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Bear Flattening

“Never memorize something that you can look up.”

-Albert Einstein


Looking back, one of the most impactful professional epiphanies I had as a young analyst was not pretending to know stuff.


The propensity to feign understanding is pervasive – even in meetings and discussions with smart institutional investors. 


Information turnover (in the brain) is an individual specific but inescapable reality - especially if you have kids, too little sleep, too much caffeine and interests outside of starring at numbers inside of small rectangles all day. 


I don’t know a lot of stuff and I’ve forgotten and relearned dozens of things dozens of times. In truth, if it’s not something I’ve been particularly focused on over the last month or so, I’ve probably forgotten a lot of the technical specifics.


Maybe it’s just me, but I suspect not. 


Here’s the deal: If our experience and particular investment specialty isn’t uniquely aligned, then give me the 3-minute, 5th grade level intro of whatever it is we’re talking about then get into the technical meat. That way the next 45 minutes of meeting won’t be a complete waste of time with us both pretending we know what the other is talking about. 


Sure, superficially we’ll kind of get the salient points but scattered and incomplete intuition doesn’t make a thesis click together like some investment alpha Rubik’s Cube without first leveling the field and establishing a baseline level of context for the discussion.


Not knowing things shouldn’t be closeted as a terminal vulnerability. 


2016 - less pretense purveying, more common sense mongering.  


Bear Flattening - CoD1 YS vs FF


Back to the Global Macro Grind ….


In the spirit of that intro, this morning I’d like to do a little didactic exploration of 3 topics. 


  1. Yield Spread Compression
  2. Earnings Management
  3. Raising Rates | The How


This morning’s note is a little longer than usual, so feel free to jump around and/or pick your own Macro adventure below. 


Yield Spread Compression: As the chart above illustrates, the yield spread plots as a cyclical function, flattening as the economy slows with policy driving the short-end higher and defensive positioning and/or discounting of lower future growth/inflation driving the long end lower.


Yesterday we had Dollar ↑, Rates ↓, and XLU (Utilities) the lone green sector as the yield spread compressed another -5 bps.  


That cross-asset class, price action cocktail is about as conspicuous a deflationary macro signal as there is with strong dollar deflationary forces perpetuating bond market expectations of slower-and-lower-for-longer on both growth and inflation. 


The steady compression in the yield curve back down to 7-year lows yesterday is what fancy market types affectionately call a #BearFlattening.     


How many tightenings does it take to get to the deflationary center of a global macro pop. The world may soon know (HERE if you don’t get it).


Earnings management: Last week some academics from Cambridge & California published an analysis on the prevalence of earnings manipulation among public companies HERE.


Unsurprisingly they did, indeed, find it to be prevalent. Further, they found the capacity for a given company to manage EPS and manufacture a string of positive earnings surprises lasts roughly two years and the motivation for it evolves over time. 


  1. In the beginning, it’s designed to drive management compensation (ties to earnings growth or share-price targets) and multiple expansion
  2. Towards the end, it functions to simply prop up elevated valuation


The implications are relatively straightforward: At the end of an earnings management cycle (which also tends to correspond to the end of a market/eco cycle), you have both artificially inflated EPS and overvaluation. This dynamic makes the late-cycle meeting with reality all the more epic as both earnings and multiples contract simultaneously – compounding the price impact.


In the Chart of the Day below we show the spread between the # of companies beating by <3% and the # of companies missing by < -3% (black line) vs. S&P500 Operating Margin (pink line).


In the absence of earnings management and/or systematic analyst error, you’d expect equal dispersion around the zero-line with the # of companies beating and missing by a small amount to be roughly equal. 


But it’s not: 


  1. The spread is always positive – the number of companies barely beating is always higher than the number barely missing, suggesting a little “messaging” of the numbers. 
  2. The spread correlates well with the trend in margins: when margins are expanding, the levers or capacity for earnings management is higher.  The converse holds true as well. 


The simple takeaway is that with corporate profitability now past peak and margins contracting, the capacity for manufactured beats is lower and declining. With repo activity down some 75% in 3Q, that management lever is now apparently past peak as well.   


Policy Implementation | The How: This has been pretty well covered in recent weeks but in talking with people yesterday, more people than not still seem to not know, mechanically, how the Fed plans to manufacture higher rates.  


Here’s the layman summary:  


  • Fed Funds Market | Traditionally: The Fed sets the policy rate via intervention in the Fed Funds market (where banks lend to each other overnight). Traditionally, activity in the Fed Funds market was dominated by domestic banks with smaller participation from the federal home loan banks (who they are isn’t particularly important here). 
  • Fed Funds Market | Post-Crisis: Banks have trillions in excess reserves and don’t need to borrow in the Fed Funds market, leaving the home loan banks as the primary participants.
  • Interest Rates on Excess Reserves (IOER): In the post-crisis period, banks can park excess reserves at the Fed and earn the IOER (was +0.25%, now 0.50%), the federal home loan banks cannot - so they are left participating/looking for yield in the Fed Funds market


What’s Been happening Post-Crisis: Banks borrow from the remaining participants in the Fed Funds market (those who are ineligible to park excess cash at the Fed at the IOER rate). They lend to banks at a rate below the IOER and the banks then arbitrage the difference and earn the spread between the market Fed Funds rate and the IOER.


In this setup, the Reverse Repo Rate (was ~0.05%) = the floor in rates and the IOER represents the ceiling (note: the “Reverse Repo” rate sounds very sophisticated but all it refers to is the rate at which the Fed borrows money overnight – Company X gives the Fed dollars overnight in exchange for a bond from the Fed, and the Fed pays them interest on it. The interest rate the Fed pays is the reverse repo rate.)   


In other words, non-bank participants can either lend at the RRP rate to the Fed or lend to banks at something above that but below the IOER (which they are ineligible to receive).


So that’s the setup. How, mechanically, will they march rates higher:  


  • IOER: The Fed raised the IOER from 0.25% to 0.50% …. Again Raising the IOER effectively creates the ceiling on the interest rate corridor – same as before.
  • RRP: The Fed raised the reverse repo rate from 0.05% to 0.25%, allowing money market funds and participants in the fed funds market to earn the 0.25% yield being offered by the RRR. Again, this effectively creates the floor - why lend at less if you can earn that yield from the Fed.


The Hope: Because market participants can now earn the rate offered on the RRP (0.25%) from the Fed they aren’t incentivized to lend below that rate. The arbitrage opportunity for the banks that existed before (borrow somewhere above the RRP rate and park at Fed at the IOER rate) still exists, it’s just stair-stepped higher. The hope is that the effective rate will fall between the RRP (0.25%) and the IOER (0.50%) … so, if the RRP rate = 0.25% and IOER rate = 0.50%, the Fed hopes the effective rate will fall somewhere around 0.35% - which is exactly where it was on post-liftoff day 1.


Viola, higher rates. 


So, now you know. And as everyone knows, knowing is 1/2 the battle. The other 1\2, of course, is good 80’s cartoon references.  


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 2.12-2.32%

SPX 2003-2060

VIX 17.67-24.87
USD 98.22-99.76
Oil (WTI) 34.13-38.29


Best of luck out there today,


Christian B. Drake

U.S. Macro Analyst 


Click Image to enlarge

Bear Flattening - CoD2 EPS Mgmt

USD Ramps & Rates Fall

Client Talking Points


Re-testing the go-zone of $99-100 on the USD Index with the EUR/USD risk range suggesting $1.05 is next. In 2016 “forecast” terms, this remains grossly misunderstood from a foreign currency, commodity, EM, credit, etc. risk perspective.


The Canadian Dollar crashed to new lows yesterday and EM ASIA were slammed again overnight (Thailand -2.2%, Indonesia -1.9%. Russian Stocks were down -2.6% (and -12% in the last month) as the CRB Index made a fresh new year-to-date low yesterday down -26% year-to-date.


2.21% = lows of the week AFTER the almighty “rate hike”- don’t forget that Industrial Production for NOV was down -1.2% year-over-year (recession) and consumer spending put in its 6 year cycle peak (alongside employment gains) in Q1 of this year too.


*Tune into The Macro Show with Hedgeye CEO Keith McCullough at 9:00AM ET - CLICK HERE

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

MCD remains one of our top LONG ideas in the restaurants space. All indications are that all day breakfast is working, bringing back old customers and driving growth of new customers. Customers are pairing both breakfast and lunch items together in the lunch and dinner day, part which is helping drive additional sales.


McDonald’s Canada opened its first standalone McCafe this month. The much simplified concept intends to appeal to customers by offering both speed of service and low cost. They intend to be faster than their main competitor Tim Hortons and cheaper than Starbucks, carving out their own niche in the market.


MCD remains one of our top LONG ideas in the restaurants space. All indications are that all day breakfast is working, bringing back old customers and driving growth of new customers. Customers are pairing both breakfast and lunch items together in the lunch and dinner day, part which is helping drive additional sales.


McDonald’s Canada opened its first standalone McCafe this month. The much simplified concept intends to appeal to customers by offering both speed of service and low cost. They intend to be faster than their main competitor Tim Hortons and cheaper than Starbucks, carving out their own niche in the market.


Implicit in our long TLT/short JNK bias is an expectation for high-yield spreads to continue along their recent trend of widening throughout the YTD.


“The U.S. economy is #LateCycle and the probability of a recession commencing by mid-2016 is extremely elevated – both in absolute terms and relative to the belief held by the overwhelming majority of investors and policymakers. Moreover, the risk of a global recession is also great in this scenario.”


The economic cycle doing what it always does (i.e. decelerate into a recession before bottoming and then reaccelerating) is reason enough to be bullish on the long bond and bearish on junk bonds, which are accelerating into full-blown crisis mode (the JNK ETF declined another -2% on Friday and is down -4.1% WoW, -5.8% MoM and -12.7% YTD).

Three for the Road


Real Conversations: A Paradigm Shift In Private Equity  https://app.hedgeye.com/insights/48144-real-conversations-a-paradigm-shift-in-private-equity… @LawrenceCalcano



Take time: much may be gained by patience.

Latin Proverb


Today in 1787, New Jersey became the 3rd state to ratify the Constitution.

December 18, 2015

Hedgeye's Daily Trading Ranges are twenty immediate-term (TRADE) buy and sell levels, with our intermediate-term (TREND) view and the previous day's closing price for each name.  Click HERE for a video from Hedgeye CEO Keith McCullough on how to use these risk ranges.


  • Bullish Trend
  • Bearish Trend
  • Neutral

10-Year U.S. Treasury Yield
2.32 2.12 2.30
S&P 500
2,003 2,060 2,041
Russell 2000
1,106 1,160 1,135
NASDAQ Composite
4,901 5,143 5,002
Nikkei 225 Index
18,533 19,807 19,353
German DAX Composite
10,122 10,907 10,738
Volatility Index
17.67 24.87 18.94
U.S. Dollar Index
98.22 99.76 98.64
1.05 1.10 1.09
Japanese Yen
120.33 123.81 122.68
Light Crude Oil Spot Price
34.13 38.29 36.11
Natural Gas Spot Price
1.76 2.02 1.74
Gold Spot Price
1,049 1,079 1,050
Copper Spot Price
1.99 2.10 2.04
Apple Inc.
106 113 108
Amazon.com Inc.
643 685 670
Alphabet Inc.
747 782 769
Facebook Inc.
102 109 106
Kinder Morgan Inc.
13.50 17.48 15.37
Valeant Pharmaceuticals, Inc.
84.28 119.33 111.38



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Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta

Takeaway: We hosted our latest deep dive BlackBook presentation yesterday on WisdomTree. The call replay and relevant materials are enclosed.

Click HERE to watch the replay of this presentation. 

Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF BlackBook invite

Click HERE to listen to the audio replay. Click HERE to access the assosciated slides. 


The Wisdomtree business is a very good one that has been smartly launched to gather assets in the market share shift from mutual funds to ETFs. That being said however, expectations are sky high for this small cap company and the stock has substantial growth to backfill to grow into its near 30x forward earnings multiple. We are currently forecasting earnings over -20% below the Street for 2017 and see downside risk in shares.


Our main contention is that the important international hedged equity products have a beta construction weakness and actually underperform local benchmarks in local currency:


Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 2

Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 3


The proposition then becomes that this benchmark underperformance has to be made up by the firm's rolling currency hedge. Historically, the hedge has consummed the local underperformance however this is risky considering that across cycle there are more instances than not of local currency exposure actually stabilizing foreign equity returns:


Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 4

Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 5


The foreign FX products require liquid and favorable interest rate differentials in the non deliverable forward (NDF) market, which mean that only a few currencies and hence geographies qualify for FX hedged products. Currently only the UK pound, the Euro, the Yen, and the Swiss Franc would be available for FX hedged products. Thus, because the company already has product in the Yen and Euro, the firm has likely already launched it most successful funds in our view:


Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 6

Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 7


There is a lot of wood to chop to backfill the Street's high growth expectations. The stock sports nearly a 30x P/E before evening thinking about that Consensus is some 20% too high for 2017.


Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 8

Best Ideas Call REPLAY | WisdomTree (WETF) - Not So Smart Beta - WETF 9



Please let us know of any questions,


Jonathan Casteleyn, CFA, CMT 




Joshua Steiner, CFA





Takeaway: e-commerce trends appear to be bifurcating further between Nike and FL as we head into year-end. FL remains Best Idea Short.

Please…somebody explain to us how the charts below are not really bad for FL. Specifically, the online data we track – from a number of sources such as Alexa, Compete, Google, and Comscore as well as our own analysis – shows a continued slowdown in Foot Locker’s online business since the end of the third quarter. This is not just an industry thing, or a category thing. We’re seeing Nike’s web traffic explode to the upside (‘explode’ is a strong word, but when you see the chart you’ll get what we mean), UA and AdiBok tracking well, suggesting that the share shift from traditional retailers to the Brands is taking hold. While the data looks quite ugly for FL, we want to reiterate that this is a fat-tailed transition that won’t play out entirely in a single quarter. But, the negative on-line trends for FL that reared its head in 3Q seems to be carrying into 4Q.


As a reminder, FL is at the top of our Best Ideas Short List. While our short thesis goes far beyond a few unfavorable data points, the question around timing has been a big issue for people who agree with our TAIL call, but can’t quite get there over the near term. For many reasons, we think that $4.20 will likely prove to be the high water mark in this economic cycle, and the consensus estimates in years one through three are high by $1-$2 per share. We think that emerging competition from its top vendor, Nike (≈80% of sales), will stifle growth, and leave the company with an earnings annuity somewhere around $3.50-$3.75 per share. Is that worth $64? Not a chance. Not for a company that is Nike’s best off-balance sheet asset. And definitely not when the Street is in the stratosphere approaching $6.00 in EPS (#NoWay). 


Importantly, we think people generally misunderstand why the rate of growth between Nike and Foot Locker will be slowing materially. It’s not because Nike hates its largest customer. It’s not because the ‘basketball cycle’ is rolling over (the basketball cycle actually does not exist, at least in the way people think). It is slowing because Nike has largely tapped out its growth inside higher-end US distribution, and simply has to turn to its own DTC platform – which finally exists after nearly a decade of investment. Yes, it used the cash flow from US wholesale growth to fund growth around US wholesale when the time arises. It’s as simple as that. And yes, the time has arisen.  




TRAFFIC RANK (EX 1): This is primarily made of Alexa data, which shows the year-year change in the web rank for footlocker.com. “Web Rank” is simply a relative measure of footlocker.com’s total traffic by week relative to the average company on the web. Looked at in isolation, the data for a given quarter is rather useless, but on a year/year basis, it becomes quite relevant. Note that FL’s e-commerce growth fell to +29% in 3Q versus +40% in 2Q – marking the first time in two years we saw growth below 30% in this business. The trend in the chart below accurately captured that slowdown. 



FL | THIS IS BAD - FL YOY Traffic Rank Index Change


SEASONALITY: It’s important to look at the seasonality of traffic. After all, each retailer has its own cadence on a week to week basis. Our point is that you can’t compare FL vs DKS, as the seasonality of the sporting goods business is different from mall-based athletic retailers. Exhibit 2 shows that we should have seen a notable seasonal upswing in October of 2015, but we really didn’t see much of anything. Just a flatline. The gap between this year and last year is exceptionally tight right now. Too tight.



FL | THIS IS BAD - FL 2014 15 Indexed Traffic Rank


BRANDS vs RETAILERS: Exhibit 3 shows the performance (web traffic) of FL vs. a composite of the brands. While all major brands are on a healthy trajectory, Nike makes up for the biggest upswing. Needless to say, look for Nike to put up a big e-commerce number when it reports next week.  Nike will still talk about how they still love their wholesale model, which they do. But that does not mean that they won’t grow around it to put up results shareholders demand.


Looked at a different way, Exhibit 4 shows that the traffic spread is growing at an accelerating rate and is sitting at historical peak.



FL | THIS IS BAD - Compete T3M Visitation Trends  FL vs Brands 



FL | THIS IS BAD - Compete Visitation Spread  FL vs Brands


Real Conversations: A Paradigm Shift In Private Equity

Is the cloistered world of private equity opening up to more modest investors? In this recent Real Conversations interview, Hedgeye CEO Keith McCullough sits down with former Goldman Sachs partner Lawrence Calcano, a managing partner of the private equity platform iCapital Network. Calcano discusses how his firm’s technology offers private equity funds to wealth managers, registered-investment advisors and family offices who wouldn’t otherwise have enough scale to access them. 

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