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The Present

“Confine yourself to the present.”
-Marcus Aurelius
The Shanghai Composite was up 4.5% overnight. Depending on which media pundit’s point of view you subscribe to, this move either represents a partial rebound, a dead cat bounce or a lower high.
I had never worked as an analyst prior to joining Research Edge. When I joined Keith here early last year and began to participate in the morning meetings, the process of articulating an investment thesis to an audience seemed very exotic to me. Prior to that my investment experience had been confined to managing a portfolio and I was judged solely by the performance of my P&L, not WHY anything in the book went up or down but simply IF it went up or down. There was no report to be filed, no discussion about the catalysts, timing or risks, no degrees of right or wrong; there was only a single number at the end of every period by which I was judged.
Describing the complex, rapidly evolving, highly volatile current situation for Chinese equities is one of the most difficult things I have ever attempted to articulate in writing, let alone to develop a cohesive investment and risk management thesis for. Our process for China to date has been about three things: 1) trying to maintain objectivity, 2) trying to maintain humility and, 3) confining ourselves to the present.
The first point is simple enough: We have learned to say “I don’t know” and try to take nothing for granted. When we discuss China with investors of all types the one question that comes up again and again is: “Don’t they make up much of the data you rely on”? Our response is usually to remind them that no one in this market, not even the leaders at the National Bureau of Statistics, believes that the economic data produced by the Chinese government is accurate enough to be relied on completely. Like sailors with a bad map, we have to navigate by keeping an eye on the horizon and gather as much marginal data from objective sources to test every component of our thesis at every opportunity. Every one of these tiny data points (a report from a Brazilian metals exporter, comments by a Singapore chip producer’s CFO, a speech by a regional bureaucrat in some provincial city you can barely envision on the map) gets thrown into the process to be vetted.
The second point, humility, is similar to the first but more sublime. We strive to hang on to our fear; to avoid overconfidence. Years working as a trader taught me that only a disciplined mind following a process can consistently outperform, but that perversely is the very success of any process and can be its undoing if that investor becomes arrogant. The development of China’s economy as it moves towards growth fed by internal consumption that has seemingly unlimited potential is a narrative that can be intoxicating. During the rapid run up of the Shanghai Composite in the first half of this year it would have been easy for us to become overconfident. Instead, with every passing 5% up move we became more and more obsessed with finding holes in our thesis –until the initial pullback on July 28th, which came as a relief strangely enough since it validated our fears and forced us to retest our process.
The third point may be the most critical. Before I started this job I believed that the role of an analyst was to look across the horizon and attempt to predict change. I now understand that an analyst’s job is ultimately the same as portfolio managers –to look at the horizon and predict change IN THE CONTEXT OF THE PRESENT.  We are witnessing profound changes in the Chinese economy that may well be the largest economic driver of growth for this century, but in the here and now Chinese equities are also trading based on short term credit levels, investor euphoria and flawed reporting methods. To get somewhere on the map, first you need to know where you are, and that is the cornerstone of our process. Analysts and economists who ignore price action and sentiment in favor of pure data may be right in the long run, but the process of successful investing requires risk management for the present.  
In the coming week we will be reporting frequently on China as our thesis continues to evolve with each new data point. We will be trying to articulate this to you in real-time, with our eye on the horizon and our head in the present.
Andrew Barber

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 reflation call.

XLK – SPDR Technology Tech and Healthcare remain the two sectors most primed for accelerating M&A activity in Q4. Both look great from an intermediate term TREND perspective, but at a price.

EWC – iShares Canada We bought Canada on 8/11. Canada has what THE client (China) needs, namely commodities, which we believe will reflate as the buck burns.   

QQQQ – PowerShares NASDAQ 100 We bought Qs on 8/10 and 8/17 to be long the US market. The index includes companies with better balance sheets that don’t need as much financial leverage.

EWG – iShares Germany Chancellor Merkel has shown leadership in the economic downturn, from a measured stimulus package and budget balance to timely incentives such as the auto rebate program. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; factory orders and production as well as business and consumer confidence have seen a steady rise over the last months, while internal demand appears to be improving with the low CPI/interest rate environment bolstering consumer spending. We expect slow but steady economic improvement for Europe’s largest economy, which posted a positive Q2 GDP number.

XLV– SPDR Healthcare Healthcare has lagged the market as investors chase beta.  With consumer confidence down and the reform dialogue turning negative we like the re-entry point here.

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.

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.

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. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient 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.

DIA  – Diamonds Trust- We shorted the financial geared Dow on 7/10 and 8/3.

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.

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.

McCullough Favors Shorting Darden, Research In Motion

Sorry - No Crash Again Today: SP500 Levels, Refreshed...

Crash callers were all over my screens at 6AM… “did you see China”… “did you see China”…


Yep – I was up for a few hours at that point, and guess what… a lot of people see China. Lots of people live there.


If you’re looking for negatives, I can assure you that you will find them. If you are looking for positives for anything priced in US Dollars, just watch the Buck Burn. As the US Dollar reversed today, so did all of the hope of the bears that their dreams of calling a crash anytime soon would come true.


At my 999 immediate term TRADE level of resistance, the SP500 is only -1.2% off of her YTD high. It’s not a crash; it’s called a correction. I’m a better buyer lower. If you show me green bananas, I’ll sell them short to you at 999. That said, a close above 999 puts higher-highs back in play.



Keith R. McCullough
Chief Executive Officer


Sorry - No Crash Again Today: SP500 Levels, Refreshed...  - 819


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 80.46%
  • SHORT SIGNALS 78.35%

Charting China...

Having been bulls on China since December of 2008, and having published a “China Black Book” recently, you know we have an opinion on the monkeys calling China a “bear market” today. Stock market drops of -19.8% since August 4th matter, but so do year-to-date gains of +53% that include a -19.8% drop!


As a point of accountability, in Andrew Barber’s “China Black Book” there was a tactical overview section called “The Path Ahead.” It was there that Barber put some responsibility behind our recommendation, reminding our clients that the big YTD move in China was behind us.


Barber wrote on July 21, 2009:


“We believe that after this extended rally in Chinese equities, the “easy money” is now behind us and that at present the Shanghai composite has the potential to correct to its immediate term TRADE line of support of 3020 (a 7.5% correction from its peak) without any significant fundamental change in the underlying data. Price momentum carries risk. If there is a sustained breakdown of the 3020 level, the intermediate term TREND line of support for the SSEC is 2713 (a 17% correction from the peak) and that would be a critical risk management level in our model. Furthermore, the likelihood of a pullback of this magnitude occurring has increased exponentially as more “hot money” has surged into the market.” 


Today, of course is August 19th, and one month later we are looking at the manic media freaking out about China being “over” at a closing price of 2,785 on the Shanghai Composite Exchange. Again, Barber’s TREND line of support is 2,713.


Could we, should we, will we, see a breakdown of 2,713? We will have to see about that wont we. For now, all we saw in China that was “over” was a bull market that was OVERBOUGHT.


In the chart below, my man AB and his crystal ball shows the long term TAIL line of support for the SSEC at 2,364. We suggest you use the manic media as your backboard to generate alpha in global macro. We remain “bullish of” Chinese equities, at a price.


Our long term China piece can be found at the link below.





Keith R. McCullough
Chief Executive Officer


Charting China...  - a1


Dick’s: Same Store Sales Trend Correlation with Sports Apparel and Footwear Data

As many of you know, we pay careful attention to the weekly footwear and sports apparel trends from two data service providers (Sportscan and NPD).  We recognize that weekly data can be both a blessing and a curse.  On one hand, we see trends develop and change with a great degree of frequency, while on the other hand we see the volatility that exists in the “real world” of retailing.  Nonetheless, we are often asked the question about the relevancy of the data and if there is any conclusion to be drawn for the publicly traded athletic footwear retailers and manufacturers.


As shown in the chart below, the footwear and apparel data suggests that the industry backdrop was less favorable in Q2 for DKS and sales results may not substantially exceed expectations (as we saw last quarter).   At the end of 2008, DKS’ management guided Q109 comps to a range of -9% to -12% and ultimately reported a -6% result.  This prompted a change in quarterly and annual guidance from a range of -8% to -12%  to a new range of -6% to -9% (the Street is currently expecting a -6.7% comp).  Yes the backdrop is getting better on the margin in recent weeks, but the to-be-reported quarter was marked by a sequential deceleration following a post-holiday rebound.


A little more detail on our analysis.  It is important to note that Dick’s does not report their weekly sales to the two data providers that we use.  However, given geographic, product, and pricing trends represented in the sample set, there is value in the comparison.  The bottom line is, quarterly sports apparel and athletic footwear trends have a strong historical correlation with DKS’ reported same store sales.  Based on our analysis, the correlation between a weighted average of apparel/footwear trends and DKS’ historical same store sales is 80%.  To arrive at this conclusion, we aggregated our weekly data sets in order to properly align DKS’ fiscal quarters with the corresponding Sportscan/NPD information. 


Ultimately, we can’t claim 100% accuracy in the predictability of using the weekly trends to forecast DKS same store sales for any given quarter.  However, marrying the data with historical sales results shows directional changes and inflection points with a high degree of accuracy.  Based on Sportscan and NPD alone, we see that Q209 trended down measurably from Q109.  Again, this suggests 2Q results could be weaker than the slight deceleration expected by the Street.  On the other hand since June, it appears that sporting apparel sales are holding even, while athletic footwear is showing a slight uptick.  Consistent with many other retailers and recent weekly data, we expect commentary on back to school to be incrementally positive.


Dick’s: Same Store Sales Trend Correlation with Sports Apparel and Footwear Data - 1


Note:  DKS quarterly comp trends correlate most with a blended footwear-apparel data set.  The blend is comprised of a two-thirds weighting in sports apparel from Sportscan and one-third footwear data from NPD.  The blended data set is designed to best represent Dick’s product mix in these categories, with the obvious limitation of not representing any hard goods in the analysis (hard goods represent 54% of DKS total sales).


Weekly Sports Apparel Update


Sports Apparel posted a positive week in the thick of the back to school season, with strength in the Full Line Sporting Goods (increased 12.1%) and Family Footwear channels (up 29.2%).  All channels experienced a sequential improvement in total sales growth.  Average selling prices remained relatively stable while there were some signs of sequential deceleration in  ASP growth.  In general, the environment does not appear to be overly promotional or aggressive.  Sport Retailers have been easing into the 2009 BTS season with incrementally slower ASP growth for the last 5 weeks, culminating with essentially flat ASP’s this week.  Geographically, the South Central and South Atlantic showed the biggest change in sales trends, helping to drive the total sports apparel category back into positive territory.  New England and the Mid-Atlantic (both later back to school markets) showed the weakest trends for the period.


Dick’s: Same Store Sales Trend Correlation with Sports Apparel and Footwear Data - 2


Dick’s: Same Store Sales Trend Correlation with Sports Apparel and Footwear Data - 3


Dick’s: Same Store Sales Trend Correlation with Sports Apparel and Footwear Data - 4




PFCB - Diversification

Earlier this week, PFCB announced that it has entered into an exclusive licensing agreement with Unilever to develop a line of frozen Asian entrées for the U.S. under the P.F. Chang’s brand.  The terms of the agreement were not disclosed and the launch date of the new products has not yet been set. 


This new agreement sounds familiar to the trademark licensing agreement California Pizza Kitchen has with Kraft.  CPKI partnered with Kraft in 1997 to distribute a line of CPK premium frozen pizzas in the U.S. and Canada.  Kraft distributes CPKI’s frozen products, which now include flatbread melts, in about 20,000 select grocers in the U.S.   CPKI collects royalties from Kraft, based on a percentage of Kraft’s net sales of the frozen products.  This licensing agreement has provided CPKI with a high growth and highly profitable royalty stream, contributing $6.6 million to the company’s 2008 sales, up nearly 40% from 2007.  Most importantly, Kraft is required to spend a percentage of net sales on advertising and promotion of California Pizza Kitchen’s licensed products, which acts an extremely effective marketing platform for CPKI.


We don’t know yet how PFCB's agreement is set up.  We don’t know what percentage of sales PFCB will earn, the price point of the new frozen entrees or whether Unilever will provide the marketing dollars for the new products.  I would suspect that PFCB has watched CPKI’s success with Kraft and is working to create its own high-return royalty stream.


PFCB - Diversification - CPKI Kraft royalties

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