Ignorance and Leverage

“When you combine ignorance and leverage, you get some pretty interesting results.”
-Warren Buffett
Last night CNBC had clips of Maria Bartiromo interviewing Tim Geithner. That was quite the combo.  Combining economic ignorance with the levered long leader of the willfully blind is pretty interesting Mr. Buffett, indeed!
On the question of leverage, Geithner proclaimed his mystery of faith stating that “credit is the oxygen”…
On the question of plans to address the Burning Buck… well… Geithner didn’t have any…
I couldn’t make this up if I tried, but rather than provide Bartiromo with a proactive plan to address the Currency Crisis, Geithner said that he doesn’t usually talk about daily activity in the currency markets. Timmy, understanding that the daily analysis is more of a real-time risk management approach, how about weekly or monthly? Quarterly? Annually? Newsflash: the US Dollar is down another -2.2% this week and has lost -16% of its value since March! Wakeup.
Never mind the marked-to-market price, Geithner went on to point out that the US Dollar’s strength was most readily apparent when the world was screaming with fear. Finally, he concluded that, as a result of how the US Dollar acted during last year’s apocalypse, the US Dollar’s strength remains readily apparent.
This guy was serious. Under this line of thinking, I guess all we have to do is create another Global Leverage Crisis and we’ll get our currency back! While hope is not an investment process, I can only hope that the Chinese and Japanese didn’t watch the YouTube of those CNBC clips…
This morning the Buck continues to Burn. Are they Bombing Out The Buck? Or are they just getting started? Niall Fergusson at Harvard thinks that the bombing is going to be for another -20% down move in the US Dollar within the next 6-12 months. I like Niall’s research, a lot. But Niall, if that happens… all I have to say is ‘lock the barn doors Sally’, because every American with a pitchfork is going to be coming at those of us who work in Financial Services.
Away from not trusting him, my biggest issue with Tim Geithner has to do with competence. He doesn’t do global macro, so I don’t think he really has any idea how to approach this secular Global Currency Diversification exercise. Being a New York centric banking man has its privileges to the Groupthink Suite.
If Geithner’s answers pertaining to the US Dollar last night weren’t alarming enough, here’s what the Treasury issued as a statement to The Client (China) this morning:
“Both the rigidity of the renminbi and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 framework”…
Again, I couldn’t make this up if I tried, but Geithner is so clueless right now that he is choosing to antagonize the Chinese in the Treasury’s semi-annual report on currency policy. The Chinese are already a net seller of US Treasuries and Dollars. What are you doing Timmy? Wakeup.
If you are looking for another opinion on this other than mine and Fergusson’s, here’s Alan Greenspan’s this morning: “I’m not overly concerned about the most recent decline in the dollar”…

Gee, thanks Alan. You haven’t been concerned about this country’s currency for a long time. Now your boy, Bernanke, is following your lead. We issue our citizenry a ZERO percent return on their savings accounts, fire up the inflation machines, and are teeing up Investment Banking Inc. to pay out more bonuses on the back of this Piggy Banker yield curve in 2009 than we did in the year that preceded this said “Great Depression”!
Never mind the long term implications of the US Dollar trading close to 38 year lows. This, of course, is all just fantastic for the US stock market in the immediate term. We Bomb the Buck, and everything priced in bucks reflates. Yesterday, I called this the Minsky Meltup. Today, I’ll call it the same.
The Minsky Model isn’t one that the levered loan originators of Investment Banking Inc. like to read about. Shhh – keep that under wraps. Ignorance and leverage is a powerful compensation structure for those who have an entitlement to game the US Financial System.
My immediate term upside resistance level this morning for the SP500 is at yet another higher-high (1103) and my immediate term TRADE support line is at another higher-low (1069). Meltem’ up boys, and hope that the American people are as ignorant as Geithner in understanding that the last crisis was born out of a weak-dollar debt-financed asset-price-appreciation bubble.
Best of luck out there today and have a great weekend with your families,

XLU – SPDR Utilities We bought low beta Utilities with a reasonable dividend yield on 10/13.

EWT – iShares Taiwan With the introduction of “Panda Diplomacy” Taiwan has found itself growing closer to mainland China. Although the politics remain awkward, the business opportunities are massive and the private sector, now almost fully emerged from state dominance, has rushed to both service “the client” and to make capital investments there.  With an export industry base heavily weighted towards technology and communications equipment, Taiwanese companies are in the right place at the right time to catch the wave of increased consumer spending spurred by Beijing’s massive stimulus package.

EWG – iShares Germany Chancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats. We expect to see continued leadership from her team with a focus on economic growth, including tax cuts. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; with fundamentals improving in a low CPI/interest rate environment, we expect slow but steady economic improvement from Europe’s largest economy.

CAF – Morgan Stanley China Fund A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the more volatile domestic equity market instead of the shares listed in Hong Kong. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth. Although this process will inevitably come at a steep cost, we still see this as the best catalyst for economic growth globally and are long going into the celebration of the 60th Anniversary of the People’s Republic.

We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. We like defensible growth with an M&A tailwind. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.

CYB – WisdomTree Dreyfus Chinese Yuan
The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP – iShares TIPS
The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

XHB – SPDR Homebuilders We were the bulls on a Q2 housing turn but, as the facts change so do we: now we are getting cautious on 1H 2010 US Housing. Rates up as access to capital tightens is not good for new home builders as we enter into a new year and series of potential catalysts for renewed pressure in the secondary market, including the expiration of the $8,000 tax credit.

USO – US OIL Fund WTIC Oil traded just north of our overbought line on 10/12. With the US Dollar hitting another higher-low, we shorted more of oil’s curve.

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds  If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.

McCullough Says Fed `Absolutely Dovish,' Favors Gold

MCD - The Hambuglar Strikes

MCD is scheduled to report 3Q09 earnings on Thursday, October 22 before the market opens.  From a revenue standpoint, I think current street estimates are too bullish, and I would not be surprised to see MCD report earnings that fall a penny short of the $1.11 consensus estimate. 


As I have said before, however, the tax rate and nonoperating income/expense line, which includes gains and losses on company investments, are extremely volatile quarter to quarter and difficult to forecast so there could easily be a penny of upside/downside from such items relative to my expectations. 


From a stock performance perspective, I think investors will be more focused on recent sales trends (MCD will be reporting September comparable sales numbers by segment as well) than earnings, unless of course, it is a huge miss/beat, which is not likely.  When MCD reported in line 2Q09 earnings, the stock still traded down 4.6% on the day because the company also reported below trend June same-store sales results. 


To that end, I think September same-store sales growth could come in below expectations with the U.S. posting a +1% number, which would point to continued deceleration in 2-year average monthly trends (a +3.3% number or better is needed for 2-year average trends to be even with or better on a sequential basis).  I am expecting September 2-year average trends in both Europe and APMEA to remain about even with August, which implies about 10% and 3.5% growth, respectively. Based on these assumptions, 3Q09 comparable sales growth will have decelerated on a 1-year basis and 2-year basis in two out MCD’s three geographic segments.  I am looking for 1.8% same-store sales growth in the U.S. (vs. +3.5% in 2Q09), +1.7% in APMEA (vs. +4.4% in 2Q09) and +6.9% in Europe (in line with last quarter). 


Traffic in the U.S should be helped in the quarter by the increased number of promotions MCD has offered, particularly around McCafe and the Angus burger.  The obvious downside to that is the impact on average check and U.S. margins.  It will be difficult for the company to sustain its last two quarters of 50 bp YOY U.S. restaurant margin growth with this level of promotional activity though the margin comparisons continue to be easy with YOY restaurant margins down 20 bps in 3Q08 and down 60 bps in 3Q07. 


Other things to consider in the quarter that will help to offset top-line weakness include the YOY easing of commodity costs and currency in the second half of the year.  Specifically, management guidance stated that in the U.S. its basket of goods should increase 3%-3.5% for the full-year, which implies about a 1% increase in the back half of the year.  In Europe, the company’s revised outlook assumes commodity costs increase 3%-3.5% as well, resulting in relatively flat costs in 2H09.  On a consolidated basis, food costs as a percent of sales should decrease YOY (even with the increased discounting in the quarter), marking the first time this number has come down in 6 quarters.  The magnitude of this YOY favorability will become even greater in the fourth quarter as food costs as a percent of sales in 4Q08 were up 170 bps YOY (vs. up 90 bps in 3Q08).


Relative to MCD’s currency guidance, the company said that based on current rates at that time that the negative impact of currency translation would decrease to about $0.04 in the second half of the year (-$0.06 in 3Q turning into a $0.02 tailwind in 4Q) from the negative $0.17 per share impact in 1H09.  Looking at rates now, this expected $0.02 benefit in 4Q09 could move higher. 


There are still reasons to love MCD.  Proving that MCD is a cash machine, the company recently announced a 10% increase in its quarterly cash dividend and stated that it expects to end the year near the high end of its three-year, $15 billion to $17 billion total cash return target.  At first glance, this 10% quarterly increase seemed low to me relative to the 33% increase last year, but on a full-year basis, MCD’s dividend will be up 26% in 2009 versus up 8% in 2008.  MCD has enough free cash flow to even trump that $17 billion target through increased share repurchases to help provide the financial engineering to make the numbers. 


MCD - The Hambuglar Strikes - MCD 3Q09 stock price

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Hybrids Impact on Oil Demand

We released our Oil Black Book in September and our two key underlying themes related to flat lining production globally and the fact that increased investment does not seem to be growing production.  While these are the important facts relating to supply, on the demand side we do need to seriously start considering the impact of more fuel efficient vehicles, particularly in the United States.


The United States uses roughly 20% of the world’s oil and roughly 50% of that is used for gasoline for cars.  As a result, any real change in gasoline usage for transportation in the United States will impact global supply and demand dynamics directly.  We wrote the following in our Black Book:


“In aggregate, oil accounts for almost 95% of all transportation energy around the globe. This is the single most substantial area for potential demand alleviation as fuel intensive transportation methods begin to be gradually displaced by more economical modes of transportation. As an example, Fisker Automotive is expected to introduce a car shortly that will get upwards of 65 miles per gallon. Tesla, GM and Nissan also are in the midst of introducing cars that may get upwards of 100 miles per gallon, although it is not yet clear that these cars will see wide spread use as the mpg calculations are based on limited daily use. Nonetheless, this advancement could lead to a dramatic increase in average miles per gallon which is currently estimated to be in the ~24 mpg range in the United States.”


The reality is that based on hybrid vehicle technology, the MPG in the United States has the potential to change dramatically over the coming years.  Estimates suggest that globally, hybrid sales are still barely over 1% of all vehicle sales.  In a scenario, whereby hybrids reach 5, 10 and even 15% of vehicle sales in the United States that would have a meaningful impact on average MPG, and overall demand for oil.  In the table below, we have outlined a scenario where the base of cars becomes increasingly more hybrid and operate at a MPG of 50, which is comparable to a 2010 Prius. Let’s take a look at the rough math:


Hybrids Impact on Oil Demand - hybrid table


The punch line is that as hybrids continue to take market share, we can and will see a dramatic decline in oil demand in the United States as it relates to gasoline use.  At a point when 15% of all vehicles are hybrid, MPG will increase by 16.3%, so vehicles will be that much more efficient.   The implication is that, all else being equal, 50% of American demand for oil will decrease by 16%+ when hybrids are penetrated to 15% since 50% of oil used in the U.S. is turned into motor gasoline.


To put this in a frame of reference, gasoline demand over the past ten years from October 1999 to October 2009 has only increased by 8.3%, so to the extent that some of the general estimates relating to hybrids are accurate, namely that 20% of all car sales by 2020 will be hybrids, we could potentially see a dramatic decline in gasoline demand in the U.S. that offsets natural organic growth in demand.  In fact, over the last decade, we would have actually seen a net decline of demand of ~8%.  Keep your eyes on the hybrids!



Daryl G. Jones
Managing Director 



Eurozone Deflation Holds Steady

Position: Long Germany via EWG


We’ve had our EYE on Eurozone inflation and forecast to see mild inflationary numbers into year-end and next. Today Eurostat released Eurozone CPI at -0.3% in September year-over-year, with monthly inflation at 0.0%. While still deflationary on an annual basis, and down from -0.2% in August, we expect a slight uptick in inflation over the intermediate term, buffered by a strong Euro. 


As always, divergences in inflationary/deflationary numbers reflect structural issues on an individual country basis within the framework of the Eurozone, and will remain a political football for the ECB when it considers raising interest rates. As of yet, there’s been little rhetoric on the WHEN, however Trichet has recently signaled displeasure with a strong Euro (now bordering on the $1.50 mark) as it erodes the competitiveness of Eurozone exports.


September inflation data shows a clear divergence among countries:  Ireland and Portugal are experiencing the most deflation, at -3.0% and -1.8%, respectfully. The two largest economies in the region, Germany and France, stood at -0.5% and -0.4%, near the region’s average, while Malta and Finland topped the inflation charts at +0.8% and +1.1%. As before, we continue to believe that structural issues that weighed on certain countries into the downturn will encourage and prolong deflation, and therefore recovery, as we move out on duration.


The major components driving annual CPI deflationary were Energy (no big surprise) and Transport costs, down -11% and -3.7%, while Food and Housing saw declines of 1.3% and 1.6% respectively.  Due to tax and duties, Alcohol and Tobacco saw strong inflationary pressures at +4.4% annually.


Alongside inflation we’re beginning to see upward revisions for GDP growth across the Eurozone. Importantly, Germany was revised up to 1.2% in 2010 (from a recent IMF prediction of +0.3%), with Chancellor Merkel stating that even average growth of about 1% would only show that Germany is “slowly emerging from the trough.”  Yet, she also stressed in a recent speech that Germany’s industrial base shall help the economy outpace many of its peers, a point we agree with. Further, the Bank of Italy said the country emerged from recession in Q3, expanding 1% Q/Q. Cited for stepping up manufacturing, Italy’s push from a Q2 GDP of -0.5% is bullish for an economy that is heavily dependent on trade with the Europe.


As economies melt up, we expect inflation to follow at a relatively stable rate across the region.  We continue to like Germany, including its low inflation environment as it encourages consumer consumption.



Matthew Hedrick



Eurozone Deflation Holds Steady - EACPISEP



This note is to share our tactical insights into the ETF and options markets. ETFs and options have unique risks and may not be suitable for all investors.  Please consult with a qualified investment professional before investing in these instruments. 


During our quarterly strategy call earlier today, we received questions about the use of leveraged ETF products.


We do not like leveraged ETFs for overnight positions. The structure which allows theses products to be created, by definition, limits the correlation to the underlying security, commodity or index to intraday moves.  For investors who have an intermediate or long term directional conviction, and who wish to leverage their position, options on a non leveraged equivalent ETF or on the underlying index may be a viable alternative.


Some basics: purchasing an option limits the potential loss in the position to the price paid, selling an option without an offset in the underlying investment will expose an investor to a potential loss of either the entire underlying (selling a naked put) or an infinite amount (selling a naked call). In other words, if you haven’t used options before, read the educational literature on the CBOE’s website thoroughly and actually read the information your broker provides rather than just clicking “I accept” before you start trading.  We would encourage you to make sure your broker actually understands how these instruments work – sadly, not all do – before you entrust your capital to their advice. I can’t stress this enough (I have spent the majority of my adult life trading derivatives and have as many gruesome stories about accidents as a career EMT).


The crux of this matter is that purchasing an option contract that is out-of-the-money (above the underlying price for calls, below the underlying price for puts) provides a significant amount of leverage and can pay off handsomely with a big movement in price. The value of one of these “lottery tickets” evaporates rapidly however as the time to expiration erodes or the underlying price moves in the wrong direction, presenting a great deal of risk. Purchasing an option that is near the current price or even actually “in-the-money” will provide a lower risk of erosion based on time or price action, but the absolute dollar cost will be more significant and the potential payoff profile will be more limited than that of an out-of-the-money contract if there is a big move in the underlying.


Options can be a useful investment tool (provided that you do your homework first) but they may not present the tactical flexibility a shorter term investment requires. For an investor looking to capture a directional movement of a few days to a week, a directional position in an unleveraged ETF may well provide more maneuverability than an option position, while providing true (if unleveraged) performance tracking the underlying.


The only time a leveraged product that resets daily makes sense is when it is being employed intraday.  Your broker may not be able to explain this to you, because financial professionals are not required to be knowledgeable about ETFs, even if they invest their clients’ money in them.  Now more than ever, buyer beware.



Andrew Barber



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