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Chasing The Tails

"Dream as if you'll live forever.  Live as if you you'll die today."
                                               -James Dean
 
We've sent Keith to Scotland for the week to get some rest, smoke a few cigars, and hopefully improve his golf game.  As a result, different members of our research team are going to take turns writing the Early Look this week, and applying our own unique individual lens to the interconnected world of global macro risk management.
 
Ironically, Keith and I have very different modus operandi when it comes to approaching every research day.  He operates under a strict regimen that incorporates getting into the office at exactly the same time.  My daily process is more based on chaos theory, or is at least chaotic. I get in every day at a different time, take a different route, and read a different collection of articles every morning (my girlfriend calls me the anti-type A).   
 
Despite these differences, Keith and I have worked together effectively for many years, starting on the hockey rink at Yale, working together at a major hedge fund in New York, and finally building a business that, we believe, is reinventing a broken sell side research model.  We sell our research for a simple fee, produce it real time, and have no conflicts of interests that are ever-present in banking, trading, or a prop desk.  
 
In terms of how we operate on our Macro Research Team, Keith focuses on the day-to-day grind of the market, while I spend more time thinking and writing about the longer term trends.   As the James Dean quote above implies, Keith manages risk like every day is the last, while I dream about the investment trends of the future.   We call these longer term trends TAILs, and it's my job to chase them.  
 
A TAIL, to us, is a theme and price that has duration of up to 3 years.  Often ideas with longer duration are less obvious, hence the term tail, which is a statistical term that is used to refer to the extreme area of a distribution.
 
When we look at the global investment landscape, we see a number of themes that are sitting there out there on the TAIL, these include:
 
1.       Demographic share taking  - Globally, we are seeing the Middle East and Asia take massive population share and this will only accelerate in the coming years (these regions are growing at 2.0% per annum), as the former Soviet Union and Europe have stagnant population growth patterns (growing at less than 0.5% per annum).  Domestically, we are seeing the emergence of a powerful demographic know as the Millennials (those born between 1), which will be much larger than the cohort before them, Gen X,  given that live births in the U.S. reached 4MM for first time since 1965 in 1985, and have stayed at that level since.  Companies that are positioned for age groups and regions that are taking population share, will inevitably have higher organic growth rates than their peers.
 
2.       Scarcity of resources - When we think of scarcity of resources, we are referring primarily to oil.  According to the BP Statistical Review of World Energy, from 2004 - 2008 global supply of oil grew at a CAGR of 0.5% and demand for oil grew at CAGR of 0.8%.  Despite massive investment in exploration and production from 2004 - 2008, the supply of oil globally barely budged.  If it were not for the global recession of late 2008 / early 2009, which will lead to an estimated decline of -2.9% in oil demand in 2009, the global oil market would be incredibly tight.  The reality is that the recession has only prolonged the inevitable tightness of world oil supply and demand.  Oil speculators aside, the reality remains that with any economic recovery we will see a tight oil market for years to come with the potential for exponential increases in the price of oil in the foreseeable future.
 
3.       Potential loss of American dominance - President Obama is approaching foreign policy with a very unique strategy versus his predecessors.  He is reaching out to our perceived enemies such as Iran and militant Islam broadly, and owning up to historical transgressions of the U.S. government.  This policy has the potential to make us look weak and embolden our enemies, or alternatively encourage them to engage in diplomacy, which could hasten the spread of peace.  To date his strategies appear to have mixed results.  On the economic front, China and Russia continue to publicly denigrate the U.S. dollar and questions its dominance.  While on the national security front, North Korea, as of this weekend, is threatening to send missiles towards Hawaii.  Additionally, Iran continues forward with its nuclear program and appears to be suppressing the popular support for Mir Hossein Mousavi despite pleas from President Obama to do otherwise.  The U.S. currently represents roughly 25% of global GDP, therefore any major shift in U.S. economic or foreign policy dominance will have a material impact on the global investment landscape.


Themes on the TAIL are not always actionable, but often accelerate into a closer time frame sooner than we expect.  Chasing the TAILs should be part of any proactive risk management process.
 
Keep your head up and eyes on the tail,
 
Daryl G. Jones
Managing Director
 

LONG ETFS

EWZ - iShares Brazil-President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. Brazil is a major producer of commodities. We believe the country's profile matches up well with our re-flation theme.


QQQQ - PowerShares NASDAQ 100 - We bought Qs on 6/10 to be long the US market. The index includes companies with better balance sheets that don't need as much financial leverage.


EWC - iShares Canada - We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich British Columbia should provide a positive catalyst for investors to get long the country.   


XLE - SPDR Energy - We think Energy works higher if the Buck breaks down.  


CAF - Morgan Stanley China Fund - A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.


TIP- iShares TIPS - The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%. We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

 
SHORT ETFS

EWI - iShares Italy - Italian Prime Minister Silvio Berlusconi has made headlines for his private escapades, and not for his leadership in turning around the struggling economy. Like its European peers, Italian unemployment is on the rise and despite improved confidence indices, industrial production is depressed and there are faint signs at best that the consumer is spending. From a quantitative set-up, the Italian ETF holds a substantial amount Financials (43.10%), leverage we don't want to be long of.


XLY - SPDR Consumer Discretionary - We shorted XLY on 6/19 as our team has turned negative on consumer in the last week.  


XLP - SPDR Consumer Staples - We shorted XLP on the bounce on 6/17.   


SHY - iShares 1-3 Year Treasury Bonds - If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.


UUP - U.S. Dollar Index - We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. Longer term, the burgeoning U.S. government debt balance will be negative for the greenback.

 
EWW - iShares Mexico - We're short Mexico due in part to the repercussions of the media's manic Swine flu fear.  The country's dependence on export revenues is decidedly bearish due to volatility of crude prices and when considering that the country's main oil producer, PEMEX, has substantial debt to pay down and its production capacity has declined since 2004. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.


MAY STRIP REVS SHOULD LOOK BETTER THAN AIRPORT #S

Low hold on slots and tables in May 2008 should allow the total revenue decline in May 2009 to look better than the 11.5% decline in McCarran airport traffic.  Assuming normal holds on tables and slots, we project that Strip gaming revenue will decline only about 5%.  In terms of YoY revenue change, May could be the best month since September 2008.  As a refresher, gaming revenues declined 16% in April 2009 which was the 7th consecutive double digit monthly decline.

Before we get too excited though, our sources indicate that June looks a little weak and the hold comparison is a little challenging.  Las Vegas is not yet out of the woods.

MAY STRIP REVS SHOULD LOOK BETTER THAN AIRPORT #S - May Strip metrics


WEN – Was my initial assessment right?

June 19 (Bloomberg) -- The rally in high-yield, high-risk bonds may have spawned its first dividend deal in two years. Wendy's/Arby's Group Inc., which issued $565 million of 10 percent notes due in 2016 yesterday, will use the proceeds to repay debt and make a "distribution," potentially for dividends and stock repurchases, the Atlanta-based company said yesterday in a statement. Billionaire Nelson Peltz's Trian Fund Management LP is the largest shareholder of Wendy's/Arby's.

Increasing leverage to buy back stock does not create long-term shareholder value.

 

 

 

 


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Grounded Norway

A look under the hood

Position: No active position; bullish bias

The nose dive of the Norwegian stock market (OBX Stock Index) on 6/17 in the wake of the Norwegian Central Bank's decision to cut the overnight deposit rate 25 bps to 1.25% peeked our interest as an outlier. The market's reaction to the cut, closing down 4.97%, appeared bearish, yet in a broader context the close didn't look as harsh:  (1.) the cut came unexpectedly as economists predicted that the Central Bank would first consider a cut in August, and (2.) most of Western and Eastern Europe also sold off on negative US-centric news, including increased fears of the expansion of the US government balance sheet, the threat of near to immediate-term inflation, and Obama's plan to restructure the financial industry.

While Wednesday's close was bearish, the stock market is up 31.3% YTD and we believe the country sets up nicely from a fundamental standpoint. Being outside of the EU, Norway has the ability (and some say luxury) to better maneuver its economy through monetary policy. With economies in contraction throughout Europe, it's become increasingly apparent the challenges the ECB faces in affecting policy for varied economies. In contrast, Norway's control over interest rates and currency levels has allowed it more flexibility to manage its economy. [From an autonomous perspective similar considerations could be made for Sweden (via the etf iShares EWD) and Switzerland (EWL), which we had in our portfolio on the long and short sides respectively this year.]

Fundamentally, Norway looks relatively healthy compared to some of its European peers.  Already lower interest rates and stimulus measures have encouraged shoppers to spend, confirmed by retail sales rising 1.4% on a monthly basis in April and consumer confidence improving. Inflation rose to 2.9% in May year-over-year and is expected to average 2.5% this year before pulling back to 1.75% in 2010 according to the statistical office.  The mainland economy (which excludes oil, gas and shipping) is forecast by Norges Bank to contract 1.5% this year and return to grow of 2.5% next. We'd be quick to point out the prospect of stagflation, yet Norway's rate of GDP decline is manageable, especially as the economies of the Eurozone and Sweden, its main trading partners, improve. 

Playing to its Strengths: Oil & Gas

Norway's economy benefits from its rich off-shore oil and gas fields. Norway's petroleum industries account for ~23% of GDP, close to 50% of exports, and about 31% of government revenue in 2007, according to the latest IMF paper under the listing "Summary of Norway's Transparency Practices for Petroleum Revenue Management".  If oil could sustain this level or better it would be decidedly bullish for Norway's economy as both an exporter and beneficiary of oil and gas royalties.  The chart below illustrates the prospect of this price level for Brent based on a three-year moving average.  Oil's YTD upward move of ~55% has certainly helped to propel the stock market to over 30% YTD, while neighbor Sweden stands at 17.5% year-to-date, and export-giant Germany's stock market (DAX) is up less than 1% YTD, as a comparison.

Today Royal Dutch Shell Plc, Europe's largest oil company, said it discovered a natural gas bed in the northern Norwegian Sea estimated to hold 10 to 100 Billion standard cubic meters of gas. While the discovery isn't particularly noteworthy considering Norway's net gas output was 99 Billion cubic meters last year, should Norway supply Europe's demand for natural gas it would have major geopolitical implications. You'll recall that we've been tracking the rising geopolitical tension between Russia and Europe over natural gas, which hit a crescendo over the New Year when Gazprom shut off supply to Ukraine and limited gas through Belarus (two main transit routes to Europe) that led to reduced capacity throughout Europe. The move, which disturbed many (esp. following Russia's invasion of Georgia), encouraged great debate among the European Commission to find an alternative to Russian natural gas, in short, to bypass Russia's political leverage over gas. Debate has included resumed talks of LNG capabilities, increased investment in renewable technology such as wind harvesting, and alternative pipelines to bypass Russian territory such as the Nabucco project, yet talks (and action) have stalled due mainly to price: Russian gas is still the cheapest option by and large. 

Conservative Banking Practices

The historically conservative lending practices of Norwegian banks, focused more on prudent products and domestic loans rather than exotic credit products and global reach, has helped them not only weather the recessionary environment, but better position themselves for future lending. Despite leverage to Icelandic banks and customers, by and large the conservative nature of Norwegian banks has favorably positioned them. We believe this may encourage Norway to outpace its Eurozone peers on a recovery basis.

Managed Economy

Norway's economy has a unique blend of free market and state controlled enterprise. The latter is concentrated in its main industries, including: petroleum sector (StatoilHydro), hydroelectric energy production (Statkraft), aluminum production (Norsk Hydro), Norway's largest bank (DnB NOR), and telecommunication provider (Telenor).  Norway has a very manageable population of less than 5 Million and due to the historic wealth of the country (Norwegians have the second highest GDP per-capita after Luxembourg), it has not seen major economic swings-such as an extensive housing bubble or excessive amounts of foreign debt-that have plagued some of its European peers. 

Despite this positive fundamental set-up, and to the dismay of investors, neither Norway nor Scandinavia has an ETF or liquid product to get long the country. StatoilHydro (STO) currently trades on the NYSE and could be an oil play for us as we get more conviction on a longer term trend.   

Matthew Hedrick
Analyst

Grounded Norway - brent


SBUX – GRASS ROOTS SALES SURVEY FOR MAY 09

The street is decidedly negative (25% of the ratings are Buys) on Starbucks relative to the other large capitalization QSR restaurant companies, according to Thompson/Reuters. Interestingly, the company with the biggest rating is Burger King (75% of the ratings are Buys) and it is the worst performing QSR stock: down 30% this year. The fact that there is a large Private Equity firm with a big position has nothing to do the analyst opinion of the company.

 

SBUX – GRASS ROOTS SALES SURVEY FOR MAY 09 - ratings

 

I still believe that there is a significant catalyst coming for Starbucks when we settle the perception that McDonald's McCafe is not taking significant share from SBUX. We are getting closer to that day.


I don't care how negative people are on Starbuck's; the core of the business model is very healthy and is showing very sustainable trends that were not there three to six months ago. For the past two quarters the company has posted sequential improvements in operating margins and will report year-over-year improvement in 3Q and 4Q of 2009. This is directly attributable to the progress SBUX has made on its cost cutting initiatives. In 2Q09, SBUX delivered $120 million in cost savings, exceeding the $100 million target. For the balance of the fiscal 2009, SBUX has cost savings of approximately $150 million in 3Q09 and $175 million in 4Q09. In order to sustain continued stock price appreciation, SBUX cannot rely on cost saving initiatives alone. Investors will expect to see an improvement in same-store sales to keep the stock working.


That being said, I set out to come up with a way to gauge SBUX's progress toward improving monthly sales trends, which resulted in the inception of the SBUX monthly "grass roots survey." The stores surveyed represent a geographic mix across the U.S.


STARBUCKS MARCH "GRASS ROOTS SURVEY" SALES TRENDS:


The survey indicates that May same-store sales on average were flat to -1%. This compares to our previous survey indicating that March same-store sales on average were flat to -3%. As I said in March, these numbers are so good I don't believe what I'm seeing. Naturally, I provided a haircut to the numbers, but that would still put SBUX same-store sales at down 3-4% versus 5-7% in March.


This would be a significant improvement from the trends in fiscal 2Q09 when same-store sales declined 8%. I continue to think that it is more important to focus on the numbers on a directional basis, rather than looking at the absolute numbers, and directionally, these May numbers look better than what we have been seeing for some time from Starbucks' U.S. business. These numbers are even more impressive given that McDonald's was heavily promoting McCafe in May.


Other highlights of the survey:
(1) 80% of the stores reported a sequential improvement in sales trends in May from April
(2) 58% of the stores reported positive comps up from 21% in March - the average was +4%
(3) The stores reporting negative comps were down 5-6%
(4) The average number of breakfast combo's was 14 in May down from 19 in March. Note that 1/3 of the stores in March were not selling breakfast combo's yet
(5) Suggestive selling helps improve the attach rate of combo's.


Right now, I think SBUX could be tracking down 5-6% in same-stores sales for 3Q09.

 

SBUX – GRASS ROOTS SALES SURVEY FOR MAY 09 - sbuxsss


Risk Management Map: SP500 Levels, Refreshed...

In t-minus an hour, I'll be turning off my screens for the next week. Ahead of that, I felt like I should leave a map.

Below are the risk management lines of the SP500's current setup. While plenty a pundit continues to try to call for squeezes and crashes (AFTER the big ones occurred), I think its most sensible to dial down your gross long exposure and trade this proactively predictable range.

•1.       I am dropping my immediate term TRADE support line for the SP500 down to 901 (from 904). Intermediate term TREND line support is significant at 848 (thick green line in the chart below).

•2.       On the upside, there's an immediate term TRADE line of resistance at 928 (I made a total of 6 sales up and into that line this morning), and the most important line resistance at 967. This is a new duration product that we are developing called the long term TAIL, which is 3 years or less, and very much a dominant force of price gravity.

Top to bottom, this is a 14% point range. That's a lot different than the -57% peak-to-trough crash, or the +40% trough-to-peak squeeze that ended last Friday at 946. Manage your daily risk accordingly, and best of luck.

KM

Keith R. McCullough

Chief Executive Officer

Risk Management Map: SP500 Levels, Refreshed...  - ahead


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