November 10, 2009


We’ve seen a bifurcation is sentiment within retail. Given the current set-up, we’ve got to particularly weigh earnings catalysts vs. incremental changes in expectations. It matters now more than ever.




In our virtual portfolio we went to 69% cash this morning, and took US and Int’l equities down to only 3% each as a percent of the portfolio. As it relates to retail, two things are front and center for me – 1) catalysts and 2) sentiment. Let’s take a look at the latter.


Our analysis below triangulates short interest as a percent of float (Y Axis) with our Sell-Side Sentiment factor rating. We’ve definitely seen movement here in the past few weeks.


Call Outs:

  1. This market hates, hates, hates, LIZ, UA, SKS, CAB, ETH, GAP and SHLD. These are names where both the buy side and sell side are overwhelmingly negative.  Others to keep an eye on: DDS, BONT (flashed green on stock screen frequently), COLM and OSTK. HIBB is worth noting as well – though sell side is positive, the buy-side is polar opposite.
  2. On the flip side, there’s no shortage of names where there’s a buy/sell-side love fest love fest. Those include GIL, COH, AMZN, GCO, DLTR, KSS, TGT, WMT, CVS, TJX, KR, and VFC.  If you’re long these names and can’t find a positive earnings catalyst – you might be in the wrong place.





Some Notable Call Outs


  • Hidden in Crocs’ recently filed 10-Q was the disclosure of a lawsuit filed against the company by Porsche. The lawsuit essentially alleges misuse of the “Cayman” name, which in this case is used for both the iconic Crocs clog and the mid-level sports car. While I’m not a lawyer or legal expert, it is hard to believe Porsche really thinks consumers are confusing the luxury car with the rubber shoe. After all, wasn’t Cayman a tropical place even before either of these products existed?


  • According to the eholiday study, four out of five e-commerce sites will offer free shipping this holiday season, however many offers will have “strings attached”. In other words, minimum order size, quantity of items purchased, or date restrictions will likely determine “free” eligibility. Approximately 57% of sites are expected to offer straightforward free shipping with no stipulations.


  • In one of the more head-scratching licensing deals we’ve seen in a while, Jamba Juice (yes, think smoothies) struck a deal to develop a line of branded apparel. The t-shirts, sweatshirts, headwear, and totebag are slated to be sold in mass, specialty, and upscale retailers. There’s nothing like developing an apparel line in an effort to sell more smoothies. It would be one thing if the actual Jamba stores were selling some logo apparel, but targeting other retailers seems like a lofty goal.





Firms Loaded With Cash in Position to Diversify - As weaker fashion companies scramble to keep goods flowing and the bankers at bay, the powerhouses that managed to sock away money during the credit crunch might just start putting their extra millions to work. Options include new lines of business, IT makeovers, store refurbishments and even acquisitions. You may still see some companies starting to wade back out there and start to spend some money. Still, the world hasn’t stopped. Retail stocks hit a 52-week high on Monday. The stockpiles make these firms, and a few others, doubly dangerous. Not only do they have the underlying businesses that produced that cash, but the funds also now give them the flexibility to adapt and take advantage of the shifting retail and fashion landscape. <>


Talbots Said to Seek to Refinance Debt, Hire Perella as Adviser - Talbots Inc., the U.S. women’s clothing chain, hired an adviser to help it refinance about $225 million in debt, according to two people familiar with the situation. Talbots hired Perella Weinberg Partners LP, according to the people, who declined to be identified because the decision hasn’t been made public. The chain, based in Hingham, Massachusetts, has posted losses for the past five quarters. Chief Executive Officer Trudy Sullivan has made three rounds of job cuts since 2008, with the company saying in June it would eliminate 20 percent of its corporate positions. Talbots posted a loss of $24.5 million in the quarter ended Aug. 1. <>


Apparel Importers Pressure Suppliers as Sales Lag - Apparel importers are looking to their suppliers to provide greater value and efficiency as they confront a challenging holiday season and an anticipated slow rebound in consumer spending. During last week’s annual Textile & Apparel Importers Trade & Transportation Conference in New York, speakers at all levels of the supply chain indicated that most of them were treading water as they awaited a significant change in the consumer psyche. At the same time, brands, retailers, suppliers and logistics providers were aware that the depressed business environment could drag them under before that moment arrives. “This recession has taught us one thing — consumers are consuming less and saving more,” said Janet Fox, director of sourcing at J.C. Penney Co. Inc. and chairman of the U.S. Association of Importers of Textiles & Apparel. <>


China Targeted in Antidumping Measures - Three emerging economies — Argentina, Brazil and Turkey — launched the largest number of antidumping investigations on textile imports in the 12 months through June, with shipments originating in China the most heavily targeted, a new World Trade Organization report said. Out of 28 new cases, Argentina and Brazil initiated seven antidumping actions each, Turkey had five, and India and Indonesia each had three. Argentina launched investigations on imports of Chinese fibers and yarns, denim and plain weave fabric, and separate cases against imports of fibers and yarns from India, Indonesia and Taiwan, and shipments of plain weave fabric from Brazil. Under global trade norms, dumping occurs when an exporter sells goods abroad at a lower price than they trade for in the home country or at below cost. <>


IT Holding Restructuring Under Review - The special commissioners for IT Holding SpA, which has been in government-backed bankruptcy protection since February, submitted their restructuring plan for approval on Monday to Italy’s minister of economic development. A company spokesman said an abstract of the report, which is expected to recommend a breakup of the group, would be made public in the next few days, but was unable to confirm when a decision could be expected from Minister Claudio Scajola. Commissioners Andrea Ciccoli, Stanislao Chimenti and Roberto Spada invited letters of intent at the end of September to identify possible buyers for some or all of IT Holding’s assets. Ciccoli told WWD in October the plan may or may not include recommendations to break up the fashion group, although experts believe a sale is likely. <>


Wilkes Bashford Files Voluntary Chapter 11 - Wilkes Bashford, the San Francisco-based men's wear institution, has filed a voluntary Chapter 11 petition. As part of the agreement, Bashford has reached an agreement with the Mitchell family of Westport, Conn., to acquire the assets of the business. The deal is subject to an auction process and approval of the bankruptcy court. In a statement late Monday, Wilkes Bashford, chairman, said, "During this period, it will be business as usual. Customers will continue to be served by our world class associates and we will continue to provide our customers with their favorite fashions." <>


US: CPSC to vote on product safety recommendations -The US Consumer Product Safety Commission (CPSC) will vote on recommendations proposed by Intertek and the American Apparel and Footwear Association (AAFA) regarding testing of children's goods including apparel. The CPSC's approval of their guidance document on Consumer Product Safety Improvement Act testing and certification procedures would codify Intertek and AAFA's recommendations as formal agency policy. The industry foresees that successful adoption of the policies would "save manufacturers millions while improving reliability of product testing". <>


Hong Kong: Q3 domestics exports fall sharply - Hong Kong recorded sharp falls in the value of its domestics exports in Q3, according to the Census and Statistics Department of the Hong Kong Special Administrative Region, with the apparel industry suffering most. The value of garment exports falling 84.7% year on year to 1.1 billion HK dollars (US$141 million). The basic metals industry trailed with a fall of 49.1%, followed by the paper and paper products, and printing and reproduction of recorded media industry. The chemicals and chemical products industry was also one of the biggest losers. The computer, electronic and optical products industry saw a fall of 8.8% in the value of domestics exports. The above five industries together accounted for 60% of Hong Kong's total domestics exports, or the exports of goods produced or manufactured in Hong Kong. <>


Forever 21 Founders to Give Deposition - The founders of Forever 21 will be deposed in a copyright lawsuit filed by Express, a Los Angeles judge ruled. Express charged in a lawsuit filed in California’s Central District Court in June that Los Angeles-based Forever 21 copied four of its copyrighted plaid patterns for men’s shorts that were introduced in its stores in December 2007, and also alleged trade dress infringement for a zippered jacket the retailer introduced last December. A trial is set to begin in September. <>


Retail Stocks Reach 52-Week High Monday - Retail stocks hit a new 52-week high Monday, rising 2 percent as global markets rallied after the finance ministers and central bankers of the G-20 said they would continue to support the economy until the recovery finds its footing. The S&P Retail Index retook the 400 mark, advancing 7.74 points to close at 403.08, near its high for the day. <>


'Middle-class shoplifters' in record crime wave - Levels of shoplifting hit a record high over the past year as the ‘middle-class shoplifter’ turned to crime to fund a high standard of living in the recession.

Shop theft in the UK soared nearly 20% during the past 12 months, costing retailers a record £4.88bn – a £750m increase on last year. According to the 2009 Retail Global Theft Barometer, the UK tops the retail crime league table in Europe. Clothing and accessories experienced one of the steepest increases, rising 8.8%, with branded and designer clothing, football shirts, lingerie and leather goods proving particularly popular among shoplifters. <>


Goodman Joining Sears as Chief of Apparel and Home - John Goodman, the well-traveled retailer who was most recently chief executive officer of Charlotte Russe Holding Corp. in the months leading up to its acquisition by Advent International Corp., has rejoined Sears Holdings Corp. as executive vice president of apparel and home, a new post. He will also serve as interim president of Kmart Apparel until a permanent officer is named to that post. Sears said Goodman will be based in San Francisco and establish an office there for the company along the lines of the design office set up in Manhattan three years ago. He reports to Bruce Johnson, interim president and ceo of Sears. <>


Google pays $750 million for a mobile ad technology company - Google Inc. has agreed to acquire AdMob, a mobile display ad technology provider and ad marketplace, for $750 million in stock. This acquisition will enhance Google’s existing expertise and technology in mobile advertising, while also giving advertisers and publishers more choice in this growing new area, Google says. <>


ARO announced its plans to donate 100,000 brand new winter coats to homeless teens this holiday season - The donation is the culmination of Aeropostale's year long initiative to improve the lives of the growing number of homeless teens throughout the United States and Canada. During the month of November, Aeropostale will be delivering these coats to over 130 shelters and homeless agencies in all 50 states and Canada. Aeropostale designed these 100,000 coats exclusively for this outreach program; they will not be available in its stores or online. <>






  • Michelle Wilson, SVP, sold 9,600 shares in a 10b5-1 trading plan transaction for a gain of $1.15mm.
  • Tom Alberg, Director, sold 1,700 shares is a 10b5-1 trading plan transaction for a gain of $204k.


RL: Jakcwyn Nemerov, EVP, sold 10,500 shares for a gain of $840k.


FDO: Charles Gibson, EVP, sold 10,500 shares after exercising options to buy 10,500 shares for a net gain of $92k.


BGFV: Steven Miller, President & CEO, sold 5,000 shares for a gain of $89k.


TUES: Madison Dearborn Partners, 10% Owner, sold 20,000 shares for a gain of $65k.


ICON: Yehuda Shmidman, EVP-Operations, sold 3,300 shares for a gain of $34k.




As we often say at Research Edge, prices don’t lie. The market is always telling us something. Here are some names that are showing outside movements relative to the market, peers, and volume trends...


  • Consumer electronics was the best performing group with large volume driven by gains from RSH (which was upgraded yesterday – probably the right call).
  • Leisure equipment and products and apparel, accessories, and luxury goods outperformed yesterday on positive volume – a reversal of a weakening volume trend. RL, LIZ, JNY, OXM, PERY, and COH led the apparel, accessories, and luxury goods sector while only KCP, DLA, and APP took losses yesterday.
  • Internet and catalog retail was the worst performing sector with only a 0.2% gain for the day on light volume. LINT.A, LQDT, DSC, BIDZ, and PAYD helped internet and catalog underperform.
  • Outperforming stocks yesterday included ZLC, RSH, CHRS, and BKS. BKS is a big callout because it has had one of the largest turnarounds of any consumer discretionary stocks. Looking at the longer trends, this stock marked a bottom about 2 weeks ago off of longer broken durations and has been gaining momentum on the 1 week and 1 day with volume to confirm it all. ANF gets a positive callout for making the list of top 9 retail stocks for the first time in ages.
  • GOLF, CROX, ZUMZ, PSUN, and BIDZ were the worst performing stocks yesterday. CROX is breaking down on all durations but volume is weak.





Almost Perfect Parachutes

“Just because nobody complains doesn’t mean all parachutes are perfect.”
-Benny Hill
The Benny Hill Show was British comedy that featured sped-up film. Some nights, when I fast forward the Kudlow Report, I feel like I’m with Benny Hill in the 80’s all over again. Many thanks to Michelle Caruso-Cabrera for providing last night’s entertainment. Her currency analysis is definitely in a league of its own.
Benny Hill’s sketch-comedies usually closed with a chase scene where Hill would run after scantily-clad women. Ironically enough, after proposing to three different women in his real life, Benny never married.
Do you want to get married to the US stock market at yesterday’s closing high? I don’t. I took my cash position up to 67%. That’s the highest Asset Allocation I have had to Cash since the end of July 1st, 2009.
These Golden Parachutes of 2009 Wall Street compensation ($30 Billion in bonuses to the Big 3 Bankers – JP Morgan, Morgan Stanley, and Goldman) are almost perfect for the Too Big Not To Pay. Almost. Fortunately, almost isn’t good enough for the risk manager in me.
Per our friends at Wikipedia, the term Golden Parachute “is used to describe the effort to pay off someone in power… Originally, the term was used to describe bail-out packages given to dictators”...
Just because no one with political power in Washington complains about the Burning Buck moving into crisis mode doesn’t mean this perceived parachute of DOWN dollar is going to reflate your hard-earned life right before you have to comply with the laws of gravity. I am not in the business of trusting these politicians to pull the rip cord for my family either.
Yesterday, you saw the biggest one-day down move in the US Dollar since July. Was that the YTD low? What if it was? What if it wasn’t?
1.      If it was, the US stock market has a very stiff wind ahead of herself into year end.

2.      If it wasn’t, the US stock market only has one precedent of lower prices from here – the 2008 crash.

So that’s why I am selling down my exposure to virtually everything. At a price, Dollar down will start to hurt as much as Dollar up can. How bad can it hurt? I have no idea – and I’m not about to “take a chance again”, as Timmy Geithner is suggesting we should, either!
Yesterday was the 6th consecutive day of gains for the SP500. Since its March low, the SP500 has ripped the rails off of the Great Depressionista tracks for a +61.7% REFLATION. Benny Hill couldn’t speed this comedy up any faster than it’s played out. This has been the most expedited and hated rally in US stock market history.
As I was selling my long position in Germany (EWG) yesterday and pairing back my position in TIP (inflation protection), I was second guessing myself. I always do. But I woke up this morning and peeped my hockey head into my son’s room, and then walked down the stairs smiling. Selling early is cool.
One of my favorite investment quotes is from Bernard Baruch: “I made my money by selling too soon.” I think it’s a favorite because, philosophically, it stands for preservation of capital. I have never used leverage in my career. That has never made my returns the highest. But I have never lost money in a down market year either (2000, 2001, 2002, 2008).
When I first started this firm, I tried being everyone’s everything. That’s not me. My name is Keith McCullough, and I sell too early.
There are a few ways that I express a more conservative investment stance:
1.      Asset Allocation to cash – that’s climbed steadily for the past 6 days

2.      Virtual Portfolio – my ratio of longs to shorts has dropped from 3:1, to 1.2:1.0 (19 longs versus 16 shorts)

My investment model is to show everything I do, real-time, and mark it to market. If I am wrong (which I have been for the past 3 days on some shorts), all of our subscribers see that. There is no Level 3 drawer or a “side-pocket” in this thing.
I use a multi-factor global risk management model to augment my decision making. It’s not always right – but when it comes to losing money, it’s rarely really wrong. Here are some of the domestic market factors that have started to flash amber lights in the last few weeks:
1.      Daily risk/reward ratios for the SP500 have moved to a range of -3.5%-5% (downside) versus +0.5-1% (upside)

2.      Volume studies have collapsed as prices have risen (yesterday’s volume was down -17% versus last Monday’s market down day)

3.      Financials and Small Caps (leading indicators for liquidity risk) have broken their immediate term TRADE lines

Globally, we have recently seen markets like South Korea and Japan break both immediate and intermediate term lines of TRADE and TREND support. Despite China closing up for the 8th day in row last night (+74% for 2009 to-date), the Indian stock market remains under pressure (closing down again last night) as the government moves to quell domestic inflation (removing stimulus and raising rates).
The Golden Parachute of global free moneys isn’t a perpetual ride. It’s definitely not one that I need to be sped-up through, Benny Hill style, to the alter today. Getting married to stocks is for those Burning Buck sky-divers who are much braver than I. Gravity kills returns.
Best of luck out there today,



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 on 10/20. TRADE and TREND bullish.

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.   

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.

EWY – iShares South Korea South Korea has joined Japan in the ominous position of broken TREND and TRADE. This is not China or Taiwan. This is an early cycle economy that we want to be short against China/Taiwan.

XLI – SPDR Industrials We shorted Industrials again on 11/9 on the up move as the US market made a lower-high.  This is the best way for us to be short the hope of a V-shaped recovery.   

EWU – iShares UK Despite areas of improvement, broader fundamentals remain shaky in the UK: government debt continues to expand, leadership in critical positions lacks, and the country’s leverage to the banking sector remains glaringly negative. Q3 saw its GDP contract by -0.4%. Further bank stimulus and the BOE’s increase in its bond purchasing program suggest that this will not end well.

XLY – SPDR Consumer Discretionary We shorted Howard Penney’s view on Consumer Discretionary stocks on 10/30. TRADE and TREND bullish.  

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. There continues to be 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.


The Macau Metro Monitor.  November 10th, 2009



Sands China is seeking to raise as much as HK$25.96 billion from Hong Kong’s second-largest stock market listing this year behind China Minsheng Banking Corp’s planned share sale.  The Macau company said it had secured commitments from lenders for US$1.45 billion of the US$1.75 billion being sought in new debt financing, according to a pre-listing document posted yesterday.


Sands China plans to use the new project financing loans to complete Lots 5&6.  Commentators are unsure that the market will support the 16.5x 2010E EBITDA multiple being sought for the shares.




Macau may be forced to ration drinking water as reservoirs run dry.  There are signs that non-essential supplies may be cut off as early as this weekend.  Some suggest that Macau only has ten days of fresh water left.  Macau’s usual water sources have been depleted by drought and, unless a deal is struck with water companies in Guangdong province, rationing could come into effect. 


Hong Kong struck a deal with Guangdong province last year that would guarantee water supplies.  Macau’s government may seek to strike a similar deal to protect its main revenue source from the impact of the drought. 

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The positive momentum should continue



Great Canadian is reporting Thursday after the close.  Barring abnormal hold issues, we think they should beat consensus.  The Street projects a sequential uptick in revenues to $97.8MM but margins down 100bps, and therefore flat EBITDA at $30.4MM.  We have 3Q09 revenues at $99.5MM and EBITDA at just over $33MM.


Local Government Share of GC's BC property revenues increased 6% sequentially for the three month period ended Sept 30, 2009.  The local share of government revenue is usually a good directional indicator for GC's results.  The completion of two projects and the opening of the Canada Line should have a positive impact on the next few quarters.  Unlike other expansion projects, View Royal and Georgian Downs were truly "capacity constrained" properties and therefore we believe that the additional slots should produce healthy ROI's.


We expect GC to continue to have positive momentum going into the 2010 Olympics, although, like everything else, GC isn't quite as cheap as when we initially turned positive on it back on 4/5/09 in our "GC: GOOD CANADIAN GAMING" post. 





Construction/renovation commentary:

  • The completion of River Rock’s redevelopment project and the associated opening of the Canada Line will obviously assist that property.  However, in an effort to combat the slot play pressure, we are also making modifications to the gaming experience at not only these facilities but all our British Columbia casinos.
  • A more significant refresh of our gaming option is currently taking place at every one of our BC casinos.  I anticipate that this refresh, which will involve both machine replacements and conversion, will be immediately appreciated by our more frequent patrons.
  • We expect that View Royal on Vancouver Island will add 120 new slot machines on August 18th
  • We expect Georgian Downs in Ontario will add 400 machines on August 26th.  Despite that province being especially hard hit by a weakened economy, Georgian Downs’ gaming volumes have remained resilient, underscoring our belief that its market is crucially underserved.
  • Canada Line will commence operation on Monday of next week, August 17th.  By the end of September, we expect to finish construction on the associated parkade.  And in November, we expect River Rock’s own renovations, as well as the walkway connecting the facility to the station, to reach completion.
  • We’re not going to make decisions to bring things [deferred projects] back until we see very definitively that people are coming and that the existing expenditures are utilized to their maximum. And only when we’re busting at the seams and it’s absolutely clear that additional CAPEX needs to be spent, that’s when we’ll bring them back.



  • Go-forward would expect a [EBITDA] margin of around 32 percent? 
    • Yes, that’s what we’re thinking.  We do believe the vast majority of these cost reductions are sustainable going forward and, you know, barring that things don’t get worse
  • Can just comment quickly on...what the [3Q] quarter so far looks like in terms of traffic and gaming dollars, if there’s been any improvement?  
    • It has not gotten worse, that’s for sure
  • On View Royal can you give us an idea of what the incremental costs might be for that additional gaming capacity?
    • Minimal



  • Average spend is, again, the most significant thing that’s affected us, the first thing that we noticed and that continued on.  Visitation levels have softened a little bit but not significantly.  The biggest part is average spend.


MCD is so competitive at breakfast it’s tough to imagine that a typical McDonald's store can support more customers during that day-part (you can only get so many people through a drive-thru).  The major QSR competitors don't have a competitive breakfast offering and those competitors who serve breakfast don't have a drive-thru that's competitive.


It looks increasingly like MCD will be rolling out a nationwide $1 menu at breakfast.  The first test market for the new $1 menu was Chicago. 


Today, Dunkin' Donuts is debuting a new 99-cent menu at 500 Chicago locations and handing out 20,000 cards pre-loaded with $2 each. 

The 99-cent menu includes a sausage, egg and cheese wrap; bacon, egg and cheese wrap; egg and cheese wrap; raspberry Danish; hash browns; and a pack of five Munchkins.  As part of its 99-cent menu, Dunkin' is offering a new wrap -- a sausage version -- available only in Chicago. 

According to the company, the 99-cent menu at Dunkin' will only last through Dec. 26, but the reality is that it will be a permanent fixture on the menu.


Extreme discounting is now moving to the most profitable part of the day.

Slouching Towards Wall Street… Notes for the Week Ending Friday, November 6, 2009

The Efficient Regulator Hypothesis – The SEC Beats The Index Funds


He Hate Me – Mary Schapiro And The Extreme Regulatory League




Brush Up Your Shakespeare – The Efficient Shylock Hypothesis



Value Proposition


It’s been a busy week for SEC Enforcement Chief Robert Khuzami.


It started when the CEO and the former Chief Compliance Officer of Value Line agreed to a settlement that will cost them $45 million and see them barred from the industry and from holding executive positions in public companies (4 November, SEC release 2009-234, “SEC Sues Value Line Inc. And Two Senior Officers For $24 Million Fraudulent Scheme”).


The SEC Order covers activity spanning the period from 1986 through 2004, during which time Value Line, as adviser to the Value Line Funds, ran a self-dealing bonanza called the “commission recapture program.” 


“Value Line arranged for one of three unaffiliated brokers to execute, clear and settle the Funds’ trades at a discounted commission rate of $.02 to $.01 per share.  Instead of passing this discount on to the funds, Value Line had the unaffiliated brokers bill the funds $.0488 per share and then ‘rebate’ $.0288 to $.0388 per share to VLS.”  This arrangement resulted in VLS receiving “over $24 million in bogus brokerage commissions.”  Please note that the scammers were paid substantially more than the brokers who facilitated these transactions.  A penny here, a penny there...


Here’s why we particularly like this outcome.  It shows Khuzami as a thorough and serious practitioner in the public sector, winning big settlements that actually make a difference.


Here’s why we don’t like this outcome.  Who on earth was responsible for auditing Value Line for the past 23 years?


The alleged activity started in 1986 and ran for eighteen years.  It did not take the SEC two decades to build its case.  Is there another allegation of massive SEC failure lurking beneath the surface?  Judge Rakoff (of whom more below) did well to reject the SEC’s rush to settle the B of A case.  We would be well served to see his insistence on full transparency applied across the board.  Indeed, it may be unavoidable.  We get the sinking feeling that the SEC has done nothing since the days of Arthur Levitt.  In Wall Street’s Monkey Years, that’s a long, long time.




Somebody Up There Hates Me


Does Mary Schapiro stare in the mirror each morning troubled by the thought that God might be out to get her?  It seems nothing short of divine orneriness that the first massive Enforcement case brought on her watch should be assigned to none other than Judge Jed Rakoff, who has already shown the Commission the back of his learned hand in the Bank of America settlement.


Here’s our theory on the BofA settlement: We give Schapiro credit for brilliant political maneuvering.  Realizing she could never force full clarity through the layers of political protections built up around Ken Lewis, Schapiro rushed through a clearly flawed settlement.  Knowing that Judge Rakoff would reject it, Schapiro stage-managed the political coup of the year by getting clarity forced upon the case, while continuing the tough political balancing act that brought her to this high position.  Fantasy, you ask?  Chairman Schapiro has been around a long time.  We wouldn’t put it past her.


Now, however, the stakes are significantly higher, and Chairman Schapiro may not be in a position to finesse this one.


There was much sound and fury at Friday’s press conference, with assurances of more arrests to come, and a highly articulate Enforcement Director Khuzami telling the world in no uncertain terms that the Bad Guys are on notice.


We think Khuzami is not the kind of Enforcement official to go off half-cocked.  Our immediate take on the Rajaratnam arrest was that Khuzami is too good to go public with anything less than a slam-dunk case.  The SEC, its credibility already shredded beyond repair, can’t risk a billionaire perp walk unless it’s a dead cert.


But as the saying goes, Man proposes, and God disposes.  And in the judicial lottery, God disposed the case that could make or break the future of America’s regulatory system into the hands of a judge who has a very noisy bee in his judicial bonnet over the SEC’s disregard for its own highest brief, which is to ensure the integrity of the marketplace.


In America, plaintiffs get two bites at the apple.  The ability of injured parties to bring both criminal and civil cases is an odd legal structure, not standard in the rest of the world.  It played well with OJ Simpson, who was not convicted in the criminal trial but was found against for substantial damages in the civil trial.  The higher standard of Reasonable Doubt in a criminal case is designed to protect against prosecutorial abuse, while the broader Preponderance of Evidence applied in civil cases protects the interests of the injured by bringing the jury’s decision down to common sense.


Enter the SEC, which has a mandate to keep the markets clean – in other words, to rout out criminal activity – but does not have the ability to bring criminal prosecutions.  Typically, the SEC teams up with the US Attorney’s office to run cases which are filed together, but prosecuted separately.  The criminal case generally precedes the civil case, for a number of reasons.


First, if a criminal conviction is won, or a plea bargain struck, that takes the bad guys out of circulation with immediate effect, and saves time and taxpayer dollars.


But there are tactical reasons for bringing the criminal case first, not the least of which is the extensive discovery process in a civil case, which enables the accused to see every shred of evidence that will be used against them, and gives defense counsel time to prepare.


One of the uglier outcomes of the SEC two-step occurs when the government loses the criminal case, and the Commission starts all over again with a civil case.  This is tremendously disruptive to the lives of the defendants who, having gone through months of grueling hearings where they spent millions of dollars on representation, now must start from scratch with a different standard of proof.  In addition, in order to fully prepare their case, the SEC often does not even bring the civil suit until many months after the criminal case is closed.  Defendants often have to cool their heels for a year in between winning in criminal court, and being dragged into civil court.


As far as batting average goes, the SEC is about a .500 player when it comes to insider trading.  This means it wins half the cases it brings.  It also means it loses half of them.  If we were looking for a lawyer to represent us, we would not settle for someone who lost half the time.  Why should the taxpayers have to finance this kind of performance?  And isn’t the most important marketplace in the world entitled to better? 


We think Congress must create clearer standards for insider trading, and give the SEC more resources to attack specific cases.  It is political cowardice to saddle a regulatory agency with a messy, unclear set of standards, then excoriate them for not winning more convictions – but then, cowardice is the bread and butter of politics.


We do not go so far as some who say that insider trading is a positive process, because it gets more information into the system.  We can’t take that position seriously – and we find it troubling that editorials masquerading as reportage have found their way into the pages of the mainstream press suggesting that insider trading is good for the markets. 


As just one example, the Wall Street Journal ran a piece in their weekend section (24 October, “Learning To Love Insider Trading”) that claims insider trading makes markets more efficient by getting the information into the price of the stocks in question.  This is linguistic legerdemain.  “Efficient” markets do not mean “better” markets, or “fairer” markets.  Rather, the Efficient Market Hypothesis posits that all available information is reflected in the price of a stock at any given moment.  But note that all information being “reflected” does not mean the stock in question is trading at the “right” price, but only at the price that all current buyers and sellers agree to.  At best, in market efficiency, the “real” price comes out eventually, but it can be a long-drawn process, which is why Market Efficiency looks best when paired with that other academic standard, Buy And Hold.


There has been a flurry of articles lately on the Efficient Market Hypothesis as a culprit creating the conditions precedent for the latest market meltdown.  It is true that the institution of the MBA and the PhD economist lend a patina of academic credibility to the business of buying and selling pieces of paper using other people’s money.  But it is a substantial reach from an academic paper by a Chicago PhD to the series of miscalculations, mistakes of fact, negligence in oversight, and occasional outright lies that connect a busted mortgage on a single-family home in Western Pennsylvania to the 40% decline in your 401K.


Market efficiency, then, does not guarantee fairness.  That is the job of our lawmakers and regulators.  Our market model is based on a guarantee of equal access.  If all available information is embedded in a stock’s price, then it is the job of the individual investor or analyst to tease it out and determine whether the stock is priced correctly.  Those who are better at understanding information will profit.  Those who use information not available to the rest of the marketplace violate a fundamental principle of the system.  The American capitalist model is predicated on fairness, and we believe we have the right to demand that of the System and its participants, as well as of the theoreticians who support that system. 


American capitalism, predicated on guaranteed opportunity, abhors the notion of guaranteed outcome.  Information that finds its way unnoticed into a stock’s price will yield a superior outcome – in the form of financial reward – for those able to identify it first.  In this form, the efficient market is like a vast field where we know there is a buried treasure.  If we all dig, someone will find it.  All who come with shovel in hand are willing to accept the risk that someone else may find the treasure.  Everyone has an equal chance of being disappointed.


Misappropriating corporate information is stealing the treasure before the official start of digging season.  We do not agree that insider trading adds to even a hypothetical form of Market Efficiency, as the information does not immediately enter the price of the stock.  It is not available to any normal means of accessing market information.


Those who argue that corporate information belongs to the corporation, that corporations should be permitted to define the parameters of treatment of such information, fail to take into account the fundamental point that market information belongs not to the company or its agents, but to the marketplace.  We should be leery of making intellectually feeble leaps such as tying the SEC’s defeat in the Mark Cuban case to the allegations surrounding Octopussy and his ring of informants.  Insider trading, of the type alleged in the current case, is not Fraud on Google, or Fraud on Intel.  It is Fraud on the Markets.


The integrity of our marketplace rests on disclosure.  The economics of the marketplace stipulate that a public company is worth more than a private company because of public availability of information.  We are all in favor of smart people outsmarting less smart people, whether in the form of algorithmic statistical arbitrage, high-frequency trading, or developing proprietary models to project earnings more accurately than the competition.  But it is dangerous to allow the misappropriating of information to be sold to the public as a Greater Good.  It is not.


We understand that the US Attorney’s office and the SEC had not yet fully coordinated their information, when they learned that Rajaratnam was planning to leave the country.  Fearing he had gotten wind of the pending indictment and was about to vanish, they nabbed him and perp-marched him out to the full complement of news media and TV cameras.


Playing their part in the legal minuet, the SEC filed their formal complaint along with the US Attorney.  In it, they referenced wiretap records which, because of the haste triggered by Rajaratnam’s arrest, they had not yet seen.  Figuring they would run the standard give-and-go, the SEC assumed the US Attorney would start with the criminal case, giving the Commission time to backtrack and fill in the blanks.


But then along came Judge Rakoff and said in essence, you filed your case, now bring your case.  This seems to have thrown the SEC team for a loop.  It appears they tried to get a stay, entering into a convoluted deal with the defendants’ counsel wherein the defense would petition the court for a 90-day continuance, in return for which the SEC would share the wiretap information with the defense.  Judge Rakoff didn’t go for that either.  As of this writing, both the US Attorney’s criminal case, and the SEC’s civil case are set to go forward. 


Adding a further level of complexity is the sheer number of individual scams alleged.  The SEC’s case indicates that many roads lead to Galleon, but a significant number completely bypass the hedge fund and its employees.  It will be a tough prosecutorial balancing act to keep all the players in the courtroom, and there is always the risk that a setback in one case might lead to the unraveling of others. 


One thing is for sure: there is no regulatory, legal or legislative structure that can prevent bad people from doing bad things.  Both the Value Line case and the metastasizing insider cases revolving around Galleon include key participation by those designated as guardians of the system. Compliance officers and lawyers lie at the heart of these massive fraud allegations, which reaffirms the verity that our system needs both a robust framework, and robust enforcement.


Judge Rakoff has thrown down the gauntlet to the SEC.  What’s at stake is nothing less than the credibility of our marketplace, and the SEC’s ability to guarantee that credibility.  If the SEC stumbles along, plays .500 ball, and comes up with a slapdash settlement, based on hasty legal work, the country and the markets will be the worse for it.  For those who, like Harry Markopolous, have stated that the SEC “should die,” this will be a good outcome.  For those who believe the SEC is a necessary entity that needs a serious retooling, it would be devastating to see this high-profile case go by the boards.


The game is on.


We think Khuzami is the man for this job.  He is plenty tough.  He spoke highly of his legal team and, given what we know to be his standard for performance, he may not be exaggerating.  We think Chairman Schapiro, for all the political pressure she has to deal with, is putting together an admirable team.  For the sake of our markets, we sincerely hope the new SEC Enforcement team will be equal to the challenge.




Hail, Mary!


The SEC has announced its new head of the New York Office of Compliance Inspections and Examinations (3 November, Release 2009-231, “Norm Champ Named Associate Regional Director For Examinations In SEC New York Regional Office”).  Norm Champ will be taking over the Commission’s highest visibility compliance examinations position, and we are delighted that Chairman Schapiro has snagged such an outstanding executive for this job.


Champ’s academic credentials include Princeton (summa cum laude), a Fullbright Scholarship at King’s College, London, and a Harvard law degree (cum laude).  He left the law firm of Davis Polk & Wardwell to serve as General Counsel at Chilton Investment Company, a major global hedge fund operator.  This is a real win for the Commission.  Champ brings to the job a world-class mix of background, experience and operating knowledge of the markets.  Like his predecessor in the job, Tom Biolsi, Champ has the operating knowledge of the markets to know where the Commission should be looking – and where they should not be wasting their resources.  We even suspect Mr. Champ may have the intestinal fortitude to push past the bureaucracy and actually get things done.  We applaud Chairman Schapiro on this appointment. 


With hires like Robert Khuzami, and now Norm Champ, Chairman Schapiro gives us reason to hope that the SEC may one day be able to do its job.  Talk about leveling the playing field.




Brush Up Your Shakespeare


O, what a goodly outside falsehood hath!

                   - Shakespeare, “Merchant of Venice


The Wall Street Journal featured Yale economist John Geanakoplos (3 November, “Crisis Compels Economists To Reach For New Paradigm”) whose work focuses largely on the nature of collateral, a critical yet under-studied component of the financial marketplace.  The article attributes Geanakopolos’ focus to an insight gained from reading Shakespeare’s “Merchant of Venice”, which is focused on “collateral, with the money lender Shylock demanding a particularly onerous form of recompense if his loan wasn’t repaid.” 


Professor Geanakoplos’ work appears to be vitally important to the current economic debate, and we hope it will be brought out of the lecture hall in included in a meaningful way in future discussion.


But the article got us musing.  For “Merchant” holds more fundamental and broad-ranging messages for America today.


“Merchant of Venice” and “Othello” are Shakespeare’s only plays set in Venice.  In Shakespeare’s intellectual world, the Republic of Venice enjoyed a fabled status, along the lines of an idealized New York City.  It was a free city-state founded on principles of commerce.  It guaranteed equal treatment of its citizens and equal access to its financial markets, business and international trade.


In both of his Venetian plays, Shakespeare tests the limits of the ideal society’s tolerance by planting in their midst – and in a role as savior of their way of life – an outsider who is foreign to their culture in every respect.  Both Shylock and Othello are culturally, racially, and religiously foreign to their adopted city.  When the clash of cultures erupts Venice, rather than stay true to its stated principles, reverts to a base type and crushes them both.  Both plays are about the clash between policy and reality, about what happens when a society’s legal protections are put to the test in an existential crisis. 


To quote a line variously attributed to Henry Louis Gates, Jr. and H. Rap Brown, “When white folks say “justice’, they mean “just us white folks’”.


 “Merchant”, once a staple of high school literature classes, has fallen on hard times because of misplaced political correctness.  But the failure to engage on difficult social phenomena such as racism is the surest guarantee they will be perpetuated. 


A serious reading of the play shows Shylock to be the most flexible and fascinatingly protean character in the Shakespeare canon.  There is literally no wrong way to depict Shylock, and the character has been played to great success as a hero, a villain, a clown, a tragic figure, a man of noble spirit, a conniver, a Moses-like lawgiver, a dastard, and a fool.  Even a cursory study of Shakespeare’s life and times reveals that his own Catholic family suffered religious persecution at the hands of England’s then-dominant Protestants – indeed, his wife’s cousin was publicly executed for being a Jesuit.  Hardly the recipe to turn the subtlest observer of human nature into a bigot.


Shakespeare’s misunderstood masterpiece has much to teach us today, as our society transitions from a bastion of equal opportunity to a Goldmanocracy.  The promise of equal treatment and equal access was written on a piece of paper that is becoming increasingly inconvenient in the current environment.  We look for it soon to be declared irrelevant.


America is The Forgotten Man.  Our money is out of money.  Our markets are out of credibility.  Our political system is rotten.  Washington sends flu vaccine, not to our schools, but to Goldman Sachs.  Our Treasury Secretary, like a stockbroker who has just wiped out his best customer, begs the world to “give us one more shot.”  Washington pumps trillions of dollars to Wall Street, which proceeds to pay all-time record bonuses.  While true unemployment ramps up to 17%, Washington masks reality with bogus statistics like “jobs saved.”  The newsmedia, instead of cogently revealing all this for public debate, are a hate-mongering shriek-fest, and we increasingly suspect that our next door neighbors are stocking weapons in their cellars.  When we are come to pay our pound of flesh, shall we be required to deliver it wrapped in the Constitution? 


If you prick us, do we not bleed?


Moshe Silver

Chief Compliance Officer


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