Pascal's Extremes

“Two extremes: to exclude reason, to admit reason only.”
Blaise Pascal was one of the most influential mathematicians of the 17th century. He is most commonly known for his contributions to mechanical calculators, but his work on the arithmetic of triangles still finds its way into our investment meetings here in New Haven.
Pascal’s Triangle is of interest to risk managers because it really provides a basis for measuring probabilities. Our Gaming guru, Todd Jordan, doesn’t come down to my office to play online poker, but Pascal’s conclusions were actually born out of his friend’s interests in gambling problems.
Pascal died at the age of 39, but left this world “in search of the truth.” This, unfortunately, had him go off the deep end of religion from time to time, but at the end of the day, I do respect his quest for making people accountable using Geometry. I can’t imagine today’s Washington/Wall Street listening to him any more than they do Paul Volcker. Stick the math guys in the corner and let the storytelling politicians suck the oxygen out of the room.
The science of mathematics isn’t trivial. Whether it’s a Pascal binomial coefficient or today’s dominating global macro inverse correlation embedded in the price action of the US Dollar, it’s all one and the same. Impossible to refute, after the fact.
Friday’s smack down close of the SP500 (down -2.8% on the day) came on another breakout to the upside of the US Dollar above my immediate term TRADE line of $76.20. Call it alchemy. We math guys just call it the math. REFLATION trades led the market lower (Financials -4.7%, Basic Materials -3.6%).
On the week, the Bombed Out Buck closed UP for the first week in the last four. For the week, the US Dollar was up +1.1%, and virtually everything priced in Dollars was down. On a week-over-week basis, here was the math associated with giving the Buck a Bid:

1.      SP500 -4%, Nasdaq -5.1%, Russell 2000 -6.3%

2.      CRB Commodities Index -3.6% (Oil -4.3%, Copper -2.6%, Gold -1.5%)

3.      Volatility (VIX) +38%!

Again, we know what happens when the US Dollar goes up. There is no need to be extreme about this in any way. Being too bullish when the Dollar is down can hurt you as much as being too bearish when the Dollar is up. We want to avoid being extreme Macro strategists right now. People who missed both the crash and the recovery are being plenty extreme enough. We simply want to watch the US Dollar and make risk management moves accordingly.
Some would argue that last week’s down move in the US stock market was extreme. The math supports that claim. It was the worst week for US equities since May. Others, who either “exclude reason” or “admit reason only”, will have you believe they timed this perfectly and have had this right all along.
Alan Abelson at Barron’s is  a fantastic writer, but his extreme bearishness is as predictable as the sun rising in the east. Right on time, he titled his weekend missive “Going to Extremes”, and went on to quote one of the Depressionistas, David Rosenberg, saying things like “if companies, both financial and non-financial are big believers in this new post-recession V-shaped recovery that seems to have the hedge funds and most strategists so excited… why are they still cutting back…”
These guys are funny. They think that they are the only analysts of this American Gong Show to “admit reason.” Sorry guys, Howard Penney and I haven’t been extreme about anything other than not shorting the lows and getting suspiciously quiet at the YTD highs. Reasonable analysts understand that these GDP prints are not going to be sustainable. Your opinions are much further from unique as your missing a +62% stock market move was.
Another extreme view was issued this past week by Bill Gross at PIMCO. I have learned a great deal from this great investing mind over the course of my career, not the least of which is that great players can be wrong. Gross wrote, “my sense is that nominal GDP must show realistic signs of stabilizing near 4% before the Fed would be willing to raise rates.” How convenient for Gross – he runs some of the world’s largest bond funds!
Extreme and self perpetuating views fuel the art of writing about and managing money. After all, the art of managing money Mr. Gross, is having money to manage, right? Since Rosie, Abelson, and I will all agree with your view on the un-sustainability this US economic recovery, should we keep rates for our citizenry at ZERO and create the last mother-load of a bubble in US Treasuries? I’m sure your asset management fees will perform well in that scenario.
I don’t want to be on the sell side or the buy side of extremes unless extreme circumstances call for it (September 2008). Those extremes are usually revealed by the math. It doesn’t have to be Pascal’s, but I’ll surely ask for his model’s mathematical outputs before I start asking for those of perceived Wall Street sages.
In terms of US equities, I have maintained my low exposure. US Equities has the lowest invested exposure in our Asset Allocation Model at 6%. I am long US Healthcare (XLV) and Utilities (XLV), and short the higher beta Consumer Discretionary etf (XLY). I have immediate term TRADE levels for the SP500 of 1031 and 1065, respectively.
Best of luck out there this week,



 EWZ – iShares Brazil
President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt –leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. Brazil is a major producer of commodities. We believe the country’s profile matches up well with our reflation call.

 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.

XLU – SPDR Utilities We bought low beta Utilities on discount (down 1%) on 10/20. TRADE and TREND bearish.

FXC – CurrencyShares Canadian Dollar We bought the Canadian Dollar on a big pullback on 10/20 and again on 10/28. The TREND and TAIL lines for the Canadian Dollar remain bullish.

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.

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.

XLY – SPDR Consumer Discretionary We shorted Howard Penney’s view on Consumer Discretionary stocks on 10/30. The sector is finally broken, from an immediate term TRADE perspective.

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.

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.

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.

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Today, RUTH reported that 3Q09 same-store sales growth declined 24%.  The chart below is just plain ugly, but I am not posting it to show just how abysmal the company’s trends are, but instead, to make a comment about the upscale segment of restaurants in general.  Management stated that it has held market share through the first nine months of the year relative to Malcolm Knapp’s upscale dining index.  A company cannot maintain share with year-to-date same-store sales down 22% unless that segment is at risk of going away.   If there is any truth to this statement, fine dining restaurants are in real danger. 


I do not quite understand why MRT traded up today following this news.  MRT is scheduled to report 3Q09 numbers next week.  The company’s 2Q09 same-store sales growth declined 26.1% so the company is in a similar position to RUTH from a demand standpoint.



Week Ahead

The Economic Data calendar for the week is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.  


Week Ahead - Final week ahead Nov 2



The Big 3 Same-Store Sales chart below does not tell the whole story.  It does show that Burger King has lost a considerable amount of market share over the last five quarters to McDonald’s and more recently, Wendy’s.  We all know now that Wendy’s 3Q08 value launch of its Double-Stack Cheeseburger, the Crispy Chicken Sandwich and the Junior Bacon Cheeseburger for $0.99 each helped the company to gain market share, largely from BKC.  But, that was a year ago and what matters now is where we go from here. 


Wendy’s same-store sales turned positive in September 2008 when it introduced these three $0.99 sandwiches to its menu so the company lapped these improved results in the last month of 3Q09 and YOY comparisons are even more difficult come 4Q09 (facing a +3.6% comparison).  The chart below includes our flat 3Q09 same-store sales estimate for Wendy’s.  Although the company stated that comparables sales growth was up 2% in July, I am expecting the quarterly number to come in below that as a result of the more difficult YOY comparison in September. 


BKC rolled out its $1 double cheeseburger nationally on October 19.  Although the company did not comment too much on how the product has performed in the last two weeks, management did say yesterday on its fiscal first quarter 2010 earnings call that the markets that supported the new product with media plans during the first quarter (about 25% of U.S. restaurants) generated traffic growth.  With the $1 double cheeseburger now in 100% of the U.S. restaurants, BKC could gain some traffic momentum if the test market results correctly reflect what this product can do on a national basis.  As for McDonald’s, we already know that October same-store sales are trending flat to negative.  As I always say, it is zero sum game so if Burger King begins to get traction with its $1 double cheeseburger, someone else will lose.  We could see a market share shift among the big 3 in the coming months.  I am not saying Burger King will move ahead of both McDonald’s and Wendy’s, but it could steal some marginal share. 


Burger King’s potential traffic gains will not come without expense, however.  Management stated yesterday that in the markets that had already rolled out the $1 double cheeseburger, the company experienced both traffic growth and profit dollar growth, but lower YOY gross margin.  Specifically, management stated, “margins in the tests were impacted somewhere around 100 to 150 basis points, but GP dollars obviously were up. As we said, what we've seen so far continues to mirror what we saw in the test.”


BKC’s consolidated restaurant margins improved nearly 50 bps during the first quarter while EBIT margins declined.  In the first quarter, company restaurant margins in the U.S. and Canada benefited from a 210 basis point improvement in food, paper and product costs and the non-recurrence of startup charges related to the acquisition of 72 restaurants in the prior year.  I would expect margins to be under increased pressure in the second quarter with restaurant margins turning negative as well.  The company is not only lapping a more difficult restaurant-level margin comparison but the higher mix of sales coming from the $1 double cheeseburger and other value items in the quarter will likely offset the expected YOY commodity cost favorability in the U.S. and Canada. 


There are a lot of moving parts on a YOY basis relative to margins and a lot will depend on just how much the increased traffic from the value menu items hurts average check and margins.  Commodity costs in the U.S. and Canada should continue to be favorable in 2Q but become less favorable on a YOY basis in 2H10. 


Restaurant margins outside the U.S. and Canada were a drag on consolidated results in the first quarter from higher commodity costs and the negative impact of currency translation on cross-border purchases in the UK and Mexico.  Currency translation should turn positive in the second quarter and is expected to have a positive impact on earnings on a full-year basis. 


From an operating margin standpoint, higher than expected SG&A expenses in the first quarter (+8.6% YOY) hurt results, but the company is forecasting that it will still only be up about 3% for the full year so this pressure should moderate in the coming quarters.  D&A, on the other hand, was down 2% in the first quarter and is expected to be up 10%-15% for the full year. 


So there are a lot of positive and negative offsets coming in 2Q relative to 1Q, but as I said earlier, I am expecting margins to decline in the current quarter.  We could see Burger King gain some top-line momentum and in this environment, getting people in the restaurant seems to matter most to investor sentiment and stock price performance.




BKC - DON'T COUNT THEM OUT! - BKC Company Rest Margins

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