of those big deals. We wouldn't be surprised to see the stock rally further on such announcements. Historically, deal announcements have been a catalyst for upside as they often led to upward guidance/estimate revisions, not just for NSM but for peer companies OCN and WAC as well.


So, Why the Change?

We have always regarded three dynamics as paramount for NSM shares to move higher: Growing UPB, Improving Servicing Margins and Maintaining GOS. We think the company has delivered on all three fronts to date, and we are not concerned with the progress being made toward the first two dynamics. It's the third one that worries us.  


Our primary concern, and the reason for our change in view, is our expectation that Nationstar will struggle to beat estimates going forward due to pressure on both volume and gain-on-sale margins in the mortgage origination business. After spending considerable time working with our model, we are now currently expecting $1.14 in 3Q13 earnings, which is down from our prior expectation of $1.72 and is now below Street expectations for $1.27. Further, we have baked 15 bp sequential quarterly increases into our expectations for long term interest rates throughout 2014 and this has had a profoundly negative effect on our outlook for next year's earnings power. Based on that bump up in rate expectations, we're now expecting NSM to earn $5.37 in 2014, down from our previous expectation for $8.30-9.35. You may find yourself at odds with our assumption of rising rates throughout 2014, particularly in light of the Fed's recent pronouncements and Summers' withdrawal from consideration. Our basis rests upon the strengthening labor market data we track in the initial jobless claims series, which we think will exert growing pressure on prices and, in turn, should pressure the Fed to begin to constrict credit.



We've assumed that HARP volumes are relatively unaffected by the rate change. The guidance is for half of 2013's core production target of $23 billion to be HARP, or roughly $11.5 billion. In the first half of the year, we estimate the company originated $4.5 billion in HARP loans, leaving $7 billion in production for the back half of the year. We've split this evenly at $3.5 billion per quarter. However, the remaining non-HARP origination business we have haircut by 40% vs. our prior baseline forecast. Multiple datapoints support the appropriateness of such a haircut. Cardinal Financial recently pre-announced the quarter citing a 40% drop in Q/Q mortgage origination volume (both purchase & refi) coupled with material compression in gain-on-sale margins. MBA volumes 3QTD are down Q/Q by 47% for refi and purchase volumes are down 9% 3QTD vs 2Q13. Given that most of NSM's volume is refi-based, we think a 40% haircut outside of the HARP channel is reasonable. 





We've also assumed gain-on-sale margin pressure. Here's the comment management made on the 2Q13 earnings call, hosted in early August: "With the recent rise in interest rates, we've seen some pressure on market pricing, mainly in the premiums on HARP originations." Generally speaking, HARP loans fetch a 250-500 bps GOS premium to non-HARP loans based on a December 2012 Fed study, which can be found here: Fed Study. Taking the mid-point of the 250-500 bps premium, we estimate that last quarter HARP GOS revenue accounted for roughly 60% of total GOS revenue while only accounting for 38% of volume. The average 30-Year FRM rose to 4.45% thus far in the third quarter, up from the 2Q13 average of 3.67%. That 75-80 bps Q/Q increase in rates is likely to weigh heavily on HARP premiums. Remember, HARP loans fetch a smaller premium in a rising rate environment as traditional loans become more valuable. We've nevertheless been conservative in our treatment and assumed roughly a 25 bps decline in Q/Q total GOS margins.  


Based on the combination of these factors, reduced volume vs. prior baseline and lower GOS margins, we've lowered our expectation for GOS revenue to $288mn in 3Q down from our prior thinking of $365mn. While management has indicated that they can and likely will bring some further efficiency to the cost side of this business, we doubt it will be enough to offset the compressed volumes and spreads especially considering the magnitude of efficiency improvement seen in 2Q13. #ToughComps


In short, while we think the long-term opportunity in the servicing business remains attractive, we think expectations are already high on that front without sufficient deference being paid to the pressure on the originations business. We would sell Nationstar at these levels and consider an alternative without heavy origination exposure, like Ocwen.


Ocwen (OCN) as an Alternative

We think it makes sense to roll out of Nationstar and into Ocwen, ticker OCN, where investors can still benefit from the secular trend in servicing but without the significant risk to the GOS business. 


Our expectation is that 3Q13 earnings from NSM will disappoint and likely will serve as a catalyst for a rotation out of NSM and into OCN.











Joshua Steiner, CFA


Jonathan Casteleyn, CFA, CMT



Takeaway: A strong quantitative argument can be made for the FOMC board to remain on hold throughout the balance of 2013 and throughout 2014 as well.

This note was originally published September 23, 2013 at 18:01 in Macro



  • A strong quantitative argument can be made for the FOMC board to remain on hold throughout the balance of 2013 and throughout 2014 as well. This debate is likely to become increasingly mainstream in the coming weeks and months and will have meaningful implications for the US dollar, US interest rates and global capital and currency markets at large.
  • Investors attempting to get inside of Bernanke's head and/or view the economy as the FOMC board does should arrive at the following three conclusions based on the most recent data:
    • Reported US economic growth is sluggish at best;
    • The labor market has cooled off substantially; and
    • Benign reported inflation will give policymakers ample headroom to continue easing even if the labor market starts to accelerate meaningfully.
  • Regarding the latter point, both St. Louis Fed President James Bullard and Chicago Fed President Chuck Evans (the both of whom are voting members on the FOMC board) have been calling out low inflation as their chief economic concern in recent weeks/months.
  • Our analysis suggests the US economy may have to sustainably record Real GDP growth in the +3% to +3.6% range in order to generate the kind of job creation necessary for the Unemployment Rate to breach the Fed’s 6.5% threshold over the intermediate term (holding flat other factors like the Labor Force Participation Rate).


Like most market participants, we were surprised by the Fed’s decision not to taper its asset purchase program last week.


In our view, both the pace and slope of economic growth has been solid enough to justify commencing a process of weaning the economy and its capital markets off of  large-scale asset purchases (LSAP).


The critical takeaway from the aforementioned statement is not the part about the pace and slope of economic growth; rather, the key element of that declaration was indeed the phrase, “in our view”.  


Specifically, “our view” of the pace and slope of economic growth is wholly shaped by leading and concurrent indicators, such as market prices, survey data (such as New Orders PMI readings) and our proprietary analysis of that data (e.g. modeling market prices with Keith’s quantitative risk management levels or something like tracking the YoY % change in Rolling NSA Jobless Claims).


Moreover, our process is designed to front-run inflection points in the market(s) and/or policy. Thus, an overt focus on concurrent-to-leading indicators is a prerequisite for any repeatable success in doing so.  


The Fed, on the other hand, primarily focuses on lagging economic indicators, like Unemployment, Core PCE and Real GDP. Their primary responsibility is to set monetary policy based on actual – not guesstimated – economic conditions. Thus, an overt focus on lagging indicators is appropriate for their task as it is defined.


While we’d certainly prefer they apply more modern-day analytical techniques (i.e. chaos theory, behavioral economics, etc.) to their policy-setting agenda, for the purposes of keeping this note tight, we will temporarily concede to the consensus view among the academic economist community that the Fed should be more measured (i.e. less dynamic) with respect to setting monetary policy.


All told, understanding this distinction between what market participants are focused on and what the FOMC board is focused on is critical to appropriately preparing your portfolio for the Fed’s next policy move and, more importantly, the timing therein.


Looking at the economy from the Fed’s perspective, it should not have come as a surprise to see them back away from tapering at last week’s FOMC meeting. If anything, their only fault was allowing tapering speculation to percolate throughout the global financial community in the first place!


  • In the 12M through 2Q13 (the latest reported figure), the US economy has grown only +1.6% on real basis; that rate of change represents a full standard deviation below the trailing 3Y trend.
  • In the QTD, Nonfarm Payrolls have averaged +136k MoM; that’s nearly one full standard deviation below the trailing 3Y trend (-0.9x) and down sharply from an average pace of +207.3k MoM in 1Q13.
  • In the 12M through JUL ’13 (the latest reported figure), underlying inflation – as measured by the Fed’s preferred measure of Core PCE – has tracked +1.2% YoY; that’s nearly one full standard deviation below the trailing 3Y trend (-0.9x).


Investors attempting to get inside of Bernanke's head and/or view the economy as the FOMC board does should arrive at the following three conclusions based on that sequence of data:


  1. Reported US economic growth is sluggish at best;
  2. The labor market has cooled off substantially;
  3. Benign reported inflation will give policymakers ample headroom to continue easing even if the labor market starts to accelerate meaningfully.


Regarding the latter point, both St. Louis Fed President James Bullard and Chicago Fed President Chuck Evans (the both of whom are voting members on the FOMC board) have been calling out low inflation as their chief economic concern in recent weeks/months.




Absent a dramatic near-term acceleration in core inflation – which is all but impossible given the neutering of consumer price indices in recent decades – the Fed is unlikely to find it appropriate to tighten monetary policy [via tapering… tapering is tightening, FYI] over the next few months.


Looking ahead to next year, one really has to see a dramatic acceleration of momentum in the labor market in order for the FOMC board to justify tapering LSAP – irrespective of whomever winds up in charge (no disrespect to Janet Yellen).


By our math which looks at the historical relationship between the deviation from trend in MoM Nonfarm Payrolls SA and deltas in the Unemployment Rate SA, the former series would have to average somewhere between +218.1k and +260k for five quarters in order for the latter series to reach the Fed’s 6.5% “target” (FYI, 6.5% is NOT a target for the initiation of tapering, as Bernanke has repeatedly stated in his recent commentary).




Regarding the study, please note that we purposefully decided to cap our study at a 10Y look-back; similar results hold over a trailing 30Y period as well, but we decided to front-run consensus pushback about how the labor market is structurally different today vs. 20Y or 30Y ago. We get it…


Moving along, it’s worth stressing that five quarters from now is the end of next year; not ironically, that is exactly when the FOMC board expects Unemployment Rate to hit that level.


Of course, maintaining the aforementioned pace of job creation for such an extended period of time would no doubt drag up the average and dampen any future deviations from trend. We understand that and would still expect to see continued improvement in the Unemployment Rate in spite of that – the purpose of this study is simply to gauge what level of economic performance we need to see in order to appropriately front-run the Fed from here.


Looking at the historical relationship between the deviation from trend in YoY Real GDP growth and the deviation from trend in MoM Nonfarm Payrolls SA, the former series would have to average somewhere between +3% and +3.6% produce readings in the latter series that are +1x to +2x standard deviations from the trailing 3Y trend. Using the most recent data set to reverse engineer those deviations produces the aforementioned range of +218.1k and +260k.




Of course, the pace of job creation isn’t the only factor in determining deltas in the Unemployment Rate; rather, there other key indicators, such as the structurally challenged Labor Force Participation Rate, that are integral components of the calculus.


Still, for anyone looking to correlate economic growth to a pace of job creation that is appropriate for the FOMC board to authorize a reduction in its LSAP program, we’d advise anchoring on anything north of +3% YoY. That’s nearly a double from the latest reported rate.


We consider it noteworthy that the Fed’s full-year 2014 GDP growth projection is right in line with that rate, effectively confirming that their economic growth expectations are on track for a 6.5% Unemployment Rate target by EOY ’14.


Right now, our model can get as high as +2.7% for 2014E Real GDP growth, but that’s not an estimate we would advise lending any credence to at the current juncture. As mentioned our previous works, our predictive tracking algorithm is designed to capture deltas and inflection points on a rolling 1-2 quarter basis. It’s worth nothing that trying to predict anything much further out than that tends to negatively skew the balance between facts and assumptions in any economic model.




Even if the economy can get up to and sustain a +3% rate of growth over the intermediate term, investors must continue to be cognizant of the fact that subdued core inflation will continue to keep the doves on the FOMC board uneasy about the mere thought of tapering – let alone hiking the Fed Funds Rate (which is what they likely intend to do when the Unemployment Rate reaches 6.5%, assuming both reported inflation and inflation expectations are in line with the committee’s +2% objective at that time).


Not surprisingly, those market participants closest to the pin-action are already starting to bake this scenario in. The implied probability of the Fed Funds Rate being 0.0% at the DEC ’14 FOMC meeting has increased from 7.7% in early SEP to 25.5% currently. Conversely, the implied probability of the Fed Funds Rate being hiked to 0.75% or 1% at the DEC ’14 meeting has dropped to 7.8% and 1.5%, respectively, from 23.2% and 10.4%, respectively, in early SEP.




All told, a strong quantitative argument can be made for the FOMC board to remain on hold throughout the balance of 2013 and throughout 2014 as well. This debate is likely to become increasingly mainstream in the coming weeks and months and will have meaningful implications for the US dollar, US interest rates and global capital and currency markets at large.


Have a wonderful evening,


Darius Dale

Senior Analyst



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