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Reality's Illusions

“Reality is merely an illusion, albeit a very persistent one.”

-Albert Einstein

 

Today’s reality is that American and European governments are Keynesian. That is, they believe that government spending is the answer to growth, and that government’s heavy hand doesn’t perpetuate the unemployment they whine about or the inflation that they aren’t allowed to talk about.

 

Retiring Fed Head, Donald Kohn, made comments in San Francisco last night that summarize the illusion that he needs to create: “I expect unemployment to come down only slowly from its current elevated level”… and… “inflation will remain low for a while.”

 

Now, let’s set aside that Kohn has been at the Fed forever and missed seeing any of this mess coming since he joined the Fed’s Board of Governors in 2002, and consider the reality of this two-factor Fear Mongering Fed Model that he and his always dovish friends, Janet Yellen and Bill Dudley, have recently echoed:

  1. Unemployment: At +9.7%, it's high. Anyone with an internet connection gets that. It’s also the most lagging economic indicator we have, and it’s rolling over sequentially versus its peak where some at the Fed were forecasting the Great Depression.
  2. Inflation: Headline inflation (CPI) rolled over in February on a month-over-month basis to +2.1% year-over-year (yes, even the calculation that they have changed 9x since '96 to numb it down is up), and is setting up to shoot up again, sequentially, in March.

Yes, there are forecasts embedded in my considerations. This is what people who manage risk proactively call “making a call” before something happens and you can hold me accountable to it (March CPI will be reported next Wednesday). Reality’s Illusion is that Washington group-thinkers still thinks that “core” inflation is benign, because the Fed model is a reactive one that’s based on yesterday as opposed to today and tomorrow.

 

I talked to the Chairman of MFS and author of “Too Big To Save”, Bob Pozen, about this last night on Bloomberg TV. I asked Bob if the real problem with the Fed and the said leadership of American finance is whether or not the Fed operates with an ideology rather than a proactive risk management process. He said yes. Coming from a leader who is marked-to-market every day by his clients, the answer here was not surprising.

 

I understand that 2008 seems like forever ago, but the realities of what created this crisis are not illusions. In 2008, on the topic of ideology versus empirical process, Rep. Henry Waxman asked Alan Greenspan, “do you feel that your ideology pushed you to make decisions that you wish you had not made?”

 

Greenspan: “Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to – to exist, you need an ideology. The question is whether it is accurate or not. And what I am saying to you is that I found a flaw.”

 

So there you have it Mr. Bernanke and Mr. Kohn. What have you learned from the crisis and why are we still managing go-forward market risks based on a failed ideology? Markets change and so do facts; what do you do Sirs?

 

The reality is that Glenn Stevens at the Reserve Bank of Australia, Albert Einstein, and Darwin for that matter, would never sign off on individuals garnering so much political power that they allow their ideologies as to a way something “should” work override the data. It’s lunacy.

 

A persistent illusion that Keynesian economics is the written gospel of God is what brought us the inflation of the 1970s, and for whatever reason now all the Keynesians out there think “it’s different this time” because they can print moneys from the heavens. Food in India may indeed by falling from Ben’s helicopters right now, but its +18% more expensive than it was last year!

 

While the US Federal Reserve and European Central Bank mark their ideologies to their political models, the inflation data continues to roll in. And yes, inflation is marked-to-market.

 

Anyone who needs to put gas in their car or food in their children’s mouths around this good world get that, but now were even seeing inflation spikes on conflicted government data.

 

While I am still forecasting here, I’m also staring down the latest data on my sheets from this morning’s global macro run:

  1. British Producer Prices (input prices, as in the price of things someone needs to pay to make something they want to sell) were up +10.1% year-over-year for the month of March. That was the highest reading since May of 2008, when Bernanke didn’t think $150/oil was inflationary.
  2. Oil prices are trading in a Bullish Formation (bullish across all 3 of our risk management durations: TRADE, TREND, and TAIL) at $86.16; that’s up +12-21% from the WTIC oil price that was imputed into the February CPI and PPI reports don’t forget.
  3. The US Dollar Index continues to make a series of higher-highs and higher-lows at the same time as US Treasury yields continue to make a series of higher-highs and higher-lows.

Suggesting that the both Mr. Bond Market and Mr. Currency Market have this wrong alongside Dr. Copper (who is trading up at $3.61/lbs this morning; up +26% from the February lows that the Fed is straight-lining as their “benign inflation” assumption), and that the Fed’s flawed ideology is right, is something for analysts far braver than I to accept as an illusion that will be this debt laden world’s long term reality.

 

My immediate term support and resistance lines for the SP500 are now 1178 and 1194, respectively.

 

Best of luck out there today,

KM

 

Reality's Illusions - Greenspan

 


Looking Below the Surface

Looking Below the Surface

 

This morning March same store sales were released with results that unanimously exceeded expectations across the board.  While results in aggregate were amongst the strongest we’ve seen in years, inevitably there were several anomalies that stood out when we looked below the surface.  A few interesting points:

 

- While the Easter shift positively benefitted almost every retailer by 200-500 bps, Costco was the only one to report that Easter was actually a negative for the month.  Because the company is actually closed on Easter, the month had one less selling day this year vs. last.  As a result, Costco will benefit in April while the rest of the retail universe bears the negative impact of the shift.

 

- Costco and BJ’s Wholesale both noted that TV sales were weak during the month. Costco cited weakness due to both deflation and negative unit sales.

 

- GPS comments were clearly focused on its success with recent merchandising initiatives, with management going the extra mile to explain that they saw underlying strength excluding the Easter shift.  Interestingly, the company also noted that it will no longer comment on merchandising margin performance on a monthly basis.  This comes as a result of the company’s key focus being on same store sales and topline growth now that margin driving efforts are largely complete.  Clearly a shift from defense to offense.

 

- American Eagle Outfitters noted that tops priced under $20 were among the best performing categories in the store.  Clearly value remains top of mind amongst the teen customer base.  This was also evident in the strength we saw at ARO, and the lack of strength at Abercrombie and Fitch (even with gift card promos).

 

- “Conversion” was the buzzword of the day, with many retailers citing this as a key reason for strength.  Traffic was up, but “conversion” was even stronger.

 

- JC Penney noted that its home categories were the weakest in the store and online.  This is counter to trends we have seen out of TJX, ROST, KSS, BBBY, and WSM.  Historically home has been a key category for JCP, but market share losses are becoming more evident as the overall health of the category appears to be consistently improving.

 

- Nordstrom noted that March marked the 7th consecutive month in a row of increased year over year traffic.  It also posted one of the largest same store sales increases in department store history, with a 16.8% increase!

 

- Kohl’s stands out for the company’s geographic and merchandise consistency.  All regions posted at least a high teens increase, while all categories registered a comp increase of 19% or more.  

 

- Ross Stores noted that shoes and home remain the company’s best performing categories, with both increasing by 20% for the month.  Dresses were also strong, increasing in the teens.

 

- Target’s commentary on strong apparel sales, up mid teens, is a large part of the reason behind the company revising earnings upwards by $0.10. Interestingly, the new guidance of $0.84 will take Q1 earnings to the highest non-holiday EPS ever recorded in company history.  The prior peak was $0.82 back in 2Q08.

 

- Finally, it’s worth noting that ANF was one of the few companies that did not meet expectations for the month.  We continue to wonder if management’s decision to severely cut back on inventory is now meaningfully holding back sales.  Recall that management took markdowns on Spring goods before they even hit the floor (as well as diverted them to outlets) because they were unhappy with certain product.

 

Eric Levine

Director

 

Looking Below the Surface - 1 year

 

Looking Below the Surface - 2 Year

 


ECB on Hold, Greece Isn’t

Position: Long Germany (EWG); Short Euro (FXE)

 

Following the European Central Bank’s decision today to keep its main interest rate on hold at 1%, ECB President Jean-Claude Trichet held his usual follow-up press conference. Notably, the media pressed him in the Q&A session to explain the economic conditions (parameters) that will initiate the EU and IMF to inject funding for Greece, or conversely the market conditions that should initiate the Greek government to request capital. In typical Trichet fashion he was tight-lipped on such questions, but did express that “a default is not an issue for Greece”.

 

So what did we learn from today’s ECB release?

  • The ECB has decided to keep the minimum credit threshold for marketable and non-marketable assets in the Eurosystem collateral framework at investment-grade level (i.e. BBB-/Baa3) beyond the end of 2010, except in the case of asset-backed securities (ABSs).
  • As of 1 January 2011, a schedule of graduated valuation haircuts to the assets rated in the BBB+ to BBB- range (or equivalent), which will be announced at the ECB meeting in July 2010.
  • This graduated haircut schedule will replace the uniform haircut add-on of 5% that is currently applied to these assets.
  • Marketable debt instruments denominated in currencies other than the euro, i.e. the US dollar, the pound sterling and the Japanese yen, and issued in the euro area will no longer be eligible as collateral as from 1 January 2011.

One main take-away here is that with Greece’s sovereign debt rated at BBB+ by Standard & Poor’s and Fitch Ratings, further ratings downgrades will put in jeopardy Greece’s ability to borrow from the bank as stricter collateral obligations are imposed.  We’ll know more about this latter point when the ECB presents its schedule for haircuts in July, but considering Trichet’s determination of the European community to assist Greece (or other PIIGS), it wouldn’t surprise us if exceptions were made to said measures.

 

The recent spikes in Greek bond yields, rising Greek CDS prices, and a plunge in the Athex equity market have furthered investor doubts that Greece can meet its debt obligations. The chart below shows the recent spike in the 10YR Yield and the lower chart gives historical perspective on the Greek spread over the risk-free 10YR German Bund.  As Greece looks to issue more debt in the coming weeks, rising current yields will put upward pressure on future rates; as we’ve said numerous times, kicking the debt “can” further down the road does not end well.  For now, without EU policy to deal with sovereign debt issues of its member states, this game of “wait and see” from Trichet and EU leaders will prolong the underperformance of Greek bond and stock markets.

 

Matthew Hedrick

Analyst

 

ECB on Hold, Greece Isn’t - chart

 


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The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.64%
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CKR - STEALING THE COMPANY

Apparently another bidder has emerged for the assets of CKE Restaurants.

 

For those following the saga, I’m putting my stamp on what I think is a fair price for the company.  If I was a shareholder I  would be extremely disappointed in THL Partners’ offer of $11.05 for CKR.  A more appropriate price is closer to $15.

 

While a sum of the parts analysis is never an exact science, I believe my assumptions are very conservative in valuing the cash flows of the company’s two brands.  I also believe that the company was mismanaged and there are a number of opportunities to make the company more profitable.

 

First, the current management team has an inflated view of what it is worth.  For the last three years, the senior executives were some of the best paid in the industry running two of the smaller chains.  That being said, there are a number of ways for the company to reduce G&A.    

 

Second, we think there is an opportunity to enhance shareholder value by focusing on restaurant operations. While I appreciate the legacy issues surrounding the distribution business, the economics of the distribution model more than justify the company exiting the business.  Today, running a franchise restaurant company has never been more challenging; the challenges are even more complicated when management’s time is consumed with managing a distribution business and a restaurant company at the same time.  After analyzing other distribution companies, it would suggest that the economics of running the distribution business are under pressure and CKR could be well served by letting bigger, more efficient companies manage the business. 

 

CKR has justified retaining its warehouse and distribution operations for its Carl’s Jr. system because it allows the company to more effectively manage its food costs, provide adequate quantities of food and supplies, generate revenues from franchisees, and provide better service to its restaurants in California and some adjacent states.  Although these motives for keeping the business may all be true, we do not think they trump the potential cost savings that could be realized from outsourcing such operations. 

 

Hardee’s distribution business is based primarily on equipment sales to franchisees and actually generated slightly negative profits over the past five years and this does not take into account the G&A expenses associated with operating the business. 

 

It will be interesting to see where things shake out…..

 

Howard Penney

Managing Director

 

 

CKR - STEALING THE COMPANY - ckr


IT'S ALL BACCARAT

Strip gaming revenues increased 33% and it was all Baccarat. Baccarat volume and win were up 131% and 255%, respectively, thanks to CNY and a lot of luck. Slot revenue declined 9%.

 

 

Owing to the timing of Chinese New Year (CNY) and good luck on the tables, the Strip posted a 33% YoY increase in gaming revenues in February 2010.  As we wrote about a few weeks ago, we thought growth would be positive but this is much better than expected.  Of the $141 million positive variance from last year, $82 million was driven by higher Baccarat drop which increased 131%.  Baccarat win increased 255% partly due to the higher drop and partly due to a higher hold percentage - the Baccarat tables held at a 17.0% clip versus 11.1% last year.  Normal hold percentage is 12-13%.  The good Baccarat luck contributed about $65 million to the variance.  Slot revenues actually declined for the month by 8.5% all due to lower hold percentage.  The table below breaks down the YoY variance in millions of dollars.

 

IT'S ALL BACCARAT - strip7

 

While the February numbers were outstanding, a little caution is in order.  Revenues were down 23% last year so the comp was easy.  CNY fell into February of this year versus January of last year which helped Baccarat volume.  Baccarat volume and hold percentage can be very volatile and no doubt the strength on the Strip is mirroring the VIP strength in Macau.  It is unclear how sustainable these volumes are. 


The End of Quantitative Easing, As We Know It

 “It’s the end of the world as we know it and I feel fine.”

-R.E.M.

 

R.E.M. is an iconic American rock band that was founded by Michael Stipe in 1980.  While the band is not known for its thoughts on monetary policy, the line quoted above from their song, “The End of the World Was We Know It”, provides a good metaphor for the Federal Reserve’s recent decision to halt quantitative easing.

 

While many market observers expected this planned ending of policy to lead to an increase in interest rates, particularly for mortgages, we have seen only a marginal change in rates.  In fact, over the last three weeks 30-year fixed mortgage rates have only increased marginally from 5.05% to 5.25%.  In essence, the quantitative easing world has ended, but those still borrowing via mortgages “feel fine”. 

 

To its credit, the Federal Reserve did an effective job at prepping the market for the end of this policy, so new buyers stepped in and the mortgage market has remained stable.

 

Backing up for a second, though, what exactly is quantitative easing? 

 

Central Banks have basically two key tools to implement monetary policy:  interest rates and reserve requirements.  By lowering interest rates, central banks can stimulate money supply by making borrowing rates more reasonable to borrowers and the margins from lending more compelling to lenders.  On the reserve front, the central bank can alter the reserve requirements, which is the ratio of cash a bank must hold compared to customer deposits. Any increase in reserve requirements will limit a bank’s ability to lend, or vice versa.

 

In the scenario where the interbank interest rate is zero and reserve ratios have been maxed out, central banks can initiate another form of policy: quantitative easing.  In simple terms, central banks will begin to purchase financial assets from banks through open market operations.   So the central banks print money to buy assets from banks, which increases the excess reserves on the balance sheet of banks. 

 

Quantitative easing was used by the Bank of Japan in the early 2000s in an attempt to offset deflation with limited results.  In November of 2008, the United States implemented their first ever policy of quantitative easing.  The policy had two aspects to it.  First, the Federal Reserve indicated they would purchase direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Second, the Federal Reserve indicated they would purchase mortgage back securities.

 

The objective of this program according to the Federal Reserve was to, “reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”  In effect, as credit markets ground to halt in late 2008, the Federal Reserve had to take the extraordinary and unprecedented measure of quantitative easing to offset the potential risk of deflation.

 

While the program started on a smaller scale with $500 billion of mortgage backed debt, the program was increased in March of 2009.  As the program ended on March 31, 2010, the Federal Reserve had purchased $1.2 trillion of mortgage-backed debt from banks and $200 billion of direct obligation debt of Fannie Mae and Freddie Mac, for total purchases of $1.4 trillion.  As a result of these actions, the Federal Reserve now owns almost 25% of the stock of mortgage-backed securities.

 

In the chart below, we have charted the increase of excess reserves on bank balance sheets.  The current amount of excess reserves is estimated to be around $1.2 trillion.  Assuming that these excess reserves were turned into loans at a 10:1 ratio, the increase in money supply into the system would be $12 trillion.  This is larger than the current amount of outstanding mortgages in the United States!

 

The reality is simply this: we have no idea what the consequences of this quantitative easing policy action will be.  It is an unprecedented move that, in time, will have to be unwound.  If the unwinding is natural, which would involve banks reducing their excess reserves to a more normal level, the inflationary impacts on the U.S. economy could be extraordinary.

 

At this point, I’m not going to predict the “end of the world as we know it” due to this massive increase in excess reserves, but this policy will have to be unwound at some point.  Either the Federal Reserve will have to pay competitive interest rates on these reserves so as to discourage loans, or the banks will begin to lend.  And lend.  And lend.

 

I can promise you this, if the $1.2 trillion in reserves starts to make its way into the economy, money supply will increase dramatically, and with it, inflation.  While there is increasing discussion of inflationary pressures, very few people are currently considering the unintended consequences of quantitative easing.

 

Daryl G. Jones

Managing Director

 

The End of Quantitative Easing, As We Know It - Excess Reserves


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