Keith shorted CSH in the virtual portfolio earlier today at $43.85. His quantitative levels show a TRADE (short-term) and TREND (intermediate term) levels of resistance at $44.61 and $45.97, respectively.
Our bearish view on CSH is growing. There are several factors at play here.
* The YoY price change in gold is poised to roll from a 22% tailwind to an 8% tailwind in 2Q12 and if gold holds at its current level it will be a 7% headwind in 3Q12. A rough heuristic for the revenue model of a pawn store operator is that gold appreciation over the past decade has contributed 9.6%, or just over half, of the overall growth in revenue. We show this in the chart below. For CSH the effect should be more acute, because they hedge out the price of gold six months in advance. This means that when they reported 1Q12 results, they were actually reflecting the 38% 3Q11 YoY tailwind, meaning that gold price tailwinds will slow meaningfully for them for the coming 9 months.
* Judging from the divergence between expectations and reality, the consensus doesn't understand the amount of headwind the company if facing. Consider the net revenue growth expectations the Street is modeling in for the next 3 quarters relative to the headwind from gold.
Source: Factset Estimates, Hedgeye Research
* The other issue at play here is whether gold volumes are drying up for the pawn operators. We wrote a note on this following EZPW's earnings, but to summarize: both FCFS and EZPW spoke to materially declining gold volumes, and EZPW attributed it to their borrower base running out of gold. Cash America came out and denied that they were seeing the same trends in their business, but call us skeptical. The main driver of the falling volumes is the emergence in the last few years of the pop-up gold buyer - ads for these places are now ubiquitous: billboards, radio, tv. These shops are taking share from traditional pawn business like CSH, EZPW and FCFS. A secondary factor is that the borrower base is running out of gold. The rise in the price of gold over the past decade has made for a largely one-way trade: gold leaves the population of pawn borrowers and returns, via scrap, to more affluent customers outside the pawn borrower population.
Joshua Steiner, CFA
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Conclusion: We covered our mean reversion short position in long term treasuries via the etf TLT yesterday as there are number of catalysts that will keep long term yields from increasing meaningfully through the end of June. Beyond that time frame, much of fixed income looks like it could be short (at a time and price).
Earlier today, we covered our short position in the etf TLT, which represents long term treasuries with a 20+ year duration. A key insight for us to enter this position was 10-year treasuries yields hitting basically an all-time low earlier last week at 1.70%. The chart below shows the long term range of the 10-year over the past decade. Currently, the yield of the ten year is 1.79%. This is more than two standard deviations below average yield of the last ten years of 3.8%.
Over the longer duration, the risk reward set up remains asymmetric for yields to increase. We can see this in our price ranges as the TRADE range is tight at 1.66% - 1.81%. Meanwhile, the TREND resistance level is 2.03%. So, up to our intermediate term support levels there remains significant upside in yields and downside in bond prices.
In the intermediate term, despite the massive longer term reversion to the mean potential, it is unlikely to be a money making opportunity being short U.S. treasuries for two key reasons:
- Operation Twist – The Federal Reserve’s operation twist is scheduled to continue through June 30th. By some estimates, the Federal Reserve has already surpassed their target of extending average maturities by 100 months, but regardless they will keep buying longer dated treasuries for the next forty days and this will keep yield increases muted.
- Europe – As highlighted in the chart below that compares 10-year yields of Germany versus Italy and Spain, the European debt debacle is far from resolved and will continue to support the relative safety (albeit very relative) of U.S. government debt. As our colleague Josh Steiner highlighted in a note yesterday on Greek elections, the looming June 17th election in Greece will have critical impact on the future of austerity and reform in Europe, and as a derivative the yields of European sovereign debt. If there is risk in European sovereign debt, U.S. treasuries will remain a safe haven of sorts.
Longer term, the increasingly key consideration will be the U.S. fiscal and balance sheet situations, which continues to deteriorate in the year-to-date. For starters, the Congressional Budget Office raised their estimate for the deficit in fiscal 2012 by $93 billion to $1.2 trillion in March. This key reason for this is because revenue has basically been flat year-over-year. As a result federal debt-to-GDP is hovering just over the 100% mark.
The key negative fiscal catalyst for Treasuries beyond June 30thand the end of Operation Twist is the debt ceiling getting hit again and the potential for another downgrade of U.S. sovereign debt (The caveat is that the last downgrade did not lead to an increase in yields.) The current debt ceiling is $16.4 trillion and the public debt balance as of May 18this $15.7 trillion. Interestingly, roughly seven months ago the public debt balance was $15.0 trillion, which at a similar rate of growth suggest we should hit the debt ceiling by the end of calendar 2012. Once again, this will be major political football that will increase consternation related to low historical yields.
One last point we wanted to highlight in this note was that of relative yields. In the table and chart below, we compare U.S. investment grade yields to U.S. junk bond yields to the earnings yield of the Dow Jones Industrial Index to the yields of 10-year treasuries. Not surprisingly, given the bubble in treasuries, there is a relative bubble of sorts in the rest of fixed income.
Specifically, both investment grade bonds and junk bonds are trading well below their long run average yields and at, relatively, tight spreads to treasuries despite the artificially low yields in the treasury market. Trailing twelve month earnings yields for the Dow Jones Industrial Index appear relatively cheap, but, as always, equity valuations depend on the future view of growth. Interestingly, historically the earnings yield spread between the DJII and 10-year treasuries has actually been meaningfully tighter than between junk bonds and 10-year treasuries. This implies high yield could be most at risk in a mean reversion scenario or if economic growth slows more dramatically.
Clearly, Japanese sovereign debt yields have stayed low despite major growth and fiscal headwinds. The same scenario may well play out in the U.S., or, as they say, this time could be different and reversion to the mean in the fixed income market could catch many off guard. As Hemmingway famously wrote:
“It occurs very slowly, then all at once.”
Daryl G. Jones
Director of Research
Positions in Europe: Long German Bunds (BUNL)
Keith bought German Bunds (BUNL) in the Hedgeye Virtual Portfolio today. The move is a continuation of how we are thinking about Europe: there’s a relative advantage to playing the capital markets of the stronger countries on the long side and weaker countries on the short side, at a price. We’re highly sensitive to price and well aware that there’s no simple equation to pair or hedge risk in Europe: political headline risk, even from the tiniest of countries in Europe, can roll country equity indices and influence yields across the continent.
And we don’t expect political risk to abate the slightest from here. We’re also of the opinion that very little substance will come out of tomorrow’s European Summit. The market hopes to see Eurobonds rolled out to subsidize the region. While we don’t rule them out as a potential “tool” down the road, we think the strong anti-Eurobond stance of the Germans will hold weight. Further, should Eurobonds be highly considered, they’d have to be approved by 27 Parliaments across Europe. This is a tall order, especially considering the UK’s firm opposition to Eurobonds, and logistically there is no chance of this happening over a matter of days.
From a political positioning perspective, we see Eurocrats putting the ball in Greece’s court to decide its fate. Should the anti-austerity party of Syriza win elections (with a coalition) on June 17th, we expect the outcome to be a swift bank-run, bankruptcy, default, and exit from the Union. Again we don’t see this as a high probable event as polls continue to show that nearly 80% of Greeks want to stay in the Eurozone and with the EUR. The gun is loaded, do Greeks want to pull the trigger?
The only other options at hand under a Syriza victory are that the Greeks called the Eurocrats bluff, in which austerity is thrown off the table (we also view this as highly unlikely) or that another massive bailout scheme is issued (possibilities included another Eurobonds, giant EIB loan to Greece) around the election, but this too seems less probable than an outcome in which a pro-austerity coalition (probably New Democracy and Pasok) wins the elections and then maybe concessions are made to Greece’s fiscal consolidation targets.
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