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Noise Before Defeat

"Tactics without strategy is the noise before defeat."
-Sun Tzu
Managing risk around this proactively predictable trading range remains our objective here in Q3. All of the noise you hear about "200-day moving averages" to crashes and "Chinese bubbles" are just that - noise. Capitalize on it.
After getting hit on Monday, Asian equities have busted another move to the upside. With the exception of Japan which was flat overnight, most of the major Asian stock markets have tacked on an impressive 2-day rally.
Last night's moves in Asia included:
1.      China closing up another +1.4%, making its 2-day move +3.5%, and establishing yet another new YTD high of +75.2%.

2.      Hong Kong +2.1%, making its 2-day move +5.8%, and breaking out above my immediate term TRADE line.

3.      Taiwan +1.5%, Korea +2.6%, Australia +1.5%, Thailand +2%, India +3%, and Singapore +3.4%.

The Chinese strategy continues to inspire leadership in the region. Their tactics have been surgical. Their execution, flawless.
China is the 21st century's growth engine. If you are American and don't like the sounds of that - too bad. Not unlike Americans versus the British at the outset of the 20th century, the Chinese couldn't care less.
Remember that China's stated foreign reserve policy is to maintain three objectives: 1. Liquidity, 2. Safety, and 3. Returns.
By the way, those are unlevered returns backed by organic growth. No, you haven't seen the Steve Schwarzman of China yet have you? That American private equity poster child would be the antithesis of the Chinese investment philosophy.
Say what you will about your levered long lovers here in America. The Chinese have liquidity. And lots of it. This morning China reported their money stats. Chinese foreign reserves shot up another $178B to $2.13T. That "T" is as in TRILLION. And that is, like the 2009 performance of the Shanghai Composite Exchange, a new high.
Within the Chinese money stats was this little critter that US politicians don't want to talk about called the money supply. M2 (a measure of the money supply) in China ramped up to +28.5% year-over-year growth in the month of June. That too, is a new high.
With the US government creating more money than God could right now, there is a lot of money floating around out there in this brave new interconnected global world. In the immediate term, it will continue to be reflationary. In the intermediate term, it will lead to one of our Q3 2009 Investment Themes - a Reflation Rotation. And in the long term, reflation will ultimately morph into inflation.
Before you get your shirt in a knot about inflation, take it off, relax, and get a tan or something. We won't see the political football of reported inflation accelerate in the USA until Q4. In between now and then, all you need to do is buy low, sell high, and trade the range.
Chinese growth accelerated sequentially in Q2 (versus Q1). That we know. What we don't know is where that growth will end up in Q3. What we know is that economic growth comparisons for Q3 are quite easy (earthquake of generational proportions last year, plus the country's lockdown for the Olympics). What we know is that stock markets are leading indicators, not lagging ones - and our real-time update on that for both China and Asia overall is on the tape.
Stay long what The Client (China) needs, not what America wants them to need. In the last few weeks, both copper and gold have held their long term TAIL lines of support (copper = $2.08/lb, gold $871/oz). Stay away from the US Dollar (we're short) and US Treasuries (10-year yields trading back up to 3.54% this morning are signaling that my long term view of reflation morphing into inflation is going to be right).
In the immediate term, China is now OB (over-bought). So please don't run out and buy it up here with the 200-day monkeys at +75% YTD. In the immediate term, the US Dollar Index will be oversold again at $79.58 and the SP500 will bump up against its immediate term TRADE resistance line of 913 in and around this morning's open.
In the intermediate term my Range Rover call remains (SP500 871-954). In the long term, as you listen to all of the noises of those who missed both the crash and the squeeze, remember that the "tactics without strategy is the noise before defeat." China gets this, and so should we.
Best of luck out there today,


USO - Oil Fund-We bought USO on 7/6 and 7/8 on a pullback in oil. With the USD breaking down, oil should get a bid.  

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 and added to the position on 7/7 to be long the US market. The index includes companies with better balance sheets that don't need as much financial leverage.

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.

XLV- SPDR Healthcare - We re-initiated our long position in healthcare on 6/29.  Our healthcare sector head, Tom Tobin, wants to fade the public plan, and he's been right on this one all year.

GLD - SPDR Gold - Buying back the GLD that we sold higher earlier in June on 6/30. In an equity market that is losing its bullish momentum, we expect the masses to rotate back to Gold.  We also think the glittery metal will benefit in the intermediate term as inflation concerns accelerate into Q4.

XLI - SPDR Industrials - We don't want to be long financial leverage, which is baked into Industrials.

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 of Financials (43.10%), leverage we don't want to be long of.

DIA  - Diamonds Trust- We shorted the financial geared Dow on 7/10, which is breaking down across durations. We are long the NASDAQ via Qs, which is long liquidity and economic leverage.  

EWJ - iShares Japan -We're short the Japanese equity market via EWJ on 5/20. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

XLY - SPDR Consumer Discretionary - We shorted XLY on 7/9 on a rip as our team has turned negative on consumer.  

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.

XLP - SPDR Consumer Staples - We shorted XLP on the bounce on 6/17.   Added to the position on 7/1, as our stance on the consumer is no longer bullish like it was in Q2, when gas prices and mortgage rates were dramatically lower.

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.

YUM - Two Pictures Tell the Story

YUM management can talk all it wants about what it is going to do to fix KFC and Pizza Hut, but the reality is that the company needs to slow its growth. Same-store sales are one of the factors that make up the sustainability model and with trends like you see below it should be done sooner rather than later. Senior management compensation is dependent on growth in system wide sales, so it is not likely to change its tone any time soon. Unfortunately, the longer YUM grows without acknowledging the real issues, the worse things will get.

With the stock looking down today following YUM's beating 2Q EPS expectations but missing on the top-line, we are seeing a shift in pattern as the trend has been for companies' stock prices to outperform after reporting weaker than expected revenue performance but having cut costs enough to report in line or better than expected earnings.

YUM - Two Pictures Tell the Story - YUM China 2Q09

YUM - Two Pictures Tell the Story - YUM YRI 2Q09




MPEL and LVS have agreed a junket commission cap of 1.25%, effective since July 1st.  The Macau government has said it plans to limit commissions paid to junket operators, but that didn't stop MPEL and LVS taking the initiative to agree to implement a cap on the commission paid to junket operators.    The companies are effectively coordinating in order to squeeze the middle man.  Ho states that there has been no ill effect on volumes as a result of the new policy, "Our volume has been stronger than ever."

This is the first significant instance of cooperation between gaming companies since they formed a coalition in April to limit competition in the face of declining revenues. 

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We've maintained that 2009 will be an extremely difficult year in the Las Vegas locals market.  While the actual gaming revenues through the first 5 months of the year haven't been that bad, we're not out of the woods.  More importantly, a bottoming housing market and population growth should provide positive growth in gaming revenues in 2010.  The following chart shows the Locals gaming revenue trends.  Note that revenues have been getting "less bad" since December and have been stable since January.

BYD: LV LOCALS SETTING UP FOR 2010 GROWTH - LV locals delta may 

We put forth our Las Vegas Locals macro model in our 2/05/09 post.  The conclusion then was that the macro variables of housing prices, unemployment, interest rates, and population growth explain virtually all of the growth in gaming revenues.   If this relationship holds up, the LV locals market could be one of the best performing markets next year.  Given the inputs of flat housing prices, unemployment rising to 11.5% from 11% in 2009, and 1% population growth, our model projects gaming revenue growth of 5%.

The recent housing data have shown a bottoming in prices, at least sequentially, while the year-over-year decline has improved.  The average home price has been stable since March at around $170k.  Velocity has actually improved which gives us some confidence that the recent stability is sustainable.  Home sales have increased sequentially for 5 straight months.  Year-over-year home sales are up huge as can be seen in the following chart.



With 30% exposure to the LV locals market, Boyd Gaming has been hit hard by the economic calamity but will also be the prime publicly traded beneficiary of the recovery we see next year.  Considering the 25%+ free cash flow yield on the stock, investors are certainly not pricing in a recovery.

Looking at all the "factors"

As a follow up to our First Look callout on the CIT situation we'd like to point out some additional facts.

- CIT is one of the largest (and oldest) "factors" to the apparel trade, but it's not the only one. Wells Fargo, GE Capital, and Bank of America are also some of the larger players in the space. A quick Google search also lists numerous smaller and regional players which routinely service manufacturers. If CIT were to cease purchasing receivables then you don't have to be a rocket scientist to figure out that there'd be a temporary setback to the small and middle market manufacturers that require receivables based financing. After all, CIT's $6bn in its trade finance asset portfolio represents about 6-8% of total industry receivables. However, it is likely that alternate sources of funding would be found as market share would accrue to the other large players in the space.

- Looking below the surface, it's important to note that CIT is predominately a lender to the middle market and small businesses. The issue of potential failure here is really confined to the trade originated by smaller businesses that, in aggregate, could have a broader impact on the overall environment. Clearly any failure or disruption in the availability of credit is relevant, but the impact on the larger publicly traded manufacturers and retailers (indirect impact from potential product shipment disruption) is not likely to be noteworthy.

- The real risk in this situation lies in the cost of capital. As Keith and our Macro team have repeatedly pointed out, the risk in the current market lies with companies that are saddled with financial obligations in a rising cost of capital environment. This holds true for the mom and pop, local, or regional player that is most dependent on factoring to boost the cash flow cycle. Even if vendors are to find new sources of financing it is likely to be at an increased cost, resulting in further pressure on sales and margins. The flip side of this equation is that the larger players with clean balance sheets are likely to gain share at the expense of their smaller competitors. With our day to day focus centered on the public markets, we tend to forget that there is still a substantial amount of small business activity centered in the retail and apparel trade. Of the approximately $200 billion in US apparel retail sales, the top 20 national brands account for only 30% of the total volume. We also estimate that about 60% of apparel in the US is sold through a publicly traded entity.

- With the decks already stacked against the smaller player whose financing options may already be limited, the CIT situation may force the hand of owners to seek partners or outright sales of their businesses in an effort to stay afloat. We've been talking about consolidation moving up the spectrum to larger scale deals, but a sustained dislocation in financing could lead to a change in activity as it relates to size. At the end of the day, this is yet another driver of consolidation albeit in a less efficient manner than the likes of a Linens or Circuit City.

Looking at all the "factors" - cit portfolio


Bottom Forming in Home Furnishings

We know that government data tends to lag the "real time" information we get on same-store sales day.  However, it's worth taking a look at the latest chart tracking home furnishings' sales, which was updated this morning with the June report.  Consistent with anecdotal evidence that the home category continues to improve, the government data supports commentary from the horse's mouth.

Bottom Forming in Home Furnishings - Home Furnishings Chart

Now what does this mean for BBBY?

- BBBY has demonstrated substantial outperformance and market share gains in both positive and negative environments. The 2001-2002 spread is just about the same magnitude as the 2008-present spread. I would chalk up the earlier period share gains to aggressive store growth and the original "category killer" positioning. The latter is part Linens, part independents going away, part overall superior execution.

- When looking at the big picture, the longer term chart clearly indicates a positive inflection point in what appears to be the worst period for the industry in a decade. Even more interesting is how BBBY underperformed the industry when the housing boom was at its best. This to me further indicates a point I have made in the past that BBBY is much more consistent than people think.

- Finally, the 3 year trend on PCE for home furnishings has finally turned. This delta is notable albeit just a very minor inflection point. With BBBY already showing acceleration in comp trends versus the overall industry it isn't far off to assume positive comps by year end. The worst comp in the past 10 years was in 4Q08. Yes we know all of this already, but this momentum has legs and profitable ones at that. Remember, the key here is a more rational competitive environment with BBBY regaining control of its promotional destiny. Less coupons=profitable market share gains.

Bottom Forming in Home Furnishings - BBBY Comps and the Industry

Bottom Forming in Home Furnishings - Spread BBBY

Bottom Forming in Home Furnishings - PCE Consumer

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