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September 12, 2014

September 12, 2014 - Slide 1



September 12, 2014 - 2

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September 12, 2014 - 5

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September 12, 2014 - 8

Bernanke: Yep, He’s Back

Client Talking Points


Yep, he’s back – speaking for fees and making comments that are in line with his forecasting track record on growth #reckless. Allegedly (at a Morgan Stanley lunch yesterday) Bernanke said growth was going to surprise on the upside and he was surprised that the UST 10YR was still < 3%. We think he’ll be dead wrong on this forecast.


We weren’t there, but looking at the intraday, we have no doubt Bernanke was somewhere saying something like that. It’s sad, but we have to risk manage this until Yellen tones it down next week – immediate-term risk range has widened (that’s dangerous – leading indicator for bond market volatility) to 2.33-2.58%.


Basically everything macro is one big correlation trade all of a sudden to Up Dollar, Up Rates (i.e. Down Oil, Down Gold, Up SPX, etc.) – with 30-day correlations vs. USD close to +/- 0.8, there’s huge TREND reversal risk now across macro markets if/when this Bernanke thing is proven wrong and/or Yellen backs the market off the higher rates expectation.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

The Vanguard Extended Duration Treasury (EDV) is an extended duration ETF (20-30yr). Now that we have our first set of late-cycle economic indicators slowing in rate of change terms (ADP numbers and the NFP number), it's time to really think through the upcoming moves of this bond market. We are doubling down on our biggest macro call of 2014 - that U.S. growth would slow and bond yields fall in kind.


Fixed income continues to be our favorite asset class, so it should come as no surprise to see us rotate into the Shares 20+ Year Treasury Bond Fund (TLT) on the long side. In conjunction with our #Q3Slowing macro theme, we think the slope of domestic economic growth is poised to roll over here in the third quarter. In the context of what may be flat-to-decelerating reported inflation, we think the performance divergence between Treasuries, stocks and commodities may actually be set to widen over the next two to three months. This view remains counter to consensus expectations, which is additive to our already-high conviction level in this position.  Fade consensus on bonds – especially as growth slows. As it’s done for multiple generations, the 10Y Treasury Yield continues to track the slope of domestic economic growth like a glove.


Restoration Hardware remains our Retail Team’s highest-conviction long idea. We think that most parts of the thesis are at least acknowledged by the market (category growth, real estate expansion), but people are absolutely missing how all the pieces are coming together to drive such outsized earnings growth over an extremely long duration. The punchline of our real estate analysis is that a) RH stores could get far bigger than even the RH bulls seem to think, b) Aside from reconfiguring 66 existing markets, there’s another 19 markets we identified where the spending rate on home furnishings by people making over $100k in income suggests that RH should expand to these markets with Design Galleries, and c) the availability and economics on large properties for all these markets are far better than people think. The consensus is looking for long-term earnings growth of 28% -- we’re looking for 45%.  

Three for the Road


FX Volatility is officially on again thanks to Draghi and Bernanke



You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.

-Buckminster Fuller


China remains bullish in our model, the Shanghai Composite is up another +0.9%  to 2014 highs of +13.6% year-to-date.

CHART OF THE DAY: The New Fundamental Analysis: Front-Running Fed Leaks!

CHART OF THE DAY: The New Fundamental Analysis: Front-Running Fed Leaks! - Chart of the Day


Bernanke allegedly (and recklessly) told a group of investors during a secret lunch yesterday that US GDP growth was going to surprise to the upside (i.e. be better than 3% consensus) and that he could not believe the 10yr was still trading under 3%. In Fed whisper speak, that’s code for Janet is going to get more hawkish (look at the intraday chart, post lunch) … but is she?

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Hydra-Headed Fed

“A monster, a hydra-headed monster…”

-Andrew Jackson


That’s what President Andrew Jackson called the Bank of The United States as he took office in 1829 – a “hydra headed monster equipped with horns, hoofs, and a tail so dangerous that it impaired the morals of our people, corrupted our statesmen, and threatened our liberty.” (Hamilton’s Curse, pg 69)


And that’s what I am going to call Ben Bernanke’s legacy as of this morning – the Hydra-Headed Fed. After doing what he allegedly did at a super secret Morgan Stanley lunch yesterday, that is exactly what this man deserves – someone calling him out on a new and tangible market risk that he just created.


Hydra-Headed Fed - hydra bernanke


Again, allegedly (because I wasn’t there), Bernanke recklessly told a group of investors that US GDP growth was going to surprise to the upside (i.e. be better than 3% consensus) and that he could not believe the 10yr was still trading under 3%. In Fed whisper speak, that’s code for Janet is going to get more hawkish (look at the intraday chart, post lunch) … but is she?


Back to the Global Macro Grind


Notwithstanding the fact that Bernanke was getting paid bank to whisper these sweet nothings into the ears of those with a seat at the almighty’s table, is this what the “transparent” and “accountable” Fed wants? Is Bernanke on the same page as Janet? Or, fully loaded with Draghi talking up the drugs in Europe, is this hydra-headed-un-elected beast out of communication control?


If you don’t think this matters, think again. And think of it in risk terms (i.e. what happens if something like the opposite happens at the Fed meeting next week). What happens if and when Janet Yellen says, ‘hey, I want to be “data dependent” and the recent employment and housing data slowed’?


In real-time market risk management terms what Bernanke’s comment does is:


  1. Widens the immediate-term risk range of the 10yr to 2.33-2.58%
  2. Ups the probability of accelerating bond market volatility
  3. Confirms the recent breakout in foreign currency volatility


In other words, the Hydra-Headed Fed is going to perpetuate the one thing Bernanke trumpeted (both in 2007 and now) as his great success – eviscerating market volatilities.


If you don’t follow it as closely as some of us do, the context of this moment in US central planning history is as critical as it gets. You have to go all the way back to when the Jeffersonians crushed Hamiltonian big government guys (200 years ago) to get what I think The People are really going to get right if the Fed, ECB, and BOJ create the next crisis.


They are going to get that these Policies to Inflate didn’t work.


For the economy, that is…


Now if you ask some of the perma bull economists out there how the economy is doing, it’s just peachy. Yesterday, I think Nancy Lazar wrote that US “consumer confidence is breaking out to the upside.” Maybe Wall Street consumer confidence is… but, please, do not confuse that with the real America’s confidence in negative purchasing power and real wage growth.


By the Federal Reserve’s own admission (they published this research last week), 2/3 of Americans never left being in a recession. Median incomes declined -5% for the bottom 60% of Americans over the 2010-2013 period as the cost of living in the US has ripped to all-time highs.


Oh, but gas prices are going to fall (then rise)… right…


Again, this is where the Hydra-headed monster of market expectations really matters – it’s called correlation risk:


  1. When Fed heads use communication tools to talk up rate hikes (like Bernanke just did) USD and rates rise
  2. When USD and rates are rising, at the same time, commodities, oil, Gold, etc. go down
  3. The machines (quants) then chase macro correlations, and macro markets get overbought/oversold


After the biggest weekly rate of change move for the currency market since 1997 (not a good reference date for globally interconnected macro risks!), on a 6 week duration, here’s the macro market’s current correlation to USD:


  1. Euro vs USD = -0.99
  2. Silver vs USD = -0.93
  3. Gold vs USD = -0.90
  4. Brent Oil vs USD = -0.74
  5. SPX vs USD = +0.72


That’s why I use the word “recklessly” to describe what Bernanke did yesterday. If Yellen doesn’t talk up the US Dollar and Rates (which Americans should love by the way), the entire macro trade dominating markets right now can easily (and quickly) reverse.


Is this normal? Is this acceptable? Was this the America we all like to think of as “free market capitalism”?


If there ever was a day to be scared of the monster of expectations that both the Fed and Old Wall has created, this is probably it.


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 2.33-2.58%


RUT 1154-1181

USD 83.66-84.91

EUR/USD 1.28-1.30

WTIC Oil 91.64-95.36

Gold 1


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Hydra-Headed Fed - Chart of the Day


TODAY’S S&P 500 SET-UP – September 12, 2014

As we look at today's setup for the S&P 500, the range is 15 points or 0.67% downside to 1984 and 0.08% upside to 1999.                                            













  • YIELD CURVE: 2.00 from 1.99
  • VIX closed at 12.8 1 day percent change of -0.62%

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30am: Retail Sales Advance, Aug., est. 0.6% (prior 0%)
  • 8:30am: Import Price Index, Aug., est. -1.0% (prior -0.2%)
  • 9:55am: UofMich Confidence, Sept. prelim. est. 83.3 (pr 82.5)
  • 10am: Business Inventories, July, est. 0.4% (prior 0.4%)
  • 1pm: Baker Hughes rig count



    • Senate, Congress out of session
    • 8am: Natl Assn of Federal Credit Unions wraps up congressional caucus mtg, with speakers incl. Treasury’s Gerety
    • 11:30am: Keith Higgins, director of SEC’s corp. fin. division. speaks at American Bar Assn mtg
    • 11:30am: FTC Chairwoman Ramirez delivers remarks at Hispanic National Bar Association annual convention
    • 7:30pm: Attorney General Eric Holder gives keynote address
    • U.S. ELECTION WRAP: Iowa Fuel Issue; NRSC Outlook; Ark. Debate



  • Citigroup’s Diners Club said to draw interest from Japan banks
  • BASF buys oil, gas assets from Statoil to secure European supply
  • China credit gauge misses estimate as growth risks rise
  • LinkedIn says China needs ‘open door’ for foreign internet firms
  • Alliance Data to buy Conversant for advertising technology
  • Bank moves to avoid overseas swap rules watched by U.S. treasury
  • Google taps biggest app market in effort to close Apple gap
  • Hertz reaches deal with billionaire Icahn to replace 3 directors
  • GE may invest in Polish wind farms amid renewable law changes
  • U.S. video-game industry sales rise 8% on consoles



    • BRP (DOO CN) 6am, C$0.08
    • Darden Restaurants (DRI) 7am, $0.32
    • Hudson’s Bay (HBC CN) 7am, (C$0.07)



  • Wheat Extends Drop to Near Four-Year Low as Global Supply Climbs
  • WTI Oil Rises Second Day as Losses Seen Excessive; Brent Steady
  • China’s Coal Production Cuts Seen Lifting Prices by 10%: Energy
  • Tin Smelters in Indonesia Seeking $600 Premiums to London Rate
  • Zinc’s Advance Narrows Biggest Weekly Slump in Almost Two Years
  • Solar Storms Sending Biggest Threats to Earth Today and Tomorrow
  • Kurd Pipeline Only Realistic Route for Kirkuk Export: Julian Lee
  • MRPL to Process Basrah Light Crude First Time in About 15 Years
  • Zinc Rises to Pare Biggest Weekly Drop in 23 Months: LME Preview
  • Coffee to Cocoa Head for Weekly Declines on Stronger Dollar
  • China Coal Ban Plan Might Stop Dry-Bulk Freight Rebound: Platou
  • Chinese Delegation to Sign Soybean Purchase Pact With U.S.: News
  • Gold Traders Split on U.S. Outlook to Prospects for More Buying
  • Gold Falls to 7-Month Low as Silver Slumps on Outlook for Rates


























The Hedgeye Macro Team

















CAT: Downtrend Resumed?

Takeaway: CAT’s bounce may be over.

Is CAT the new GE?


We see CAT as caught in a multi-year downswing in resources-related capital spending. Since mid-2012, CAT shares have lagged the index by 23%, but have outperformed YTD amid large dealer inventory builds, easing comps for Resource Industries, and pre-buy activity in Energy & Transportation.  In context, however, the outperformance from late 2013 to mid-May looks like a bounce within a longer-term downtrend.


CAT: Downtrend Resumed? - cater1



CAT shares have resumed their relative underperformance since mid-year.  In 2H 2014, dealer inventory drawdowns and challenging markets outside of the U.S. should pressure Construction Industries margins.  At Resource Industries, price declines in key commodities signal ongoing challenges that can be worse than weak mining capital spending.  Energy & Transportation may suffer in 2015, after benefiting in 2014, from new emissions standards.  In many ways, what we are suggesting is that CAT may be a new GE: a large index constituent poised to underperform over a long period…occasional painful bounces aside.



Resource Industries (RI)


No Rebound Coming:  While investors may want to write-off Resource Industries, management does not.  CAT remains positioned for a mining investment rebound, with significant capacity still in place.  We believe that there is no meaningful rebound pending, as declines in resources-related capital spending represent a return to normal levels, not a decline from them.  Equipment pricing is likely to continue lower as better priced orders exit the backlog.


It Can Be Worse Than Lower Mining CapEx: When Phelps Dodge was struggling, their plan to manage low copper prices included: “suspended stripping in a higher cost portion of the mine and will allow for the redistribution of a variety of mining equipment…” High prices yield declining ore grades; low prices improve ore grades.  Equipment from curtailed or shuttered mine sites can find its way to would-be buyers of new equipment, pushing new equipment demand well below normalized levels.  That is pretty typical for a severe capital equipment downturn.  Credit risk is another significant exposure.


Iron Ore, Copper , Coal: Key End-Markets Weakening


Iron Ore: With iron ore prices back on the decline amid ongoing massive supply increases, it is widely expected that higher cost iron ore mines will close.  ‘Low’ prices generally result in mine closures after some pain, although it wouldn’t be shocking to see Chinese mines receive some sort of support to maintain local economic statistics.  Struggling or shuttered high cost mines create challenges for CAT and other makers of mining equipment beyond weak orders and deferred maintenance.  Financed equipment can lead to credit losses; does anyone really want to go pick-up a rope shovel at a bankrupt Australian mine?  The iron ore downturn may well be in its early stages.


CAT: Downtrend Resumed? - cater2


The idea that iron ore prices are ‘low’ is also a bit fanciful.  Less than a decade ago, iron ore sold below $20/ton and often below $15/ton. Our read is that the marginal cash costs for 2015 production, a level at which prices would be ‘low’ or near a ‘bottom’, are well below current spot prices.


Copper:  We reviewed the long-term dynamics of copper in our Mining & Construction Black Book last year.  Copper supply growth is, by our estimates, set to expand rapidly in 2015 and 2016.  Prices have weakened from $3.73/lb at the beginning of the year to $3.07/lb.  While not as serious as iron ore, supply growth may further pressure prices.


Coal:   U.S. coal and natural gas prices received a boost from last winter’s ‘polar vortex’.  Prices for both have since weakened.  With the EPA’s MATS rules set to take effect in April 2015, the outlook for U.S. demand appears negative.  Coal companies have already shown some credit issues (JRCC, for example).  The EIA expects coal consumption “to fall by 2.6% in 2015, as retirements of coal power plants rise in response to the implementation of the Mercury and Air Toxics Standards[MATS]…”. Continued pressure on coal mine investment seems likely.


RI Dealer Inventory:  Declines in dealer inventory were a major headwind in 2013, adding to the broader collapse in mining equipment demand.  Recent dealer sales have been slightly less terrible, likely due to easing comps and a brief period of higher coal prices.  CAT’s North American Resource Industries dealer sales popped up as US coal prices increased following the ‘polar vortex’ last winter.  We expect dealer inventories to decline in 2H 2014, but at a slower rate than 2H 2013.  


CAT: Downtrend Resumed? - cater3



Construction Industries (CI)


Dealer inventory builds combined with stronger end markets helped Construction Industries report record 1H 2014 margins.  However, CI dealer sales growth slowed noticeably in recent months.  Slowing demand and dealer inventory reductions in the back half of the year should depress margins from recent highs. 


1H 2014 Context and Estimates:  To give some context to the dealer inventory builds in 1H 2014 and the drawdowns expected for 2H 2014, we’ll throw out some of our guestimates and understandings.  CAT has previously indicated that “Dealer inventory, by and large, they have somewhere … around 3.25-3.5 months of inventory”. (DeWalt, 11/22/12)  Excluding parts, this suggests CI dealer inventory of roughly $4-$5 billion.  If that estimate is accurate, the 1H 2013 to 1H 2014 change in dealer inventories was a surprisingly large 20%-25%, or ~10%-11% of the segment’s 1H sales (dealer inventory drawdown of ~$400 million in 1H 2013 vs. build of ~$700 million in 1H 2014).  The gap between dealer sales growth and CAT Construction Industries sales growth matches the ~10%-11% estimate reasonably well in the chart below.


2H 2014 Tougher Comps:  In addition to slowing dealer sales, the inventory drawdown guided for 2H 2014 looks set to create difficult comparisons to 2H 2013.  We estimate inventory reductions in both periods, but 2H 2014 looks set to be about $1 billion larger.  Given the high incremental margins that CAT has been reporting for CI, it seems likely that margins will decline meaningfully.  If CAT reports the flattish CI revenue growth and significantly lower segment operating margins, as we expect, it seems likely that the recent CI optimism would fade.


CAT: Downtrend Resumed? - cayer4



Energy & Transportation (E&T)


2014 Prebuy Ahead of Big Engine Tier IV Final:  In 2H 2014, E&T may well continue to perform well.  2015 looks like a different story, however.  CAT has many strong attributes as a company, with its huge engines for gensets, mining/heavy construction equipment, and locomotives being among its most dominant.  Tier IV Final U.S. emissions standards go into effect for these large engines in 2015.  While a pre-buy is evident in locomotives, it is also a likely significant factor in certain other large engine markets. Cummins noted the following on power generation equipment:


Quarter-over-quarter increases were driven largely by increased power generation demand in North America and strong truck and construction demand in Europe ahead of the Tier IV Final and Euro VI emissions regulations.” – CMI Investor Presentation 2/6/14


Recent declines in natural gas/oil prices may prove an additional headwind.  Better orders from oil and gas end-markets helped in 1H 2014, partly due to an abnormally cold winter.  The disclosed dealer sales miss large parts of the E&T product portfolio, but a rough correlation to natural gas/oil prices seems likely (with a slight lag).


CAT: Downtrend Resumed? - cater5


Dealer sales growth has slowed in the last few months, which has corresponded to declining E&T segment topline growth.  It will be interesting to see how much E&T revenues and margins are impacted by Tier IV in 2015.  We think it may prove an underappreciated risk.



CAT: Downtrend Resumed? - cater6




It seems the combination of dealer inventory builds, higher N.A. coal demand, and a Tier IV Final pre-buy drove a sharp bounce in shares of CAT relative to the sector.  We did not anticipate those events effectively, but continue to improve our process and communication.  Nonetheless, it appears to us that CAT’s bounce is over and longer-term underperformance has resumed.  In the long-term, we think CAT may look like GE a decade ago: a large index constituent to underweight or short pair against better positioned machinery names.  


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