"Don't let the fear of striking out hold you back."
After yesterday's move in the market, it's only fitting that today's Early Look is U.S. focused. We are swinging away everyday at Research Edge without fear.
Largely on the back of "better than bad" economic news, the S&P 500 increased the most in two months since crushing the 200-day monkey average (875) short seller like a bug. The move higher was convincing with volume up 31% day/day and breadth was very positive (86% advancers/12% decliners).
The good news does not end there. Last night China reported that GDP grew 7.9% (better than consensus) and now trends in Japan are "less bad" as The Bank of Japan raised its economic assessment for a third month.
While the VIX remains broken across all 3 durations, yesterday it was up alongside the S&P 500; this has only happened 13 times since 1990. My guess is the VIX was reflecting the fact that there are still lingering reminders that things are not perfect in this world.
Apparently, the CIT Group Inc. is probably not going to receive a federal bailout. Finally, the government is doing the right thing. While I have a good friend that works at CIT, the federal government SHOULD NOT bail out CIT. I have no desire to spend my money bailing out another CEO, who may have taken on risk at a time when he should not have. Let the chips fall where they may!
Yesterday's rally was all about REFLATING assets or as we call it "BURNING THE BUCK" - the dollar index got smoked yesterday, down 1.0%. Not surprising, the consumer names underperformed as they should; the trends impacting the consumer remain weak. It's being reported today that the US issues with housing are not getting much better. The number of U.S. households on the verge of foreclosure soared by 15% in 1H09, and foreclosure filings rose more than 33% in June year-over-year and were up nearly 5% from May.
For the next two weeks it's all about earnings and so far the earnings season has started out relatively strong. Of the 6% of the S&P 500 that has reported earnings so far, 71% have reported a positive earnings surprise relative to analysts' expectations.
Although, as we learned from YUM Brands a positive surprise does not always lead to positive commentary about the balance of 2009, which is another small reminder that consumers around the world are feeling a pinch - still.
We have laid out our 3Q themes, and most of them seem to be playing out as expected early in the quarter. Yesterday, the "BUCK WAS BURING," REFLATING parts of the market. REFALTION coupled with a powerful short covering rally (inspired by INTC) led the market to the higher end of our other theme "RANGE ROVER" - a call that the S&P 500 will trade in a tight trading range of 9% in the intermediate term.
The futures are slightly lower right now; the economic reality is that the world is healing but the wound is still open and CIT is reminding us there is still trouble in corporate America.
Function in Disaster; finish in style
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.
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. We want to short this ETF ahead of GE reporting on Friday.
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.
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.
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.
"Don't let the fear of striking out hold you back."
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.
President and Director of Research
The two Cotai powers colluding to control runaway commission expenses sounds good on the surface. Cotai versus the peninsula is a battle that started with the opening of City of Dreams on June 1st. It does make sense for Venetian and CoD to continue to work together and commissions are an obvious place to start. After looking at the June data and July so far, Cotai is clearly winning the battle.
One issue with self-regulating commission rates is that the other players probably won't follow the cut. Is Jack Lam going to reduce his commission at the Mandarin from a very lucrative 1.40-1.45%? I doubt it. Given the competitiveness in the VIP segment, pricing is a key variable. Junkets can easily bring their customers to the higher commission casinos. The second problem is the lack of transparency in junket commission rates. It's good PR to announce a commission reduction, but will CoD know that Venetian is cheating and vice versa? Will Venetian know if CoD is making other concessions to the junkets that don't show up in the official junket rate?
Even a government enacted commission cap would be difficult to enforce. The operators have been expecting government action since late last year and still nothing has been enacted. We are skeptical of any government action until at least late 2009 when the new Chief Executive takes over.
We continue to believe there is upside in both MPEL and LVS for different reasons, none of which involve commission caps. For MPEL, the incremental news flow should be positive as CoD continues to ramp. For LVS, Macau margins could look much better than expected as drastic headcount reductions and numerous one-time expenses will improve "ongoing" margins.
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Research Edge Portfolio Position: Long CAF
The staggering 28.4 % year over year increase in June M2 data released by the PBOC today took a back seat in the media to the news that foreign currency reserves have topped $2 trillion (see charts below). For the US, this data means that China will continue to buy treasuries. For China this data may mean that more speculative money is flowing into already extended markets.
By all measures the liquidity sloshing through the system is having a pronounced effect, and concerns over the negative impact of these easy money policies are beginning to loom ever larger. With no clear indication that regulators are moving rapidly enough to fully reign in speculative asset bubbles or that any capital injections are being planned for AMCs in order to handle fresh "special mention" loans there is real concern among observers on the ground that there is not enough being done by authorities to prepare for the pain in the pipeline.
From our perspective, the issue is fundamental: China's stimulus program was and is an attempt to buy growth -and growth is always very expensive to purchase. If data shows that internal demand is broadening -in other words that that consumers are buying more than just replacement trucks and vans with government tax rebates and factories are turning out more than just girders and beams for state infrastructure projects, then these measures will likely prove worthwhile despite the negative impact of the inevitable defaults and popping bubbles.
Bullish for the economy in the longer term, but underscoring the risk of correction in the equity and real estate markets in the near term, today's data leaves us with many unanswered questions. In the coming days we will receive Q2 GDP and Industrial Output data that will provide us with more solid answers.
When looking at Europe we've cautioned against reading too much into aggregate EU/Eurozone data as we believe markets there are often uncorrelated and influenced by varied underlying fundamentals. Today's report from EuroStat estimated that June inflation in the Eurozone fell 0.1% from a year earlier will give investors a general metric of guidance for Europe, yet the averaged number misses the mark for further understanding the divergence between economies.
One important take-away from today's report is that, as with the US, energy was a major driver -down by 11.8% Y/Y in this latest reading. The deflationary pull from energy should come as no great surprise based on last year's spiking oil price. Core inflation, which excludes energy and food prices, slipped to 1.4% on an annual basis, from 1.5% in May. Conversely, total CPI rose on a monthly basis 0.2%.
This year we've held the position that countries with economic leverage will outperform those with financial leverage. Sticking to inflation, we're seeing countries with financial leverage (think loan leverage combined with a real estate bust in Ireland and Spain) see measured deflationary pressure on an annual basis (Ireland -2.2% and Spain -1.0), whereas Germany, a country we've been bullish on due in part to its fiscal conservatism, posted annual inflation at 0.0%, a level we believe is healthy on a relative basis as the country works through the constraints of reduced export demand. In contrast we see disinflationary pressure in the UK (outside the Eurozone) on an annual basis, with CPI at 1.8%, from 2.2% in May.
In an environment in which output and wages have decline greatly, with soaring unemployment rates and credit tightening, we're likely to see deflationary pressure continue in the immediate term through much of the Eurozone. June's retail sales number declined for the 13th consecutive month; it's clear that retailers are lowering price to move inventory while consumers have tightened spending and are anticipating lower prices going forward.
We'll continue to monitor the patient on an individual country basis, while recognizing the importance of the collective health of the EU for individual countries.
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