KNIGHT: The Roundtable Falls

Knight Capital Group, one of the big players in retail brokerage order flow and market making on the Street, lost $440 million this week and is scrambling for funding after a “technology screw up” that caused the firm to screw up quotes for NYSE-listed stocks. We don’t believe that they will be able to get more than $60-80 million in funding and will be forced to go into bankruptcy or reorganization of some sort.


Knight’s counterparties are no longer routing order flow or using algos with the company. The entire Street has shunned them. This has really hurt confidence with investors, similar to the events of the flash crash and MF Global. The Financials SPDR (XLF), has been down significantly after big events like the aforementioned, and this will likely happen.


There will most likely be some kind of hearings in Washington or some kind of investigation. The Knight event will no doubt be used as fodder for regulation, particularly the Volcker Rule. We’ve been bearish on Morgan Stanley for some time and question how Knight will affect them. Counterparty risk affects the firm quite a bit but there hasn’t been a huge flight from the firm.


The Other Side

This note was originally published at 8am on July 20, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“If one side of every transaction is wrong, we have to ponder why we should think it’s not us.”

-Howard Marks


Yesterday afternoon, as I was flying back to New York from California, I was watching the market go against me by -0.12% (I’m short the SP500 at 1375). It’s never easy taking The Other Side of a market up move. Being a successful short seller in this business is the ultimate game of survival. Your skin needs to be thick, and you need to be able to take a punch.


I’ve made thousands of short sales in my career. Each time feels different. Feeling in this profession is what you’re not supposed to do. But you do. You’re going to feel the love when you are right. You’re going to feel shame when you are wrong. No matter what you are feeling, the best advice I can give is to keep searching – keep asking yourself what you’re missing.


Mr Macro Market is usually pretty good at reminding you when and where you could be wrong. That makes our search easier. Embracing the uncertainty that each and every dynamic risk management factor throughout each day brings is at the core of what I do. As Howard Marks wrote in his recent June letter: “Active management has to be seen as the search for mistakes.”


Back to the Global Macro Grind


The Other Side of the bear case for the SP500 is the current bull case – bailouts. Yesterday’s US economic data was awful. US Leading Indicators (LEI) slowed -0.3% in June versus +0.4% in May. Existing Home Sales for June dropped -5.4% and weekly US jobless claims shot straight back up to their YTD highs of 386,000.


So, on the “news” the market sold off and went red for an hour or so, but quickly recovered and went green as more #BailoutBull calls for Qe5 re-surfaced. In conjunction with the Bernanke Begging, the US Dollar went down, Oil went straight up, and all was well in the land of another no-volume stock market rally to lower long-term highs (-12% from the 2007 peak).


So what’s on The Other Side of the other side? What happens if the Global Macro and US Economic data goes bullish? Would that make me more wrong being short the SP500 (and Oil, we shorted that at yesterday’s highs too)? Or would that just make me wrong on my research view which, in turn, takes out the #BailoutBull and makes me more right for the wrong reasons?


Who knows…


Regardless, this is starting to sound all too complex for we commoners being centrally planned by the 112th to simplify.


The Other Side of the bull case for this SP500 rally to continue has 3 core factors:

  1. PRICE – SP500 immediate-term TRADE overbought anywhere > 1375
  2. VOLATILITY – VIX immediate-term TRADE oversold anywhere < 16
  3. VOLUME – continuing to register the nastiest volume signals ever in my model

That last factor was easily the most controversial topic I debated with clients in CA this week. Since US Equities continue to see outflows, where is the stock market’s bid coming from? I say short covering. And the ultimate question we need to answer this morning is how much of that do we have left?


The good news is that short interest data is trivial. Darius Dale highlights one way to look at long-term short-interest as today’s Chart of The Day. What you’ll note in this chart is that short interest as a % of the NYSE shares outstanding has been oscillating between 3-5% since this whole gong show of free money bailouts started in late 2007.


What you’ll also notice is that short interest spiked back up to 3.86% in June 2012, but that it came from a relatively low place (on a 5 year basis) for the 4-6 months prior to that. Yes, Beta Hedgies short low and cover high.


Are the consensus hedge fund short sellers covering high when the VIX goes low, again? I can literally see it in each security I am bear hunting in. Where I could be wrong is if I am hunting in the wrong neck of the woods. If I am right, eviscerated short interest looks like it’s turning into a huge market liability. Markets fall fastest after the consensus shorts have covered.


Where else could I be wrong on this? All over the place. What if short interest is absolutely ripping to the upside (4-5% of total shares outstanding) here in July? What if no one has covered any of their shorts this week? What if it really is different this time and 15 VIX is a cover all your shorts signal?


Only time will tell. But, in the meantime, I can assure you of this – very few PMs understood this in Q4 of 2008. Remember when every fundamental #GrowthSlowing short seller was being dared to cover their shorts in fear of the next central plan? Remember “shock & awe” rate cuts and Hank Paulson’s “bazooka” daily whip around in the market?


I do. And so does Santayana: “Those who cannot remember the past are condemned to repeat it.”


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Italy’s MIB Index, and the SP500 are now $1556-1591, $102.28-108.79, $82.75-83.94, $1.21-1.23, 13,468-13,703, and 1354-1381, respectively.


Best of luck out there today and have a great weekend,



Keith R. McCullough
Chief Executive Officer


The Other Side - Chart of the Day


The Other Side - Virtual Portfolio


TODAY’S S&P 500 SET-UP – August 3, 2012

As we look at today’s set up for the S&P 500, the range is 20 points or -0.66% downside to 1356 and 0.81% upside to 1376. 











  • ADVANCE/DECLINE LINE: on 08/02 NYSE -722
    • Up  versus the prior day’s trading of -779
  • VOLUME: on 08/02 NYSE 825.56
    • Decrease versus prior day’s trading of -19.47%
  • VIX:  as of 08/02 was at 17.57
    • Decrease versus most recent day’s trading of -7.33%
    • Year-to-date decrease of -24.91%
  • SPX PUT/CALL RATIO: as of 08/02 closed at 0.97
    • Down from the day prior at 1.26 


  • TED SPREAD: as of this morning 35
  • 3-MONTH T-BILL YIELD: as of this morning 0.09%
  • 10-Year: as of this morning 1.51%
    • Increase from prior day’s trading of 1.48%
  • YIELD CURVE: as of this morning 1.28
    • Up from prior day’s trading at 1.26 

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30am: Change in Nonfarm Payrolls, July, est. 100k (prior 80k)
  • 8:30am: Unemployment Rate, July, est. 8.2% (prior 8.2%)
  • 8:30am: Avg Hourly Earnings M/m, July, est. 0.2% (prior 0.3%)
  • 8:30am: Avg Weekly Hours All Employees, July, est. 34.5 (prior 34.5)
  • 10am: ISM Non-Manufacturing, July, est. 52.0 (prior 52.1)
  • 1pm: Baker Hughes rig count


    • House is out for Aug. recess. Senate may be in session
    • NASA announces winners for the next round of funding to develop spacecraft capable of carrying astronauts, 9am
    • FCC holds an open meeting on cable television technical and operational requirements and the use of microwave for wireless broadcasts, 10:30am


  • July gain in payrolls probably failed to reduce U.S. unemployment
  • Knight said to open books to suitors as loss pressure grows
  • Knight losses ignite call for stronger SEC trading oversight
  • Citigroup is said to join firms refraining from Knight trading
  • Some ETF spreads widen as Knight is fighting to survive
  • Joyce faces Knight extinction after computers wipe out profit
  • NYSE 2Q earnings drop 20%, beating est.
  • Fidelity said to plan jump into ETF business with active funds
  • CF Industries to buy Viterra’s interests in CFL for C$915m
  • BofA says Libor probe prompts subpoenas over rate submissions
  • ECB-politicians’ crisis bargain emerges after 2 1/2 yrs
  • Toyota 1Q profit beats est., increases sales forecast
  • SAP will pay at least $306m to Oracle in a copyright- infringement lawsuit
  • American Express may be forced to pay refunds amid CFPB review
  • Morgan Stanley should cut fixed-income unit by half, ISI Says
  • BHP to take $3.3b in charges on shale, nickel assets
  • Nomura ordered to improve business by FSA on insider leaks


    • Alliant Energy (LNT) 6am, $0.47
    • Northwest Natural Gas Co (NWN) 6am, $0.16
    • Pason Systems (PSI CN) 6am, C$0.18
    • Immunogen (IMGN) 6:30am, $(0.30)
    • Sirona Dental Systems (SIRO) 6:30am, $0.77
    • WellCare Health Plans (WCG) 6:30am, $1.21
    • Buckeye Partners (BPL) 7am, $0.64
    • Brookfield Office Properties (BPO CN) 7am, $0.26
    • Gartner (IT) 7am, $0.41
    • ITT (ITT) 7am, $0.37
    • Procter & Gamble (PG) 7am, $0.77
    • Viacom (VIAB) 7am, $1.00
    • Exelis (XLS) 7am, $0.48
    • Health Net (HNT) 8am, $0.67
    • RBC Bearings (ROLL) 8am, $0.61
    • TELUS (T CN) 8am, C$1.00
    • Telephone & Data Systems (TDS) 8:02am, $0.45
    • United States Cellular (USM) 8:03am, $0.72
    • PNM Resources (PNM) 8:30am, $0.30
    • SNC-Lavalin Group (SNC CN) 9:10am, C$0.61
    • Morguard Real Estate Investment Trust (MRT-U CN) 4pm, C$0.34
    • UIL Holdings (UIL) 4:10pm, $0.33
    • WGL Holdings (WGL) 5pm, $0.01
    • Berkshire Hathaway (BRK/A) 5:15pm, $1,777 (possible)


  • Bull Market in Crops Extends With Spreading Drought: Commodities
  • Israel Finds $240 Billion Gas Hoard Stranded by Politics: Energy
  • Natural Gas Matches Coal as Top U.S. Power Fuel: BGOV Barometer
  • Oil Rises From Three-Week Low on Forecasts U.S. Hiring Increased
  • Corn Swings Between Gains, Declines on Drought, Ethanol Usage
  • Sugar Seen Falling as Brazil Harvest May Accelerate; Cocoa Gains
  • Gold Cuts Weekly Drop in London as Price Slump Spurs Purchases
  • Copper Seen Rising as Employment Report May Show Stronger Hiring
  • Gold Imports by China From Hong Kong Decline for Second Month
  • India’s Power Crisis May Signal Copper Demand: Chart of the Day
  • Coal Rally Seen as China’s Cuts Dwarf Australia: Energy Markets
  • China to Pay Higher Prices for Soybeans on Drought, USDA Says
  • Natural Gas Extends Biggest Decline in Three Years on Stockpiles
  • Japan Shifts to Brazilian Corn From U.S. as Prices Reach Record
  • Brazil Coffee Growers Harvest 70% of Crop as Dry Weather Helps
  • Drought Assistance for Livestock Producers Passed by U.S. House





USD – we got longer yesterday (9 LONGS vs 6 at start of the day) but will not overstay my welcome on any cheerleading market open; will watch USD Index as my leading indicator; its down as we type, but as long as it holds $82.35, the Dollar up, deflation of stocks/commodities to lower highs on bounces will continue to be on.






SPAIN – IBEX was +2% into Draghi, dropped 7% intraday (not a typo) on Draghi, then rallies “off the lows” +1.8% this morning – add all that up and you get the point – this is a complete gong show. Q308 didn’t see country indices whip like that; it’s not the same; it’s much more globally interconnected this time - and expectations for bailouts are a lot higher.






JAPAN – Asian stocks continue to move independent of these Western media stories; Nikkei and KOSPI dropped another -1.1% last night (both remain in Bearish Formations) and the Nikkei is down -16.6% now since March. That’s a lot – so you’ll see the central planning begging move to the BOJ now.











The Hedgeye Macro Team

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

Sucker Economics

“Markets are increasingly distorted by central banks’ attempts to squeeze drops of growth…”

-Louis Bacon


What do Louis Bacon, Stan Druckenmiller, and George Soros all have in common? They’re some of the best players in this Global Macro game, and they’re all either giving money back to their investors or getting out of the game completely.


They think these central planners are right nuts. So do I. But does the manic media that perpetuates this entire gong show get that? Have these pundits ever traded a macro market in their life? Or, like the worst players at a poker table, are they just the suckers trying to remain relevant until their ratings and/or credibility goes to zero % too?


As the old saying goes, look around the poker table; if you can’t see who the sucker is, you’re probably it.


Back to the Global Macro Grind


We got longer yesterday (cutting our Cash position to 58%) but it was still a clean cut example of what Louis Bacon coined in a recent letter (explaining why he is giving back $2B to his investors) as Disaster Economics: “where assets are valued based on their ability to withstand a lurking disaster as opposed to what they may yield or earn, is now the prism through which investors are pricing markets.”


Don’t think this is turning into a Q308 like disaster? Ok. What would you call this?


1.   745AM EST (yesterday), Spanish stocks rip to the upside, +2% on the day, after the ECB decides not to cut rates, but plenty of print, tv, and radio pundits proclaim their faith that “it’s at 830AM that we get the good stuff.”


2.   835AM EST (yesterday), Spanish stock stop going up, and fast, as pundits comb the release looking for “hints” that the ECB really is going to deliver the drugs, like Bernanke was supposed to in the day prior.


3.   1130AM EST (yesterday), Spanish stocks close down -5.2% on the day, a 7% (not a typo) intraday reversal. Pundits feel shame.


Or do they? 430AM EST, I get up this morning and “European stocks rally” on new news that Spain (as in the country) is going to hold a press conference about something.


I couldn’t make this up if I tried.


Notwithstanding the simple math of the matter (a market that loses 7% of its value needs to “rally” +7.5% to get whoever got suckered in at 830AM EST yesterday back to break-even), I’d say Bacon is on to something here.


Then you have the other running narrative of people who are in the business of markets going up saying “but the SP500 is up 10% for the year-to-date.” That one is just a beauty – it’s as if people think about their life-long net wealth on the same calendar as Old Wall Street’s bonus season.


Just to get the record straight – and I mean how real people with real money think about the return of their moneys:

  1. SP500 is not +10% YTD anyway, it’s up +8.5%
  2. SP500 is down -3.8% from Q1 2012 (when #GrowthSlowing started)
  3. SP500 is down -12.8% from its 2007 high, where almost everyone of the Q1 2012 bulls were the same people

So, lucky you – you only have to be up +4% and +15% to get back to your 2012 and 2007 break-evens. This better be one heck of a US Employment Report this morning.


Better yet, if you’ve noticed this other little thing called a broad leading indicator (the Russell 2000 has led the SP500 the entire way):

  1. RUSSELL2000 is only up +3.6% YTD
  2. RUSSELL2000 is down -9.1% from its 2012 Perma-Bull high (March 26th, where the VIX bottomed at 14.26)
  3. RUSSELL2000 is down -6.1% in the last month alone

I know, I know. Don’t be spinning that storyline on us KM, we’re still living large over here on the everything fine front. Until you aren’t. What’s happened this year at MF Global, JP Morgan, and Knight Capital is an obvious reminder of Disaster Economics too.


As returns (both buy and sell-side) get tougher to concoct, we’ve created a culture on Old Wall Street of cheating and corner cutting so that people A) don’t get ridiculed by their peers internally and/or B) get paid.


That pressure is cultural.  It’s also called causality. Much like central planning policies to suspend economic gravity, it’s only sustainable until it goes away.


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Spain’s IBEX, and the SP500 are now $1, $105.09-107.32, $82.95-84.11, $1.20-1.23, 5811-6649, and 1, respectively.


Best of luck out there today and enjoy your weekend,



Keith R. McCullough
Chief Executive Officer


Sucker Economics - Chart of the Day


Sucker Economics - Virtual Portfolio


Despite at least 4 sell-side downward revisions in July, we still have MGM missing the quarter by a wide margin


The Vegas recovery is very much hanging in the balance and that’s not good news for this Strip-centric company.  May on the Strip was a disaster and we think June will likely prove to be down YoY as well (see our 7/10 and 7/31 notes).  LVS and WYNN already punted in Q2 at their respective LV properties.  The only question will be how much of this has already been anticipated by the buy side.  Considering how much the stock is down - 34% since their last earnings report – the whisper may already be at our level.


We are more concerned about estimates going forward.  The Street looks too high for 2012 and 2013.  We are currently 13% below the Street in EBITDA for both Q3 and Q4 2012 and 14% below for 2013.  Our below Street numbers are predicated on our cautious macro outlook, way too aggressive Street growth estimates, inflationary cost pressures, and the unfavorable demographic picture we’ve highlighted over the past two months:



MGM will report Q2 earnings on August 7th.  We estimate $2.3BN of net revenue and $517MM of consolidated property level EBITDA.  We also look at wholly owned EBITDA plus MGM’s pro-rata share of MGM China and City Center, less corporate expense which produces EBITDA of $417MM.  Our net revenue estimate is 1% below while our comparable EBITDA is 8% below consensus.





We project MGM’s Strip properties to produce net revenue of $1,236MM and EBITDA of $287MM, 2% and 3% below Street numbers, respectively.  We average RevPAR growth of 3%, low single digit casino and other growth and low single digit operating expense increases.

  • Bellagio:  $285MM of net revenue and $76MM of EBITDA, 2% and 7% below consensus, respectively
    • 4% increase in RevPAR
    • 2% growth in casino & other
    • 4% expense growth
  • MGM Grand:  $241MM of net revenue and $37MM of EBITDA, 2% and 12% below consensus, respectively
    • 5% increase in RevPAR
    • 4% growth in casino & other
    • Flat YoY expense
  • Mandalay Bay:  $213MM of net revenue and $56MM of EBITDA, 1% below and 4% above consensus, respectively
    • 4% increase in RevPAR
    • 1% growth in casino & other
    • Flat YoY expense
  • Mirage:  $150MM of net revenue and $29MM of EBITDA, in-line and 3% above consensus, respectively
    • 3% increase in RevPAR
    • 4% increase in casino & other
    • 1% increase in expenses

Other US

  • MGM Grand net revenue of $142MM and EBITDA of $38MM, 3% and 12% below consensus, respectively
  • Mississippi net revenue of $128MM and EBITDA of $27MM, 1% below and 4% above consensus, respectively

MGM Macau should report $690MM of net revenue and $164MM of EBITDA (the street is at $687MM and $166MM, respectively.)  Our assumptions in HK$MM’s are as follows:

  • Net casino revenue of $5.3BN and total revenue of $5.4BN
    • Net VIP win of $3.4BN
      • VIP Turnover: 159,170 assuming 7% direct play
      • Hold of 3.29%
      • Rebate rate of 35% or 1.15%
    • Mass table win of $1,375MM
    • Slot win of $560MM
  • Variable expenses of $3,253MM
    • $2,827MM of taxes and gaming premiums
    • $395MM of commissions to junkets
  • Fixed expenses of $830MM
  • $95MM of branding fees

We estimate that City Center will report $35MM of EBITDA on $256MM of net revenues

  • Aria:  $204MM of net revenue and $24MM of EBITDA
  • Mandarin Oriental:  $13MM of revenue and $1MM of EBITDA
  • Crystals:  $13MM of revenue and $7MM of EBITDA
  • Vdara:  $22MM  of revenue and $6MM of EBITDA
  • $3MM of development and administrative expenses

Other stuff:

  • D&A:  $235MM
  • Corporate & other:  $38MM
  • Stock comp:  $9MM
  • Net interest expense:  $284MM
  • Income from unconsolidated affiliates & non-operating items from unconsolidated affiliates of ($36MM)
  • $33MM of tax credits
  • Minority interest of $63MM

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