“It solved practical questions that were unanswerable by any other means.”
-Sharon Bertsch Mcgrayne
That’s how Sharon Bertsch Mcgrayne summarizes using a Bayesian approach to problem solving in an important book for your risk management library – The Theory That Would Not Die.
“Although Bayes’ Rule drew the attention of the greatest statisticians of the 20th century, some of them vilified both the method and its adherents, crushed it, and declared it dead… In discovering its value for science, many supporters underwent a near-religious conversion yet had to conceal their use of Bayes’ Rule and pretend they employed something else.”
Much like during Bayes’ revolutionary times (18th century), where “mathematics was split along religious and political lines” (pg 4), today we are at the crossroad for the same in economic analysis. If you tell me what someone’s political and/or financial motivation is, I can usually predict their answers. If you’re Bayesian in your approach, your answers are far less certain.
Back to the Global Macro Grind…
We hosted an astute group of RIAs (Registered Investment Advisors) at HedgeyeHQ after the close yesterday where I gave a teach-in on our #process. One of the main examples I like to use is Bayes trying to locate a billiard ball’s location (blindly) on a table…
Each incremental throw gives you more information on where the ball is not. After multiple throws, you can narrow the probability of the ball’s location to a probable range. I call this the Risk Range. And I have no business telling the table where the ball has to be.
What happens if there are multiple competitors at the table, all racing to figure out where the ball is at the same time? That’s what makes a market. Whether you like my competitive style or not, I fully intend on coming out of the room with the ball (read Diary of a Hedge Fund Manager for details!).
If you want to beat your competitors in this game, not only do you need to play your game (read: #process), but you need to understand where the other players at the table are positioned and why. One really simple way to look at this from a consensus hedge fund positioning perspective is through CFTC Non-Commercial net LONG/SHORT futures/options.
I cite the rate of change in this Bayesian information as frequently as I can, but whether I do in a timely fashion or not doesn’t mean that the information ceases to exist. Yesterday’s rip (higher) in the Long Bond (TLT +1.2%) and drop in the SP500 (SPY -0.73%) can be (partly, but importantly) explained by the Consensus Macro’s net positioning as of Friday’s close:
- SP500 (Index + Emini) net LONG position ramped +61,389 week-over-week to +59,263 contracts
- Long Bond (10yr Treasury) net SHORT position got way shorter (-91,399 contracts) to a net short position of -173,755
In other words, into the “everything is awesome” jobs cheerleading report:
- Consensus Macro ramped to the highest NET LONG position (in SP500 futures/options) terms of 2014, and…
- They took the NET SHORT position in the Long Bond to a fresh YTD high
“So”, no matter what you think consensus is… that’s what it was - and the next Bayesian probabilities to weigh have everything to do with why consensus is positioned that way. Isolating why on both GROWTH and INFLATION, here are a few A/B tests (toss the ball):
A) On GROWTH, they must think US growth, employment, wages etc. are fixing to achieve some sort of “escape velocity”…
B) Or they realize that even if they are wrong on growth… that the Fed, BOJ, and ECB bails them out anyway
While its perverse, that B) scenario is credible. It’s the levered-long heads you win, tails you win bet – throw the ball anywhere on the table (other than the Russell 2000 and Energy stocks) and you win, right? How about we roll the queue ball on INFLATION?
A) As #deflation expectations accelerate, consensus must think the Fed is going to raise rates into that? …
B) Or that consumption growth is going to be so strong that the Fed will dismiss #deflation as a risk and hike anyway
The problem with what we call the #Quad1 scenario: A) US growth accelerating B) on inflation decelerating is that it’s a theory, not yet a reported reality. And that’s the thing about theories – they are for people who are smarter than me that don’t need to keep taking more reps with the uncertainty ball. They just need a survey confirming their pre-determined belief.
What if McDonalds (MCD) reporting a down -4.6% year-over-year same store sales number for November has something to do with the non-Wall Street economy that still has no wage growth? What if the recent Retail Sales, real personal consumption growth, and jobless claims numbers reported by the government are right (they’ve been slowing)?
Well, that will make Friday’s Consensus Macro position in SPY vs TLT wrong… and it might remind some of us that practical questions are unanswerable by any other means than by embracing the uncertainty of each risk management day.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.16-2.32%
WTI Oil 61.27-68.02
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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TODAY’S S&P 500 SET-UP – December 9, 2014
As we look at today's setup for the S&P 500, the range is 24 points or 0.45% downside to 2051 and 0.71% upside to 2075.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.63 from 1.63
- VIX closed at 14.21 1 day percent change of 20.22%
MACRO DATA POINTS (Bloomberg Estimates):
- 7:30am: NFIB Sm Business Optimism, Nov., est. 96.5 (pr 96.1)
- 10am: JOLTs Job Openings, Oct. est. 4.795m (prior 4.735m)
- 10am: Wholesale Inventories, Oct. y/y, est. 0.2% (pr 0.3%)
- 10am: IBD/TIPP Economic Optimism, Dec., est. 47 (prior 46.4)
- 11:30am: U.S. to sell $25b 1Y bills, 4W bills
- 1pm: U.S. to sell $25b 3Y notes
- 4:30pm: API weekly oil inventories
- Senate Republicans hold closed-door discussion on whether to return to 60-vote threshold for advancing presidential nominees
- 8am: Politico, Google, Tory Burch Foundation hold second annual “Women Rule Summit: Upping the Game,” w/ VP Joe Biden, Sens. Susan Collins, R-Maine, Cory Booker, D-N.J., House Minority Leader Nancy Pelosi, D-Calif.
- 9:30am: Senate Finance Cmte hearing on whether Social Security adequately addresses challenges women face
- 10am: Supreme Court may issue opinions
- 10:30am: Senate Judiciary panel hearing on sexual assaults on college campuses
- 11am: Senate Banking subcmte hearing on inequality, opportunity in housing market
- 2pm: Sec. of State John Kerry testifies at Senate Foreign Relations Cmte hearing on use of military force against ISIL
WHAT TO WATCH:
- Repsol Is Said to Revive Talks With Talisman Energy Over Possible Deal
- SEC Said to Seek Standard & Poor’s Suspension of CMBS Rating
- Fed ‘Considerable Time’ Rate Pledge Under Scrutiny Ahead of FOMC
- Sumitomo Mitsui Said to Buy Citigroup Japan Retail Bank
- Cubist Barred From Blocking Generic Cubicin Beyond 2016
- JPMorgan Said Among Banks Telling Clients to Take Cash Elsewhere
- China Spurs Bond Rout as Riskier Debt Removed From Repo Market
- Big Banks Face U.S. Capital Rule Tougher Than Global Agreement
- Deutsche Bank Sued by U.S. for Alleged Scheme to Evade Taxes
- U.S. Spending Plan to be Unveiled Today as Funding Deadline Nears
- CIA Torture Report Set for Senate Release
- Valeant to Stop Acquisitions in Near Term: Reuters
- Lone Star Said to Compete With Springleaf in Bid for Citigroup’s OneMain
- Obama Proposes Expanding China Solar-Cell Levy to New Suppliers
- Greek Government Bonds Drop as Presidency Vote Brought Forward
- Analogic (ALOG) 4:15pm, $0.41
- AutoZone (AZO) 7am, $7.16
- Conn’s (CONN) 7am, $0.68
- HD Supply (HDS) 6am, $0.53
- Hudson’s Bay (HBC CN) 7am, C$0.06
- John Wiley (JW/A) 8am, $0.84
- Krispy Kreme Doughnuts (KKD) 4:05pm, $0.19
- NCI Building Systems (NCS) 4:05pm, $0.17
- Transcontinental (TCL/A CN) 8:05am, C$0.74
- UTi Worldwide (UTIW) 8am, $0.05
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Crude Rebounds From Five-Year Low Amid Shale-Oil Spending Curbs
- Iron Ore Outlook Cut by JPMorgan as BHP, Rio Shares Extend Slump
- Kuwait Sees Oil Stuck at $65 for Six Months Until OPEC Moves
- Cheap Oil Also Means Cheap Copper, Corn and Sugar: Commodities
- El Nino-Like Weather Seen by Morgan Stanley in South America
- Gold Rises a Second Day as Lower Dollar and Equities Spur Demand
- Iraq Follows Saudis Discounting Oil for Asia to 11-Year Low
- Nickel Leads Industrial-Metals Declines on China Demand Concern
- OPEC Early Meeting Seen More Likely by Analysts Amid Price Fall
- Anglo American Cuts Capex, Sees 2016 Div. Funded From Cashflow
- New York’s Snow Lovers to Get Stuck With Rain in Storm Pinwheel
- Wheat Drops on Warmer Black Sea Weather, Slow U.S. Export Demand
- Bullion Board Seen by Council as Way to Manage India Gold Demand
- Putin Plan to Ship Gas to Europe Via Turkey Seen as Unrealistic
- More Beef From Down Under Heading for U.S. Tables as Herd Drops
The Hedgeye Macro Team
This note was originally published at 8am on November 25, 2014 for Hedgeye subscribers.
“We should burn what wagons we have, on order that our cattle not be our generals.”
According to ancient Greek #history, that’s what an emerging Athenian leader, Xenophon, told his men they should do as they marched against their Persian King. “Moreover, let us also abandon other superfluous baggage, except what we have for war or for food.” (Xenophon: The Anabasis of Cyrus, pg 108)
Yep. That’s the stuff I am reading these days. If you want to call it my confirmation bias in being bearish against central planning overlords (i.e. that this will not end well), I’m cool with that.
Buying the Long Bond (TLT) is as close as I am going to get to war with US and global growth bulls. And I probably won’t stop riding this bearish growth view, until the US elects to burn the yield chasing wagons – letting rates rise.
Back to the Global Macro Grind…
In case you didn’t know that one of the only ways out of this centrally planned Liquidity Trap (Total US Equity Market Volume was -29% versus its YTD avg yesterday) is to stop doing what didn’t work, now you know. Or at least the bond market does…
BREAKING (updated growth “survey” from Hedgeye): US 10yr Treasury Yield is ticking down to a fresh November low of 2.29% this morning and the Yield Spread (10yr minus 2yr yield) has compressed towards its 2014 YTD lows of 176 basis points this morning.
These are clean cut #GrowthSlowing signals. But you already know that.
What you also know is that at this stage of the central planning war, equity markets going up really has nothing to do with real-growth anyway. It has everything to do with Japan, Europe, USA, China, etc. trying to resuscitate drowning inflation expectations.
On that real-time score, as you can see in today’s Chart of The Day (US TIPS, 5 year Breakevens), so far… no good.
While the 2 day China rate cut “pop” in everything inflation expectations that’s been dropping was fun to watch, it didn’t change #Quad4 Deflation expectations. Both global growth and inflation expectations are still slowing, at the same time.
Other than one of the Fed’s preferred ways to monitor #deflation expectations (Breakevens), here’s what else I’m looking at:
1. US Dollar Index vs both Burning Yens and Euros = +10% YTD
2. CRB Commodities Index -0.7% yesterday to -4.6% YTD
3. WTI Oil flattish this morning at $76.01, down -17% YTD
4. Copper flat this morning at $3.01/lb, down -10% YTD
5. Russian Stocks (RTSI) -1.2% this morning to -23.3% YTD
6. Energy Stocks (XLE) down (again) -0.8% yesterday to -0.8% YTD
Then, of course, you can look at some late-cycle stuff like US wage Inflation… where 2/3 of the country has seen real wages deflate since the Fed undertook their unprecedented Policy To Inflate (see Federal Reserve’s own papers on the matter for details).
Or you can just find a “survey” that tells you something that has been the complete opposite of the wage deflation and no-capex cycle data. And say that the “market is up” on something like that.
But when you say “market” don’t forget that my preferred risk adjusted market to be long in 2014 (Long Term Treasuries) has had a much higher absolute return on much lower realized volatility than US small/mid cap stocks have.
Even if the July to October +160% ramp in the VIX is forgotten (for now), that doesn’t mean that the non-linear and interconnected economic risks associated with #Deflation Expectations Rising cease to exist.
What also exists as of this week is non-survey computed options positioning in Global Macro (non-commercial CFTC futures and options consensus positioning):
1. SP500 (Index + Emini) has moved to its biggest net LONG position since late SEP at +29,110 contracts
2. Long Bond (10yr Treasury) hit its biggest net SHORT position of 2014 at -128,032 contracts
3. Oil still has a net LONG position of +276,213 contracts, only down -12,971 week-over-week
“So”, what does that tell us?
1. After shorting the OCT lows, hedge funds have covered their shorts and are chasing the bull run in SPY (again)
2. Consensus Macro continues to think the risk in interest rates is to the upside (we reiterate downside!)
3. Perpetual expectations for another central plan (OPEC) remain for a non $65 oil price
Since Consensus Macro is not my expectations general, I say you burn the groupthink wagons and do the exact opposite of where those options are positioned: BUY Long Bond (TLT, EDV, etc.), and SHORT SP500 (SPY), Oil, and its related stocks and bonds.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.28-2.34%
WTI Oil 73.04-77.51
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Takeaway: We think that RH will come out on the positive side of what we think is a binary set-up into the print.
Conclusion: This is a binary set-up for RH and the market knows it. The company needs to put up a significant reacceleration in its top line. With 31% of the stock held short, there are plenty of people betting it won't. But we think the unit growth, category expansion, comp, and margin opportunities are coming together for RH, and will be apparent this quarter. RH remains our favorite name in Retail.
We feel good about the RH earnings event on Wednesday after the close. Revenue should accelerate meaningfully as RH has finally hit the inflection point (after 7+ years) where square footage starts to enhance as opposed to shrink the top-line algorithm. We’re also seeing great strength in the brand’s online momentum, and should see a catch up from revenue that was delayed by problems with the sourcebook in 2Q. All-in, we’re looking for 24% growth, which is over 1,000bp better than the (unacceptable) 13.5% we saw in 2Q. The Street is straddling guidance at about 20-21%. On the EPS line, we’re at $0.52, which compares to the Street at $0.47 ($0.46-$0.48 guidance).
While the EPS beat should be nice, we think that there’s a binary nature to this quarter. Why? RH has never missed EPS, and it’s not going to start now. But it missed 2 of the last three quarters on the top line by an average of 4%. Even though the trendline growth rate (2-yr) remains well above 20%, the fact is that we’re arguing that RH will add $700mm in revenue next year alone (31% growth) and another $2.4bn over the following 3-years. We’re the first to call out that while the company undergoes its real estate build-out, there will be ongoing volatility in its’ top line on a quarter to quarter basis – that should last another 2-3 years. But weakness in 2Q needs to manifest itself in the 3Q revenue line. To be clear, we think that will happen. But if it doesn’t – timing or not – it will be very tough to argue a big multiple for RH over the near-term.
Details of Our Thesis. The way we see it, we think that RH will ramp from $2.50 in EPS this year to $11 in 2018. It’s an ambitious model, but completely achievable. The biggest barrier to getting there is RH itself. We think a few factors remain misunderstood – 1) The degree to which the high-end home furnishings market can be consolidated – not unlike what Ralph Lauren did to high-end apparel in the 1980s. 2) Our view that there are over 20 markets that could sustain a 50,000+ foot Design Gallery at a productivity rate of $1,200/foot. 3) The impact that occupancy leverage will have on Gross Margins, ultimately pushing GM% to 40%. Our key modeling assumptions are in the table below.
With Growth Comes The Multiple. If our model is right, then the company will be growing EPS at a CAGR of over 40% for the next four years. What kind of multiple is fair for a high-end category leader with a low-cost advantage that’s growing EPS at over 40%? We hate to just make-up multiples. But there are businesses growing at lower rates that carry a much higher multiple. UnderArmour grows at 25-30%, and yet it trades at near 70x earnings. Perhaps UA is grossly overvalued, and perhaps the market likes that someone came first and paved the way (Nike) showing what UA could look like when it grows up. With RH, people will have to use their imagination. But using 40x 2015 and 2016, we get to $150 and $230, respectively.
Why Revenue Should Accelerate In 3Q
Here’s a few supporting points for why we think revenue will accelerate.
- Square Footage Turns Decidedly Positive. We’re looking for 3.5% growth in square footage this quarter. That might seem like it falls into the ‘who cares’ category. But this is a company that has largely been shrinking its store base since before the last recession. This quarter it turns positive, and should be up roughly 30% by the end of next year. Note that the Atlanta Design Gallery that opened on November 20 falls into 4Q, and should account for about a 6% pop in consolidated square footage.
- RH Online Presence Has Strong Momentum. There are several tools that we use to track the online momentum for consumer brands, including RH. The chart below shows the spread in ‘reach’ versus last year. The percentages are irrelevant – as they show the percent of all internet users that visited www.restorationhardware.com. What we care about is the direction of the line. Up is good, and RH has been increasingly up.
- Deferred Revenue Buildup. Every quarter, RH books deferred revenue, which represents product that has been ordered but is not yet delivered (RH gets paid when the consumer takes final delivery). There’s an exceptionally strong relationship between deferred revenue, and the upcoming quarter’s realized revenue. That is, except for 2Q. That’s when revenue stalled due to timing associated with a Friends and Family promotion, as well as what we think are miscues in its Sourcebook (ie 3,300 pages at once was a mistake). The deferred revenue alone synchs with our 24% revenue growth forecast.
- Inventory Supports Revenue Growth. One of the only times that deferred revenue will not accurately accrue to the upcoming quarter would be when there is not enough inventory on hand to fulfill orders. Then RH has a problem. That is absolutely not the case this time around, as RH ended 2Q with inventories up 35% -- and ready to ship to fulfill 3Q deliveries.
Some More Detailed Modeling Considerations
- RH added one new store during the quarter on Melrose Ave. in Los Angeles. That equates to 10% growth in selling sq. ft. year-over-year and the addition of 9K sq. sequentially as the new 23,000 sq. ft. Design Gallery replaced the now idle 13,800 sq. ft. Beverly Boulevard location.
- With the opening of the first 2nd Generation Design Gallery in Atlanta during the opening weeks of 4Q, square footage growth is now done for the year.
- For the year the square footage growth algorithm looks like this: Design Gallery square footage +77%, Legacy Store square footage -6%, total selling square footage growth +9%, and total average selling sq. ft. growth +8%. *Note we model NYC store as a Full Line Design Gallery.
- Initial guidance for 2015 implies 4 to 6 openings and 30%-40% sq. ft. growth. Those will be heavily weighted towards the back half of next year.
- This may be the hardest line on the entire P&L to model as the store additions/subtractions and remodels make for a lot of moving pieces. For the quarter we are at 18%.
- Additional details
- Boston and Indy entered the comp base during June of this year. This will be the first full quarter where those two properties show up in the consolidated comp number.
- New York was removed from the comp base after the 17,000 sq. ft. remodel during the 2nd quarter. This is the most productive store in the entire fleet.
- The 13,800 sq. ft. store on Beverly Boulevard exited the comp base once Melrose opened at the tail end of the quarter. This store was operating in excess of $2,000/sq. ft.
- On the last call, management indicated that DTC growth would outpace Retail growth until the real estate transformation catches up to fit the expanded product assortment. For the quarter we’re at 25% growth in the DTC channel. Up 700bps sequentially on the 1yr trend line and 1000bps on the 2yr.
- Visitation statistics were solid for the quarter. Up over 65% in every month during the quarter and 77% for the quarter in aggregate (+48% on the 2yr). The company was comping against a visitation suppressed 3Q13 when the company eliminated the fall source book. That coupled with the late shipment of the Source Book this year and prospecting efforts are the main drivers of the growth.
Combined Brand Comp:
- Putting the two pieces together, 25% DTC growth and 18% Retail comp, equates to a 22% combined brand comp for the quarter.
- Guidance of $475-$485 implies 20%-23% growth. An acceleration of 1000bps sequentially on both the 1 and 2yr trend line.
- The Source Book timing issue caused books to arrive in homes about a month later on average compared to last year. Some of those sales were lost forever especially in seasonal categories like outdoor. But, given the company’s extended shipping window and strong traffic trends in the DTC channel we believe there was a healthy backlog headed into 3Q.
- Stores in Greenwich and New York were open for the entirety of the quarter. And, there was very little interruption caused by the shift from Beverly Boulevard to Melrose Ave. in Los Angeles with the late October opening.
- We’re modeling 100bps of Gross Margin expansion in the quarter. Here’s a quick look at the headwinds and tailwinds for the quarter…
- Promotions: Margins were up 230bps in 2Q. Part of that was due to reduced promotional selling during the company’s Friends & Family event in July. Some of that may have been pushed into the early October Friends & Family sale. Which we should note was the exact same timing as last year.
- Dead rent: The company started to feel a drag from new properties scheduled to open in ’15 in the quarter. That will be more pronounced in 4Q due to the back-half weighting in the opening schedule next fiscal year and the companies 6-12 month buildout schedule. But, it’s something that we are aware of.
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