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Valuation Consternation

This note was originally published at 8am on November 21, 2013 for Hedgeye subscribers.

“I love everything about investing except maybe the fact that I’m actually in the investment industry.  If you see how sausage is made you probably wouldn’t eat it.”   Yours Truly, ~10 hours ago

 

 

One day back in high school my friend Michael decided to start referring to himself as “Mike Nice.”  Quoting yourself to jumpstart an investment missive is about as cool as trying to give yourself your own nickname....but the message fits the theme today, I can’t think of anything else and at 4am, questionable ideas have a sneaking ability to cloak themselves as appealing.

 

Anyway, back to the Global Macro Grind….

 

It has been difficult to escape the valuation discussion the last few weeks as bubble speculation has been ubiquitous alongside higher nominal, and real, highs for domestic equities.   We added our own speculative cogitations to the already teeming cauldron of valuation commentary yesterday (see BUBBLE MONGERING for more) in a note surveying a current cross-section of market valuation measures.  We reprise those below, but the takeaway was fairly straightforward -  across the balance of metrics, equities are, indeed, moving towards overvalued.

 

To recapitulate the selection of metrics we considered yesterday:

 

Shiller PE:   The Shiller PE ratio attempts to normalize the price to earnings ratio by adjusting for economic cyclicality.  It does so by dividing the price of the S&P500 by the 10Y average of inflation adjusted earnings.   At its current reading of 24.9X, the CAPE ratio is moving into the top decile of its historical range.   Mapping the Shiller PE by decile 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 (ie. average forward returns by decile decline as multiples move higher).   

 

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 underneath its application – after all, why buy an asset when you can “re-create” it for less and compete away existing, excess profit.   Currently, the q-ratio sits just below the 1.0 level 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.

 

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.  On a historical basis, we are certainly entering “expensive” territory as we push towards breaching 100% to the upside.  At current levels we are approximately equal to the 2007 highs and well above the long-term average. 

 

FORWARD/TRAILING P/E:  On conventional P/E metrics, the market is moderately expensive currently at 17X trailing earnings and 15X forward earnings.  Valuing the market on a single year of (recurrently over-optimistic) forward earnings estimates has its myopic trappings and, additionally, any perceived cheapness in current multiples should be discounted to account for mean reversion downside off peak corporate profitability (more below). 

 

PEAK MARGINS:  In the Chart of the Day below we show after-tax corporate profits as a percentage of GDP.  The latest 2Q13 data marked another higher high in corporate profitability at 11% of GDP – this is some 85% above the long-term average.  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 operating margins remains asymmetrically to the downside.

 

ESTIMATES: Topline growth estimates for the SPX (market weighted) don’t look unreasonable at +4.8% YoY for 2014.   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 (+100 to +250bps in incremental expansion over 2014) above already peak corporate profitability.  Of course, iteratively ratcheting down expectations and subsequently beating deflated growth estimates over the course of the year remains the prevailing (and hereto successful) playbook strategy for higher equity prices.

 

So, generally speaking, we are overvalued.  Practically, what do you do with that?

 

A chief problem for the bear camp is that that the overbought-overvalued market narrative has become 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.

 

Valuation-in-isolation narratives are some of the sell-sides finest sausage and sirenic when expertly crafted.  But Valuation isn’t a catalyst. 

 

At Hedgeye, 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.

 

We get that valuation matters in anchoring return expectations over the longer term.  Underneath the technicals, acute policy catalysts, and reflexivity that drives immediate and intermediate term price trends sits the steady drumbeat of fundamentals and an accordion-like tether to ‘fair value’. 

 

However, Price, not deviation from estimated intrinsic value, together with our view on marginal changes in macro fundamentals are the signals we use to risk manage immediate and intermediate term exposure.

 

With the Price signal bullish (SPX and all nine S&P sectors in Bullish Formation) and fund flows, decent domestic and global macro data, rising M&A activity, near universal acknowledgement of the existent ‘bubbliness’ (can you really be in the terminal stage of a bubble if everyone agrees it’s a bubble?), and the lack of a discrete negative catalyst all supporting equities in the immediate term, we’ll continue to lean long until the price signal changes. 

 

Tops are process and we have continued to Buy The Bubble on shallow corrections within our published risk ranges while taking down our gross and net equity exposure since the No-Taper announcement in September.  We’ll probably continue to run tight and #RemainActive as yesterday’s FOMC Minutes only extended the confused communication policy out of the Fed.

 

Raise some cash.  Embrace the uncertainty and volatility of it all.  Don’t eat the sausage.  Eat a snickers… Don't invest like a Diva

 

Our immediate-term Risk Ranges are now as follows:

 

UST 10yr Yield 2.67-2.83% 

SPX 1762-1802 

DAX 9139-9266 

Nikkei 14779-15388 

VIX 11.98-14.28 

USD 80.62-81.37 

 

 

Christian B. Drake

Associate

 

Valuation Consternation - drakeam

 

Valuation Consternation - 577


THANKSGIVING/EARLY DECEMBER CRUISE PRICING UPDATE

Holiday discounting, recovery, and Royal Caribbean outperformance.

 

 

Apparently, CCL/ NCLH engaged in some aggressive promotional discounting through Thanksgiving weekend.  However, at least CCL recovered post weekend in the slow bookings period before Wave.  The Royal Caribbean brand was the standout in our latest survey but the picture is mixed for RCL’s other major brand, Celebrity.  In Europe, Summer 2014 looks encouraging.  Please read on for details.

 

Below are some observations from our proprietary pricing survey (>12,000 itineraries) for CCL, RCL, and NCLH.  We analyze YoY pricing, as well as sequential trends which is determined by comparing pricing relative to the last earnings/guidance date for a cruise operator i.e. CCL: 9/24; RCL: 10/24; NCLH: 10/28.   For a more in-depth and quantitative analysis, please contact sales at .

 

MAJOR TAKEAWAYS FROM LATEST SURVEY:

  • CCL:  Volatile pricing by Carnival brand due to Thanksgiving week promotions
  • RCL:  RC brand showing healthy pricing gains for FQ1 but mixed picture for Celebrity
  • NCLH:  Continues to discount Caribbean pricing due to increased competition

 

CCL ANALYSIS

 

NORTH AMERICA 

  • For their Thanksgiving Week promotion, Carnival brand lowered pricing for Summer 2014 double digits relative to early November for the Caribbean and Mexico
  • Pricing surged back post the weekend promotion with pricing for 2Q/3Q nicely higher
  • Alaska pricing is mostly steady

CCL North American Brands - FQ1 sequential chart:

F1Q sequential pricing remained higher relative to late September.  We saw a bearish pricing trend (red circle) in mid-July as pricing deteriorated significantly relative to pricing seen in late June. A bullish pricing trend (green circle) emerged in mid-October as pricing broke the downtrend seen in the past few months and was actually slightly positive relative to pricing seen in late September. 

 

THANKSGIVING/EARLY DECEMBER CRUISE PRICING UPDATE - ccl1

 

CCL North American Brands - FQ2/FQ3 sequential chart:

For very early Summer 2014 itineraries, we saw weak sequential pricing in mid-October, which continued into Thanksgiving weekend.  Pricing strongly recovered immediately after Cyber Monday. It remains to be seen whether the higher pricing is sustainable heading into Wave Season.  We look for the next pricing survey for bullish confirmation.

 

THANKSGIVING/EARLY DECEMBER CRUISE PRICING UPDATE - ccl2 

 

Carnival Brand (Caribbean) - F1Q/2Q/3Q YoY change chart:

On a YoY basis, mainly due to difficult comps, F1Q pricing continued to be lower for the Carnival brand in the Caribbean.  However, in early December, F2Q/F3Q showed the strongest YoY pricing performance yet. 


THANKSGIVING/EARLY DECEMBER CRUISE PRICING UPDATE - ccl3

 

EUROPE

  • Costa
    • Weak FQ1 2014 European pricing remains but FQ1 has the lowest capacity by quarter for the year
    • Modestly higher pricing for FQ2-FQ4
  • AIDA
    • Weakness in Eastern Med/Western Europe offset by better performance in Western Med
    • Overall 2014 sequential pricing is a tad lower
  • Cunard
    • Improvement in FQ2 pricing offset by weaker FQ3 pricing

RCL ANALYSIS

 

CARIBBEAN

  • RC brand
    • FQ1 pricing has reversed into positive territory
    • Flat pricing for FQ2/Q3, with sequential trend slightly positive
  • Celebrity
    • Modest discounting for FQ1 relative to early November
    • Modestly higher pricing for FQ2
  • Pullmantur
    • Pricing is mostly steady

Royal Caribbean Brand (Caribbean) - F1Q/F2Q/F3Q YoY pricing chart

F1Q pricing is now modestly higher while F2Q/F3Q pricing has flatlined. 

 

THANKSGIVING/EARLY DECEMBER CRUISE PRICING UPDATE - ccl4

 

EUROPE

  • RC brand
    • Solid pricing for RC brand
  • Celebrity
    • Flat pricing for FQ2 but significant discounting for FQ3
  • Pullmantur
    • Pricing has finally stabilized

OTHER

  • Alaska:  RC brand weakness offset by Celebrity (ex Millennium) strength
  • South America quite robust

NCLH ANALYSIS

 

CARIBBEAN

  • Pricing lower during promotional period but not as aggressive as Carnival
  • Pricing remained lower following holiday week, particularly for FQ1 2014

EUROPE/ALASKA/HAWAII

  • Steady 2014 pricing

TRADING PLACES: U.S. + EUROPE

Our Top Q413 Global Macro Theme remains #EuroBulls. Long both the British Pound (which has broken out to new highs) and European Growth Equities is almost the same call we had on the US Dollar and US Growth a year ago.

 

It’s all born out of the same process.

 

On a related note, Lucerne’s Pieter Taselaar is one of the sharpest (and top performing) bottom-up European long/short equity managers we know. The video below augments some of our current views here at Hedgeye. The only downside to the video is that I’m in it. 

 

Have a great evening.

KM

 

Keith R. McCullough
Chief Executive Officer

 

 

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Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.28%
  • SHORT SIGNALS 78.51%

YUM ANALYST DAY

YUM reported November comps for its China Division earlier this week.  Total China comps (+1%) beat expectations (-1%) as Pizza Hut comps (+7) and KFC comps (+0%) showed strength during the month.  KFC comps were largely driven by a half-price bucket promotion during the first 10 days of the month which saw comps run +16%.  Even though this implies comps were down -8% for the rest of the month, this successful promotion indicates that Chinese consumers are warming back up to chicken. 

 

Overall, total comps improved 600 bps sequentially from October and turned positive for the first time since February.  As we mentioned in our last note, we expect China comps to be positive in December and throughout 2014, as the business stabilizes, sales momentum builds, and YUM rolls over easy comparisons from a year ago.  On the domestic front, management announced a 2014 national breakfast launch at Taco Bell which is expected to drive incremental sales in the U.S.

 

While today’s analyst meeting didn’t necessarily provide us with any new news, it did give us further confidence in our bull case.  Management expects at least 20% EPS growth in 2014, approximately 40% operating profit growth in China, and impressive unit growth of 1,850 new international restaurants, including 700 new units in China, and 150 new units in India. Management believes that the fair value of its stock is $90 based on a SOTP and DCF analysis.  We believe YUM has tremendous opportunities for potential growth through various channels, particularly in China where it is well positioned long-term to take advantage of a growing consumer class that is expected to double from 300mm+ in 2012 to 600mm+ by 2020.

 

YUM is our favorite LONG in the big cap QSR landscape one of the best positioned stocks heading into 2014.  The main risk to our thesis continues to be persistent volatility in China, although we believe this is largely played out.  In our view, easy comparisons, new unit growth, and positive earnings momentum will lead to margin and multiple expansion over the next several quarters.  

 

 

 

YUM ANALYST DAY - chart1

 

YUM ANALYST DAY - 12 4 2013 1 36 13 PM

 

 

 

Howard Penney

Managing Director

 


AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN?

Takeaway: The key to a safe “landing of the [growth] plane” is an expedited, well-implemented deregulation of FDI and portfolio flows.

CONCLUSIONS:

 

  • Conflicting signals from Chinese officials have made it difficult to handicap China’s TREND & TAIL GIP outlook(s) in recent months. We offer our latest thoughts in the note below.
  • We are decidedly back to analyzing China with a sanguine lens and are increasingly of the view that it probably warrants playing China alone (i.e. not via consensus ancillary “China plays”) on the long side with respect to the intermediate-term TREND.
  • With respect to the long-term TAIL, we still would like to see concrete implementation of capital account and FX reforms, as well as more safeguards put in place to limit the risk of a broadly destructive transition to a fully liberalized financial system (email us if you’d like to receive a walk-though of the specifics and a recent collection of confirming evidence).
  • It could be over a year before we have meaningful clarity on the latter, so our best solution for clients at the current juncture is to overweight “new China” (i.e. consumption and deregulation) while underweighting (or shorting) “old China” (i.e. the concomitant bubbles in credit and fixed assets investment), as highlighted in the chart below.

 

At the bare minimum, 2013 has been a weird year to be involved in China – either directly through Chinese equity exposure or indirectly through consensus ancillary plays like EM assets, commodities, and the currencies of commodity-producing nations.

 

While we consider it a huge victory for our team to have kept our clients out of or on the short side of those ancillary plays all year (and prior), that is certainly not to say we’ve nailed China or anything to that nature.

 

In the following table, we highlight the absolute bloodbath that has occurred across the commodity complex since we first introduced our structurally negative view on commodities back in APR ’11 as part of our Deflating the Inflation quarterly macro theme. We’ve obviously followed that up with numerous notes and presentations over the past couple of years, so please email us if you’re not yet familiar with our long-held bearish bias on the commodity complex and we’ll be happy to forward you the relevant materials.

 

AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN? - 1

 

Going back to not nailing China, we’ve been keen to change our stance on China multiple times in the YTD (% changes reflect the performance of the Shanghai Composite Index over the respective duration):

 

 

The predominant reason we’ve changed our tune on China so many times this year has been due to policy inflections that have materially altered (or complicated) our rolling-thee-to-six-month forward expectations for the Chinese economy. Amid this ~3M long period of admittedly-unattractive neutrality, we’ve analyzed China in both a positive and negative light, highlighting both the key opportunities and risks to China’s long-term GIP outlook along the way:

 

Sanguine tone:

 

Pessimistic tone:

 

We are decidedly back to analyzing China with a sanguine lens and are increasingly of the view that it probably warrants playing China alone (i.e. not via consensus ancillary “China plays”) on the long side with respect to the intermediate-term TREND.

 

With respect to the long-term TAIL, we still would like to see concrete implementation of capital account and FX reforms, as well as more safeguards put in place to limit the risk of a broadly destructive transition to a fully liberalized financial system (email us if you’d like to receive a walk-though of the specifics and a recent collection of confirming evidence).

 

It could be over a year before we have meaningful clarity on the latter, so our best solution for clients at the current juncture is to overweight “new China” (i.e. consumption and deregulation) while underweighting (or shorting) “old China” (i.e. the concomitant bubbles in credit and fixed assets investment), as highlighted in the chart below:

 

AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN? - 2

 

Going back to the intermediate-term TREND outlook, we think China has the opportunity to surprise consensus growth expectations to the upside into and potentially through 2014, after what is likely to be a brief dip into Quad #3 here in 4Q13:

 

AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN? - CHINA

 

AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN? - 4

 

AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN? - 5

 

Moreover, we think China has the potential to continue distancing itself from the carnage that has become the emerging markets space. It will seek to accomplish this by enticing international capital flows (both FDI and portfolio) away from beleaguered EM economies, at the margins, through a combination of strengthening the CNY and promoting its use internationally, as well as through incremental deregulation and investor-friendly incentives.

 

AVIATING CHINA: CRASH LANDING OR SMOOTH TOUCHDOWN? - 6

 

Below is a compendium of data points we’ve come across in the past couple of weeks that support this view:

 

  • Reuters noted that the PBoC said China will begin rolling out financial liberalization reforms in the Shanghai free-trade zone within three months. PBoC Shanghai chief Zhang Xin said the reforms would be launched within three months, evaluated after six months and formal policies would be fully implemented by the end of a year. He added the policies will serve as models for other regions as they move to create their own FTZs. (StreetAccount)
  • Xinhuanet noted that Zhang Xiaoqiang, deputy head of the National Development and Reform Commission, said China will simplify its foreign investment approval process in order to introduce a registration-based system for foreign investment projects. Zhang said that the government will further enhance the role of foreign investment in its market-oriented economic development. (StreetAccount)
  • Reuters reported that the yuan overtook the euro in October to become the second-most used currency in trade finance. SWIFT said the market share of yuan usage in trade finance grew to 8.66% in Oct, up from 1.89% in January 2012. The yuan now ranks second behind the US dollar, which has a share of 81.1%. (StreetAccount)
  • Dim Sum bond issuance has accelerated to the fastest pace since June 2012 as China’s pledge to move toward yuan convertibility boosts demand for the currency. Sales reached 27 billion yuan ($4.4 billion) in November, almost five times as much as October’s 5.8 billion yuan, according to data compiled by Bloomberg. Yuan savings in Hong Kong rose the most since April 2011 to a record 782 billion yuan in October. (Bloomberg)
  • The WSJ noted that foreign real estate developers eager to capitalize on rising consumption in China are increasingly raising funds to invest in warehouses and shopping malls. Data from PERE showed developers and their subsidiaries have raised $3.5B for China projects so far this year, eclipsing the $2.2B raised in all of 2012 and just shy of the $4B raised by private-equity and other fund managers. (StreetAccount)
  • Xinhuanet noted that Zhou Xiaochuan said China should increase the qualification and quota of QDII and QFII investors to help them with their activities. He added that administrative approval procedures for QDII and QFII qualification and quotas shall be eliminated "when conditions are ripe". (StreetAccount)

 

All told, we still think China has a lot of credit bubble-related skeletons in its closet that will increasingly become a headwind to Chinese economic growth over the long-term TAIL. For the time being, however, we think Chinese officials are putting the right policies in place to offset those headwinds, at the margins.

 

Please feel free to email us with any follow-up questions.

 

DD

 

Darius Dale

Associate: Macro Team



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