This note was originally published at 8am this morning, November 16, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“Sean: See you Monday. We'll be talking about Freud and why he did enough cocaine to kill a small horse.”
-Good Will Hunting
Yesterday, the Italian police reported intercepting 1 ton of pure cocaine inbound on 4 tractors from Brazil. The street value was estimated at 250 MILLION Euros ($341M USD). That’s a lot of Fiat currency. That’s a lot of coke.
Since it was the largest intercepted transaction of cocaine in 15 years, I figured I’d start to analyze the matter. After all, Quantitative Guessing (QG) has many unintended consequences, not the least of which are moral.
Like creating “sugar highs” in markets for those who are levered-long of them, cocaine is a stimulant of the central nervous system. It suppresses the addict’s appetite to manage reputational risk. When it’s uncut, or “pure”, some really wild and crazy stuff starts happening post consumption.
According to one anonymous tweeter with knowledge in the crystalline tropane alkaloid space, pure cocaine “has no filters to increase the weight of the product. Dealers will usually “step on” their product to the tune of 30 or 40% of some other substance (usually Demerol, baby laxative, or B12) to increase their profits.”
As I dug deeper into my research, I couldn’t help but remember that this is exactly what 18th century Coin Clippers used to do to the their citizenry’s currency. Before we had central banking dealers clean up the messaging and delivery of the coin clipping business it was, per Wikipedia, “considered by the law to be of similar magnitude to counterfeiting, and was occasionally punishable by death.”
The good news here is that Americans are starting to figure this whole matter of feeding free money to debt addicts out. It actually didn’t take very long for consensus to come to realize that QG and Burning The Buck are bad things. This is progress.
We’re long the US Dollar (UUP) here and covering some of our US Equity short positions, not because we trust the alchemy of Alan Greenspan or Ben Bernanke, but simply because we are starting to see some of the cocaine highs of the last few weeks wear off. After all, over time, a stronger sovereign currency that isn’t being clipped by charlatans of government sponsored volatility is a good thing for America.
As risk managers, we are tasked with measuring real-time market prices, volatilities, and volumes. The output of this research results in probability-weighted market timing. As correlations and r-squares change, we start to change our positioning.
Today is November the 16th. To understand where markets can go next, we have to contextualize where they came from. So let’s look back at global macro correlation risk relative to the US Dollar on a THEN and NOW basis versus October 16th…
THEN (immediate term TRADE correlations to USD):
- SP500 = -0.80
- CRB Commodities Index = -0.88
- Brazil’s Bovespa Index = -0.92
- Oil = -0.91
- Gold = -0.96
- Copper = -0.95
NOW (immediate term TRADE correlations to USD):
- SP500 = -0.29
- CRB Commodities Index = -0.20
- Brazil’s Bovespa Index = -0.60
- Oil = -0.11
- Gold = -0.08
- Copper +0.10
The way to read this is very straightforward. Copper is undergoing the most glaring mathematical change, swinging from an INVERSE correlation of -0.95 to a POSITIVE correlation to the USD Dollar of +0.10 in only one month. This is a major new development in the risk management landscape.
While I wasn’t brave enough to buy Copper yesterday, I did buy-back my long Gold (GLD) position (email firstname.lastname@example.org if you’d like my intraday note titled “Gold Diggers: Gold Levels, Refreshed”).
Last Tuesday, my asset allocation to Commodities was a Bernanke (ZERO percent). This morning, after seeing the CRB Commodities Index correct by -4%, the Hedgeye Asset Allocation to Commodities is back up to 6% (GLD = 3%, CORN = 3%). Managing your cash position dynamically isn’t rocket science. It’s called contrarian sobriety.
One of the most critical lessons I’ve had to learn in making global macro calls on markets is that the derivatives, correlations, and divergences embedded in the math are never perpetual. In other words, once it gets so easy that a coke-head can do it, it ends…
The SP500 is down for 5 out of the last 6 days and should test a critical level of immediate term TRADE support this morning. In the Hedgeye model, that line of support is 1190. If it holds, that’s bullish. If it breaks, that’s bearish. My immediate term TRADE line of resistance is now 1212.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Conclusion: The Republican landslide in the recent election all but guarantees State & local government fiscal headwinds will continue to materialize in 2011. These headwinds will likely result in material spending cuts and tax hikes going forward, which will create a drag on the economy going forward and increased risk for State and local bond defaults.
Position: Bearish on Muni Bonds
With the incoming 112th Congress coming in overwhelmingly Republican on the margin, State & Local governments will likely see their fiscal troubles deteriorate into FY12 (which starts on July 1st, 2011 for all but four States), due to an erosion of federal budgetary support. States have only a remaining $6 billion in American Recovery and Reinvestment Act funds left to patch the FY12 budget gap of an estimated $140 billion. Incremental funding from H.R. 1586, the August 2010 Jobs Bill, buoys State spending on Medicaid only through June 2011 and adds only $10 billion to the State Fiscal Stabilization Fund.
If State & Local government revenues come in in-line with our bearish estimates, where will the much needed additional funding come from as States evaluate their budgets mid-year and as they prepare FY12 budgets? Likely not from the federal government, given the Republican Party’s platform of cutting spending and lowering taxes. Given this material erosion in funding sources, we outline below some key programs and sources of funding that may disappear in 2011 as well as some proposals that will exacerbate State and local government fiscal headwinds going forward:
Build America Bonds
The Build America Bond program has helped fund $158 billion into local public works projects since its inception, with the federal government subsidizing 35% of the interest on these taxable securities. The program is set to expire at the end of the year, unless it gets extended. Twice this year, the program has passed the House only to be shot down in the Senate (likely due to it being wrapped in with other contentious programs). If it does not make it past the lame-duck session of Congress (which began yesterday), it will likely not be extended when the 112th Congress takes session.
The program has been quite popular thus far from issuers and underwriters alike; should it fail to be extended, current estimates suggest tax-exempt muni bond issuance would increase roughly 30-35%. That’s not good for muni bond yields – especially when taken in the context of bearish underlying fundamentals of many State and municipal governments across the country.
Pledge to America is a Pledge to Cut Discretionary Spending
House Republican leaders have pledged to cut non-security discretionary spending by 21.7% in FY11. If adopted, the program would provide roughly $105 billion less for all non-security discretionary programs than Obama’s current 2011 budget. According to the Center for Budget Policies & Priorities, that translates to roughly a $32 billion haircut for State & Local government budgets, given that State & local government grants represent nearly a third of all non-security discretionary funding. If transportation programs are factored in, the haircut is a full $11.8 billion larger, for a total of $43.4 billion of lost funding in 2011. States are already projecting a $134 billion deficit in FY12; needless to say, an incremental 32% addition to the gap will require further cuts and/or tax hikes going forward, as States are mandated to have balanced budgets (w/ the exception of Vermont).
Obama’s Business Tax Break
President Obama’s proposed tax break for businesses to deduct the full cost of capital investments in the year expenses were made (rather than a full depreciation schedule) may end up costing states $20 million in tax revenues through 2013, according the Center for Budget Policies & Priorities. Further, the center suggests States may end up recouping only about 85% of the funds despite the immediate write-offs being replaced by those of later years, due to NPV calculations among other factors. All told, 24 States automatically change their definition of taxable income to conform to federal government code and another 22 update it every year to reflect any changes made on the federal level, meaning that 46 States will be directly negatively impacted by this proposal should it pass.
Getting Up To Speed
With the struggles of State & local governments making more and more news of late, we’ll continue to remain diligent in keeping you appraised on this topic. We’ve written extensively on State & local government fiscal headwinds YTD; email us if you’d like to receive copies of any/all of the following reports:
February 24: DOMESTIC PIGS – A recent release by the PEW Center on the States shows a $1 trillion gap between the $3.35 trillion in pension, health care, and other retirement benefit-related liabilities currently on States balance sheets and the $2.35 trillion in assets they have to cover them. While we are not calling for the U.S. to default on its sovereign debt, the likelihood of a State and/or local government defaults(s) may potentially lead to a downgrade in the U.S.’s credit rating.
April 20: GOVERNMENT’S MARKING TO MODEL – Property tax rates and property tax receipts continue to rise in the face of a weak domestic housing market, showing just how much the government marks their “assets” to model. We break down the convoluted municipal property value appraisal system and highlight the oncoming headwinds to local government property tax collections in the coming years.
July 21: IN A SORRY STATE INDEED - Waning federal funding, slowing tax receipts, and declining home prices will put additional strain on State and local government budgets, which have an incremental negative effect on the U.S. economy at large.
September 13: BREAKING DOWN MUNI BONDS – We firmly disagree with the relative “safety” of muni bonds, as current yields are at a disconnect with the underlying negative fundamentals that will begin to reveal themselves over the next 2-4 quarters.
October 13: CONTRACT FOR AMERICA: EVEN SLOWER GROWTH AHEAD? - Careful analysis of State & Local Government fiscal headwinds suggests that a Republican takeover of Congress may lead to decisive spending cuts, which could negatively impact U.S. economic growth in the intermediate term. Furthermore, State and Local Government’s FY11 revenue projections are very out of line with economic reality, which suggests further cuts are on the way. In this report, we analyze this divergence in great depth.
R3: REQUIRED RETAIL READING
November 16, 2010
- While sales strengthened at quarter end for URBN, one of the key callouts in the quarter is the divergence in fashion trends emerging between regions. Not only are there differences between coasts, but including the Midwest as well suggesting that retailers with inadequate planning and allocation systems could be at an increasing competitive disadvantage headed into the holiday.
- For the first time, the success of Dick’s Sporting Goods’ shared service (self-help) format available in the footwear department was quantified with management highlighting 500bps of comp outperformance relative to typical footwear chain results. Not surprisingly, the company will be stepping conversions beginning next year with 20 slated on a base of only 46 stores.
- With sell-through rates of regular priced product nearing historical highs, Nordstrom’s management noted an opportunity for further gross margin upside from a less promotional selling environment. A return to sales outpacing inventory growth certainly helps.
OUR TAKE ON OVERNIGHT NEWS
Loehmann's Files for Ch. 11 - Loehmann’s Capital Corp. Monday filed a voluntary prepackaged Chapter 11 petition in Manhattan bankruptcy court. Whippoorwill Associates Inc. and Istithmar World have agreed to invest $25 million into the firm upon its emergence from bankruptcy, expected in the first quarter of 2011. Whippoorwill owns 70 percent of the senior notes and Istithmar is the equity sponsor. The two also agreed to a restructuring plan in which the retailer’s debt will be reduced and its balance sheet recapitalized. According to court documents, the new capital structure will allow Loehmann’s to reduce debt by $115 million. The prepackaged filing also will preserve 1,900 jobs and the Loehmann’s brand. A reorganization of some kind has been considered a foregone conclusion since Oct. 29, when the company failed to complete a debt swap and defaulted on its credit agreement. Crystal Financial, Loehmann’s lender, is providing a $45 million debtor-in-possession credit facility. Loehmann’s said it will have “sufficient liquidity and the financial flexibility to fund daily operations.” The petition filed with the court estimated the number of creditors at between 1,000 and 5,000, with both assets and liabilities each estimated at between $100 million and $500 million. The five largest unsecured claims were listed as the ladies’ division of G-III, New York, $774,498; Tahari Ltd., Pittsburgh, $580,939; Urban Outfitters, New York, $569,438; Juicy Couture, Newark, $519,131, and Republic Clothing Corp., New York, $509,240. Joseph Melvin, Loehmann’s chief operating officer, chief financial officer and secretary, said in an affidavit that net sales fell $30.4 million, or 6.7 percent, to $422.2 million in fiscal year 2009 from $452.5 million in fiscal year 2008. <WWD>
Hedgeye Retail’s Take: While not a surprise following the failed debt swap in October, the two callouts here are 1) duration with the company already expecting to emerge from bankruptcy next quarter, and 2) URBN and LIZ on the hook among the largest unsecured claims. While the size of the claims are similar its more material for Juicy, which is a quarter of the size of Urban.
Robust 1H Results from Burberry - First-half profits at Burberry Group plc rose 46.3 percent to 83.1 million pounds, or $126.3 million, from 56.8 million pounds, or $86.3 million, on the back of a 21.6 percent increase in revenue for six months to Sept. 30. Dollar figures have been converted from euros at average exchange rates for the period. “The continued focus on the brand, ongoing investment in our digital, IT and retail infrastructure, especially in China, and a disciplined approach to driving growth underpin our confidence in delivering long-term sustainable returns,” stated chief executive Angela Ahrendts. In the second half, Burberry said average selling space is expected to increase by about 25 percent, and 15 percent of that new space will be in China. Wholesale revenue, excluding China, is set to increase by around 10 percent at constant currency, led by emerging markets and travel retail. Wholesale revenue including China, where the brand has repurchased its retail operations, is expected to be down by a low single-digit percentage at constant currency. <WWD>
Hedgeye Retail’s Take: With the expectation of 25% square footage growth, Burberry has one of the more aggressive expansion plans among global retailers over the next 6-months.
Adi Eyes #2 Spot in China - Adidas AG, the world’s second- largest sporting-goods maker, will increase China stores by 9 percent to 6,100 by the end of next year as it forecast sales growth of at least 10 percent in the country. Adidas plans 500 net store openings in the world’s most populous nation, with Greater China sales projected to exceed 1 billion euros ($1.36 billion) next year, Chief Executive Officer Herbert Hainer said in an interview today in Shanghai. The clothing and footwear market in China may be worth 334 billion yuan ($50 billion) in 2010, almost double what it was five years ago, data from Euromonitor International show. Adidas competes with Nike Inc., the world’s largest sporting-goods maker, and Li Ning Co. in China, where retail sales growth averaged 18.3 percent in the 10 months through January. “I’m quite confident” in China, Hainer said. “We’ll see double-digit growth in China over the coming years. It’s a big population and a lot of people want their sneakers.” Adidas plans to add about 2,500 stores in smaller Chinese cities over the next five years, expanding its presence to 1,400 cities from 550 now. <Bloomberg>
Hedgeye Retail’s Take: Adi plans on taking back its position as the #2 brand in China by the end of next year. Fortunately for all involved, the Chinese market is growing at such a rate that even in the face of market share loss, other top players are still likely to see outsized growth.
Gucci's Polet Highlights Impact of China and Tech on Retail - Great changes and new opportunities are emerging as the legacy of the three years of economic doldrums. The postrecession future of the fashion industry was discussed by a panel of international executives during a summit organized by Pambianco consultancy here on Monday, titled “Fashion: Nothing Will Ever Be the Same.” Robert Polet, president and chief executive officer of Gucci Group, highlighted the appearance of two major cornerstones: “The development of China and emerging markets, which we’ve never, ever seen in this business, and the technology, internal and external.” The direct contact with customers and the fact that technology allows the company “to engage with millions of customers one-on-one” made “a dream come true,” said Polet. As for the “ultimate luxury experience,” he identified it with the Gucci app, “which costs zero. It’s the same as if you had the bag and it shows you are part of the [Gucci] crowd.” Polet also urged small and medium-size companies to make changes through technology. “This is your biggest opportunity, or you are doomed,” he said. The executive said that, year to date, Asia Pacific is the fastest growing market for the group, gaining 25 percent and accounting for 30 percent of turnover. Sales in Europe rose 15 percent, accounting for 35 percent of revenues. As the Chinese government allowed Chinese to travel in groups around the world, Gucci realized 70 percent of sales in Europe come from Asia and Chinese people traveling. Describing this as a “tremendous influence,” Polet predicted “it will happen soon in the U.S., too.” The executive also noted how 60 percent of customers in China are men. “The next growth will take place when women will be coming out,” he said. <WWD>
Hedgeye Retail’s Take: While China continues to be a primary focus for retailers in pursuit of growth, the tourism stats here are the real callout – 70% of Gucci sales in Europe are coming from Asian travelers! While it’s suggested this will happen in the U.S. ‘soon,’ we’d certainly argue increased sales of luxury leather goods and timepieces are already reflecting the benefit from those capitalizing on the currency arb.
Apparel Customer Satisfaction Survey Results - A strong performance by VF Corp.’s brand portfolio lifted the company to the top spot within the apparel sector in an annual study on customer satisfaction, and also put apparel at the top of list of categories in the manufacturing nondurables area. Apparel was the only sector to register a gain in the American Customer Satisfaction Index as athletic footwear was flat and food manufacturing and pet food both registered declines. Apparel’s overall score moved up 1.2 percent to 83 on a scale of 100 from 82 in the third quarter of 2009, principally on VF’s move to 85 from 81 a year ago. VF’s brands include Wrangler, Lee, The North Face, Seven For All Mankind, Nautica, Vans and JanSport. “Other brands” rose to 83 from 82 while Hanesbrands declined to 81 from 82, Jones Group and Levi Strauss both fell to 81 from 83 and Liz Claiborne descended to 79 from 82. <WWD>
Hedgeye Retail’s Take: Couple notable moves here with VFC gaining while LIZ took a few steps back relative to last year. Similarly, Adi recorded the greatest increase on the footwear side up 5% to 82 while New Balance and Skechers recorded the most significant drops down -4% to 80.
Wang Closes Bridesmaids Business - Vera Wang, who built her reputation on bridal gowns and bridesmaids’ dresses, is closing her directly owned bridesmaid business. Monday was the last day that her 100-plus doors would take orders for her bridesmaids’ dresses, which retailed from $180 to $330. The stores will honor the orders that have already been placed. Mario Grauso, chief executive officer of Vera Wang, confirmed the exit and said the bridesmaid business would “shift over to David’s Bridal.” Last May, Vera Wang struck a deal with David’s Bridal to design a less-expensive bridal collection called White by Vera Wang, with bridal gowns retailing from $600 to $1,500, with most under $1,200. The arrangement will begin with wedding gowns this February at 150 David’s Bridal stores, and the line will expand to bridesmaids’ dresses and shoes. According to Grauso, the White by Vera Wang bridesmaids’ dresses, which will hit stores in June and July, will retail from $150 to $200. The dresses are expected to be “very similar in feeling” to Wang’s bridesmaids’ dresses, said Grauso, adding “it’s classic Vera.” The line, designed by Wang and the David’s Bridal team, will be offered to over 300 David’s doors and on David’s Bridal’s Web site, beginning in June, he added. Wang’s bridesmaid business was reportedly doing $5 million in wholesale volume at its peak several years ago. However, the business, which was a special order business for bridal salons and specialty stores, became increasingly difficult to maintain and volume deteriorated. <WWD>
Hedgeye Retail’s Take: Just looking at the math on this one it implies only 2-3 wedding parties a month (~16 dresses) per store when sales were at peak – not exactly a high volume business. Given that wedding gowns go for a considerable multiple, the right choice appears to have been made here.
New Outerwear Fabric Available to Brands - GE is making its eVent Fabrics collection of waterproof-breathable fabrics available for customers to brand as their own. The change puts the customer’s label on the outside with proven eVent technology on the inside to create an innovative partnership. For entrepreneurial brands, this offers a new level of design freedom, ushering in a new era of innovation in waterproof-breathable apparel, footwear and gear. “GE is a company driven by innovation. Our flexible, customer-centered approach enables us to help our customers build true innovation while enabling them to build their own brands,” said Glenn Crowther, product line leader for performance fabrics at GE. Mountain Hardwear has chosen to partner with GE for the launch of its proprietary collection of DryQ waterproof-breathable apparel, debuting fall 2011, because of the proven performance of GE’s membrane technology and the flexibility it brings to the internal design process. DryQ apparel offers a never before seen collection combining Mountain Hardwear’s knowledge of textiles, backers, DWR technology, glues and tapes, with GE’s highly-breathable membrane technology. <SportsOneSource>
Hedgeye Retail’s Take: With numerous new fabrics driving product innovation in sports apparel, marketing will become a key differentiator in winning over consumers headed into the holiday season. Frequency is not nearly as important as the campaign with numerous brands claiming to have this year’s latest innovative product.
Borders Launches New Site - Bookseller Borders Group has unveiled a new version of its e-commerce site, marking the event by offering free shipping on all orders placed today. Borders Direct, the e-commerce arm of Borders Group Inc., relaunched its e-commerce site today with more discounts, free shipping options and other upgrades, in keeping with the company’s growing emphasis on the web. Borders Direct, No. 194 in the Internet Retailer Top 500 Guide is discounting on the site more than 100,000 of its top-selling hardcover and paperback fiction and non-fiction titles. The retail chain unveiled its redesigned web site to coincide with the heart of the holiday shopping season as it seeks to position itself as a key online shopping destination. “Ensuring a world-class online shopping experience is at the core of Borders’ brand transformation strategy,” says CEO Mike Edwards. “We’ve listened to our customers, discounted tens of thousands of our top online titles, and rolled out new product lines and a streamlined, more social online experience.” <internetretailer>
Hedgeye Retail’s Take: A case of poor timing with free shipping now the new ante thanks to Wal-Mart.
Chinese Vendors Seek Ways to Offset Pressures - Faced with an appreciating yuan and rising labor costs, Chinese apparel, textile and accessories vendors played up quality and workmanship at this season’s China Sourcing Fair. Buyers and sellers complained about escalating prices, as well as a worldwide cotton shortage that’s further driven up costs. To cope, Chinese apparel and accessories makers have been seeking to move up the food chain, producing higher-quality, more labor-intensive goods. Buyers, on the other hand, reported moving some basic manufacturing to cheaper locales such as Bangladesh and Cambodia. The fair, which ended its four-day run at Hong Kong’s AsiaWorld Expo on Oct. 30, had nearly 1,000 exhibitors, including 600 fashion accessory makers and around 200 booths of apparel and textiles. Vendors reported being squeezed by escalating prices and said order sizes have been smaller. According to a recent survey of 239 exporters by Global Sources, 60 percent of respondents expect some decrease in export orders, while 8 percent believe sales will be hit significantly because of a stronger yuan. To cope with the yuan’s appreciation, 30 percent of exporters surveyed by Global Sources said they intend to increase focus on the domestic market, 15 percent plan to use more imported materials and 10 percent believe focusing on high-end products may bring in higher profits. King Lee of South Korean textile maker King Tex said he’s been seeking out more Asian clientele. European clients once made up 90 percent of his revenue, but since the economic crisis in 2008, that figure has dropped to 30 percent. Hong Kong and Chinese clients now make up 25 percent of revenue, he said. <WWD>
Hedgeye Retail’s Take: This is all well and good, but the bulk of the industry remains mid-tier, not high-end.
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