“What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”
How prescient the “Oracle of Omaha’s” simple statements continue to be… this past week’s action across stock markets, globally, implied that consensus couldn’t have possibly have been realistically understood. Since the 10/27 lows, the Hang Seng Index and the S&P500 rallied +30% and +15%, respectively. If you weren’t short that, or “all in” on the “going to cash” call, congratulations! US denominated cash ended up losing over 4% in that same period of time.
Bottoms are processes, not points. We have been hammering home that we see a bottom forming in consumer and investor confidence, globally. While any data set can get worse, we are paid to be realists, not alarmists. Provided that Obama wins tomorrow, the election math implies that over 50% of American voters will soon see the USA as a better place than it was yesterday (see out Macro note titled, “Could Obama Signal A Bottom In Confidence”, 10/31).
Daryl Jones wrote an outstanding thematic piece for our ‘RE Macro’ clients this weekend titled “Eye On Behavioral Finance: The Power and Pitfalls of Confidence” (www.researchedgellc.com, 11/2). This is clearly one of the misunderstood frontiers of finance, and one that we will continue to explore in the coming months. Wall Street has had a long history of “old boy club” investing based on what Nasim Taleb labels “narrative fallacies” (story telling that supports your invested position). As this weekend’s ‘Economist’ notes on its cover, “It’s Time” – it is time for these reactive and qualitative investment management styles to take a turn warming up the bench. It’s time to proactively manage risk. It’s time to quantify all investment scenarios. It’s time to ‘You Tube’ our business for what it is, and rebuild it.
Despite all of the excuse making in the market place, two of the last three weeks have been positive ones for the S&P 500. Stock markets, globally, are beginning to discount better than toxic expectations for the immediate days ahead. Alongside the aforementioned rallies in the US and Asia, Europe is trading up for the 5th consecutive day this morning. We are long Germany via the EWG exchange traded fund where the stock market has appreciated +17% since the 24th of October. Unemployment in Germany remains low, and inflation readings have began to abate. This is progress.
Progress, at least in capital markets, can reveal itself in many forms. One of the most critical ones is expectations. This morning the European Union is leveling expectations for 2009 by cutting its economic growth outlook to zero. Yes, zero… Could they be worse than zero? Sure. Is this easier to swallow than the unrealistic expectations of the said economic forecasting savants of horse and buggy whip investment banks past? Definitely.
Alongside credit markets thawing, and yield curves steepening, our expectations for appreciation in our equity portfolio allocation continues to be positive (see ‘Hedgeye Portfolio Allocation’ above). Away from the US Dollar underperforming last week (we are short it via the UUP etf), so did gold. Gold wasn’t down much, but the point is that it was down – like credit spreads and slopes, this is one more global macro sign of stress in the global economic system abating.
Context is always critical, and you don’t need to look too far from the vacuum of available financial media to come to realize that, on a week over week basis, last week saw the S&P500 +10.5%, the CRB Commodities Index +5%, and the Volatility Index (VIX) drop -24%. Just as ole Bushy gets to see Hank the Tank’s “Investment Banking Inc.” ice get “unstuck”, he’ll be waving goodbye to the prospects of John McCain leading another reactive “B” Team at the US Treasury into 2009’s global economic battle.
Nobel Prize winning economist, Robert Aumann, who is holds a special place in my investment heart for his game theory conclusions, came out this weekend simply calling Paulson “not smart.” At least I have some decorated company in my camp now. Perhaps the most important catalysts of an Obama victory, will be a wholesale change to the American lineup at the US Treasury.
Team “Buffett, Volcker, and Summers” has a better than bad ring to it… with all time lows in US consumer confidence in our rear view mirror, that might very well be all this stock market needs in order to support the current squeeze. Everything that matters in markets happens on the margin, and “how realistically you define” what you may not know is going to occur next. Keep your eyes open for more of the unexpected.
Have a great week,
JO – iPath Coffee – India’s Coffee Board estimates January – October exports increased 3%, slightly more than anticipated after problematic weather.
EWG – iShares Germany – Commerzbank to receive 8.2bn in EUR from the government after a write down. The stock is up +6.8% post the announcement.
FXI – iShares China – China’s state news agency reported that the central bank removed temporary controls on loans to bolster economic growth. China Purchasing Managers Index fell to 45.2 in October from 47.7 in September, the largest contraction since the survey began.
EWH - iShares Hong Kong – The “hairy crab index” has dropped between 30 – 50% in recent months, which is used as a proxy for consumer luxury spending in Hong Kong.
VYM – Vanguard High Dividend Yield ETF – Credit Default Swap contracts on the CDX North America Investment Grade Index of 125 companies in the U.S. and Canada increased 5 basis points to 203 on Friday.
UUP – U.S. Dollar Index – The USD is down for the 4th straight day against a basket of currencies and ahead of the ISM manufacturing report in the U.S. this morning.
EWU – iShares United Kingdom – European Commission data estimates UK debt levels will exceed 60% of GDP in 2010. PMI data indicates that manufacturing has declined for 6th consecutive month.
IFN – The India Fund – Central bank lowers benchmark rate by 50bps to 7.5% and the reserve ratio by 1% in surprise move. The reserve ratio cut is expected to add $8.1bn to India’s financial system.
“What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”
“What the WSJ did not report is that the testing in Detroit is a result of the proven fact that the African American consumer has little interest in the fancy coffee drinks. Remember, all of Michigan has had these products for over two years so they've proven the weakness in the urban setting.”
“Even though sales aren't strong the outstate MI, stores sell two specialty coffee drinks for everyone one sold in Detroit metro. So this means that the sales of specialty coffee index at about 75% for AACM to the General Consumer Market during promotional periods. During sustaining periods without heavy promotion sales in the AACM is about 50% of the GCM. Hence the change in formulas (adding chocolate) being tested in Detroit”!
Casino operators are preparing their Capex budgets right now. I know they’re scared. Gaming revenues are down considerably and September was one of the worst months ever. Most importantly, senior managements are very worried about liquidity and covenants, particularly in the first half of 2009. Slot Capex comprises the largest part of maintenance Capex and is the easiest to delay.
I think the suppliers are overestimating 2009 slot demand. Part of this miscalculation is the classic forecasting error of assuming that current trends will continue. Additionally, the suppliers are getting indications of slot demand from casino level management. Unfortunately, 2009 slot decisions will be made at the corporate level and not at the casino level. Another price of excessive leverage.
The chart below examines current Street estimates for slot unit demand and revenue for the first half of 2009. For the Big Three, Analysts are projecting market growth in both metrics over this time period. In the case of BYI and WMS, the estimates are even less believable. I understand that both companies have stolen market share from IGT and may continue to do so. If you believe, as I do, that unit demand and revenues will decline in the first half of next year, further market share shifts would have to be dramatic for WMS and BYI to hit those numbers.
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During the 1920s Mustafa Kemal, an officer who emerged from the war as the hero of Gallipoli, gained power and rebuilt his nation over the following decades -creating a modern secular democratic state. Today Kemal (known as “Ataturk”) is still revered to the extent that it is a crime to publicly disparage him and his policies. Each year on November 10 –the anniversary of his death, the entire nation observes a minute of silence. Kemal was a transformational leader who guided his country through a volatile period of history; it’s likely that this November 10th Turkish thoughts will be focused on how their nation can best navigate the current world crisis.
Over the past decade Turkey has gone through a manic series of highs and lows. A devastating earthquake in 1999 and humiliating IMF bailout after the collapse of 2001 were followed by reform and years of rapid economic growth which saw the former “sick man” rise to be the 6th largest economy in Europe. The prospect of EU membership in 2005 –at first a source of euphoria, has since become a sore subject as issues like Cyprus and the Armenian genocide controversy have slowed the ascension process to a crawl. Meanwhile, tensions with NATO partners over Kurdish separatists on the Iraqi border and internal debate between Islamic beliefs and Turkish secular values have been ongoing sources of friction.
This year the Turkish markets have been battered by the global storm. Since the beginning of the year the ISE 100 stock index has lost half of its value –surrendering over 20 % in October alone. The Lira has been hurt in 08 as well, declining 20% against the dollar so far.
The data supporting the negative consensus case for Turkey is simple:
· The country has never fully recovered from the 2001 crisis. The current account deficit stood at 5.8% at year end 2007, statistically high by the standards of major emerging economies and its credit rating remains speculative, leaving it prone to external credit shocks;
· Turkey has seen its fortunes rise with the EU (responsible for over 50% of Turkey’s foreign trade) and, now that the economies of their trading partners to the north are slowing (if not stalling completely), Turkey will suffer disproportionately in the coming recession as a weaker peripheral player. Meanwhile its other major trading partners, the US, Russia and Japan are facing prospects equal or worse than the EU; and
· The security issues that come with sharing borders with Iran, Iraq and Georgia are nightmarish.
We are beginning to explore a contrarian thesis, based on less negative data points:
· Turkey has successfully reduced external debt as % of GDP to just over 37% since the 2001 crisis -although with a speculative credit rating it will not necessarily have access to credit markets anytime soon, this lessened debt load may help insulate it from the prospect of downgrades. Additionally, the main trade deficit driver has been oil and other commodities, which are now in freefall;
· So far the Turkish banking system has proved relatively resilient (there is some speculation that the regulatory environment there made it made it more difficult for Turkish banks to hold derivative instruments on their balance sheets during the credit market boom years than it was for their foreign counterparts, thus protecting them);
· According to the OECD’s July report: “Turkey continues to have some of the most rigid labor and product market regulations of the entire OECD area. Doing business in compliance with the law remains less attractive than in most other OECD countries”. With abundant inexpensive skilled labor and a geographical position that provides access to not only the EU markets but also the Gulf States via Iraq and Central Asia via the Caspian states, Turkey could help attract more foreign investment if its government took steps to lower these barriers to entry- an idea that appears to be gaining support among political leaders; and
· Although unemployment continues to be a real issue (a factor that could well be compounded by slowing opportunities for work abroad in EU nations) consumer inflation has been held in check for the past 4 years, hovering around 10%, and internal consumer demand has been relatively resilient in recent months.
In the coming weeks we will continue to keep our eye on Turkey as we weigh its prospects on a relative basis against its EU and Middle East neighbors. If, after consideration, we decide that the glass is half full we will report back.
Those who have been tracking my analysis know that I’m pretty much obsessed with operating lease structures for retailers. Not out of morbid curiosity, but by the way that striking such agreements as it relates to duration, and varying step-up factors can meaningfully distort current earnings streams. Here are two Exhibits showing two overriding themes. 1) Minimum lease obligations over 5 years versus current operating margins, and 2) The incremental change in that rate over the past 2 years. Some interesting conclusions…
1) Those with the healthiest lease obligation ratio include Timberland, Warnaco, Philips-Van Heusen, Columbia, Payless, Hibbett, Carter’s Nike and VF Corp. These are companies that have a call option to alter lease terms (i.e. lower near-term payments, but higher escalators, or for example), and improve operating margins. Whether or not this strategy is wise, it is an option.
2) The companies with the poorest positioning are Dick’s, DSW, Skechers, and BJ’s. I’d even highlight Coach and Abercrombie as high margin, low flexibility portfolios. That’s not to say that there is massive risk to those models, but simply that if business slows meaningfully, their respective options are more limited to tweak the portfolio to ease a margin pinch.
CHANGE IN PORTFOLIO
1) In looking at the incremental change in ‘flexibility ratio’ over the past 2 years, there are some clear standouts. Timberland, Finish Line, Columbia, Ralph Lauren, Van Heusen, Warnaco, and Hibbett all look particularly good, with improvements of 10 points or more.
2) On the flip side, Skechers, Quiksilver, Carter’s, VF Corp, Nike, and to a lesser extent Abercrombie all register at the opposite end of the spectrum. These companies have been taking up forward minimum obligations relative to current payments. This is not always bad, as it might be explained away by a change in business mix (i.e. JNY’s got worse bc it divested Barney’s). But overall, it is a way for a company to boost current margin run-rate, and is a key factor to watch.
Positive Standouts: Timberland, Columbia, Ralph Lauren, Phillips-Van Heusen, and Hibbett.
Negative Standouts: Skechers, Dick’s, DSW, Carter’s VF Corp and Nike.
Click on charts below for a larger view, or email me for the Excel file.
Investors have a love / hate relationship with confidence. On one hand, being confident in your analysis, process, and team is critical to making sound and successful decisions. On the other hand, overconfidence, especially to the point of hubris will lead to risk taking, which can ultimately lead to losses that become insurmountable.
The word hubris finds its root in the Greek work hybris. In ancient Greece, hybris referred to actions of those who challenged the gods or their laws, which led to their eventual downfall. In fact, hybris was considered the greatest sin of the ancient Greek world. The story of Icarus is one of the most telling examples of hybris in ancient Greek mythology. Despite repeated warnings from his father Deadalus, Icarus was overcome with the giddiness of being able to fly and flew to close to the sun. He burnt his feathers, was no longer able to fly, and fell into the sea.
In investing it is critical to be aware of overconfidence and protect against the development of hubris, particularly after a recent period of success in the markets. This success can lead to, naturally, a feeling of overconfidence and more rampant risk taking. This psychology predicament is well known in many fields. In the military, this is referred to as “victory disease” as successful military commanders have a tendency to demonstrate poor judgment after a series of military victories. Napolean’s ill fated invasion of Russia is, perhaps, one of the more notable examples.
From an investment perspective, overconfidence creates at least three fatal flaws: miscalibration, better than average effect, and illusion of control.
- Miscalibration occurs when investors overestimate the precision of their knowledge and tend to use confidence intervals that are too narrow. In a paper by Graham and Harvey, CFOs were given a multi-year survey and asked to give their 80 percent confidence interval for stock market close over the next year. When over 4,300 forecasts were measured against the actually results, only 30.5 percent, or less than a third, were accurate within the 80 percent confidence interval.
- Better than average effect occurs when people grossly misjudge their abilities. This was highlighted in a recent Washington Post poll in which, “94 percent of Americans said they were above average in honesty, 89% in common sense, 86 percent in intelligence, and 79 percent in looks.”
- Illusion of control involves the belief that one may be able to influence random events. In a famous study by Langer and Roth, participants were asked to flip a coin ten times with rigged results. When asked how they would do in a game of 100 flips, those who started with a series of wins expected to do much better and, additionally, almost forty percent believed they would get better with practice.
Overconfidence is much more than just a behavioral economic trait that we need to be aware of it, it also has an actually physiological foundation in the way of dopamine, which is a chemical that the body generates to reward “success” and by creating a feeling of pleasure. Keith has previously posted on the impact of dopamine and Richard Peterson summarizes this effect well in his book “Inside the Investor’s Brain”:
“The dopamine-based reward learning process encodes a profitable pattern of behavior. Subsequently, however, highly profitable traders may have difficulty maintaining the same level of attention to risk management because of a chemical shift in their brains. They become slightly bored and push the limits of their abilities and risk exposures in order to continue to feel challenged. The combination of low relative dopamine levels during during trading (because they have already learned profitable techniques) and elevated norepinephrine levels provokes increased boredom, distractibility, and scanning for new opportunities.”
Too much success, in effect, can change an investor’s brain and lead to chemically based overconfidence that will lead to excessive risk taking.
To be clear, as we attempted to highlight in the quote from Buffet at the start of this note, confidence in your abilities is also critical in the achievement of investment success, and success in life broadly. If you do not believe in your process and your team, then your ability to make timely decisions will be limited, but this confidence must be framed in rationality. In effect, you can only achieve what you believe you can achieve. As Jack Schwager wrote in Market Wizards:
“One of the most strikingly evident traits of all the market wizards is their high level of confidence . . . But the more interviews I do with market wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, as much as contributing factor to their success as a consequence of it . . . An honest self appraisal in respect to confidence may be one of the best predicators of trader’s prospects for success in the markets.”
A starting place of any success, whether in investing or otherwise, is in confidence, but at the same time we must be very wary of the pitfalls of overconfidence. A method we use at Research Edge is to keep investment journals. While this seems trivial, it is also a way to quickly and accurately verify when your success is based on skill versus luck. It also provides us the ability to look back and learn from our mistakes.
Daryl G. Jones
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