"Definitive crashes have occurred across many global macro markets in recent months," our macro team recently wrote. "Is the U.S. equity market next in line?"
Takeaway: In the first few days of the fourth quarter, equity volumes are white hot with options and futures burning off a tougher comp
Weekly Activity Wrap Up
U.S. cash equities are coming out of the gate strong so far in the fourth quarter. Fourth-quarter daily volume is averaging 7.9 billion, a +12% year-over-year and +8% quarter-over-quarter expansion. Meanwhile, options and futures have not started with the same gusto with tougher comps. U.S. equity options activity is averaging 17.2 million contracts per day in the new quarter, 0% growth versus the fourth quarter of 2014 and a -5% contraction versus 3Q15. Futures activity is averaging 19.0 million contracts per day in the fourth quarter, a -1% year-over-year contraction and +2% quarter-over-quarter expansion.
U.S. Cash Equity Detail
U.S. cash equity trading is running at 7.9 billion shares traded per day in the fourth quarter to date. This is +12% year-over-year growth for U.S. stock activity. The market share battle for volume is mixed. The New York Stock Exchange/ICE is taking a 25% share of fourth-quarter volume, a +3% year-over-year increase, while NASDAQ is taking a 19% share, a -7% year-over-year decline.
U.S. Options Detail
U.S. options activity came in at a 17.8 million ADV this week, bringing the 4Q15TD average to 17.2 million, 0% Y/Y growth and a -5% Q/Q contraction. The market share battle amongst venues continues to be one of losses at the NYSE/ICE, which has lost -12% its of share year-over-year settling at just 18% of options trading currently. Additionally, CBOE's market share has been falling recently and has started off the fourth quarter at 26%, -16% lower than 4Q14. NASDAQ, on the other hand, started the quarter strong, increasing its market share by +16% compared to 3Q15, bringing itself back into line with the 24% share it held a year ago. BATS' share has been falling recently but at 9% in 4Q15TD it remains +40% higher than in 4Q14. Finally ISE/Deutsche's 15% share in 4Q15TD remains consistent with 3Q15, which brings it to +67% Y/Y growth.
U.S. Futures Detail
CME Group volume came in this week at 13.9 million contracts per day and is averaging 14.1 million for the fourth quarter, a -5% year-over-year contraction. However, CME open interest, the most important beacon of forward activity, currently tallies 99.1 million CME contracts pending, good for +18% growth over the 84.1 million pending at the beginning of 2014, an expansion from the prior week's +15%.
Activity levels on the futures side at ICE hit 4.8 million contracts this week and are averaging 4.9 million contracts per day in the fourth quarter, a +13% year-over-year expansion. ICE open interest this week tallied 64.7 million contracts, a -7% contraction versus the 69.2 million contracts open at the beginning of 2014, an improvement from the prior week's -8%.
Monthly Historical View
Monthly activity levels give a broader perspective of exchange based trends. As volatility levels, measured by the VIX, MOVE, and FX Vol should rise to normal levels after the drastic compression this cycle, we expect all marketplaces to experience higher activity levels.
Sector Revenue Exposure
The exchange sector has broadly diversified its revenue exposure over 10 years as public entities with varying top line sensitivity to the enclosed trading volume data. The table below highlights how trading volumes will flow through the various operating models at NASDAQ, CME Group, ICE, and Virtu:
We recently presented our investment thesis on the Exchanges. To summarize,
- Long CME: Financially oriented CME Group (CME) is enjoying a long awaited boom in activity, as trader counts and open interest in Treasuries, Eurodollars, and FX products are swelling. The decade long concentration on trading energy and commodities is over and with steeply shaped forward curves and more profitable opportunities, financial products are seeing rapid adoption.
- Short ICE: We see collateral damage from the ongoing rapid price decline in energy and commodity markets. As a result, these important products at ICE will be less active than the Street expects, as commercial hedging and speculative energy trading dries up.
We think CME has $5 per share in earnings power in the out year and the stock will revisit near $140. As outlined in our presentation deck and replay below, a CME long position can also be paired with a short ICE position, with favorable fundamental exposures on each side of the trade.
Separately, recent IPO Virtu (VIRT) is being valued incorrectly by the market. Our main qualm is that the company takes intraday prop risk, but has no tangible equity capital to cover any potential trading losses. Shares of VIRT are currently on our Best Ideas list as a short with a fair value in the mid-teens (30-40% downside).
Hedgeye Exchange Black Book Replay HERE
Hedgeye Exchanges Black Book Materials HERE
Please let us know of any questions,
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
Takeaway: We added JNK to Investing Ideas on the short side on 10/8.
THE HEDGEYE EDGE
Our edge right now with High Yield Fixed Income is our macro team's continuing dissection of the cycle. Look no further than corporate activity YTD…
With a phase transition in volatility that has crushed buy-side performance and sent U.S. equities on a roller coaster ride over the last couple months, confidence in what has been a 6-year bull market is waning. Just 37% and 43% of S&P 500 companies recorded sequential acceleration in sales and earnings growth, respectively, in the latest quarter. Operating margins have already peaked.
That sounds like a slowdown.
Rather than experiencing organic growth, large companies are attempting to manufacture growth by buying back shares, sidelining capital investment projects, and acquiring other companies. 2015 will be a record year for M&A activity. The previous record? 2007...
From our perch, debt-financed buybacks at peak valuations, peak margins and new highs in corporate leverage does not equal long-term shareholder value creation. Buyback trends are a classic contra-indicator with activity peaking at the end of the cycle.
Bottom line: This kind of corporate activity in aggregate is just another late-cycle indicator.
INTERMEDIATE TERM (TREND) (the next 3 months or more)
Our proprietary Growth, Inflation, Policy (GIP) model is signaling that Q3 GDP, on a year-over-year basis, faces very difficult comparisons (this year vs. last year) in Q3 and Q4 of this year. Our estimated range for GDP for Q3 is 0.1-1.5% which is still below consensus despite estimates that have been taken down by Central Bankers and consensus Wall Street.
If GDP prints in that range, forward-looking growth expectations will be downwardly revised as evidenced in bond yields going lower and credit spreads widening.
LONG-TERM (TAIL) (the next 3 years or less)
When the economic cycle begins to roll-over, a drawdown in the equity market manifests, volatility ensues, and credit spreads widen. There is a rotation into what is considered safer fixed income (TLT and EDV for example) at the expense of riskier borrowers (worse credits). The commonalities of a cyclical slowdown and secular headwinds are matching up to give us visibility into our #superlatecycle call which happens to be one of our top Q4 2015 Macro themes.
ONE-YEAR TRAILING CHART
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This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.
Takeaway: We added TIF to Investing Ideas on the short side on 10/5.
THE HEDGEYE EDGE
If you’re looking for a U.S. Equity to play our macro team’s #LateCycle #SlowerForLonger bearish themes, here’s a name wrapped in a "Little Blue Box" just for you.
We all know Tiffany. Generally speaking, this is a structurally sound business. It is definitely not a ‘headed to zero’ short like we’d argue for a company like Wayfair (W). But stocks of good companies like Tiffany go down all the time, and we think TIF is headed lower.
Common perception seems to be that “just because TIF blew up earlier this year, it can’t blow up again.” We disagree. It actually blew up twice this year. And we think there will be another. We didn’t like TIF into the latest print, and we definitely don’t like it on the way out. The company lowered back half guidance, which we expected to see, but we’re not sure if $0.10 is enough off of 2H14’s $2.27 base. We’re inclined to think ‘no’.
The bigger tell for us will be how much consensus numbers come down for next year. They currently sit at $4.56. If the macro environment plays out like we believe, then we think we’re looking at a number closer to $4.00.
The problem here is that management is adjusting guidance based on what it sees at the time of the earnings report – not based on how the environment will likely deviate from what they see in front of them.
Also keep in mind that the company is at peak productivity of $3,500/ft (some less productive Apple stores – the highest s/sqft in retail -- do $3,500), peak Gross Margins, trough SG&A margins, peak diamond exposure (59% of units has a diamond, which is gross margin accretive), and only can grow square footage by 2-3% on its best day.
We have no doubts in the quality of the management team or brand name, but the reality is that there are no obvious margin levers to offset the declining growth profile in the business, especially amidst increased late cycle risks.
It is trading near a peak multiple (18.5x) on peak margins (21%), a peak earnings ($4.20E TTM and NTM) that isn’t growing, peak returns (18%), has the worst cash conversion cycle we’ve ever seen (490 days), while sentiment is sitting at all-time highs.
It’s feast or famine – if one of those metrics breaks, then they all do.
ONE-YEAR TRAILING CHART
Takeaway: We added Wayfair to Investing Ideas on the short side on 10/2.
THE HEDGEYE EDGE
Wayfair is one of those polarizing stocks in the investment community where there is plenty of love, plenty of hate, and not much in between. Use whatever emoji you want…we’ll stick to research, our investment process, and simple math. Those three things combined tell us that Wayfair is unlikely to earn money – ever.
With a market capitalization of $3.5bn (roughly on par with Restoration Hardware) we can be pretty certain that our view is not currently represented in the stock. While it might take a while, we think that Wayfair is ultimately headed to zero.
Let’s first respect the Bull case (it takes two to tango) and start with the positive. The speed at which W has achieved such strong brand equity in such a fragmented space (Home Furnishings) is incredibly impressive. It’s emerging as something of a ‘buyers agent’ for Home Goods the same way WMT and COST have done for their consumers. That buying power will be hard to compete with for anyone. Ad costs are coming down incrementally, and although we think they’re ultimately headed much higher, it should help margins over the near term (and the bulls know it).
To be clear – if this management team wants to, it could pull back on investment spending (bad long term move) and temporarily report a small profit. But when a company with 58x inventory turns flirts with profitability, the risk to the upside could be both dramatic and painful. There’s your short term risk. But to be clear, that’s the exact event we’d use to get even heavier on the short side.
This is a name where you keep selling Green.
Now for the Bear Case – the Hedgeye Bear Case. First off, Wayfair has considerably higher penetration in its TAM (total addressable market) than people believe. People – including Management, are using numbers like $200bn-$300bn as an addressable market. That’s just flat-out wrong.
We’ve done extensive research on this one, and when all is said and done, we think that the end market is no more than $30bn. To put that into context, it suggests that Wayfair has about 10% share of its market. That’s 2-3x the share of players like RH and IKEA. There’s absolutely no reason why this should be the case.
The primary reason is that Wayfair sells furniture and home goods. The purchasing process for a consumer durable like a set of bunk beds, for example, almost always includes in-store visits as well as online research. You get that at Williams-Sonoma, Restoration Hardware, and even Pier 1. But you can’t touch and feel the seven million items sold by Wayfair before you buy. In fact, our research suggests that W’s target consumer has a ‘blind buy’ threshold of around $750. That’s well below the prices listed for furniture sold on its websites.
Now…that only applies to furniture, but what about thinks like lamps, linens, and kitchen utensils? Yes, that’s where we think Wayfair will drive incremental volume. But how defendable is it when that product can also be bought online/in-store at Bed Bath & Beyond, Kohl’s and Target?
Overall, our work shows that the incremental customer is likely to be much more price sensitive, which not only challenges long term Gross Margin targets, but takes customer acquisition costs higher off a reprieve in 2015. We do think there’s 500bp upside in Order Margins over time, but we need to see 700bp to get Wayfair in the black.
Also, we previously thought an AMZN take-out was a safety net. That’s no longer the case. There’s little that Wayfair has that Amazon cannot build on its own. Heck, look at Etsy. That was also a rumored AMZN target. On October 8, AMZN announced a home-grown site that competes directly with ETSY. In this case, W is on its own to sink or swim.
Maybe Management realizes that with $11.2mm in insider sales since the stock hit all-time highs in mid-August, and $40mm since the lockup expiration at the end of March.
ONE-YEAR TRAILING CHART
Takeaway: UA’s Wisconsin deal another notch against NKE. Tough Sept for AMZN US? OSTK furniture @ 86% off. C-Suites getting younger.
UA - Under Armour signs 10yr deal to outfit University of Wisconsin. Under prior Adidas deal, Wisconsin was getting $1.375mm in product and $800k in cash. UA will provide $2.45mm in product and $4mm in cash annually. Importantly, UA now has 3 of the 14 Big Ten teams (Maryland, Northwestern, Wisconsin).
Wisconsin is just a drop in the bucket compared to what UA spent to lock down the Fighting Irish (UA - $10mm per year) and what Nike doled out for U of Michigan ($11.2mm per year), but there are a few interesting points we took from the deal…
1) Adidas is backing down meaningfully. The PR department at AdiBok was sure to throw in its public statement that it 'chose not to renew the deal'. Just like the company chose not to renew the deals with Michigan, Notre Dame, Tennessee, etc. By saying "chose not to renew" Adidas is saying "can not afford or get a positive ROI".
2) Obviously the team/league sponsorship hasn't worked in the US, but we're also skeptical about the efficacy of the stepped up endorsement spend on individual athletes where NKE especially, and UA to a lesser extent , already dominate. To cite one example -- Adi is spending $200mm on NBA MVP runner up James Harden, and is having a hard time getting the athlete to wear the brand in public.
3) UA now dominates the Chicagoland sports scene with partnership agreements inked with Northwestern, Notre Dame, and Wisconsin all of which have a big presence in the city. And the company owns the naming rights to the Cubs spring training facility and is one of the 5 legacy partners with the team. That's no coincidence given that the brand opened a 30k sq. ft. Brand House smack dab in the middle of Michigan Ave. Keep in mind that Chicago is the penultimate 'Jordan Town'. At least, it has been...
URBN - Urban Outfitters asked some salaried employees to volunteer at a fulfillment center in Pennsylvania expecting a busy October. Company said hourly employees were willing to help, but were rejected to comply with labor laws. To URBN's credit, it's rare that people will work for free in any profession. But all-in, the request from URBN crosses the line.
W, OSTK - Overstock.com is offering 16% off furniture to celebrate its 16th birthday. At face value, we thought "that doesn’t seem very steep, the regular discount is 40-50% on OSTK." But if you check out the website you see that it's the standard discount (which is currently 70%) plus an additional 16%. Basically, OSTK is selling furniture for 86% off. People don't look at OSTK as often as they should when analyzing Wayfair -- but they should. This discounting is severe.
WMT - CFO Charles Holley to retire Dec. 31, 2015 after 20 years. Brett Biggs, 47, will succeed Holley. Now WMT has a 49 year old CEO and 47 year old CFO. The age trend for retail executives continues to head lower. Note that with Ralph Lauren's recent announcement, the average age of the C-Suite went from 61 to 49 years.
AMZN - Comps from ChannelAdvisor are out. This is actually a reasonable underlying directional indicator for AMZN's business, as outlined by mapping out the 2-year run rate for each on a quarterly basis. The bad news, however, is that September slowed on both a 1 and 2 year basis.
Can Everlane Really Become the Next J.Crew?
Ikea to open a Jacksonville, FL store in 2017. Store planned to be 294,000 SqFt. This will be Ikea's 1st store in North Florida, and its 5th in the state.
WMT - Laura Phillips to become senior VP of sustainability. Current VP, Manuel Gomez taking position as VP of e-commerce strategy for Walmart Mexico/Central America.
UA - Under Armour settles lawsuit around issue of new non voting stock to protect CEO Plank's control of the company. The company issue additional compensation to the holders of Class C stock in the form of a dividend with a value of $59 million.
ASNA - Golden Gate discloses 9% stake in Ascena Retail Group
ARO - Aeropostale Signs License Agreement With Himatsingka America For Home Textiles
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