The Hedgeye Daily Outlook

TODAY’S S&P 500 SET-UP – December 12, 2014

As we look at today's setup for the S&P 500, the range is 26 points or 1.29% downside to 2009 and 1.11% upside to 2058.                                                                                                                               



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  • YIELD CURVE: 2.43 from 2.42
  • VIX closed at 20.08 1 day percent change of 8.36%


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The Hedgeye Macro Team

CHART OF THE DAY: Headwind: Unemployment's Tail

CHART OF THE DAY: Headwind: Unemployment's Tail - 12.12 2


Editor's note: This is a brief excerpt from today's Morning Newsletter which was written by Hedgeye Director of Research Daryl Jones.


In Chart of the Day below, we compare the U.S. unemployment rate with the Eurozone unemployment rate going back to September 2010, which very pointedly highlights that the U.S. has seen a marked employment recovery, while Europe has not.  In effect, the European recovery remains a lot more slack, which will help amplify deflationary pressures.


The other key takeaway from the chart is the unemployment rate for people 25 or younger in the Eurozone.  This rate is over 22% and climbing.   So again like Japan, Europe has a longer term demographic challenge.  In Japan, of course, it is the aging population, but in Europe it is the creation of a lost generation -- a generation that is grossly underemployed and unproductive.

The Japanese Road

“L’enfer est plein de bonnes volontes et desirs (the road to hell is paved with good intentions).”

-Saint Bernard of Clairvaux


I’ve been in London all week grinding away at client meetings with my colleagues and decided to treat myself to a nice dinner last night so I went to NOBU.  Now of course a small town Canadian lad like me eating at NOBU in London may indeed be the best sign that we are in an asset class bubble, but that aside, as I was eating my raw fish last night, it made me really think about the increasing parallels between the European and Japanese economies.


On our proprietary economic model, the U.S. has some chance of bouncing out of Quad 4 in Q1 2015, even if briefly, but not so much for Europe.   The Europeans will be solidly mired in this decelerating growth and disinflation environment for much of 2015 based on our current projections.   As the real time economic data increasingly reflects this, it will likely give ECB President Draghi the cover he needs to go full on Japanese style monetary intervention.


In the chart directly below, we show the U.S. 10-year yield versus the French and German 10-year yields.   No surprise given the collapse in these yields, the question of what is going on in the European sovereign debt market has been a big point of discussion in our meetings in London this week.  The answer is pretty simple:  the bond market is basically front running decelerating growth and deflation and the stark reality that the ECB is likely to put Europe on the Japanese path to economic perdition.


The Japanese Road - V. Japanese Style Road to Zero


The quote at the beginning of this note effectively sums up the mindset of many global central bankers.  They believe they have the best of intentions, but don’t truly understand the path they are setting economies on.  


There are actually a number of psychological studies that validate this old maxim.  In fact Professor Theodore Powers from the University of Massachusetts concluded the following in a study entitled “Implementation Intentions, Perfectionism and Goal Progress: Perhaps the Road to Hell is Paved with Good Intentions”:


“The results of both studies revealed a significant backfire effect of the implementation intentions on goal progress for participants high on a particular dimension of perfectionism.”


So yes indeed, it seems the road to failure, if not hell, is paved with good intentions.


Back to the Global Macro Grind...


Staying on Europe for a second, one of the most glaring structural challenges we see at the moment is employment.  In Chart of the Day below, we compare the U.S. unemployment rate with the Eurozone unemployment rate going back to September 2010, which very pointedly highlights that the U.S. has seen a marked employment recovery, while Europe has not.  In effect, the European recovery remains a lot more slack, which will help amplify deflationary pressures.


The other key takeaway from the chart is the unemployment rate for people 25 or younger in the Eurozone.  This rate is over 22% and climbing.   So again like Japan, Europe has a longer term demographic challenge.  In Japan, of course, it is the aging population, but in Europe it is the creation of a lost generation -- a generation that is grossly underemployed and unproductive.


In aggregate, there are 5.5 million people 25 and younger that are unemployed in Europe.  To put that in context, it is roughly the population of Denmark.  The numbers in some of the southern European countries are even more staggering.  In Spain and Greece this cohort is 50% unemployed; in Italy it is 41% and in Portugal 36%.


Most social psychologists agree that the longer term issue with an inability to find a job when first entering the work force is a “scarring” effect.  This lack of confidence or belief in oneself can, and does, lead to long term unemployment and under earning that can last decades.   Because of this, the future in many parts of Europe does look extremely bleak.


Luckily for southern Europeans, their futures still aren't as bleak as Russia’s at $60 oil.  For those that haven’t been watching, the Russian stock market is down-23% in the last month and now down -44% for the year-to-date.    While perhaps there is now some value to be found in Russian stocks, the reality is that Russian economy is at risk of a major recession if oil stays at current prices.


Based on our math, the Russian economy shrinks by more than 1.25% for every $10 drop in the price of oil.  So in aggregate, if oil stays at current levels the Russian economy can be expected to shrink 6 – 7% next year.  When combined with a current inflation rate of +10%, you can easily see why one might be better off being young and unemployed in Spain!


Staying on the topic of oil, and to the benefit of the Russians, our commodities analyst Ben Ryan actually made the case for a bounce in oil in the short term.  As he wrote:


“While we have been in front of the downside risk in oil in Q4, the expectation for lower prices (from here) is certainly becoming a psychological and consensus expectation, which we will fade when the time comes. The expectation for future volatility is blown-out. The commitments of traders report from the CFTC shows that the sum of aggregate positions in futures and options markets is between 1-2 standard deviations shorter than it has been over the last year. As a contra-indicator should work, the longest market positioning of 2014 was at the June highs in WTI.


We have a simple back-test model that tracks 60-day price performance in oil markets once contract positioning becomes +/- 1 standard deviation extended over different trailing durations. The result is that market positioning that chases price is a very obvious indicator to fade.”


With headlines now claiming OPEC is dead and traders leaning bearishly, there likely is reversion to the mean trade in oil waiting somewhere in the shadows.


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr yield 2.12-2.24%

RUT 1151-1172

VIX 14.56-22.71

YEN 116.88-121.55

Oil (WTI) 58.41-64.72

Gold 1185-1236 


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


The Japanese Road - 12.12 2

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December 12, 2014

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Macro Tryptophan

This note was originally published at 8am on November 28, 2014 for Hedgeye subscribers.

“I wish you [turkey] didn’t have to die, but a bunch of white people put on sweaters.”

- Peter Griffin, Family Guy


Tryptophan – the amino acid in turkey responsible for the Thanksgiving post-gluttony coma - has to cross over the blood brain barrier in order to elicit its stuporous effects. And it can only do that in the presence of sufficient amounts of insulin/carbohydrates.


Without digressing into the underlying (paradoxical) physiological mechanics, the relevant peri-Thanksgiving takeaway is that if you only eat turkey & no carbs alongside it, you won’t get tired.


You can weigh the psycho-social cost-benefit of that biochemical reality for yourself as you ferret through the leftover’s fridge.


Back to the Global Macro Grind….


To attempt to crosswalk that holiday anecdote over the relevancy barrier to the investment space, the tryptophan paradox could be viewed similarly to the de-couplers fallacy.


Sure, you could go to Thanksgiving dinner and just eat some turkey and nothing else, but I’d probably only make that bet…with someone else’s stomach.


The U.S. could ramp into full, escape velocity de-coupling mode while the balance of the global economy harmoniously converges to a state of disinflation and decelerating growth but, right here, we’d probably only get long that improbability via high-beta, early cycle exposure…with someone else’s money.


The first chart of the day below is our global macro summary table which consolidates global estimate trends for growth and inflation.


I know you can’t really see the table detail but that’s not really necessary here - one need only observe the ubiquitous red, which represents negative growth and inflation estimate revisions, to see the global transition to Quad 4 manifesting in real-time.


Oil’s expedited descent to sub-$70 and the massive underperformance in the XLE are acute examples of the stuporous deflationary realities of Quad #4 as the duo of disinflation and decelerating growth remains the scourge of energy assets and inflationary leverage.


Macro Tryptophan  - EL chart1


Given the pervasive, negative revision trends and the re-crescendo of the currency wars and central bank interventionism, both the market and policy makers are discretely acknowledging the deceleration in growth.


Extending the logic chain, an investor overweight and long of high growth (global) equities would then seem to fall into two broad categories:


Wrong: in terms of a fundamental forecast (why would one be levered long into slowing growth?)

Having & Eating Cake: Long under the premise that if growth accelerates you’ll be along for the ride and if it slows equities will (again) get juiced by a global “central bank put”


Given the frequency and magnitude of policy intervention over the last 5+ years and the near-Pavlovian, positive response in market prices, copping to strategy number 2 is somewhat defensible as it amounts to “playing the game that’s in front of you” and not the one you think you should be playing.


The binary nature and exogenous dependency (i.e. the fulcrum thesis driver being completely external to economic or company fundamentals) of that strategy, however, kind of divorces it from true “investing” in an organic sense. It’s also akin to Nassim Taleb’s Turkey problem.


To review Taleb’s popular probability parable:


“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race…On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”


It doesn’t take a lot of imagination to extend that metaphor to the equity market farm and envisage who’s the turkey and who’s the farmer.


Anyhow, getting back to the domestic decoupling…..


Inclusive of the crush of pre-holiday data on Wednesday, decelerating growth appears to be the emergent main course for 4Q.


Initial Claims deteriorated for a 3rd week. Peak improvement in claims has been a consistently solid lead indicator of the economic cycle. Are we pushing past peak?

Durable and Capital Goods spending softened (again). We expect the ISM/mfg data to soften alongside declining export demand, shifting seasonals, and middling domestic capex

Household Spending and Income saw tens of billions of dollars of income and savings revised away.


To delve into the last point a bit deeper.


Estimates for personal income were revised for the April-to-September period and the adjustments were remarkable as total disposable personal income saw some $200+ billion (SAAR) shaved away vs. prior estimates.


Alongside a meaningful downward revision to the savings rate in recent months, a net effect of the revision was a complete shift in the trajectory of salary and wage growth.


Whereas, prior to revision, the slope of aggregate wage growth in 2Q/3Q was one of acceleration, after the revision, it shifts to one of flat-to-modest deceleration.


Specifically, private sector salaries and wages were initially reported to be growing +6.1%, +6.0%, +5.9% over the July-to-September period. With the revision, those growth rates were marked down to +5.0%, +4.9%, +4.9%, respectively.


So, prior to revision, wage income was accelerating to a new cycle high alongside higher highs in savings. Thus, the capacity for incremental consumption growth continued to improve even if increased savings was muting the translation to actual spending growth.


The step function revision lower in both wage growth and the savings rate constrain the upside for consumption growth relative to that prior to the revision.


As the 3-D scatterplot below shows, the multiple regression between Disposable Personal Income growth and the change in the Savings Rate (independent variables) vs. the change in Consumer Spending (dependent variable) has an R-square of 0.95 across decades of data. More simply, growth in Disposable Income and the change in the Savings Rate explains ~95% of the change in aggregate household spending.


As we distilled it in our institutional note on Friday:


If ya don’t have it (no savings), ya ain’t gettin it (wages), and ya ain’t borrowing it (credit)…ya can’t spend it (PCE).


Macro forecasting can be complex and confounding but, every once in a while, it’s worth re-remembering that the strength and prospects for an economy boil down to some simple and very common sense realities.


To close the holiday Friday with some meditative macro invocation,


Grant me the serenity to accept a global entre into Quad #4.

The insight to understand the lagged benefit of lower energy prices.

And the wisdom to know (& time) the difference.


Christian B. Drake

U.S. Macro Analyst


Macro Tryptophan  - EL Chart2

LULU - Long, But On A Short Leash

Takeaway: Nice stock reaction, but really a lousy quarter on most metrics. We still need major change to make this name work. All eyes on the CFO.

Conclusion: We’ll take the market reaction, but this was actually a really lousy quarter – especially considering the pain it is lapping vs last year. The irony is that victory can be achieved by simply running this company like how it should be – not what it was built to be. The management team that exists today can likely never earn over $2.50 without a lot of luck.  We think that the Board dynamics are such that the pending CFO hire will be a game changer, raising the profile of the Finance Organization at LULU – even if it means eventually getting rid of the ‘new’ CEO.  That’s when we can talk about $3-4 in earnings and a $100+ stock. We’re still Long, but with a short leash.




We’re not as excited about this LULU print as the market is. Don’t get us wrong – we’ll take the upside, as the name has been on our Best Ideas list on the Long side since June 15 of this year.  And for now it’s staying there. But let’s face reality – the stock was up because business is ‘less pathetic’ than it had been. Comps were +3.0% (Constant $), new store productivity was stable at 63%, and revenue was +10.4%. That’s all good. But from that point, the growth algorithm pulls a sharp 180. Gross profit was up only +3.2%, and EBIT was down -12.1%, and EPS off by -6.9%. Can we celebrate progress? Yes. But make no mistake, the financial model remains broken.


A few more thoughts on the print.

1.  Why Aren’t Numbers Better, Sooner? We’re seven quarters removed from the Luon (see thru pants) debacle, and 4 quarters removed from the last of the ensuing PR problems that plagued the company. Numbers should, without fail, be getting better.

2.  Questionable Risk Management. The West Coast port issues have been lingering in the news since July, yet this is the first consumer company we heard that actually adjusted revenue guidance because of inventory delays at the ports.  Either it has very poor risk management processes to divert freight away from Long Beach, or it simply planned very poorly. We’d argue that it is both as a) this is not a process-driven company that places a priority on risk management, and b) with all the new employees hired in product planning over the past quarter, LULU simply didn’t have enough people in place when it mattered (that’s likely why they hired).


3.  We’re mixed on the Gross Margin erosion (-353bps).  When all is said and done, we think that LULU will be sitting here in 2-3 years with a 48% Gross Margin vs 51% today. It can either get there offensively, or defensively.  We prefer offense.

a. Offense means that the company invests proactively in its R&D platform and innovation agenda, its ability to flow product more accurately throughout a multi-channel distribution platform, while maintaining price integrity, and its premium brand status. It accelerates sales at a premium merchandise margin, but does so through appropriately investing in the areas needed to win (like Nike and UnderArmour).
b. Defense means the exact opposite. It means that the company does not have the product engine to grow the brand, nor can it flow product down the price curve as a season progresses through an increasingly unmanageable number of doors. The best example of this is Coach. The company has been married to its Gross Margin for so long, and it ultimately cost Coach’s top line all hope of doing anything other than going straight down. When Laurent talks about returning to a mid-50s GM% on the conference call, we wish he could see half of his investor base grimace. Our strong sense on this one is that nobody will pay for Gross Margin improvement. They will pay for sheer growth – even if it comes at a lower gross margin than what the company is churning out today.  


4.  Still no convincing plan to fix the company. That’s actually one of the things that attracts us to the story. The brand, despite its problems, remains very relevant. As hard as Chip’s organization seemingly tried, it did not kill the brand. There is almost zero chance that there is a well-articulated plan internally that we’re simply not hearing. Trust me, if Laurent had rock solid strategic and financial models, we’d know about them. You don’t let your CFO go (or push him out) because ‘the financial model is just too good’. When JC Penney has articulated a better growth plan than you, then you should probably rethink a few things. 


That Brings Us to Why We Still Like LULU.

No, we don’t like the lack of a financial model, we didn’t like the growth algorithm, or the inability of the company to accelerate growth at the precise time when it is anniversarying problems from last year.  In sum, we simply don’t like management.  They’re nice people, but we think that Potdevin (CEO) is punching far above his weight.  This was Currie’s (CFO) last conference call, and it sounds like a new CFO will be on the next call. We almost never get too upbeat about a single individual in an organization.  But we think that this role is the exception. Why?


For starters, the Finance function at LULU has always been extremely weak. Currie was appropriate to be Chip’s numbers guy in the early days of the company, but Chip purposely kept the entire function at bay as the company grew up, as he thought it would hurt the culture of the company.


At the same time, the Chairman of the Board is now split between Mike Casey (former CFO of Starbucks) and David Mussafer (Advent/new to the Board). The new CFO will not be hired by Laurent, he/she will be hired by Casey and Mussafer, who both know the caliber of person needed to get this company back on track. Our sense is that this person will be tasked with rightsizing the company. If Laurent wants to follow, then great. Everyone wins. But if he resists, then the new CEO will soon be the old CEO.


So What Does this Mean for the Stock?  

The risk/reward definitely is not what it was 35% ago. LBO is off the table at this valuation, as is a sale of the company. Now we have to bet on an actual rebound in the business. If we had to make that bet on the team that’s in place today, it’s pretty clear that they’d get a vote of no-confidence, and we’d be out. At a price, we’d actually go the other way and short the stock.


But, we’re very interested to see the caliber of the individual that the company hires. It’s odd…in our conversations with investors, people agree that Currie had to go, but don’t necessarily think that there’s a problem with the finance organization being so weak at LULU. We think that people will only realize how problematic this has been once it is fixed.


There’s a lot of extremely competent leaders out there in or around retail finance that have proven that they can run businesses far bigger than LULU. Consider Nike, for example – which is a mere 300 miles South of LULU. It has at least eight divisional CFOs who run businesses at least 2x as big as LULU (and Nike North America is over 10x). The point is that the talent is out there, and our sense is that Casey and Mussafer are taking their time for a reason. This hire could be a game changer.


It will be painful along the way, but how we’re modeling it, we get to a 20% EPS CAGR, and earnings back above $3.00 by FY17. The stock is trading at about 24x next year’s number ($2.17), and if we hold that multiple – which is not a ridiculous assumption given accelerating growth to 20%, then we’re looking at $64 and $75 1 and 2-years out, respectively. Not a huge return, but we’ll take it.


LULU - Long, But On A Short Leash - LULU FinTable

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