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Perpetually Preferred

No problem can be solved from the same consciousness that created it.
-Albert Einstein

In a made for CNBC headline announcement last night, Larry Kudlow proclaimed the mystery of his faith… No socialist bailout is too far from him buying into, provided that it can make the stock market go up; especially if Warren Buffett rubber stamps it.

I wrote my senior thesis here in New Haven on Buffett. He remains, The Man. He also remains the only investor of consequence who has unlimited duration in his investment mandate. This morning, he is the only investor with these “perpetual preferred” terms on Goldman’s stock. So before you get all heated up and run out buying into consensus TV’s take on this “deal”, stop, breathe, and think about it. There’s one man in this world who gets this deal. The rest of you get the scraps of Goldman’s $5B raise that they just doubled down on. No, no – never mind what the company said yesterday, last week, and last month that they don’t need money. We simpletons are supposed to be stupid, and not hold people accountable to what comes out of their mouths.

Reality TV’s session with Hank Paulson yesterday enlightened America on the enormity of their financial system’s confusion. Confusion in markets breeds contempt. After this morning’s pre-market futures love fest, we’ll be staring down Paulson’s ‘You Tubing’ session with Chuck Schumer at 10:00AM tomorrow in front of the Joint Economic committee, then again at 2:30PM EST in front of Barney Frank and the Financial Services Committee. This is not going to be a positive catalyst folks. America has already voted.

In the Bloomberg/LA Times surveys this morning, 80% of Americans are now saying the country is headed in the wrong direction. More interestingly, 55% oppose the Paulson Plan vs. 33% supporting it, and 45% of Americans think Obama is more apt to handle this economic situation vs. McCain’s 33%. This mounting contempt is both unprecedented and warranted. Wall Street investment banks have compromised the integrity of their handshakes. If you didn’t get that yesterday, you’ll have another chance to watch it on Thursday.

Not surprisingly, the rest of the world isn’t stupid either. If you show people something on TV, they neither need to read or count to understand whether someone looks like they are afraid. It’s called intuition. Asian, European, and Middle Eastern stock markets are screaming this right now, and I think you should be paying attention to their vote.

Asia opened higher, and closed mixed. Bailout master of the universe, Japan, closed +20 basis points last night – hooray. European markets opened higher and have now turned lower as I hit these keystrokes. The major indices across Asia and Europe are broken, and they realize that the only investor getting a 10% preferred dividend in Goldman, is an American.

The contagion associated with our investment bankers losing the world’s trust is now spreading to the Middle East. Prince Alaweed threw up his hands last week and said, “I’m out.” This morning, despite the preferential All American investor treatment, why is the Saudi stock market trading down -5.5%. Why has the mother of all “Sovereign” support (Saudi’s Tadawul Index) dropped -21% in the last month? Why are Qatar and the United Arab Emirates trading down -3.7%, and -3.5% respectively this morning despite oil trading higher to $108/barrel? I think it’s because they aren’t stupid.

Pakistan is calling in the 1-800 US bailout line this morning. Moody’s downgraded their debt yesterday; their stock market gets stoned by their own people; and their currency has lost -21% of its value year to date. Their new “leader”, Zardari, is allegedly a lot of things, but one of those things may not be stupid. He meets with Condi Rice on September 26th. Is he going to ask for something the US cannot afford to give? What will he have to do if/when the answer is no?

It’s global this time. And yesterday assures you that there are more questions to answer locally, never mind globally. The US has a “perpetually preferred” investor who is much larger than Warren Buffett – the common American tax payer. That tax payer is not going to let the investment bankers one up him/her this time. Been there, done that.

I shorted the S&P 500 yesterday. Hopefully the government doesn’t ban me from doing so tomorrow. My immediate downside target is now 1150.57.
Good luck out there today,
KM



Point Counterpoint: PSS, GPS, UA, FINL

I focus on fundamentals. Keith focuses on stocks. Together we generate Alpha. Here are some names that KM highlighted to me, as well as my response. Some changes on the margin…

COLLECTIVE BRANDS (PAYLESS – PSS)
KM: PSS continues to impress, posting + divergence days when the market swoons.
BM: Still one of my favorite fundamental stories. Top line visibility improving, cost synergies from Stride Rite evolving into revenue synergies. Cash flow growth should accelerate meaningfully with or without a steadier consumer backdrop.

GAP, INC (GPS)
KM: GPS is bullish, but not if it breaks down and closes below 17.75.
BM: I really like the Athleta acquisition, and yy EBIT growth trajectory looks good relative to the group. But I still think that GPS needs to take up SG&A ratio by 2-3pts in order to take the model to a point where it can grow at a sustainable rate. Any bullish action near-term is purely a ‘Trade’ not a ‘Trend.’

UNDER ARMOUR (UA)
KM: UA continues to hold the pos. momentum line, which shows me support at 34.66.
BM: I still think back half expectations are too high, but with 45% of the float short the stock, this one falls into the basket of names that will pop if the company hits the quarter even if by accident. I’m increasingly confident in top line growth in footwear, and FX here is a non-event. If margins find a bottom in 2H (which I think is a distinct possibility), this name could start one of those blistering 50% runs we’ve grown to love from UA.

FINISH LINE (FINL)
KM: FINL is teetering on the edge of a major breakdown all of a sudden, the next move will be big either way.
BM: I wouldn’t go near this name in advance of Nike’s quarter Wed pm (FINL is a day later), as unfavorable risk/reward with Nike could take FINL with it. But fundamentally, this is another name I am warming up to for several reasons. I’ll be back with more color on this one – but my inclination is increasingly to swap out of FL and into FINL.

MORE ON THE ALL IMPORTANT RELATIONSHIP: PRICE VS. TRAFFIC

O’Charley’s said at an investor conference yesterday that based on the casual dining industry numbers it is seeing, August was the worst sales period in 30 years. This statement reaffirms our view that the industry has not yet entered a period of stabilization, but instead continues to deteriorate at an accelerated pace. Management went on to say it would expect to see casual dining operators raise prices more aggressively than normal (up 3%-4% or more) in an effort to protect margins. The company said this is in line with Darden’s comments that it expects to increase FY09 prices at the higher end of its historical 2%-3% range versus its more typical 2.5% increase.

The primary driver of recent same-store sales weakness for casual dining restaurants has been negative traffic. In August, traffic declined 6.0% after falling 6.2% in July so although I am encouraged to hear O’Charley’s is focused on its margins and not just offering promotions across the board, I do not know if aggressive pricing is the answer to deteriorating traffic trends.

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Short Selling Ban, Part III: Implications for Implied Volatility

Compromised markets create compromised data.

The impact of the short ban on the equity options market has been profound. There is debate surrounding the S&P level for Friday’s open that was used to calculate settlements given the fact that the final status of outlier prints on financial stocks from that morning is still up in the air. Meanwhile, bid ask spreads in some put series are wide enough to drive a truck through and the normally staid volatility levels for blue chips like GE are in the 40’s or higher.

When we say “volatility” we are talking about one of two things –either realized historical volatility or the volatility implied by option premiums. The VIX Index, the most commonly used barometer of market volatility, is a measure of the implied volatility of options on the S&P 500.

Implied volatility is calculated through a process of reverse engineering. Using a pricing formula such as Black Scholes, the premium for an option is used to derive the implied volatility level by backing out the known aspects (the maturity and strike price) as well as assumptions (the financing rate and hedge). These pricing formulas are all based on the assumption that a trader will be able to freely hedge the option exposure in the underlying market. The shorting ban leaves implied volatility calculations for those stocks heavily compromised by asymmetrical liquidity.

This may sound very abstract and irrelevant at first, but consider what a significant portion of equity trading volume is generated by quantitative managers who rely on implied volatility as an input for their modeling process. By changing the rules mid-game the SEC may be forcing these players to head for the sidelines.

Andrew Barber
Director

Hail Hagupit

Typhoon Hagupit is causing significant disruption in South East Asia, resulting in flight cancellations and ferry service suspensions. Hagupit is currently classified as a Gale Signal 8 (out of 10) which is the equivalent of a category three hurricane. The worst effects of the typhoon may be felt in Macau late afternoon today, Eastern Standard Time (early tomorrow morning Macau time), according to our source in Macau.

While we expect the existing casinos to withstand Hagupit with only limited damages, there is risk to the gaming projects currently under development. LVS has some major projects under construction on lots 5 and 6. Parcel 5 will include three hotels (two Shangri-La Hotels and Traders and one St. Regis), a casino, a retail shopping mall and approximately 320 serviced luxury apartment hotel units. Parcel 6 will be comprised of two hotels (Starwood’s Sheraton brand), a casino and a retail shopping mall. City of Dreams, a project being undertaken by Melco PBL Entertainment, could also see construction disruption. Damages and opening delays are likely.

We will have an update on any damages later today or tomorrow.


These Senatorial Statements Don't Sound Supportive...

I don't want to breakdown each of these politically partisan statements. If you are watching this on TV right now, you'll notice that both the ranking Republican and Democrat are equally negative on Paulson's plan.

Be careful out there. This is going to take time to fix.
KM

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