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Correlated Causations

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

“Ignorance more frequently begets confidence than does knowledge; it is those who know little, not those who know much, who so positively assert that this or that…”

-Charles Darwin

 

Having fun out there yet?

 

If like us, your conviction on what an appropriate gross and/or net exposure should be has wavered in recent weeks, Darwin’s quote probably resonates with you. With respect to financial markets, I, for one, don’t understand how anyone could’ve had enough conviction to positively assert anything beyond a simple “I don’t know” in recent weeks, but that’s just me. What do I know?

 

Without speculating on the level of ignorance (or lack thereof) implied by the views of any market participant(s), we continue to tip our hat to the “QE is effective; see, I nailed it all along” community – if for nothing other than their unwavering confidence.

 

Does QE actually “work”, however? Moreover, how does one go about determining its effectiveness? This debate really centers on the question we asked in the video we published earlier last week:

 

“Does the price of money determine the pace of economic activity or does the pace of economic activity determine the price of money?”

Without getting all philosophical before breakfast, our answer to that question was simply, “It’s reflexive.”

 

Considering, it would seem that trying to determine the causality behind the demonstrable acceleration in economic growth we’ve witnessed in the YTD is little more than a fool’s errand. Was QE responsible for producing economic growth or were expectations of QE’s eventual demise the stimulus the economy needed?

Sourcing the data, the reflexive relationship between the US dollar, US interest rates and the slope & magnitude of real GDP growth is almost impossible to disregard without being completely subjective or grossly qualitative. Whether you’re looking at the current economic cycle or the past three decades of economic cycles, the data speaks for itself:

  • 2013: In calculating monthly averages for the DXY and UST 10Y Yields, we see that the USD and US rates were most strong (on a YTD percentile basis) in the JUL/AUG/SEP periods. Coincidentally, that’s precisely when the ISM Non-Manufacturing and Manufacturing surveys, Conference Board Conference Board Consumer Confidence Index readings and the NFIB Small Business Confidence Index readings were also recording their strongest levels in the YTD (on a percentile basis). Moreover, the slope of the DXY and UST 10Y has tracked the slope of the aforementioned high-frequency growth data nearly perfectly in the YTD.
  • 1983-2013 (trailing 30Y): In calculating quarterly averages for the DXY and UST 10Y Yields, we see that concomitant QoQ appreciations in both indicators are closely associated with both relatively rapid economic growth and periods of #GrowthAccelerating. Specifically, Real GDP growth has averaged +4.2% on a QoQ SAAR basis in #StrongDollar + #RatesRising periods; that compares to +2.4% for #WeakDollar + #RatesFalling periods. From a 2nd derivative perspective, GDP growth tends to accelerate +23bps on average in the former environment and decelerate -23bps on average in the latter environment.

To our knowledge, qualitative assertions have yet to trump basic arithmetic in any debate.

 

The more we reflect and debate internally as a team, the more we find ourselves squarely in the camp of: “Who cares about causality anyway?” As investors, all we really want to do is isolate the signals – be they quantitative or fundamental – that give us the best probability of being right on the slope of growth, inflation and/or policy.

 

From there, we can begin to speculate in financial markets using reasonably accurate assumptions for what we believe to be the three most important factors in determining asset prices.

With respect to financial markets, what matters most is what everyone thinks everyone else thinks about QE and the only way to record any consistency or accuracy in attempts to measure that is to set aside our own dogmas.

 

In short, we do not think it is helpful to engage in the debate surrounding the causal impact of QE upon the economy. In our view, it is impossible to determine causality without being qualitative or subjective because we don’t have accurate data about the expectations and intentions of all the agents that make up an economy.

As such, all we can really do as investors is interpret the signals as they come and play the ball as it lies. Focusing our attention on anything else is a clear deviation from the task at hand (i.e. making money).

 

Regarding the task at hand, we do know that QE and its associated expectations are causal to the prices of many assets globally. As such, the name of the game remains isolating the signals that give us the best forward-looking read on growth, inflation and/or policy – or the eventual tapering of said policy:

  • Quantitative: Solid comeback for the US Dollar Index right to our TREND line of 81.39 resistance this morning; will it hold? US Treasury rates (10Y Yields) – which are now trading demonstrably above their 2.63% TREND line – are suggesting a DXY breakout has become an increasingly probable event.
  • Fundamental: Analyzing economic data like a Fed Head would imply tapering is a spring of 2014 event at the earliest. Moreover, the lack of liquidity in the bond market should take a mid-to-late-DEC tapering squarely off of the table: primary dealer inventory is -73% off its 2007 highs and equivalent to a mere 0.8% of outstanding US corporate credit vs. a peak of ~4% in 2007. Please note our emphasis on the word “should”, as what we think the Fed should do and what the Fed does are quite often two very different things.
  • Correlation Risk: While three days does not a trend make, very immediate term correlations are signaling what may be a return to the pro-growth trade of #StrongDollar + #RatesRising = positive US equity beta amid decidedly negative EM beta that has: A) dominated much of the past year; and B) was interrupted by a return to the post-crisis playbook of “QE = short US dollars; buy everything else” in the weeks since SEP 18 (i.e. the day of the Fed’s “no taper” surprise). See the Chart of the Day for more details.

So what do investors do with all of these convoluted signals? In a phrase: #GetActive. If you’re not yet familiar with our call for active mangers to outperform over the both the intermediate term and long term, please ping us for a review of our 4Q13 Macro Themes.

 

Indeed, it would seem that stock-picking will become increasingly important as we start to move away from what has been an elongated period of minimal return dispersion at the sector level – likely due to the strong performance of typically low-beta, high-yielding sectors in an era of institutionalized yield chasing.

 

For those of you who are keen to add new techniques to your analytical toolkit, we’ve built a model that backtests exceptionally well in screening for prospective alpha at the single security level. For more on that, please CLICK HERE for the data and CLICK HERE for the accompanying manual. Email us if this is something you’d like to discuss further.

 

Our immediate-term Risk Ranges are now:

 

UST 10Y Yield 2.64-2.79% (bullish)

SPX 1748-1778 (bullish)

VIX 12.29-14.55 (bearish)

USD 80.93-81.53 (neutral)

Pound 1.58-1.60 (bullish)

Gold 1271-1312 (bearish)

 

Keep your head on a swivel,

 

DD

 

Darius Dale

Associate: Macro Team

 

Correlated Causations - Chart of the Day

 

Correlated Causations - Virtual Portfolio


MCD: TESTING THE ESPRESSO-BASED BEVERAGE THEORY EARLY

As outlined at the recent analyst meeting, McDonald’s will rely on beverages to drive top line sales in 2014.  As we’ve said before, we believe that allocating resources to selling more beverages, particularly hot espresso beverages, will not generate the incremental sales needed to achieve the current estimate of +1.7% same-store sales growth in the U.S. in 2014.

 

In our opinion, McDonald’s is a food first destination and whenever management shifts their focus away from food and to selling beverages, the core business suffers.  The shift in the marketing calendar for the remainder of 2013 is an early indication of where management plans to go.

 

It was recently reported that, after selling the highly successful McRib nationally for three years, McDonald’s is switching back to offering the sandwich on a regional basis.  Rather, McDonald’s will focus the balance of 2013 on selling Mighty Wings (a disaster), the Southwest Premium McWrap (hasn’t driven incremental traffic), and now White Chocolate and Peppermint Mocha specialty beverages.

 

This implies that management believes adding a premium espresso-based beverage to the menu will generate more incremental traffic than nationally promoting the McRib.  Although the McRib will be promoted locally, it will not have the full force of the McDonald’s marketing machine behind it in 2013.

 

We don’t expect MCD to report strong same-store sales for the balance of the year and well into 2014.  Looking back on 2013, MCD was forced to shift its strategy mid-year because new products and the promotional calendar were not resonating with consumers and, as it stands, all indications are for 2014 to be a repeat of 2013.

 

MCD: TESTING THE ESPRESSO-BASED BEVERAGE THEORY EARLY - MCD

 

McDonald’s will report November same-store sales on 12/09.  We will post on anything incremental after the release.

 

 

 

Howard Penney

Managing Director

 


OIL & NATURAL GAS: SUPPLY, DEMAND, PRICES AND TRENDS - EXPERT CALL

OIL & NATURAL GAS: SUPPLY, DEMAND, PRICES AND TRENDS - EXPERT CALL  - pic1

 

Our Macro Team is hosting an Expert Call featuring Tancred Lidderdale from the Energy Information Administration (EIA) for an in-depth discussion on the outlook for oil and natural gas.  As a Hedgeye Energy client, you are welcome to listen in.

 

The call titled "Oil & Natural Gas: Supply, Demand, Prices and Trends" will be held on Tuesday, November 26th at 11:00am EST

KEY TOPICS OF DISCUSSION WILL INCLUDE:

  • Oil
    • Key variables that drive the price of oil
    • Expectations for 2014 supply and demand
    • OPEC's ability to impact price
    • Why OPEC's surplus capacity is growing
    • Declining U.S. oil demand
  • Natural Gas
    • Intermediate supply outlook for natural gas
    • Current natural gas supply versus historical level
    • Drilling and drilling productivity
    • Outlook for the renaissance in U.S. natural gas
    • Current and future natural gas demand
  • Gasoline
    • Expectations heading into 2014 for demand and supply
    • Longer term trends
    • Price set versus the price of crude
    • Price implications from the spread on WTI/Brent

CALL DETAILS

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 658898#
  • Materials: CLICK HERE (Slides will download one hour prior to the start of the call.)

ABOUT TANCRED LIDDERDALE

Tancred Lidderdale is the supervisor of the team that produces the Short-Term Energy Outlook for the Energy Information Administration (EIA). Before joining the EIA in 1991, he worked for 12 years with Atlantic Richfield Company in their petrochemical and refinery operations, and foreign crude oil trading. He received his B.S. degree in Chemical Engineering from Georgia Tech, his MBA from the University of Houston, and his Ph.D. in Economics from George Mason University.

 


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BUBBLE MONGERING

Takeaway: The market is expensive here. But valuation is (still) not a catalyst.

This note was originally published November 20, 2013 at 15:28 in Macro. For more information on how you can subscribe to Hedgeye research click here.

SUMMARY:

I love everything about investing except maybe the fact that I’m actually in the investment industry.  If you saw how sausage was made you probably wouldn’t eat it.   

 

The allure of a skillfully prepared valuation narrative, however, remains one of the industry’s most enticing, sirenic delicacies. The market is expensive here but valuation is (still) not a catalyst.  Tops are processes, the price signal remains bullish currently and, up through the present, we have continued BTDB’ing (Buying the Damn Bubble) while taking down our gross and net equity exposure since the September 18th, No-Taper announcement. 

 

BUBBLE MONGERING - bub1

 

VALUATION: BLOVIATION & CONSTERNATION 

It has been hard to escape the valuation discussion the last few weeks as bubble speculation has been ubiquitous alongside higher nominal (& real) highs for domestic equities.   Reviewing a cross-section of market valuation measures (below), the summary takeaway is pretty straightforward – across the balance of metrics, equities are, indeed, moving towards overvalued on a historical basis. 

 

The problem, of course, is that the overbought-overvalued market narrative is a tired one as moderately elevated valuation has characterized most of 2013 and prices advancing at a premium to profits is not a new phenomenon – particularly in what could (amazingly still) be considered an “early cycle”,  liquidity supported stage of the recovery. 

 

 

VALUATION IS (STILL) NOT A CATALYST

We use a broad range of valuation and sentiment indicators when contemplating the direction of markets and where our view sits in the context of current prices, consensus estimates, and prevailing sentiment. From an Investment decision making perspective, valuation sits somewhere near the middle-bottom of the our consideration hierarchy. 

 

So, rather than claiming right to some specific valuation-in-isolation based insight on the immediate term direction for equities, below we survey a cross-section of canonical market valuation measures to provide some historical context for current multiples.    

 

In terms of how we are managing the current environment:  With fund flows, decent macro, rising M&A activity, bullish price momentum, near universal acknowledgement of the existent “bubbliness”, and the lack of a discrete negative catalyst all supporting equities in the immediate term, we’ll continue to ride the bull until the price signal changes.  Prune & plant within our immediate term risk ranges while holding an elevated cash balance.   

 

As Keith noted this morning: “This is a raging bull market, until it isn't.”

 

CAPE/Shiller PE:   At 24.9, the CAPE ratio (inflation-adjusted SPX price divided by the 10Y average of inflation adjusted earnings) is moving into the top decile of its historical range.   Below we’ve broken the historical CAPE ratio values into deciles and looked at average market performance over the subsequent 1Y and 3Y periods.  The mapping of the Shiller PE vs subsequent market performance suggests return expectations should move systematically lower alongside incremental increases in valuation. Historically, 1Y and 3Y returns progressively decline for each decile change in the Shiller PE.   

 

BUBBLE MONGERING - drake1

 

BUBBLE MONGERING - CAPE 12M Subsequent Performance 111913

 

BUBBLE MONGERING - CAPE 3Y Subsequent Performance 111913

 

Tobins Q-Ratio:  Longer-term valuation arguments center on the premise that returns on capital should equalize to cost of capital and  market values should normalize to economic value.  Tobin’s Q ratio is not a measure we use to tactically manage risk, but we can appreciate the intuition (why buy an asset when you can “re-create” it for less and compete away existing, excess profit) underneath its application.   

 

Historically, at extremes, it has served as a solid lead signal for subsequent market performance.   We are sitting just below the 1.0 level currently and approximately 1.0 standard deviation above the long-term mean value – a level that has generally not been a harbinger of positive forward returns historically.

 

BUBBLE MONGERING - Q Ratio

 

S&P 500 Market Cap-to-GDP:  Assuming the collective output of SPX constituents credibly reflects aggregate national production (or serves as a credible proxy for it), the Market Capitalization-to-GDP ratio effectively represents a price to sales multiple for the economy.  As can be seen, on a historical basis, we are certainly entering “expensive” territory as we push towards breaching 100% to the upside.

 

BUBBLE MONGERING - SPX Market Cap to GDP

 

FORWARD/TRAILING P/E:  On conventional LTM & NTM P/E metrics, the market is moderately expensive at present.  Valuing the market on 1Y of (recurrently over-optimistic) forward earnings estimates has its pitfalls and, additionally, any perceived cheapness in current multiples should be discounted to account for mean reversion downside off peak corporate profitability (more below). 

 

BUBBLE MONGERING - SPX PE 112013

 

MARKET COMPS AND PEAK MARGINS:  Operating Margins remain near peak with Corporate Profitability continuing to make higher highs with after-tax corporate profits advancing to a record 11% of GDP in 2Q13 – some 85% above the long-term average at current levels .  Unless you think peak returns to capital provide a sustainable path to aggregate demand growth in the face of negative trend growth in real earnings, trough returns to labor, middling productivity growth and secularly depressed investment spending, then the mean reversion risk for margins remains asymmetrically to the downside.

 

Topline growth estimates for the SPX (mkt weighted) don’t look unreasonable at +4.8% for 2014.   Expectations look similar across SPX constituents on an equal weighted basis with median 2Y growth estimates reflecting modest acceleration over the next four quarters.   However, the slope on earnings growth (+10.9% for 2014) over the NTM continues to look overly aggressive given expectations for further, significant margin expansion above already peak corporate profitability.  

 

BUBBLE MONGERING - SPX Comps 111913

 

BUBBLE MONGERING - Corporate Profits   of GDP 111913

 

BUBBLE MONGERING - Investment

 

 

Christian B. Drake

Associate


CAT: Blinded by the Sun

Overview

 

A traditional sell side firm upgraded CAT today in a lengthy report that we suspect most longs won’t read in its entirety.  Rather than respond to a boring write-up with another boring write-up, we will mostly focus on what is missing from that report: all the bad stuff. 

 

Calling the bottom in CAT is a strategy that is not working.  Investors and sell siders have been making that call since before Resource Industries had even reported a down quarter (See It Hasn’t Started, So It Isn’t Over).  CAT is the 3rd worst performing Industrial YTD in the S&P 500, so arguing that the bottom is in because the shares are holding 80 as the market rips to all-time highs is a bit facile.  Why even bother trying to call a bottom when being long CAT is not working? 

 

CAT: Blinded by the Sun - bh1

 

 

Of course, we were not born yesterday.  Management provides special access to a sell sider and select clients.  Shortly after, said analyst upgrades the stock and writes a glowing report.  We are sure that the SOLAR/dealer visit trip was great.  We’ll leave the rest to the reader’s imagination.

 

 

Leaving Aside the Bad Stuff, CAT Is Great!

 

 

Trough Earnings

 

We see the $4.50 2014 EPS figure is a straw man.  We agree that CAT should produce more than $4.50 in 2014 EPS, excluding charges and any issues at CAT Financial, but why does that matter?  2014 was last interesting six months ago.  The battleground has moved to 2015 and later, where we see little hope of a rebound.  It has also moved to the CAT boardroom and CAT Financial.  The assumption that Power Systems is a stable source of profitability is deeply flawed, as is the assumption that Resource Industries cannot operate at a loss, in our view.

 

Multiple of Trough Not Useful For Generating Alpha

 

CAT underperformed the market nearly continuously from the late 1970s until 1992.  The peak/trough multiple analysis is unrelated to generating Alpha, so it is worthless.  It gives a buy signal in ’82-’83, ’84-’85, ’87, then finally successfully in ’91-’92.  Alternatively, our process – understanding the cycle, the industry structure and the valuation – has worked well and we have published real-time write-ups demonstrating it for the past year and a half (when we joined Hedgeye).

 

CAT: Blinded by the Sun - bh2

 

 

Cyclical Industries Can Lose Money

 

The Armageddon scenarios presented are really not that bad in the context of a deep cyclical like CAT.  Why exactly can’t Resource Industries operate at a loss?  Resource Industries margins are collapsing amid vast industry overcapacity.  Pricing is increasingly competitive, with the decline slow to hit the Income Statement as the company works off better priced orders in backlog.  Resource Industries revenues have only declined for three quarters, so it is still very early in the adjustment process.  What would Resource Industries profitability look like with industry capacity utilization at, say, 30%?   Mining capital spending is likely to remain at around maintenance levels, i.e. normal levels, for something like the next decade, as we see it. 

 

Where Is CAT Financial?

 

The recent credit metrics have looked questionable at CAT Financial, so we guess it was probably easier just to leave it out.  It is just the leveraged division which comprises about 40% of the firm’s assets and is a key focus for bears and short sellers.  Given the endless focus on the comparatively tiny (in terms of assets and risks) SOLAR turbine business, a few sentences might have been in order.

 

Mining Exposure Outside of Resource Industries

 

Part of the reason for weakness at Construction Industries is that larger pieces of equipment were often sold to the mining industries at high margins.  Locomotives at Power Systems are also sold to mines on occasion (see EMD website).  Mine site power is also a factor at PS.

 

Acquisitions & Capital Allocation

 

Comparing old CAT to current CAT is not exactly apples for apples.  CAT has gone through a period of terrible capital allocation, in our view, with vastly overpriced acquisitions and soon-to-be-unutilized capacity additions.  The misallocated capital is likely >$10 billion in the last few years and has yet to be recognized, by our estimates.

 

Management Credibility & Strategy

 

Given what has happened at CAT in the last year or two, some discussion of management strategy or credibility should probably have been included, right?  We expect a management change at CAT in the next year or two, with a new team coming in to lower the performance bar.  How do you write a 47 page report about a company that needs a turnaround without mentioning the name of the CEO or discussing strategy?

 

Competitors Missing

 

Komatsu, Hitachi and other competitors seem to be conspicuously absent from the discussion, which is an important omission for both Resource Industries and Construction Industries.  As mining equipment demand dries up, these competitors are refocusing on construction equipment, negatively impacting price.  In the instance where Komatsu is mentioned, it is about their coal commentary, not their competitive response to an evaporating mining equipment market.

 

 

Top Down View of Energy Capital Spending

 

We discussed the long-term outlook for Energy-related capital spending in our Industrials Fishfinder note this morning.  Energy-related capital spending boomed along with other resources-related capital spending and has since started to decline.  We see some risk that Power Systems is in fact the next shoe to drop.

 

CAT: Blinded by the Sun - BH3

 

Dealer Inventories

 

Dealer inventories should be looked at on a dollar basis, not as a % of sales.  Finning has about 2x the value of inventories of Westrac and Toromont combined, by our estimates.  Finning still has a lot of inventory to work off as we see it.  CAT provides inadequate transparency on this issue, we think.

 

We’ll Stop Here…

 

If CAT were composed exclusively of the SOLAR turbine business, the company’s outlook might be rosier.  Unfortunately, SOLAR is a small part of total CAT.  Of course, if the sell side were composed entirely of analysts actually trying to make good calls, markets might function better.

 

Instead, we think there is little reason to expect that this is the inflection point for CAT or that all of the bad news is priced in.  Multiple of peak/trough work would be interesting if it generated useful predictions – it just doesn’t.  We see a scenario for CAT much more like the 1980s, where the boom in resource-related capital spending drops over a long period of time amid tough competitive pressures.  We also see serious strategy and management deficits at CAT, the eventual resolution of which may result in a greater capitulation in the shares.  Maybe then we join the search for a CAT inflection….

 

 

 


$WMT's New CEO: Thumbs Up

Takeaway: This is a win-win for Wal-Mart.

Editor's note: Hedgeye Retail Sector Head Brian McGough offers a quick take on news of Wal-Mart's new CEO below.

$WMT's New CEO: Thumbs Up - dmw

  • "Wal-Mart Stores, Inc. today announced that its board of directors elected company veteran Doug McMillon, 47, to succeed Mike Duke, 63, as president and chief executive officer, effective February 1, 2014. McMillon was also elected to the company's board of directors, effective immediately."
  • "Duke will continue serving as chairman of the executive committee of the board and, in the tradition of his predecessors, stay on as an advisor to McMillon for one year. The company plans to make an announcement on McMillon's successor as CEO of Walmart International by the end of the fiscal year."

Takeaway: McMillon's profile has been growing inside WMT for a while now, so this does not come as a complete shock. But we are definitely surprised by the timing. All that said, the idea of having a 47-year old CEO with heavy International experience is extremely appetizing to us. Let's face it, there's no more unit growth in the United States; and WMT can't comp consistently better than 1%. Bottom line is this guy can't exactly do any damage to the US business, and International will have a bigger profile. It is a win-win.

 

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