Am I a bull or a bear at this point? I actually have no idea. So far, today's traverse to higher highs in the SP500 makes me wrong - that I know. I thought we'd continue to make lower-highs in the SP500. On the margin, any close above the 934 line (January 6th closing high) will be a bullish US equity market factor...
If you're looking for the rest of the sobriety check, don't worry - the facts don't lie. The ISM number that was printed this morning for the month of May came in at 42.8 (see chart below). While that's the best number we have seen since September of 2008, it is still a lower-high. New orders actually accelerated to 51, which is the best report we've seen on that front since November of 2007 (everything that happened after that was just bad).
Can the ISM reading, consumer confidence, etc. charge higher yet again in June? For sure - but can these sentiment readings breakout to levels above the red line in this chart? Or will they fail? These are some of the questions that will dominate the debate in my head as to whether or not the SP500 can make a move beyond 991. The easy REFLATION money on the long side is 3-months behind us.
Keith R. McCullough
Chief Executive Officer
The following chart shows recent Intermediate Fuel Oil (IFO) 380 fuel prices. IFO 380 is the type of fuel that comprises 90% and 80% of the consumption of CCL and RCL, respectively. As shown in the graph, IFO 380 prices are up huge in the last two months.
Since CCL last issued guidance on 3/24/09, IFO 380 has spiked up 36%. Prices have increased 27% since RCL issued guidance on 4/23/09. RCL is in a better spot, however, since they are about 40% hedged for 2H 2009. Assuming prices stabilize at current level, we estimate 2H 2009 estimates/guidance need to be reduced by $0.12 each for CCL and RCL, respectively. However, West Texas Intermediate (WTI) prices are up significantly more over the past few months. Should lagging IFO prices converge to WTI, the impact could be greater. RCL actually provides guidance based on WTI prices.
Fuel prices are not hard to track. Calculating the EPS impact of a change in fuel prices is certainly not complex math. However, falling estimates could focus investors on 2010, where capacity increases, a still difficult consumer environment, and now higher fuel costs could make for an ugly year. Indeed, we are currently 35% and 40% below the Street on our 2010 EPS estimates for CCL and RCL, respectively, including higher fuel cost assumptions.
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Given my concerns with this chart, I have been getting a lot of questions as to why I have not yet shorted US Equities. The answer is obviously one of timing. Dollar down = REFLATION. Breaking The Buck has been one of our 1H09' Investment Themes, and I am very respectful of this global macro factor's influence on asset prices. Three months ago was the time to get invested on this Theme, not three hours ago.
So far, I have sold down gross long exposure as opposed to selling short aggressively into strength (taking the number of long position in our virtual portfolio down from 38 to 12, and holding short positions around 12 all the while). The most emotionally charged part of the REFLATION trade can be the most powerful. If you have a solid year-to-date performance, selling up here is a very easy decision to make. If you don't, you're forced to chase. When people are forced to chase, I like to sit back and watch.
In the chart below, Andrew Barber has shown the US Dollar on two durations:
- 1. Long Term TREND, breaking the $81.60 line of support (red line), going back to 1971 (when Nixon abandoned the Gold Standard)
- 2. Intermediate Term TREND, highlighting the last year of US Dollar pricing
In the longer term chart, we shine a flashlight on the crisis period of the US Dollar = Q407' to Q209'. This is where we see the impact of 3 camps Breaking The Buck:
- 1. Bernanke - a politicized Federal Reserve cutting rates to zero (economic crisis)
- 2. Bush/Obama - socializing the country's losses (credibility crisis)
- 3. China - getting upset (Client crisis), countering with USD replacement rhetoric as world's reserve currency
With the US Dollar down again today (despite Geithner galloping to the rhetorical rescue), my currency crisis questions remain. After paying out every politician and holder of the almighty petrodollar, when will our Chinese creditors and American savers get paid?
Keith R. McCullough
Chief Executive Officer
- Nancy McGinley
Insider trading has long been the hottest of hot buttons at the SEC. US law defines Insider Trading as trading on the basis of material non-public information. This means that if you know something that you shouldn't, and you trade on that knowledge, you have broken the law. People go to jail for this - often over ridiculously small amounts of money.
In practice, the SEC staff take the position that trading while in possession of non-public information is grounds for action. This means that if the person sitting next to you is secretly in possession of inside information - and scrupulously does not tell anyone - you could go to jail if you innocently trade the securities in question, without any knowledge of your neighbor's information.
This has led firms to erect Chinese Walls, and to create Restricted Lists and Walled-Off Business Units, and to prohibit firm employees or units from trading in the securities of an issuer if any other unit of the firm may be in possession of non-public information.
Firms generally seek to prohibit trading in securities of an issuer if they are aware of an unannounced pending transaction. This ballooned in the 1990's, when the market in PIPEs heated up and the abuses started piling on thick and fast. From criminals dumping worthless paper into the markets, to the bankers and brokers who sold the offerings, to the money managers and traders who manipulated the stocks, the scumbag factor in this corner of the market ran quite high.
Traders who were shown a deal would immediately short it. Many would then call their friends to short it as well. Often, the shares were not available for borrow - but the shares would never have to be delivered if the company was driven out of business. And with the stocks under pressure, the issuers did not have the clout to force the major clearing and prime brokerage firms to call stock for delivery.
Fund managers would blithely call one another and discuss deals, stepping aside to let each other bid on deals, or combining to short the stock in an effort to drive companies out of the marketplace entirely.
One outcome of the PIPEs market was increased employee personal trading surveillance procedures within the industry. As with every new regulatory requirement, this also spawned an industry of vendors whose products are designed to make the surveillance foolproof.
Now the SEC has a material non-public information issue of its own, and the personal trading of two of its senior attorneys is under review. The ongoing investigation is highly confidential. So much so that the SEC will not release the names of the two staffers involved - but their initials are Glenn Gentry and Nancy McGinley (WSJ 23-24 May, "SEC Slaps Trade Ban On Staff").
We won't opine on a case where we have nothing but the speculation and sensationalism of the news media to go on. Indeed, it is of little consequence whether Ms. McGinley and Mr. Gentry are exonerated or convicted. We believe the slipshod SEC will be hard pressed to find a smoking gun. Even though there appear to be many circumstantially damning emails, the SEC has been abysmally asleep at the switch. In the absence of clear standards for oversight of employee trading, we would not be surprised to see the individuals exonerated. The SEC did have a few rules - and the Journal article implies that the lawyers in question followed most of the rules, most of the time. Mr. Gentry emailed his colleague that he could not do a particular trade because the stock in question had just been restricted for SEC employees. To his compliant, her response was "Oh yuckola!"
We suspect even Harry Markopolous would not consider such a communication to be a Smoking Gun.
If these two are indicted on insider trading charges, what should happen to their supervisors at the SEC? If this were a hedge fund, the partners would be under investigation along with their employees. An indictment of the traders involved would bring an indictment of those higher up as well, likely leading to a large fine, a consent decree, and possibly a bar.
Meanwhile, the SEC has outlined the steps it will take in the wake of Yuckola-gate.
"The measures the agency is taking include:
- First, the staff has drafted a set of new internal rules governing securities transactions for all SEC employees that will require preclearance of all trades. It also will, for the first time, prohibit staff trading in the securities of companies under SEC investigation regardless of whether the employee has personal knowledge of the investigation. The rules have been submitted to the federal government's Office of Government Ethics, which approves agency ethics rules.
- Second, the SEC is contracting with an outside firm to develop a computer compliance system to track, audit and oversee employee securities transactions and financial disclosure in real time.
- Third, Chairman Schapiro has signed an order consolidating responsibility for oversight of employee securities transactions and financial disclosure reporting within the Ethics Office. And, she has authorized the hiring of a new chief compliance officer."
The requirements of pre-clearance, and the prohibition against trading in the securities of issuers under review by the Commission sound like effective procedures. All the more so since the SEC is engaging an outside firm to create a computerized surveillance system.
We have seen firms attempt to create their own internal computerized system to track all employee transactions in real time. There are also vendors whose off-the-shelf packages can be tailored to the firm's use.
All these programs require the electronic input of the daily data feeds from the brokerage firms where the employee accounts are held. This means a different set up for each broker, which is time consuming. The bidding process will take some time, and each broker set-up will require scheduling on both the broker end, and at the SEC. It will likely take six months at least from the time a decision is made to the time the SEC is receiving daily reviewable reports. Also, the brokers charge for the data feeds, so our taxpayer dollars will be spent to pay E*Trade, Schwab and Merrill to send daily electronic reports to the SEC.
An additional catch at every firm is the Favored Employee. There are always a small group of employees who are so important to the operation of the enterprise that "we can't tell those guys where to house their personal accounts." This results in a small number of accounts being held, almost invariably at small brokerage offices that are not even set up for electronic reporting. And since these are always the most important employees, they are naturally the ones a compliance officer is most interested in.
While this may not be widespread at the SEC, we wonder about individuals in temporary high-level assignments. The Commission is already contemplating bringing in Wall Street professionals for two-year stints. Will they be given special treatment?
These electronic surveillance set ups yield the compliance department a daily stream of electronic data about several hundred IRA accounts with an average balance of $12,000. But Compliance has to check the mailroom every day to see whether a trade confirm has been delivered for the firm's top-producing manager, banker or salesman, who has a seven million dollar account at a three-man shop where this account has been held for the last ten years.
The SEC receives a fair number of items in the mail each day, so it could be the work of several hours to identify the envelope in question, and it is equally likely that it would be overlooked and not found until weeks after the trade. Prudent compliance officers ask only for monthly statements, precisely to avoid being held responsible for not knowing about trades on T+2, or 3, or 5, or however long it took the mail to be delivered. Meanwhile, it only takes the Commission making a handful of exceptions for the entire project to collapse.
Is this any way to run a federal agency? Alas, we already know the answer.
There is one way, and one way only, to make a real-time surveillance program effective, and that is to place all employee accounts at the same broker-dealer and obtain real-time reporting from the broker. This still leaves it to the employees to actually make the disclosures, but it is the only way to guarantee that you will actually see everything that is disclosed, and see it on time.
We advise Chairman Shapiro not to employ a methodology that will only work 80% of the time at best - and that, only after it has been installed, retooled, tested and retested. If we had to guess, it will probably take the SEC two years to see a standardized result, in a reliably repeatable process. Think of all the damage that can be done in the meantime. And all that will accomplish is to capture trades in accounts actually disclosed by SEC employees. It will not prevent abuses.
The SEC never required firms to go beyond accepting the employees' own representations of the existence and nature of outside investments. We wonder whether a more rigorous standard will be applied to the SEC itself.
The SEC's new compliance officer will need to implement practices the SEC itself has rejected for firms under its oversight. The Commission will need to run checks on employee Social Security numbers, to identify undisclosed accounts. The Commission will need to obtain information about each employee's friends and relations. Compliance officers should know if an employee's college roommate - with whom the employee regularly socializes - is the CFO of a public company whose shares that employee trades actively.
You might be surprised to learn that most financial firms do not know who their own employees' spouses, parents or siblings are employed by. Do you know which of your traders or portfolio managers are married to senior executives of public companies? What you don't know can destroy you.
We urge Chairman Shapiro to take this to its logical conclusion. How many stockbrokers were permitted to resign without incident, who then went on to devastate another firm, and another? This practice resulted in innumerable fraudulent referrals - giving an employee a clean U-5 termination is equivalent to saying there were no problems - all because the managements refused to get involved in the regulatory process. Is it too much to ask the SEC's Compliance Officer to perform follow-up reviews of former SEC employees, to see what their current involvement is with the industry they were once charged with overseeing?
Clearly, failure to supervise was endemic at the SEC. There was no system in place for systematically reviewing employee trades - a staggering institutional failure at the federal agency charged with overseeing the investment markets. To us, the fact that employees were permitted to trade individual equities at all betrays a lack of common sense on the part of the Commission - not to mention a tin ear with respect to public opinion.
Chairman Shapiro had the good fortune to have this come to light so early in her tenure, she will not be touched by the fallout. Chairman Cox is another matter. It appears that much of the activity in question happened on his watch. Still, the details from the WSJ article support the idea that Gentry and McGinley followed the SEC's rules. The few exceptions appear to have been explainable lapses. McGinley is reported to have executed over 200 trades in a two-year period. Add to that the hours she and Gentry allegedly spent in telephone and email communication - and their regular "stock lunches" - they must have spent half their time at the SEC's offices looking for, discussing and executing trades. It is reasonable to expect that, in their haste to get back to their regulatory work, they might overlook a routine filing or two.
No one at the SEC thought it was important to put in place a system to oversee trading by staffers. You can't punish someone for breaking a rule that never existed.
No oversight of personal trading by SEC staffers? Whose idea was that? Will Chairman Cox be charged with Failure to Supervise?
On Whose Watch?
Tactics without strategy is the noise before defeat.
- Sun Tzu
Like the Single Bullet Theory, the Finger of Blame can strike multiple victims in rapid succession, its power undiminished as it ricochets down the corporate hierarchy. Indeed, it gains momentum in its downward cascade, striking those at the bottom of the heap with greater force than those at the pinnacle.
Such would seem to be the case at Morgan Stanley (Financial Times, 19 May, "Morgan Stanley 'Approved' Citic Trades By Accused Banker"). Morgan banker Du Jun "is at the centre of Hong Kong's highest profile insider trading trial," reports FT. The well-connected Mr. Du worked in Morgan's fixed income department. He testified that he was contacted by Morgan investment bankers who wanted to "leverage my relationship" with Citic Resources, a division of China's largest investment conglomerate. Morgan's hush-hush assignment: to advise Citic on a $1 billion bond offering - and its attendant hedges - to finance the purchase of an oil field in Kazakhstan. The FT reports that this was "a verbal mandate", which sounds like a way of saying the Chinese government wanted the deal cloaked in plausible deniability.
Well, it's not deniable any longer. Hong Kong authorities charged Du with acquiring some $11 million worth of Citic Resources shares during a three-month period in 2007 while in the thick of the deal. Now Hong Kong's highest-visibility securities fraud trial is in full throttle. Morgan Stanley is on one side and the client - China - while not implicated, can not be feeling the love in this relationship. One of the world's most important banks is facing one of the world's most important governments. Yuckola!
As compliance folks, we point out the following procedural matters raised in the FT story.
The Chief Operating Officer of Morgan's fixed income department routinely referred Du's personal trade requests to compliance. She claims this was because Compliance had access to the watch list, while she did not. Meaning that she did not personally oversee her senior employee's trades, but kicked responsibility over to administrators outside of her department.
The Compliance Manager who signed off on Du's request thought she was approving his purchase of Citic Pacific, a sister company of Citic Resources. "That's the only Citic stock I know from my memory," she testified. Meaning that she never bothered to verify what he was actually buying, or to check with Du's supervisors as to whether this was a permissible trade.
The compliance manager was not aware of Morgan's verbal deal with Citic Resources. Meaning that the deal was very likely kept hushed up internally, for fear of the Chinese company's plans being leaked. Meaning it may never have been formally placed on Morgan's restricted list.
And finally, of course, there's the fact that Du Jun even thought of the trade in the first place.
When the compliance manager asked Du directly whether he was "working on anything in particular on this company," he reportedly answered, "it's not my daily job." Meaning that no one bothered to dig any deeper.
This is a daisy chain of key points where an additional question was not asked, a second-step check was not performed, an assumption was not verified, a supervisor or banker was not contacted. Nor, apparently, did anyone dig deeper when the size of Du's position started to balloon. Eleven million dollars is a sizeable investment. We wonder what Morgan's policy states with respect to large employee positions.
Can it possibly be that the banker did not know he was breaking the law? Trading in one's personal account in violation of one's duty to the client, and in clear violation of the securities laws, is so blatantly stupid, we wonder what Du could have been thinking. We suggest getting him together with the senior SEC attorneys who allegedly sent endless streams of emails from their Government computers at the SEC's offices while engaging in high-volume trading on inside information.
Beyond this, we are open-mouthed at the blind reliance on representation, recollection, and lazy assumption surrounding extremely large trades in the personal account of a senor banker in a sensitive market, and at a firm of the size and visibility of Morgan Stanley. To say nothing of the effect on their client - China - at making a very public mess over a deal they apparently wanted to pursue in the shadows.
This reminds us of Johnny Carson. In his opening monologue, he always asked how many in the audience were from out of town. "Anyone here from Duluth?" he would call out, and there would be a chorus of raucous cheers from five or six folks. "Did you remember to shut off the gas?" he asked.
Lat note - a cultural aside. Two years ago our CEO, Keith McCullough, and I attended a meeting with a Chinese trade delegation. Some twenty regional and central government representatives had come to New York seeking financial partners for an industrial zone in the Chinese interior. Our General Counsel, speaking fluent Mandarin, explained our investment constraints under US law. Everything was clear to them, until he came to the concept of information barriers in banking transactions. Our visitors were baffled by the concept of the Chinese Wall.
Does it worry you that you don't talk any kind of sense?
- Hitchhiker's Guide To The Galaxy
Far out in the uncharted backwaters of the unfashionable end of the western spiral arm of the Galaxy lies a small unregarded yellow sun. Orbiting that sun - although he believes the sun orbits around him - is a bald-headed man with a hyperactive personality and a sense of self-importance so radiant it has attracted the attention of life forms on a gas giant orbiting a binary sun a hundred light years beyond Betelgeuse who, even as you read this, are motoring through the galactic soup in their quest for a reliable way to beat the market.
When, in Douglas Adams' enduring classic Hitchhiker's Guide To The Galaxy, earthling Arthur Dent reads the entry in the Guide that describes his home planet as "Mostly Harmless", he is devastated that his companion, Ford Prefect, could think of nothing more to say. It originally said only "harmless," replies his friend. The word "mostly" was added after further research.
We wonder whether Jim Cramer is having a similar moment as he contemplates the latest academic study of stock picking performance: his stock picking.
Paul J. Bolster and Emery A. Trahan, professors of finance at the Northeastern University College of Business Administration in Boston, ran a hypothetical Cramer portfolio spanning the period from July 2005 to December 2007. As reported in a NPR spot (22 May, "Study Says Jim Cramer Beat The market - Sort Of") Bolster and Trahan conclude that Cramer beat the market handily during their time frame. According to InvestmentNews (17 May, "Cramer's 'Harmless'") " During the course of the study, Mr. Cramer's portfolio had a cumulative return of 31.75%, compared with 18.72% for the Standard and Poor's 500 stock index."
This looks a damn sight better than "harmless" to us. We have not read the study, but we have also seen references over the past year to "studies" that show that Cramer has created nothing but losses for those who followed his advice.
Finally, posted on yourmoneywatch.com is Cramer's own analysis of his performance. As of the morning of 28 May it was as follows:
"Jim Cramer's 'Mad Money' Buy Recommendations: Performance Scoreboard - 7/28/05 to 05/27/09 - TOTAL: 1638 WINNERS: 303 LOSERS: 1335 UNCH: 0
Total Portfolio Performance: +3.71%
DOW -22.47% S&P 500 -28.19% NASDAQ -21.26%
Bolster and Trahan caution that, in order to attain his returns, Cramer invests in rather more risky vehicles than the average investor would seek out. As the NPR story says, his returns "come with an asterisk". They liken it with arriving earlier at one's destination, because one has driven at 100 miles per hour.
We are aware, by the way, of studies showing that the average driving speed in the US has increased substantially in the course of the last ten years, and average distance between cars on the road has gone down dramatically. This lethal cocktail has been credited with a meaningful increase in traffic deaths, but the conclusion of these studies is that the increase in fatalities is societally acceptable risk. We think this makes taking outsized shots in the stock market a no-brainer. Call your broker on your hand-held cell phone to place hat order for the double-down S&P etf while sipping your latte and taking a curve at 90 mph.
Cramer, of course, also cited Bolster and Trahan - though without the asterisk. In mentioning the report on his show, Cramer said "It shows that my performance from July 25, 2005, through Dec. 31 of 2007 was... well, excellent!" How many of Cramer's viewers do you think will bother to read the study itself? Or even the press about the study?
"Know Your Customer", indeed! Could it be the Crazy Eddie of Wall Street is onto something? If nothing else, he's certainly got the Zeitgeist by the Proverbials.
Chief Compliance Officer
Fresh Chinese PMI data shows that manufacturing activity continues to expand...
Research Edge Portfolio Position: Long CAF
Both the FLP and CLSA Purchasing Manager Indices for May registered in positive territory, with the official measure at 53.10 for the third consecutive positive reading. The market and media reaction has been enthusiastic since these latest readings continue to confirm that the stimulus measures are working, but the slight sequential decline in the pace of production recovery serves as a reminder to our process: the stimulus itself was a response to crises and, and despite the improving picture, there are still plenty of bumps on the road ahead as the process of jump starting domestic demand continues.
Official announcements detailing progress on infrastructure projects last week indicate that the rural improvement measures in the central regions are now very well underway, while in recent weeks we have noted the continued signals from domestic automakers and foreign electronic goods exporters showing rising consumer demand. Data released by South Korea's International Trade Association in recent days also confirms the bullish argument, with exports to China in April increased by 8% for the month improved sequentially on a Y/Y basis to -18.99%. Good numbers, albeit with a slightly moderating pace.
All data in aggregate continues to suggest that Beijing's stimulus measures are succeeding as planned. There are lots of factors to worry about still, with bad loans fostered by gushing credit and speculative price-inflation pockets in commodity markets being two major ones that we are focused on, but for now the positive momentum remains in place.
We are long Chinese equities via CAF, and continue to believe that the data arriving from both China and countries that supply it with commodities and production tools confirms strengthening recovery there. We are tactical investors however, and developments on the margin inform our process as we select points of entry and exit.
We will continue change as data and price action dictate; as the pace of the recovery inevitably moderates and the full cost of the stimulus comes to bear we will manage risk accordingly. That is our discipline -there will never be anything that we own in our virtual portfolio that we would not sell without a moment of hesitation the moment that the facts stop supporting our thesis.
Risk Managed Long Term Investing for Pros
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.