THE HEDGEYE DAILY OUTLOOK
TODAY’S S&P 500 SET-UP - April 25, 2011
The Inflation trade remains in place; US Dollar down (down 13 of the last 17 weeks); continued signs of growth slowing with copper down -1.2% this morning (bearish TREND); while monetary inflation skyrockets (gold and silver hitting new highs). As we look at today’s set up for the S&P 500, the range is 20 points or -1.37% downside to 1319 and 0.12% upside to 1339.
SECTOR AND GLOBAL PERFORMANCE
The Financials remain the only sector broken on both TRADE and TREND.
- ADVANCE/DECLINE LINE: 952 (-1033)
- VOLUME: NYSE 812.78 (-15.44%)
- VIX: 14.69 -2.52% YTD PERFORMANCE: -17.64%
- SPX PUT/CALL RATIO: 1.60 from 2.17 (-26.33%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 22.30
- 3-MONTH T-BILL YIELD: 0.06%
- 10-Year: 3.42 from 3.43
- YIELD CURVE: 2.74 from 2.74
MACRO DATA POINTS:
- 10 a.m.: New Home Sales, est. 280k (up 12%), prior est. up 250k (down 16.9%)
- 10:30 a.m.: Dallas Fed Manufacturing, est. 13.4, prior 11.5
- 11 a.m.: Export inspections, grains
- 11:30 a.m.: U.S. to sell $29b 3-mo., $27b 6-mo. bills
- 4 p.m.: Crop progress (winter wheat, cotton, corn)
WHAT TO WATCH:
- Average pump price climbed 11.5c to $3.88 thru April 22: Lundberg survey. Obama said last week a task force will examine if oil, gas prices driven higher by market manipulation.
- Nike (NKE) may be poised to climb as it works to control rising materials and labor costs, Barron’s
- China’s 2011 trade surplus may narrow to 2% of GDP because of rising commodity prices, Reuters says, citing a report from the State Council’s Development Research Center.
COMMODITY HEADLINES FROM BLOOMBERG:
- Silver Surges to All-Time High as Investors Seek Protection From Inflation
- Crude Oil in New York Rises a Fourth Day as Middle East Violence Escalates
- Copper Drops in New York on Signs of Ample Supplies in China, Biggest User
- Palm Oil Declines as Lower Malaysian Exports Threaten to Boost Inventories
- Corn Advances as Rains Delay Seeding in U.S.; Wheat Jumps to 2-Month High
- China's Corn Imports May Expand This Year to 2 Million Tons, Baize Says
- Rubber in Tokyo Declines as Demand May Weaken on Reduced Car Production
- Hedge Funds Bullish on Natural Gas as Nuclear Output Falls: Energy Markets
- Corn, Soybeans May Rise as Cold, Weather Slows U.S. Seeding, Survey Shows
- India Gold Imports May Fall for Third Month on Prices, Industry Group Says
- Tsunami Quickens ‘Terminal Decline’ of Northern Japan’s Fishing Industry
- Most China Aluminum Capacity Lacks State Approval, Business News Reports
- Corn Seen Topping Wheat on Demand, Raising Tyson's Costs, Helping Syngenta
- European markets are closed in observance of the Easter holiday
ASIA PACIFIC MARKTES:
- Asian stocks were mixed overnight on earnings concerns and China declined on increased inflation concerns.
- Japan March corporate services price index +0.4% m/m, (1.2%) y/y.
- Japan March supermarket comps +0.3% y/y.
- Hong Kong’s market is closed for a holiday.
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CAKE reported 1Q earnings after the close Wednesday, announcing diluted EPS of $0.34 versus consensus at $0.33 and guidance of $0.29 to $0.33.
The Cheesecake Factory reported 1Q earnings after the close Wednesday and, while the results were in line or slightly above expectations, the commodity outlook – and the question of company’s ability to pass it along to consumers – is causing uncertainty. This uncertainty weighed on the stock Thursday as CAKE traded down 3.9%.
Comparable restaurant sales came in at +1.6%, or +2.4% excluding weather, which implies a sequential increase in two-year average trends of 220 basis points. The street was expecting comps to come in at +1.2%. Exiting the quarter, CAKE had +1.4% of price on the menu. Grand Lux did experience negative comps during the quarter, coming in at -3.8%, but management attributed that weakness to a difficult compare (+4.0%) versus 1Q10 and volatility in sales at the Las Vegas locations.
In terms of ROP Margin, CAKE’s performance was less reassuring. Cost of sales increased 70 basis points year-over-year. With 60% of its food cost basket contracted, management anticipates inflation of approximately 3.5% for 2011. The prior guidance was for inflation of 3% in the food basket. Tellingly, management now forecasts the commodity impact on EPS for 2011 to be $0.11 from $0.05 prior. Along the lines of my post on CAKE in February, titled “CAKE – PUNT AND HOPE”, management is betting the ranch on food inflation falling off a cliff in the back half of the year. While that may happen, on a year-over-year basis, it is less than certain and does not jive with much of the agriculture news at present which point to disappointing harvests in grains and produce and increasing feed costs supporting protein prices. Despite having protein costs locked, to the extent CAKE has to renegotiate contracts with suppliers in 2011, the overall cost of its commodity basket could increase further than the general rate of food inflation. The company is guiding to 2.5% inflation in 2H11, with 1.5% in 4Q11, as compared to 4.5% inflation in 1H11.
In order to address this inflation, management maintained that pricing would be taken, if necessary, to absorb cost pressure. As I stated before, price was +1.4% at the quarter’s end and, with 0.7% in price rolling off the menu at the end of summer, the company anticipates taking 0.7% in the 2011 summer menu change to maintain the 1.4% price. Management also underlined its willingness to take price closer to 2% with that menu change if the commodity environment required it. G&A/labor efficiencies will also contribute to offsetting inflation, according to the company.
EPS guidance was raised at the low end, from $1.55-$1.70 to $1.58 to $1.70 (full year consensus EPS is $1.65), despite the incremental $0.06 of pressure from food costs that management is expecting. This full-year earnings guidance is based on a comparable restaurant sales forecast of 1.5-3.0%. For the second quarter, EPS guidance is at $0.39 to $0.41, which is below the street at $0.44 and will result in a shift in EPS from 2Q to 2H, absent a reduction in full year consensus expectations. I would not be shocked if 3Q inflation, which could well be as bad as, or worse than, 2Q, prompts an additional shift in EPS expectations to 4Q! Whether or not CAKE has sufficient pricing power to absorb the coming inflation will be the key question from here. I do not believe that CAKE has the ability to price its way through the inflationary period ahead. There is a significant risk of full-year EPS being reduced from here, especially given the lop-sided sentiment around the stock of late.
This note was originally published at 8am on April 19, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“I suppose leadership at one time meant muscles; but today it means getting along with people.”
-Mohandas K. Gandhi
Yesterday, the ratings agency Standard & Poor’s downgraded their view of U.S. government debt from “AAA” stable to “AAA” negative for the first time since the attack on Pearl Harbor. The implication of this new rating is that there is now a 33% chance that the S&P downgrades U.S. government debt in the next two years. To be clear, our view of ratings agencies hasn’t changed—they are lagging indicators at best.
In this instance, though, Standard & Poor’s did provide insight on the current political debate in Washington. The basis of their call is that they believe it unlikely that the politicians in Washington will come to an agreement on a budget plan that will narrow the deficit over the long term. This is the point we made in our Q2 Theme call last Friday, so of course we agree.
On the Republican side of the debate is the budget proposed by Congressman Paul Ryan from Wisconsin whose key tenets are to cut taxes, cap the size of Medicare and Medicaid, and to dramatically slash discretionary spending. Conversely, the budget plan presented by President Obama raises taxes on the rich, cuts discretionary spending somewhat, and takes a hatchet to defense spending. These are meaningfully substantive and philosophical differences with very little common ground as a starting point for negotiation.
The reaction from the Obama Administration to the rating change from Standard & Poor’s was interesting. The White House effectively dismissed the action, while the Treasury Department doubled down on the politicians in Washington. In fact, according to Assistant Treasury Secretary Mary Miller, Standard & Poor’s revised outlook “underestimates” the nation’s leadership. I’m not sure exactly what Ms. Miller thinks is being underestimated about the politicians in Washington, but fair enough.
I used the quote above from Ghandi to underscore the core of leadership, which is getting things done in conjunction with your perceived adversaries. Unfortunately, many of our perceived leaders have failed the nation on this front in the last week. President Obama failed us by turning a prime time speech about his deficit reduction plan into a campaign speech that alienated Republicans, including Congressman Paul Ryan who was stoically watching the speech live. While Tea Party leader, and Presidential hopeful, Congressperson Michelle Bachman, failed us by once again bringing up the tired old questions about President Obama’s place of birth last weekend, rather than focusing on the critical deficit issues facing the nation.
If Standard & Poor’s action yesterday did anything, it brought the lack of political leadership to solve the deficit issue completely into the mainstream. Not surprisingly, stock market operators cast their votes appropriately. While the SP500 closed above our TREND line of 1,302, it did so barely at 1,305 and it is still trading below the TRADE line of 1,319. Volume also confirmed this vote as it accelerated 28.8% on the NYSE week-over-week. Volatility did the same with the VIX up 11%.
From a sector study perspective, financials became the first of the primary SP500 sectors to break down with yesterday’s market action. On some level, this is likely the early anticipation of the ending of quantitative easing, which removes the politicization of the short end of the yield curve and hurts the lucrative business of borrowing short and lending long. As we’ve posted below in The Chart of the Day, the spread between 2s and 10s is at a near all-time high in spread. (As a way to play this reversion to the mean, we are long the etf FLAT in the Hedgeye Virtual Portfolio, which is a Treasury curve flattener position.)
Our Financials Sector Head Josh Steiner also provided some color as a rationale for yesterday’s quantitative breakdown in the sector:
“Mortgage-related costs are on the rise and managements are being more open about the accelerating deterioration of fundamentals in that business. Bank of America stated on their call that multiple charges taken in the quarter were tied to ongoing home price deterioration. MSR write-downs at other banks are an additional indication of ongoing deterioration in that business, as JPMorgan highlighted with their $1.1 billion write-down.
While most companies are beating on the bottom line it is largely being driven by credit-related improvement, but this is illusory. Most of that credit improvement comes from reserve release, specifically in the credit card business. For instance, JPMorgan’s card services provision was $226 million in 1Q11 as compared with $1.6 billion in 3Q10. One might assume that credit losses had fallen to $226 million, but in reality net charge-offs were $2.2billion in 1Q11. In other words, the company released $2 billion in reserves (defined as the difference between losses and provisions).
This reserve releasing has been substantially propping up earnings for the last several quarters, but will be coming to an end in the next few quarters as delinquencies in that business are nearing their trough.
The catch? The banks have been using reserve release from their card operations to offset growing pressure and recurring “one-time” charges in their mortgage business. Reserve release in cards will end in the next few quarters but mortgage-related weakness will persist for much longer.
Bigger picture, the industry continues to face an environment of little to no loan growth, rising margin pressure, falling non-interest income and, in 2Q11, significantly rising FDIC deposit insurance premiums for most of the large banks. From a macro standpoint, the start of the Consumer Financial Protection Bureau on July 1, 2011 will coincide with the end of QE2 on June 30, 2011, both of which are likely to be incremental headwinds for the sector.”
Needless to say, Josh isn’t overestimating the future stock performance leadership of the financial sector.
Broadly, we will see this week which bell weather companies will lead, follow, or get out of the way as earnings seasons kicks off in full force. Today, Goldman (this morning), Intel, IBM, and Yahoo all report earnings.
One last leadership quote today from the venerable Nobel Laureate Paul Krugman, who said this about the Standard & Poor’s ratings change:
“That said, it’s worth remembering that S&P downgraded Japan in 2002… Japanese bonds became known as the “trade of death”, because people kept betting on an interest rate rise, and it kept not happening. So, no big deal.”
So according to Dr. Krugman, emulating Japanese fiscal and monetary policy is no “big deal”. I’m no Nobel laureate and my PH.D is from the School of Hard Knocks, but even I know that becoming Japanese economically IS a big deal.
Keep your head up and stick on the ice,
Daryl G. Jones
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