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Dancing With The Bear

“Problems cannot be solved by the level of awareness that created them”
-Albert Einstein

I’m in beautiful Camden, Maine this morning. It’s getting chilly up here, and the bears don’t like it.
 
Born and raised in the northwestern woods of Ontario, I know a thing or two about Black Bears. My Dad likes to say that you “don’t want to dance with the bear” and, although that’s probably local consensus, that’s not a consensus you want to try fighting. Consensus can be right.
 
What is consensus? Is consensus when everyone is long or short something? Or is it when you think everyone is long or short something? Is it consensus when you aren’t making money alongside people you deem to be consensus? Or are you consensus when you say something is consensus?
 
After making enough mistakes hunting in global markets, I have come to conclude that I can either be Bullish, Bearish, or Not Enough of one of those two things. My daily risk management task is to figure out how to not to be mauled. If that means being called consensus on my bearish US Dollar stance at this stage of the hunt, so be it. I remain short the US Dollar this morning because I don’t think consensus is Bearish Enough.

To be truly Bearish Enough on the Buck requires some reading beyond your latest tweet. You can listen to the Johnny-Come-Latelys on CNBC, who are now running segments with lead-ins like “When Nixon abandoned the Gold Standard in 1971” (sound familiar?), to truly appreciate that consensus still has no idea how to analyze this fundamentally. “Problems cannot be solved by the level of awareness that created them.”
 
On the topic of the Burning Buck, Niall Ferguson at Harvard is amongst the most aware. Ferguson is what I would call Bearish Enough. He’s looking for a -20% drop in the price of the US Dollar in the next 6-12 months. That would put the US Dollar index at $60!
 
Let’s think about what a -20% drop, from here, in the US Dollar would mean. We call this TAIL risk. Since March, the US Dollar has crashed, losing -16% of its value. Over the same time period, the price of oil (priced in those dollars) has had a Minsky Meltup of +102%. Let’s say Niall is not right, and the Dollar only loses another -16% of its credibility. Using the same leverage ratio of down dollar to up oil, that could equate to $160/barrel oil. Is that consensus?
 
Required reading from Fergusson would be his book titled the Ascent of Money. This fantastic analysis of economic history was all part of the studying we did to make this Burning Buck call 9 months ago, but my having been early on this doesn’t matter anymore. What matters is the here and now.
 
The US Dollar remains in what we call a Bearish Formation. That’s simply when then TAIL sits on top of the TREND, and the TREND sits on top of the TRADE. Bearish Formations are very powerful because they force all types of investor durations (from 3 weeks to 3 years) to either pay attention or “dance with the bear.”
 
My updated risk management levels for the US Dollar are as follows:
 
1.      TRADE (immediate term) = $76.39

2.      TREND (intermediate term) = $78.03

3.      TAIL (long term) = $82.29

 
So what do you do with these levels? You definitely don’t run from them. That’s what consensus does when being chased by a Black Bear. Instead, you hold your ground, and stare at them. Start yelling too, if you want.
 
Provided that the US Dollar cannot breakout above the TRADE line ($76.39); the Volatility Index (VIX) can’t breakout above hers (VIX immediate term TRADE line = $24.19); and the SP500 cannot breakdown and close below her TRADE line at 1065, I think US equities will make another higher-low during this correction.
 
Sometimes, doing nothing – waiting, I mean – can be the best option in avoiding a dance with the bear. In Thunder Bay, Ontario, that’s local consensus – but it’s a consensus that I’m more than happy to be called.
 
Best of luck out there today,
KM

 

 

LONG ETFS
 
XLU – SPDR Utilities
We bought low beta Utilities on discount (down 1%) on 10/20. Bullish formation for XLU across durations.

FXC – CurrencyShares Canadian Dollar We bought the Canadian Dollar on a big pullback on 10/20. The currency ETF traded down -2%, but the TRADE and TREND lines are holding up next to Daryl Jones’ recent note on the Canadian economy.

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.


GLD – SPDR Gold 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.

 
SHORT ETFS
 
UUP – PowerShares US Dollar
We re-shorted the US Dollar on strength on 10/20. It remains broken across all 3 investment durations and there is no government plan to support it.

FXB – CurrencyShares British Pound Sterling
The Pound is the only major currency that looks remotely as precarious as the US Dollar. We shorted the Pound into strength on 10/16.

XLP – SPDR Consumer Staples Strong day for Consumer Staples on 10/16, prompting a short versus our low beta long position in Utilities (XLU).

USO – US OIL Fund We shorted oil on 10/12 and 10/21 and are currently off sides, but with oil getting more over bought we are adding to the position.  Ultimately, the threat of higher interest rates, will be bearish for oil.  In addition, we are concerned with the bearish supply in the shorter term.

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.


A Tale of Two Asset Classes: The Dollar and Oil

 

 

 

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way - in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.” –Charles Dickens, A Tale of Two Cities

 

 

Despite being a knucklehead hockey player, I have found time over the years to read a few classics, and Charles Dickens’ A Tale of Two Cities is one of them.   The longish quote above is, of course, the well known first paragraph of this book.   The book was set in Paris and London during and before the French revolution and would go on to become the most printed original English book with over 200 million copies. 

 

 

I won’t endeavor to make too many parallels between investing, and Dickens’ classic, but I do think the opening paragraph is an apt description for what we have seen in the oil and U.S. dollar markets in the year-to-date.  For oil bulls, it has been the best of times, while for U.S. dollar bulls it has been the worst of times.

 

 

Our Lead Desk Analyst, Andrew Barber, prepared the chart below, which outlines the performance of oil, the U.S. dollar index, and the U.S. dollar versus the Canadian dollar over the past three years.  We referenced the chart at 100 to start and then graphed the performance of all three over the past three years.   Not surprisingly, the peak of oil last summer coincided with the trough of both the U.S. dollar index and the strength of the Canadian dollar versus the U.S. dollar.  This is a theme that we have been harping on consistently all year, but was really set in motion in 2008 with the meteoric rise, and then crash of oil.

 

 

Interestingly, both the U.S. dollar index and the Canadian and U.S. Dollar exchange rate are once again near the extremes of last summer when the oil hit its all time highs.  In fact, on a weekly basis the U.S. dollar index is 87.73 as of Oct. 20th and the Canadian Dollar to U.S. Dollar ratio is 91.687 as of Oct. 20th.  These are close to the all time lows for both ratios, which imply a weak dollar. In fact, when oil peaked in July of 2008, the U.S. dollar on both ratios was at very close to the same place.  Oil, on the other hand, was north of $140 per barrel versus its current price of just under $80. 

 

 

In our Oil Black Book from September, we cautioned about using expert projections for Oil, as collectively they tend to converge around the current month price and project that forward based on recent price action.  The consensus projections for the spot price of crude oil in early September were:

 

 

A Tale of Two Asset Classes: The Dollar and Oil - a6

 

 

Obviously based on where we are today, those price targets seem way off.  And likely they will be adjusted upwards if they haven’t been already.  Now the point is not to highlight that 35+ experts in aggregate were way off (although that is important to remember), but rather just to emphasize that consensus itself can be way off, and in a much shorter period of time than anyone could have imagined.

 

 

A question we often get is whether the U.S. dollar is a consensus short.  While its weakness may be well known and the reasons for that weakness as well, the question remains, even if consensus is bearish, is it bearish enough?  While we have shorted oil recently and are currently off sides, our longer term view is that oil price has an upwards and to the right trajectory, primarily for supply reasons.

 

 

When I look at the U.S. dollar market and oil market over the last three years, I am certain of one thing, they will move together and the move will be on a larger scale than anyone expects.  So, if your thesis is that oil will retest its July 2008 highs in the coming months, a primary factor will be the U.S. dollar and in the scenario of parabolic oil prices, no one is currently bearish enough on the U.S. dollar.

 

 

 

Daryl G. Jones
Managing Director

 

A Tale of Two Asset Classes: The Dollar and Oil - a2


Slouching Towards Wall Street… Notes for the Week Ending Friday, October 16, 2009

Market Crash Anniverary Edition – Monday, October 19th 2009

 

This Week in the Screed:

Springtime for Blankfein – It’s the Real Economy, Stupid!

 

Wall Street Forced To Share The Wealth – With Washington?

 

Ken Lewis, Meet Hester Prynne – Immaterial Girl

 

 

Springtime For Blankfein

 

Let me tell you about the very rich. They are different from you and me.

                   - F. Scott Fitzgerald, “The Rich Boy”

 

It has been a treat, watching the people of this great land as they twist and writhe and try like hell to dodge each gold-clad salvo from Wall Street.  Like peas hopping in a skillet, the Common Folk have been trying to find a place where they can set down, without being set off again by the scorching metal.

 

Maybe a better analogy is a cornered fox set upon by hounds.  What a thrill to watch the tiny animal as it yelps and leaps and twists and snaps and tries to save itself from being crushed and mangled when the dogs finally decide which of them will have first go at it.

 

Yes, that would be it.  A small, cornered beast trying desperately to find an escape – even a corner to hide in, small enough that the predators can’t rout it out.

 

A year ago there was no end of hand-wringing from Washington and the nation’s press as politicians and pundits prognosticated, columnists and commentators caviled, editorialists execrated, reporters ratiocinated, nabobs nattered and bloggers… uhm… blogged about the danger that “this” might spill over into “the real economy.”

 

There’s good news.  The Wall Street Journal, in an appropriately modest one-column headline (14 October, “Wall Street On Track To Award Record Pay”), reports that Wall Street is “on pace to pay their employees about $140 billion this year – a record high.”  The top 23 investment banks, hedge funds, and exchanges paid aggregate compensation of $130 billion in 2007 – the record so far.  Lucky for them, last year saw a market meltdown of Biblical proportions.  As has by now become excruciatingly clear to all – particularly excruciating to those who are still kicking themselves for missing perhaps the greatest one-two punch short-the-world to massive-short-squeeze trading opportunity in history – the markets have been rocked by successive tsunamis of volatility.  And, in case you still haven’t figured it out, Wall Street doesn’t get paid to make you money.  It gets paid to handle transactions.

Volatility = lots of transactions.

 

Lots of transactions = lots of transaction fees.

 

Lots of transaction fees = the biggest payday in Wall Street history.

 

We hope you made some money along the way, too.  Because your broker sure did.

 

The Journal reports the combined revenues of these firms are projected to hit $437 billion – an increase of some 27% over 2007’s all-time peak of $345 billion.  At these levels, we’re talking orders of magnitude.  And you used to chuckle when you teased them by calling them “Masters of the Universe”…

 

Banks and investment firms argue that they must continue to pay top dollar, otherwise their top talent will leave.  As witness the government forcing Citi to divest its Phibro trading unit, that prediction was dead on the money.

 

Are you shocked to read (Financial Times, 14 October, “AIG Staff Resist Pressure On Bonuses”) that Neil Barofsky, the SIGTARP (“Special Inspector-General for the Troubled Assets Relief Program”.  Sigtarp – it sounds so Star Wars, doesn’t it?) “found that AIG staff were resisting paying back part of the $168m retention payments” – the “stay bonuses” that were handed out to make sure that the people who understood how these ditzy instruments worked would stay on at AIG until a good portion of their positions were unwound – although we are not told who these instruments will  be sold to.  We bet the New York Fed is on the short list of potential bidders.

 

Today, we still don’t know who received the $700 billion of TARP money – indeed, we don’t even know whom to blame for the fact that we don’t know.  And Washington has no perceptible sense of urgency regarding either transparency or significantly enhanced capital requirements.

 

In our world, a surge in market averages is equated with an overall lift in global wellbeing (WSJ, 15 October, “Dow At 10000 As Crisis Ebbs”).  “Crisis Ebbs” as in, the Crisis was on Wall Street – not Main Street.  The definition of “global” is a bit narrower than you might think.

 

The Wall Street Journal reports (15 October, “Junk Is Hot, Except On Street”) “As investors have piled into high-yield bonds this year and shown a healthy appetite for risk and returns, one contingent has remained notably cautious: Wall Street.”  That opening sentence tells the whole story, and then some.  Curiously, the Journal column does not tie up the loose ends.

 

We at Research Edge have gone to pains to point out the obvious and fundamental conflict of interest inherent in the finance industry: that the Art of Managing Money is the Art of Having Other People’s Money to Manage.  OPM syndrome drives Wall Street.  Thus, the smart move is to look at what Wall Street is selling – then run the other way.

 

Read again that opening sentence from the Journal’s report.  Investors are buying high-yield bonds, Wall Street is selling them.  Which side of this trade would you like to be on?  The article quotes one high-yield fund manager as observing that buy orders have run seven to one over sell orders in recent weeks.  The same issue of the Journal (“Bond Ebullience Is Raising Eyebrows”) reports “the BofA Merrill Lynch US High Yield Index has gained nearly 49.4%” since January of this year. 

 

Put these two reports side by side and a picture of a feeding frenzy emerges, no doubt sparked by Wall Street’s sales force.  What it fails to point out is that Wall Street also has the opportunity to charge more for each transaction. 

 

Not holding junk bonds in inventory, bond desks have to source them from the street to fill customer orders.  According to regulation and practice, this means it is “harder” to fill these orders, thereby justifying a larger mark-up on each trade.  It also leaves a gap to be filled – and Wall Street abhors a vacuum.  Watch for significant new junk offerings to come flying down the pike, no doubt signaling the death of the sector.

 

As former World Heavyweight Champion Economist Hyman Minsky would likely point out, a feeding frenzy generally ends badly.  Or, as Marlin Perkins would observe in his fabled Wild Kingdom” television series, when the voracious carnivores have eaten the last scrap, they often turn on one another.

 

Those in government and the press who noisily worried about Wall Street infecting Main Street are guilty of spreading a pernicious lie.  The global financial crisis was sparked by problems in housing finance.  These problems spawned a human crisis of massive proportions, undercutting decades of wealth building and turning families out of homes in which they had long felt secure. 

 

Government processes, legal structures, and politicians at every level failed to exercise their legal or moral authority to protect their Main Street constituents in a rush to pander to the financial interests that pay for political campaigns.  Indeed, we suspect that a detailed review of decision failure would show significant instances where local officials attempted to intervene for the benefit of their constituents, only to be warned off by officials at the state level.  This is because of the stratification of sources of campaign monies.  We believe such a detailed study would be highly informative – and we are comfortable that such a review will never take place.

 

We suffered through what was fundamentally a housing crisis.  Proposals were put forward by academics.  Professor Luigi Zingales at the University of Chicago recommended a program to replace troubled mortgages with a combination of full-recourse financing and government-guaranteed non-recourse financing.  He argued that this would ease the pressure on homeowners who had taken zero-down mortgages by placing them on the hook for what they could actually pay, while limiting the cost to the government. 

 

FDIC Chair Sheila Bair had similar comments, focused on keeping families in their homes, while limiting the cost to the taxpayers.

 

But the powers that be weren’t having any of it.  The housing crisis was sold to the public as a banking crisis, and elected and appointed officials lined up to throw America under the bus.  Let there be no mistaking what constitutes the “Real” economy in this country – it’s Wall Street.  Main Street exists to buy our inventory. 

 

In case you find this troubling, don’t worry.  We will be OK.

 

Washington does not have the political will to force substantive change in our financial markets.  Which means that as far as Goldman Sachs, JP Morgan and the other 21 largest financial institutions are concerned, the United States of America is still Too Big To Fail.

 

 

 

Tax This

 

The beggars have changed places, but the lash goes on.

                   - W.B. Yeats

 

What’s all the fuss?  You would think that the unheard-of had just been broached when the weekend Wall Street Journal ran its piece on the notion of taxing Wall Street where they live (10-11 October, “Democrats Weigh Tax On Financial Transactions”). 

 

Those who have never been in the brokerage business – or who have never scrutinized their brokerage confirms – may not be aware of the processing fees that have long been part of the standard ticket charges for every retail transaction.  As successive waves of the bull markets surged over the past decades, commissions as a percent of total transaction cost were driven ever lower, even as volume was exploding.  Back in the 1990’s major brokerage firms – and quite a lot of minor ones – started tacking a “processing fee” onto their tickets.  Household name firms with global operations were billing their retail customers $25 per ticket, in addition to commissions.

 

The justification for this was that there were many costs associated with processing trades.  The real reason the brokerage firms did it was – they could.  Occasionally a customer would balk and sometimes the charge would be stricken or reduced.  But most customers didn’t even notice.

 

In the pre-emancipation plantation economy, there were two classes of slaves – Field Slaves and House Slaves.  According to popular street sociology, House Slaves saw themselves as superior to the Field Slaves, because they worked in the homes and interacted with the families of the masters.  While a slave is a slave is a slave, we suppose some may draw a modicum of comfort from the notion that they enjoy a unique position in the Great Chain of being – that of being able to look through the window onto large masses of folks who are far worse off.

 

Everything, of course, is relative.  The retail investors at the height of the bull market were, it turns out, the House Slaves of Wall Street.  Do you remember this television commercial advertising discount stockbrokerage services?  It featured a man being wheeled into the emergency room with frantic doctors racing the gurney down the corridors and shouting “He’s got money coming out the wazoo!”  Turns out what they were really selling was a Bill Of Goods.

 

Washington has caught on.  We’re all House Slaves now.

 

 

 

The Scarlet Letter

 

A pure hand needs no glove to cover it.

          - Nathaniel Hawthorne, “The Scarlet Letter”

 

Imagine the chagrin of Citigroup’s risk managers to see their peccadilloes revealed in the Wall Street Journal (16 October, “Muted Cheer As Citi Posts Profit”): “A person familiar with the matter said the lackluster performance wasn’t due to a single bad bet as much as “a collection of immaterial items that in the aggregate were material.”

 

If that doesn’t describe the global attitude that led to the implosion in the world’s financial markets, we don’t know what does.

 

By now it is trite to observe that senior management sets the tone in every firm.  It is our hallucination that the risk managers and compliance officers at Goldman Sachs or J.P. Morgan would not have considered those items “immaterial.”  Indeed, to a truly world-beating organization, nothing is ever immaterial.  The world is now reaping the fruits of a politicized global process which steadfastly supports institutionalized incompetence and unbridled avarice.  Entitlement has been substituted for performance, and excess for risk management. 

 

How else are we to explain, for example, a multi-billion dollar industry where the seller routinely performs the due diligence for the buyer?  We refer, of course, to the ratings agencies, who fell about in a frenzy, handing out triple-A ratings to illiquid interparty contracts like cigarettes in a prison.  CDS issuers all but dictated which issues would receive which ratings, nor did the buyers perform any diligence beyond determining what rating was slapped on the issues they were loading up on.

 

Everyone – sellers, buyers and raters – knew these contracts were illiquid.  But the sellers were getting paid to manufacture product, and – like taggers in a railyard at midnight – the raters were writing their great big “A” everywhere.  The managers were getting paid a percentage of assets under management.  And what better way to attract new money than by telling your investors you have access to a unique investment with a AAA rating? 

 

Just imagine the attraction to an investor of dealing with a money manager who has an exclusive in to an investment that provides a steady, above-market yield, and with no risk.  Shades of Bernie Madoff... 

 

What underlay this cycle of blatant irresponsibility?  The issuers are to blame – but perhaps the least.  They issued instruments for which there was demand.  And, when there was a new condition to that demand – the obtaining of an investment grade rating – they dutifully complied.  The raters are worthy of blame, but their business model was always predicated on conflict, as they sell ratings to the issuers themselves, and not to the end buyer.

 

So, as shameless as the conduct of the issuers and the ratings agencies was, it is the buyers who should get the biggest and reddest “A” of all.  As managers of OPM, their fiduciary duty was to perform due diligence on the instruments in their portfolios.  This they not only failed to do – we would go so far as to say they consciously refused.  And why?

Lawyers.

 

By issuing a security bearing the AAA rating and by marketing it on the basis of the rating – and by the money managers buying it with their clients’ money – the parties to this transaction, while not particularly careful about the actual exposure to the investors, were certainly working to protect themselves against lawsuits. 

 

This gives rise to the Perfect Storm theory, where everyone gets to point a finger in a different direction, yet no one has to take responsibility for bad judgment born of willful negligence.

 

As we read about Citi, the entire world was beset by “a collection of immaterial items that in the aggregate were material.”  This is precisely the refrain we have heard from Pennsylvania Avenue, to Wall Street, to Main Street and back again.  And it doesn’t look set to get any better anytime soon.

 

In his response to well-informed questioning from Congressman Alan Grayson (D. Florida) earlier this year, Secretary Geithner said the answer to stabilizing the financial system is “Capital, capital, capital.”  Yet, last week Geithner told Maria Baritromo that “credit is the oxygen” of the financial system.  Want to have it both ways?  No problem.  Not only can we can get you that AAA rating, we also have a bunch of retired academics to tell you it’s OK.

 

By the way, the Obama Administration has gotten a triple-A rating of its own, in the person of Paul Volcker.  The former central banker, widely recognized as someone who actually knew what to do, and did it in the face of political odds, has now voiced (again) his concern that bank bailouts have created a situation of precisely the kind of moral hazard we have been clamoring against.  It turns out that Volcker is the Trophy Wife of the Obama economic team.  He gets trotted out before the press corps whenever the President needs to show off, but like other bimbos, Mr. Volcker is to be seen, but not heard.

 

And so we were swamped by a Perfect Storm of our own making. And having hit upon the formula, we appear to seeding the clouds for the next one.

 

Meanwhile, the current debate is astounding.  From Washington to the mainstream press – two well-known sources of inaccuracies, misdirection, and outright lies – we hear about nothing but lawyers.

 

The New York Times reports (16 October, “Bank Chief Forgoes Pay For 2009”) that Bank of America’s Ken Lewis has agreed to waive his compensation for this year.  The factor that appears to have weighed heavily in Ken Lewis’ decision was a change of opinion on the part of the law firm of Wachtell, Lipton, Rosen & Katz, who “initially advised Bank of America to withhold information about the perilous state of Merrill from the bank’s shareholders, but later advised it to alert federal officials to the growing losses.”

 

Here’s the bit that is missing from the ongoing debate:  The lawyers don’t make decisions.

 

We remember watching as members of Congress retreated during their grilling of Chairman Bernanke in the early stages of the BofA inquiry.  At key points in his testimony, Bernanke would reply by saying “we conferred with our lawyers.”  We were stunned at the passivity the word “lawyer” induced in the tight-lipped interlocutors.  As though under post-hypnotic suggestion, the questioners’ demeanor would instantly change and a look of helplessness would steal across their faces.  And when the questioning resumed, it was with a marked sense of lassitude. 

 

Oh, for the days of NYPD Blue!  We allowed ourselves to revel for a brief moment in a vision of Dennis Frantz smacking Bernanke across the back of the head and saying “Now I’m your lawyer, you son of a bitch!”

 

The debate has completely lost sight of the fact that it was Ken Lewis, his fellow executives (which ones, we may never find out) and – specifically – the board of directors who made the decisions to acquire Merrill Lynch, to hide the fact of the excess losses, and to cover up the whole process after the magnitude of the losses became public knowledge.  Even assuming cajoling and strong-arming from Messrs Paulson and Bernanke, it was still down to Mr. Lewis and his board to determine what course of action to take.  Lawyers give advice, based on what they believe they can justify in a court of law.  No law firm is beholden to BofA’s shareholders.  Buried in the inner page of this same story, the Times sees fit to report “Legal experts say the ultimate responsibility may lie with Bank of America, not its lawyers.”  Since when was there any question?

 

As to this current crop of disasters, no one in this sorry circle of negligence ever placed the investors’ interests first.  Rather, the guiding thought in everyone’s mind was, we will be all right if we are sued because the paper was rated AAA.  Thus has the world come to rely, not upon analysis and integrity, but upon the prophylactic use of third party advocates who, as Hamlet’s drunken porter says, “could swear in both the scales against either scale.”

 

Washington and Wall Street alike should note that even a drunken gatekeeper recognized that they could not equivocate their way into Heaven.

 

And there are some things that even your lawyers can not protect you from.

 

The New York Times (14 October, “E-Mail Shows Concerns Over Merrill Deal”) quotes an e-mail from Bank of America director Charles K. Gifford to another member of the board.  In the heat of a conference call where Ken Lewis revealed to the Board the egregious terms of the government bailout, and the staggering – and heretofore undisclosed – tally of losses on Merrill’s books, Gifford fired off an email saying “Unfortunately, it’s screw the shareholders!!” 

Thomas May, his fellow director, wrote back, “No trail.” 

 

So much for discretion.  Sending that “No trail” e-mail is the equivalent of posting a giant sign in the boardroom that says REMEMBER TO SHRED ALL INCRIMINATING DOCUMENTS.  With idiots like this on their board of directors, should any of us wonder at the position BofA finds itself in?


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Bearish Buck Consensus?

We re-shorted the US Dollar via the UUP etf again yesterday. The most asked question in my inbox was “isn’t that consensus?”

 

I don’t mean to demean the question. At this stage of the Burning Buck game, it’s the only one to answer. At the same time, you have to ask yourself if asking about consensus, is consensus?

 

After making enough mistakes (with real ammo) trading markets, I have come to conclude that you can either be Bullish, Bearish, or Not Enough of one of those two things. When it comes to the Burning Buck, I shorted it’s strength yesterday because I don’t think the newly awakened US Dollar Bears are Bearish Enough.

 

To be truly Bearish Enough requires some reading beyond your latest tweet. You can listen to the Johnny-Come-Latelys on CNBC, who are now running segments with lead-ins like “When Nixon abandoned the Gold Standard in 1971” (sound familiar?) to truly appreciate that consensus still has no idea how to analyze this fundamentally.

 

Niall Ferguson at Harvard is who I would call Bearish Enough. He’s looking for a -20% drop in the price of the US Dollar (FROM HERE) in the next 6-12 months. That would put the US Dollar index at $60!

 

Required reading from Fergusson would be his book titled the Ascent of Money. This fantastic economic history read was all part of the studying we did to make this Burning Buck call 9 months ago, but that doesn’t matter anymore. What matters is the here and now. Now all that matters are my risk management levels. I have outlined them in the chart below. The US Dollar remains in what we call a Bearish Formation.

 

The Buck is Burning to lower-lows again today (down another -0.5% to $75.19). Alongside that, the SP500 is chasing to higher-highs.

 

Questions about consensus, can also be consensus…

KM

 

Keith R. McCullough
Chief Executive Officer

 

Bearish Buck Consensus? - BUCK

 


SKX: Smoke vs. Sustainability

Casey Flavin, one of the analysts on our Retail Team, has done what I think is exceptional work on Skechers. He knows this thing cold. He visited the company a few weeks back, modeled it six ways til Sunday, and has been hitting me hard on the bull case. He thinks that the company will smoke estimates this quarter (released after the close tonight), and that the consensus is low next year by as much as a buck (yes folks, that’s 100%).  Check out his note to me below.  The irony is that I think that he’s spot-on, but I still can’t bring myself to hop on the bandwagon. They may do $2.00 next year, but there’s no reason why they can’t revert to a buck the year after.

 

I guess my problem rests in that the crux of the upside here is in the product cycle and the success of Shape-Ups, one of the better products that SKX has nailed in recent years. What’s bugging me, however, is that I am not convinced that SKX has the infrastructure to sustain the current throughput. Consider the following…

 

  1. SKX has already delayed the distribution center that was to be put in place last year. They claim that they’re fine with existing capacity, but the new DC was planned for a reason – to facilitate growth and efficiency.
  2. SXK’ revenue per employee is – by a long-shot – head and shoulder above the group average. How does that happen? I have NEVER seen an employee base that is above average productivity where the company is overly invested in capacity to facilitate growth.
  3. As it relates to product cycles, SKX is heavily susceptible with knock-offs on this one. Heck, being the king of the knock off, SKX should kow about this better than anyone. We’re already seeing similar product priced at a 60% discount at retailers like Payless.

BM

 

 

SKX: Smoke vs. Sustainability - FootwearSG RevEmp 10 09

 

 

SKX: Smoke vs. Sustainability - SKX ShapeUp Comps

 

 

This time last year our call heading into Q3 was that margins would be cut in half due to a confluence of factors (see our 9/3/08 note “Misery Likes Company”) – as it turns out, SKX reported 4% operating margins in FY08 down from 8.1% in F07. So far in FY09 profitability has continued to slide. While many of the structural flaws of this story remain, several factors are starting to improve considerably such as Fx, product costs, and the company’s sales/inventory/margin triangulation, which has shifted from the worst place possible this time last year to one of the best in just three quarters. After visiting with management a few weeks ago, not only am I confident that the company is going to beat the quarter, but also that the incremental contribution from Shape-Ups will prove current Street estimates to be too low for next year.  

 

 

SKX: Smoke vs. Sustainability - SKX S 8 09

 

 

Let’s start with the quarter – anecdotally, two competitors have indicated strong 3Q results so far with DSW’s preannouncement last week (comps up 6%-8%) and SCVL’s commentary of 11% comps in August. With only 20-25% of revenues derived from owned retail this is positive albeit modestly for SKX’s top-line. Additionally, we are seeing improved trends in domestic wholesale. Based on our analysis of industry trend data, I expect Shape-Ups to contribute an incremental $10-$12mm, or ~5% in Q3 wholesale sales helping to offset low double-digit declines in backlog exiting the 2Q. All things considered we’re shaking out at a 7-8% yy decline in revenues on a consolidated basis.

 

The upside lies with gross margins. Based on our sourcing calculation (similar to PSS with 95%+ sourced from China), we expect a ~100bps improvement from lower product costs and another ~50bps from Fx and higher margin Shape-Ups combined. Despite a clean inventory position, we’re accounting for 50bps degradation from promotional activity and 100bps of net expansion in Q3. As for operating expenses, mid-single digit G&A savings will be offset by slightly higher Selling costs related to Shape-Up spend resulting in modest operating margin contraction of 25bps – a significant improvement to the 800bps+ seen over each of the last three quarters.

 

Consider the facts regarding Shape Ups:

 

Shape-Ups were first tested domestically in Dec/Jan in select owned stores and then in larger quantities in March-May before officially launching this past summer. By the end of Q3, Shape-Ups were in just over 10% of SKX’s 12,000-15,000 domestic doors and were already sold out in several distribution channels. The shoe recently entered Europe, which is 5-6 months behind the US, and testing has been met with even greater fanfare. Even at this early stage of demand for the product, domestic and international order interest is on pace for over 1mm pair/qtr combined (primarily domestic).

 

 

SKX: Smoke vs. Sustainability - SKX Shape Ups byMo 10 09

 

 

SKX’s most successful product to date was the Energy shoe from 1, which generated ~$200mm in revenues at its peak at an ASP of $20-$22/pair at wholesale. Five-years later, the company has a larger store base, more distribution channels, and a product with a ~$50/pair price tag at wholesale. As the company broadens distribution domestically into the athletic channel (~5% of distribution currently), within existing doors and internationally, demand for 8-10mm+ units/qtr is certainly feasible. The question then becomes one of allocation. Assuming a fulfillment rate of 20%-25%, we are modeling a sell-through of ~2.3mm pair, or $130mm in revenues from Shape-Ups next year.

 

While Shape-Ups are a nice incremental boost, the direction of the core business is key to top-line trajectory. After mid-teen declines in core domestic wholesale revenues and low double-digit declines in core international wholesale revenues in FY09, we are modeling core revenues down 2% and 4% in domestic and international revenues respectively in FY10. Offset by 4% growth in same store sales in retail and $130mm in Shape-Up related revenues, we expect sales growth of 7%-8% next year. In addition, we’re modeling 250bps of gross margin expansion due to lower product costs (100bps+), higher margin Shape-Up sales (100bps+), and a greater percentage of owned retail sales. Given the expectation of selling expense to outpace sales growth and leveraging of G&A, we expect the company to return to 5% operating margins and generate earnings 40% higher than consensus estimates in F10.

 

Let’s not forget about the ongoing DC transition plan that has been years in the making. The latest expectation is for a 3Q of F10 or 1Q of F11 start date. While said to be immediately accretive to earnings, the company will have to spend another $35-$40mm of capital in the 2H (assuming 3Q start) towards the installation of equipment, software, & programming, which will impact FCF. The current facility holds roughly 13-14mm pair of shoes and turns roughly 1mm pair/week so there should be no issue handling the incremental stress of a successful new line (I would be happy to provide interested subscribers with further details).

 

Casey Flavin

 

 

SKX: Smoke vs. Sustainability - SKX Dist 9 09

 

 

SKX: Smoke vs. Sustainability - Skechers 9 09 trends byCat

 

 

 


PENN 3Q09 CONFERENCE CALL

Penn missed the quarter and lowered guidance, but the market doesn't seem to care. Taking into account the lobbying costs, the miss, and the guide-down isn't enough to spook investors. All eyes are on the Fontainebleau deal update, particularly now that PENN isn't planning on going it alone and that prudence hasn't gone out the window

 

 

“The challenging economic environment, which has resulted in lower consumer spending at gaming facilities, continued to impact operating results for both the overall industry and Penn National in the third quarter, particularly during the month of August. Penn National’s reported third quarter results were below guidance..."


"We recognize that the issues in Las Vegas are extremely challenging, and are focused on attempting to develop a creative and strategic solution that would include bringing in an equity partner."

 

3Q09 CONFERENCE CALL

  • Continue to feel challenged with the softening of the consumer - increased saving levels and deleveraging
  • Visitation continues to be flat, but spend per visitor and time on device continues to be down year-over-year and quarter-over-quarter
  • Being appropriately aggressive at reducing costs to adjust to this new environment
  • More of the same of what they saw in 2Q.  August was the weakest month of 3Q, due to lower spend per visit

 

Q&A

  • Are they satisfied with the performance of Lawrenceburg (post expansion) thus far?
    • No they are not. Gaming revenues only grew 12%, turnstile count grew over 20% though.  Not getting growth in the VIP segment that they hoped for.  They are working on improving the non-gaming amenities, like adding more meeting space and replacing a "tired" restaurant with a new dining option. Hopefully those additional amenities will be ready in 6 to 9 months
  • Any change in the consumer in October, trend-wise?
    • No change to what they saw in 3Q
  • Fontainebleau, how are they thinking about the capex there, how much would they spend?
    • Very complicated bankruptcy, are carefully evaluating the opportunity.  Ultimately, the courts will decide what the best course is.  They think that there will be a fast resolution since the building needs to be secured and maintained. Those things are a cash drain now but the alternative is a rapidly depreciating asset

    • Value of the building (sunk cost) is almost nothing, given the cost left to complete it. They will not pay a lot for the current site

    • Would only approach this project with a strategic partner that can bring more to the table than just money

    • Capital markets have gotten better, but not good enough for a greenfield project in Vegas.  Maximum available financing for this project would $500 - $600MM

    • If they do the project they would put it in a separate entity

    • Need a positive outlook on future of Vegas to do this project, and think that "in time Vegas will be fine"
  • 4Q09 lobbing spend in Ohio?
    • Can't disclose for obvious reasons. They will disclose what they spend in 4Q09 on Nov 4th.
    • Obviously there is a decent # in their guidance for the lobbying effort, but we don't think that the entire lowering of guidance can be attributed to lobbying (I assume they knew they would be spending money on this last time they gave guidance, or not?)
  • $764.4MM of cash (roughly $60MM was restricted) at 3Q09, 1.695BN of bank debt, total debt of $2.282BN
  • Ohio outcomes?
    • Not sure when and if slots at racetracks will get on the ballot for a referendum vote
  • Not sure why the state of Indiana would give Indiana Downs table games, and if they did, it would negatively impact Lawrenceburg
  • Acqueduct?
    • Not sure on the timing, originally decision was supposed to be made by Labor Day
    • They have the most aggressive proposal in terms of up-front payment to the state and think they can open the quickest
  • They don't think that Maine is getting another casino, if they did it'll be in the western part of the state and should not impact them
  • Hurdle rate at Fontainebleau? Structure of a partner?
    • "We wouldn't go there if we didn't think the investment makes senses"
    • Partner would likely be 50/50
    • Would take them 6 months or so to redesign / finish the design of the property and lock down pricing to build out the property
    • Would "take our good old time" in deciding how to proceed
  • Change in 4Q09 guidance?
    • Fundamentals - trends in September/ October
    • Ohio referendum costs
  • Capex was $88.5MM
    • $63MM of project capex ($58 for Lawrenceburg & Empress)
    • $49MM project capex for 4Q09, $26MM for maintenance
  • Texas and bid for Lonestar?
    • Think that at some point TX will allow for expansion, who knows when... (big shot at PNK given their concentration there... you can write off Lake Charles then...and the Baton Rouge issue)
    • Lonestar's purchase can't really be justified on its standalone economics - it's really a bet on eventual gaming legalization
  • What happens if they win all of their bids in various jurisdictions? Which balls would they drop?
    • There are some obvious winners on their list
    • Las Vegas is the only "risk to capital project", "no downside" in the other projects
    • Partnerships are some of their answer in terms of being able to compete in so many jurisdictions
    • Very focused on where cost of capital is
    • Some opportunities are so good that they would issue equity but they are very far away from that scenario
    • They would definitely build both Ohio free standing casinos if they win on Nov 3rd
    • Would definitely expand in PA if they pass table games, unless its the House version that passes
    • Maryland will open and they are optimistic on Kansas
    • Wouldn't do a project that wasn't cash flow positive out of the box
    • Expect to earn a mid-high teens returns on their project and their thinking hasn't changed
  • Still two other pieces challenging VLT legislation in Ohio that would need to be resolved. However, there are legislative ways to get around the referendum. There is no indication that that is the way that they are headed
  • Timeline in Ohio?
    • Earliest that something can open is late 2012 (for the free standing casinos)... a la - PA
    • For the slots at racetracks, timing is less clear
  • Last year's corporate expense also included lobbying efforts
  • They feel good about their efforts in Jefferson county, WV regarding the benefit of table games .  Campaign is Dec 5th. Spend is modest
  • Bullwackers?
    • So insignificant that they don't think that it's worth committing capital suicide (a la ASCA?) to grow there
  • How much of their cost saves are sustainable in a recovery?
    • Think that 2/3rds is sustainable even when volumes come back
    • Most of it is labor - salary and staffing (not volume dependent)
  • Thoughts / interest in Las Vegas locals market
    • Will probably continue to be tough as construction jobs grind to a halt when City Center is completed, so employment market should continue to be tough
    • Too much capacity for the next few years
    • Longer term, as the Strip recovers, they think that things will get a lot better
    • No imminent opportunities there for PENN
  • Again... not seeing any improvement in consumer trends
  • Tables in WV & PA can be easily accommodated in the existing space 
    • Shell in WV is already built out so they would just need to fit out the interior
    • Can accommodate about 35 tables in PA but can expand if the legislation is favorable, hope to know late this year/early next year. The lower the tax the higher their investment


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