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Dodging Responsibility

"It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities."-  Sir Josiah Stamp

After watching the SP500 hold my 954 line and close there for two days, yesterday Mr. Market blew it right out of the water. That makes me wrong.
 
I could dance around the math, make excuses, and hide - but I will not. That's what losers do. My vision of creating this real-time research firm is shaped by a profound belief that we need to re-establish that there is responsibility in recommendation on Wall Street again.
 
Importantly, yesterday's critical US market breakout was confirmed by volume. With US market volumes in structural decline, the best I can do right now is measure the market volumetrically on a day-over-day and month-over-month basis. Yesterday's volume spiked +28% versus Wednesday's volume. That matters - big time.
 
I have a lot of macro models. One simple three factor model that I use studies price/volume/volatility. As of now, we have the confluence of these three quantitative factors signaling very bullish outputs. With the Volatility Index (VIX) absolutely crushing the Depressionistas who look at every 1% down move as the signal of the next "crash", this should be no surprise. The VIX remains broken across all 3 of my durations (TRADE, TREND, and TAIL) and continues to make a series of lower lows.
 
As volume accelerates into higher stock market highs, no matter where you go this morning, there you are. I, for one, didn't wake up hoping for the futures to be down because "Microsoft and Amazon missed." Hope is not an investment process.
 
So what is the refreshed immediate term TRADE setup for the US stock market from here?
 
1.      SP500 support 939, resistance 984

2.      Nasdaq support 1883, resistance 1993

3.      Dow support 8719, resistance 9188

 
My macro models update every 90 minutes of marked-to-market trading. No, I don't have a "side pocket" or "level 3" accounting plug in my models. As prices and other dynamic market factors change, I do. That's not new. The only thing that is new is my waking up to being wrong on my SP500 levels ahead of this morning's open.
 
I don't intend on being wrong for Monday's US market open, so I will continue to keep proactively moving exposures in both the Asset Allocation Model and our virtual hedge fund portfolio (www.researchedgellc.com <http://www.researchedgellc.com> ). I currently have 17 longs and 15 shorts (including short MCD, which Howard Penney nailed yesterday).
 
While the top side of my Range Rover SP500 level missed the mark, that doesn't mean I was short that line. I simply missed the beta of associated with a big +2.3% US market move. In so far as I wasn't interested in chasing the 200-day Moving Monkeys over the cliff on July 10th's Q3 closing low of 879, I am not looking to clang symbols and clamor for levered long bananas here at 976.
 
The New Reality is this: a lot of people missed the -57% crash in the US stock market and now a lot of people are missing the +44% REFLATION from the March 9th low. Until Wall Street changes, career risk is at stake for those who don't freak out at bottoms and chase tops. That's the constrained US Financial System that this country has built.
 
What's the number one driver of the top end of this rally? That's simple - a US Government sponsored Burning of The Buck. As Bernanke provided Washington/Wall Street with another "Misguided" outlook, those who understand carry trading are sucking the last gasps of air that free moneys will give them. As they rightly should.
 
The dollar is down on the week, again, and has lost -13% of it's value since March. By the time Q4 hits, this won't be about DEFLATION anymore. INFLATION, inspired by US Dollar DEVALUATION, will be coming off my fingertips in t-minus 3 months. Prepare your risk management setup and portfolios accordingly.
 
History is not written on a one-day or one-year duration. Ask Alan Greenspan about that. The ex-Limitless Credit Creation Chairman himself recently stated that "there was a flaw in the model that I perceived as the critical functioning structure that defines how the world works."
 
Amen, Mr. Greenspan. Amen. Please forward your memo to Chairman Bernanke because "we cannot dodge the consequences of dodging our responsibilities."
 
Best of luck out there today. Have a wonderful weekend with your families,
KM
 

LONG ETFS

CYB - WisdomTree Dreyfus Chinese Yuan
- The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

COW - iPath Livestock
- This ETN tracks an index comprised of two thirds Live Cattle futures, one third Lean Hogs futures. We initially began looking at these commodities because of recession inspired capacity reductions combined with seasonal inflections. A series of macro factors including the swine flu scare, a major dairy cattle cull in response to collapsing milk prices and the collapse of the Argentine agricultural complex due to misguided policy provided us with additional supporting fundamental data points for the quantitative set up in price action.  

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.

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.


SHORT ETFS
 
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.

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
- As Reflation morphs into inflation, the US Consumer Discretionary rally will run out of its short squeeze steam. We shorted XLY on 7/9 and again on 7/22.

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.


MCD – FOCUSED ON THE USA

In Q209, MCD’s U.S. margins held up despite the sequential slowdown in comparable sales growth.  Margins improved 50 bps during the quarter following 50 bps of expansion in Q1.  These two quarters of growth show a marked improvement from the prior two years of decline.  Moderating commodity costs helped to offset weaker sales as the company’s overall basket of commodities increased 4.4% in Q2 relative to the 6.7% increase in Q1.  MCD expects this favorable cost environment to continue and even improve in the back half of the year with commodity costs forecast to grow only 1%.  Management revised its U.S. commodity costs outlook for the full-year to up 3%-3.5% from its prior 5%-5.5% range. 

MCD is going to need this increased cost favorability to offset continued softness in top-line numbers as July same-store sales are expected to be “similar or better” than June’s reported 1.8% increase.  Management very clearly stated that Europe and APMEA July sales trends are running better than June, which leaves me to believe that the U.S. is the segment that is currently running similar to June. 

Despite the sequentially slower sales in the U.S., MCD still grew market share on a year-to-date basis, gaining 50 bps of the formal eating out category, according to the company.  For reference, the overall formal eating out category was negative in June. 

MCD is experiencing some pressure on its average check.  Specifically, management stated that average check accounted for about 65%-70% of sales in some quarters last year, but has come down to 50% and could move below that level as we move into 2010.  Management attributed the increased pressure on average check to some trading down by consumers and the decreased level of promotion from the company around its higher priced products.  Management expects operating margins to be stronger in the latter half of the year, but increased trading down could offset some of the company’s expected commodity benefit, particularly with the company saying it is less likely to take as much pricing as it has in prior years. 

Regarding the recently launched Angus burger, the company has not yet launched a national advertising campaign around the product and admitted that the “timing’s not perfect on Angus.”  I have communicated my concerns around the direction of MCD’s recent product launches, primarily the Angus burger and McCafe, which don’t focus on the company’s core consumers, so it was encouraging to hear that management recognizes as well that the timing is off for the Angus burger.  Additionally, management said that due to lower media costs this year and a slight increase in the company’s level of investment in advertising, MCD has been able to advertise behind its core menu, largely the Big Mac, while also promoting the McCafe launch.  This continued focus on the company’s core menu is necessary in this environment and alleviates some of my concerns about the Angus burger; though I do not think it will do much to benefit average check or margins in the near-term.

That being said, I am still not convinced that McCafe will provide the lift to sales that investors are expecting.  Even with management saying that McCafe results are exceeding expectations and that the national advertising launch in May drove significant incremental unit movement, I am not yet a believer.  June same-store sales numbers (and similar trends thus far in July) are not making me feel any better about McCafe.  In response to a question, management said yes, it is on track to achieving $125K in incremental revenues per restaurant with its entire new beverage platform.  This statement does not provide any real evidence of the success of McCafe, however, because the $125K goal includes fruit smoothies, crushed ice drinks and frappes, which have not even been launched yet.  The fact that MCD is moving forward on reaching that $125K goal does not really quantify the current performance of McCafe.  I know it is still early, but it’s important to remember that implementing McCafe into the entire MCD system required a high level of investment (about $100K per restaurant).  I do not yet have the proof that McCafe is yielding the necessary returns.

 

MCD – FOCUSED ON THE USA - mcdusmargins


Data for Oil and Dr. Copper Continues to Send Mixed Signals

While oil and copper continue to compete for first place in the global commodity race for performance year-to-date (at least in US$ terms), the date points we have been following continue to suggest a mixed picture on the supply and demand side.  Ultimately, the US$ is as fundamental for these two commodities as any supply and demand data points.  That said, it is worth reviewing some recent data points for each commodity:

Oil

  • The DOE announced that oil supplies fell by 1.8MM barrels domestically, which was slightly less than the consensus estimate of 2.1MM barrels.  Currently, inventories in the U.S. are 7.3% higher than the five-year average;
  • In contrast to the DOE report from yesterday, the API signaled a much more bearish build of oil.  The American Petroleum Institute indicated that inventories had increased by 3.1MM barrels week-over-week;
  • On the demand side, U.S. daily fuel demand has average 18.6MM barrels over the past four weeks, which is down 4.8% year-over-year; and
  • In Nigeria, the Movement for the Emancipation of the Niger Delta declared a 60-day ceasefire in attacks on the oil and gas installations.

Copper

  • BHP Billiton reported a 21% decline in copper output last quarter, which is significant given its place as one of the world’s largest copper miners;
  • China in the first half of 2009 has consume 3.7MM tonnes of copper, up 12.4% from a year ago;
  • Nippon Mining and Metals recently indicated that they believe that they expect copper demand from China to ramp into October as a result of increased stimulus spending;
  • Copper inventories on the LME rose to a 1-month high on July 23rd to 271,725 tonnes.

Generally, both copper and oil data points seem to be suggesting a buildup on the inventory side, though both supply and demand for copper appear quite favorable versus oil.  The US$ seems likely to prevail as the key driving factor for the price of oil and copper.  As the dollar goes down, these commodities are inherently cheaper and, all else equal, will re-flate.  If and when the dollar stabilizes, global supply and demand points will likely become the primary fundamental drivers for price.

Daryl G. Jones
Managing Director


Early Look

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UA: This is BIG!

Brian is out, but he wanted me to pass along to our clients at least an initial take on the appointment of Gene McCarthy as the new SVP of Footwear at UA – this is an extremely positive event.

Gene was instrumental at Nike in developing Brand Jordan and was a key hire at Timberland, but was not given the latitude there that he was capable of. He gets brands and knows how to turn a $100 million brand into a $1Bn brand.

We’ll be back to add more meat on the bone on this one…

 

Casey Flavin


ORDER FLOW

Ministry of Economic Affairs export order and production data for June continued to show signs of declining contraction as the new-found warm relations with the mainland have paved the way for expanded trade.   New orders declined by 10.9% Y/Y, a big sequential jump from last month’s -20.1%, while production decreased by 11.35% Y/Y.

As in May, the key drivers for the improvement were the consumer electronics and information/communication components, which account for almost about half of the total orders received. As the Chinese tax incentives for rural buyers have spurred on demand for televisions and computers, the newly expanded direct trade channels have also contributed to the improving picture.

Although the primary conclusion to draw from this data is that the improving demand from China continues to support the bullish case for expanding consumer spending, it also underscores the political reality that Taiwan now faces. With increasing dependence on trade with a foreign market that, by definition challenges its right to exist as an independent nation, Taiwan’s government must continue to strike a careful balance.

Andrew Barber

Director

ORDER FLOW - taiwan


HOT 2Q09: CONF CALL HIGHLIGHTS

STARWOOD 2Q09 EARNINGS CALL

 

Review of 2Q09 results:

Third quarter in a row where costs saved the day

Efforts to reduce costs have been pervasive

Expect to open towards the low range of their hotel pipeline guidance

  • See growth in Asia, Africa and ME

VOI aggressive cost cutting helped them realize profits that were only down 20MM

  • Hawaii is showing modest improvement
  • Visitation trends also look like they are stabilizing

Cost cutting details:

All about flow-through at the property level

Keep saying its “permanent” – sorry we don’t believe it

Majority of the savings are sustainable aside from some “small things”

  • Incentive comp for example

Look hard at capital projects

  • Bal Harbour – evaluating their options – sounds like a downsizing to me

Brands:

I’m sorry but this whole part of the call was total fluff

  • “Growth begets growth”
  • “Creates a network effect”

Transforming W into a global powerhouse from its NY roots-plan to double the footprint

40 Alofts will be open by year end

Almost done retooling Sheraton… they say this every year, once they finish “retooling” the base they need to start all over again

Other:

He’s said Permanent cost reductions about 4x now….

Liquidity/Balance sheet:

Very well positioned from a liquidity standpoint

Good rate on timeshare note – of course the rate is good.  they have a 30% residual that they are holding providing support to the senior notes that were sold

Another securitization expected in 4Q09/1Q2010

Leverage ratio around 4.0x, post quarter total debt was $3.5BN, and expect to get to $3.2BN by year end

Expect year end leverage to be 4.3x and, even if 2010 EBITDA declines, still expect to be in compliance

Sale of the W – spoke about the how accretive the sale was and how big the multiple was… No need to comment here – you guys know what we think

In discussion on non-core assets, (some where they won’t keep their flag – capex issue I’m sure)

Claim that transaction market is improving

2Q Details:

Swine flu impact was $10MM roughly (50% in Mexico)

Occupancy stabilized in 2Q09, but rate continued to deteriorate accounting for over 60% of the RevPAR decrease

Mix is shifting to more rate sensitive leisure business

Early indications that group is coming back

  • Feels like a slow recovery though

Guidance implies that RevPAR declines continue to moderate

When they get to Q4, if rates stay constant the headwind from FX turns into a tailwind

Will continue to be impacted by Swine Flu in 3Q09, reducing revenues by $5MM or so

Things should return to normal in 4Q if there are no outbreak flare-ups

Political instability in the Asia/ ME have impacted RevPAR

Second half expectation for Asia have been lowered, but ME is performing relatively well

Timeshare:

  • Tour flow has stabilized but consumers are gravitating to lower end products
  • Increased reserves for loan losses

SG&A will be down less in the back half as comps become difficult

Q&A:

 Asset sales – how many core/non –core?

  • Very advanced discussions on non-core assets – defined as hotels where they don’t care about keeping the flag (that helps sales price when assets are unencumbered)
  • Also mentioned selling non-hotel businesses

Pipeline – how many international/conversion/under construction /etc?

  • 2/3 is international
  • Conversions are a lot less than 10% but expect that number to rise
  • 50% is financed and under construction

American Express deal?

  • Rewards card in place for several years
  • Mutual desire to extend arrangement, in exchange for extension
  • AMEX bought $250MM worth of points to use over time and paid for them cash…
    • Ah… that makes sense… that’s how they back fill some rooms
    • Accounting: will be in other liabilities

Timeshare – haven’t reduced pricing like (MAR for example)

Broader economic commentary

  • Do feel like recovery from this downturn won’t be as quick and sharp as in the past, since the growth will occur at the same time as deleveraging

Owned hotel margins/ threat to fees

  • Don’t do performance guarantees – have almost none
  • Incentive fee mix in the US linked to preferred returns is pretty small as a % of mix
    • International contracts are based on % of GOP (gross margin dollars) get cut from day 1 or so… so its hurt by flow through – so will drop at 2x international revpar (on a constant dollar basis)
  • Haven’t rolled out lean operations across the entire system, but really need rate growth to help owned margins
    • Started in March/April last year on the cost cutting – and have been doing so ever since
    • Already implemented the big savings, but some savings take longer to implement and have the attitude that there is always more room to cut costs

They aren’t interested in buying any assets right now, would find a partner if anything – don’t want to use their own balance sheet

Group booking pace:

  • June has been better than the rest of the year, but the group pace is trending in line with competitor guidance, down high teens/ 20% range
  • Think that cancellation rates going forward will be less

Other management fees

  • Termination fees helped fees this quarter

How is the rate promotion going? (50% off, I believe)

  • Short term tactical effort to stimulate interest

Sheraton RevPAR declines

  • Blaming the underperformance on renovations

400 bps FX benefit in the 4Q if FX rates stay constant

Union contracted wage growth is 3-4% and roughly 1/3 is under collective bargaining agreements in the US


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