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Government Sponsored Volatility

Thankfully, this isn’t Russia or Pakistan, and the US government has not halted trading in our markets yet, so… at 9:30 AM the market will open as usual, but, more importantly, the Senate Banking hearings will also start. I said it yesterday, and I’ll say it again this morning, governments do not put bottoms in markets. What the US government is doing right now changing the rules on the fly and sponsoring volatility and illiquidity as a result.

In the week prior to the short selling ban, we were running huge volume days on the big board (between 6.5-9.5B shares/day) – yesterday volume dropped to 4.5B, and volatility across asset classes shot straight up. Oil had a +24% intraday move! I don’t know why they don’t get this, but hedge funds are critical equalizers out there in finding efficient prices. Some days they can represent 30-40% of the volume in any given market. Now the government is changing the rules on them, banning short selling on down moves and talking about regulating “oil speculating” hedge funds on up moves. Pretty soon we won’t be able to be on any side of the “Trade”!

Confusion breeds contempt in markets, and my thought is that Paulson, Bernanke, and Cox don’t simplify this picture when they are ‘You Tubed’ by politicians this morning. This is an election year. This is too politically charged. This why I am in cash.

Asia closed lower, and European markets are down 1-2% across the board ahead of the 9:30 AM reality TV session with the US government. Yesterday, the S&P 500 failed to climb and close above my critical resistance line of 1258.11, so we find ourselves with the ominous technical combo of both the immediate “Trade” and intermediate “Trend” looking lower. I am going to move my downside S&P 500 target to 1157.22 this morning. I don’t know if we get there today, tomorrow, or on October the 3rd, but that’s my level.

Here are 3 global macro focus levels of downside support to manage risk towards:
1. Hong Kong closed down -3.9% last night at 18,872, and I see immediate downside at 17,427
2. India’s BSE Index closed down -3.1% at 13,561, and I see immediate downside at 12,954
3. London’s FTSE is trading down over -2% so far this morning at 5,112, and I see immediate downside at 4,826

The US Dollar got hammered yesterday, putting in its biggest single day drop since October, 1998. This is not American Idol folks – the world has voted on the Paulson Plan. This US$ weakness, of course, contributed to the melt up in commodities which were amplified by the aforementioned move in oil, but the CRB Commodities Index (19 components) was +3.9% on its own. Bailouts are inflationary.

The “bottom is in” crowd was all over the tape on Friday. Remember, governments don’t put in bottoms. This government is sponsoring volatility and illiquidity – that combo is not going to solve anything any time soon. This is structural. This will take time.

I wish I could see something positive in all of this. I wish I had a more creative solution than being in cash. My critics will tell you that is because I am not as smart as they are. I’d have to agree with them on that.

Good luck out there today,
KM



IS THERE A PAM ANDERSON BEHIND THOSE UGLY PASSENGER #S?

McCarran Airport reported that 424,000 fewer passengers flew in and out of Las Vegas in August versus last year. The 9.9% drop was worse than July’s 8.6% decline. However, I believe August gaming revenue (released in a few weeks) will look significantly better than the Al Franken look-alike 15% drop in July. August 2007 was a strange month. Despite a 6.4% increase in airport traffic, table drop actually declined 15% and drove total gaming revenue down 4%. Slot hold percentage was abnormally low as well. Thus, the comparison is easy from a revenue perspective but difficult from an airport traffic perspective.

For August 2008, my model projects total volume down only 3%, not good, but certainly not as bad as advertised in the McCarran data. Assuming normal hold %, I calculate total gaming revenue down only 1%. Please don’t mistake my analysis for bullishness. I’ve been consistently negative regarding the prospects of Las Vegas Strip. However, consistent with our focus on objectivity here at Research Edge, I must call them like I see them. And I see August turning out a little better than expected.

Due to a funky comparison, Aug Strip results are likely to look better than indicated by the airport data

MCD – The cost of capital is rising and access to capital is tighter

According to Bloomberg, MCD told its franchisees in an internal memo to seek alternate means of financing after Bank of America declined to increase funding. The article states that Bank of America won’t provide more money as it works on the planned purchase of Merrill Lynch. This tightened access to capital will have implications on the entire industry because if McDonald’s franchisees are having difficulty obtaining necessary financing, I can’t imagine the trouble KFC franchisees are having.

Within the memo, MCD’s Treasury Department says, “Bank of America has been taking steps to increase capacity to fund additional growth….Its announcement last weekend of its intention to acquire an investment bank and the volatility in the debt markets, especially this past week, have impacted B of A's ability to get the quick solution originally anticipated.''

This memo reaffirms my view that MCD will not be able to complete its planned coffee conversions by the middle of the next year. Based on my math (please refer to my September 17th post titled “MCD – Coffee Could be the Tipping Point!” for more details), even if MCD accelerates the conversion process in 2H08, the total number of McDonald’s stores with the ability to sell specialty coffee in the U.S. would be 2,800, which only accounts for 25% of MCD’s U.S. system. The fact that franchisees are now facing additional hurdles to obtain the necessary financing to upgrade its stores (at a time when cash flows are already under pressure from increasing commodity costs) will only further delay this conversion process. For reference, MCD will invest up to 40% of the remodel cost, which on average can range up to $75K, and the operator will be responsible for current equipment costs of approx $25K. That being said, based on the article and MCD’s comments at a recent Bank of America conference, management maintains the beverage rollout is still progressing as planned, but I remain unconvinced.

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Confessions of a Trader: The Short Selling Ban, Part II...

I am strongly opposed to the short sell ban enacted last week to protect financial stocks. This is not to say that I do not agree that there have been rampant abuses in the practices used by brokerage firms to manage short selling prior to this. I know of what I speak.

In an early phase of my career I was responsible for managing fail-to-deliver positions for OTC stocks in a major Wall Street bank’s back office. Back then we used paper ledgers and, when a position had not been resolved within 30 days, it would have to be placed into an error account and bought in. A lovely bipolar guy named Sam* who had liquor on his breath by 10AM every morning was responsible for the buy-ins. If a trade had been open long enough without properly settling Sam would come by my desk to let me know that he was going to move the position into an error accounts unless it was resolved by day’s end. That way, short sales that had never been properly borrowed would be flattened by buying shares in the open market keeping everything honest. That was the theory anyway; in practice the other broker’s identity in the ledger could be changed (say, switching the entry from Smith Barney to Merrill Lynch meaning that Merrill would DK the transaction and it would start life all over again as a brand new fail to deliver for 30 more days). In the little under a year I held that job before moving on to bigger things there was one particular position that never seemed to resolve itself, a sale of shares of a small cap stock predating my employment that had been on the books for so long that no one even knew which customer or prop desk had initiated it anymore –meaning that it would go into a departmental error account if it was bought in. It was still bouncing around when I left and I would not be surprised if it is still open and undelivered in the bowels of that bank to this day.

Later in my career, when I was a prop trader at a bank, I was once assured by a slick salesman that covered me that it would be no problem getting a synthetic short position for a hard to borrow stock –he had a buddy that would pick up market maker status on a foreign exchange that had an agreement to trade US stocks and then use his market maker exemption to short without borrow. Once he was short he would then would turn around and sell a total return swap to me (with a hefty commission for the salesman and a fat spread for his buddy of course). I turned him down. I am sure that many, many others did not. I heard later that that sales guy and others like him made a killing arranging short swaps for PIPE investors –essentially letting them take all market risk out at the point they bought into an offering. It was as a very sordid, very lucrative little corner of the business.

Yes, much as it pains me to say this, Pat Byrne was actually on to something in his own crazy way.

The problem is this, none of these abuses necessarily required new regulations –they merely required that the existing regulations be enforced. Since it took a market catastrophe and political witch hunt to cause this problem to be addressed –let’s hope that it does not inhibit legitimate shorting or overall market liquidity.

*(names have been changed to protect the guilty)

Andrew Barber
Director
Research Edge LLC

VISA VIS-À-VIS

By no means am I trying to imply that Beijing controls the government machinations of the Macau SAR. I’m actually stating it definitively. That is why I take note when Beijing summons the local Macau powers that be to the capital. I suspect there will be some more definitive action taken with regard to the visa situation. Leisure visits were recently pushed from once every month to once every two months. Effective September 1st, visa restrictions were tightened so that the circuitous route through Hong Kong to escape restrictions has effectively been closed. September gaming revenue looks like it could come in flat with last year vs. a 44% gain in August, so the visa situation is clearly making an impact.
  • What could happen at this meeting? I believe one of two scenarios. First, Beijing could maintain the visa status quo until the end of current Macau Chief Executive’s term next year. It’s no secret that Beijing is not happy with some of Edmund Ho’s public statements, especially regarding Beijing’s influence. A second plausible outcome could be a reversion to the previous visa environment; that is, back to the once a month visitation restriction and access for mainland Chinese arriving directly from Hong Kong.
  • Either of these scenarios takes a 6 month visa restriction off the table, which is big plus. You may recall, seemingly credible rumors of an even longer restriction contributed to a sharp sell-off in the Macau stocks. Investors now seem to anticipate either the current 2 month restriction continues in perpetuity or worse, so either scenario could be positive relative to expectations. On the margin, the probabilities are favorable for a near term spike in the Macau stocks. Las Vegas Sands, with 20% of the stock short, could have the most leveraged move higher.
Macau revenue growth is in Beijing's hands
Reversal of 9/1 visa restrictions would be a big positive

Debunking the Short Selling Ban, Part I

The SEC’s short sale ban created a rally by removing free market checks and balances. The long term impact on the markets will be less positive.

The SEC short selling ban covers 779 financial stocks until Oct. 2 and imposes new penalties for clearing brokers that fail to deliver on shares sold short after t+3. The FSA ban covers only 39 UK financial stocks but the window extends to January 16 of next year.

Overall the impact on market liquidity is expected to be significant. According to a report released last week by my friend Joe Gawronski at Rosenblatt Securities:

“Bans on shorting financial stocks, combined with the new disclosure and fail-to-deliver penalties, should exert considerable downward pressure on volumes. Short selling by hedge funds and other investment managers, as well as by many smaller and medium-sized high-frequency trading firms (but not their larger brethren), is likely to drop off significantly during the terms of the emergency orders.”

The options markets could be hit especially hard by this move. Options market makers have enjoyed an exemption from borrowing stocks before shorting intended to allow them flexibility as they offset their exposures. If they can’t borrow shares to deliver short then they can’t sell protection to the markets. On Friday it was reported that an SEC staff recommendation had been put forward to amend the order to allow options market makers to keep their exemption. The SEC’s waffling on this point is understandable since, with traders at bank desks sitting on their hands for want of capital, the locals are suddenly the only game in town. Without them, buyers and sellers will only be able to transact if they happen to meet in the same strike and maturity.

Decreased liquidity is obviously not the biggest negative aspect of this order. The natural checks and balances that legal short selling provide allows greater efficiency in the marketplace as short sellers are incentivized to police the market for poor performing management teams, corporate malfeasance and unrealistic valuations. By removing this force from the market we are sending a message to the world that our financial firms are too weak to stand on their own and that we will protect them despite by changing the rules of the game if need be. To some investors, this will look like the first step down a slippery slope of market manipulations that have chased foreign capital out of other markets in the past. Even if more banks failed without the short sale ban, there would remain faith in the integrity of the US market system. With this solution, we demonstrate that our market has no more integrity than our bad banks.

Andrew Barber
Director

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