Correction or Contagion, What’s Next for Equity Markets?

As stock market operators, a strong stomach and preparedness for the unknown are critical traits.  Yesterday’s action in the U.S. equity markets tested even the most savvy of investors.  But, as Robert Frost famously said, “In three words I can sum up everything I’ve learned about life: it goes on.”  Indeed it does.


While the intraday move is quickly being dismissed by the CNBC punditry as a “fat finger”, or human error, and to some extent that is accurate, it is critical to remember that markets are interconnected.  The current catch phase in stock market parlance is contagion.  A contagion in medical terms is a contagious disease, and in this scenario, cotagion implies that the whole world is going to catch the Greek sovereign debt flu.


Esteemed investor George Soros had a more apt description for contagion, he calls it reflexivity.  Specifically, market events aren’t random, but they are influenced by other events.  Taken a step further, actual fundamentals are influenced by market events, so the market and prices in effect are leading indicators.


In isolation, yesterday’s event was an isolated event and was likely some Middle Aged White Guy, or MAWG has my colleague Howard Penney called him today, on a trading desk at a major financial institution who ran the wrong algorithm or sold shares when he should have been buying, albeit on a massive scale.  But the reality is that this event, which was the largest intraday drop for the Dow in stock market history, occurred on a day and in a period when the market and investors were incredibly skittish and schizophrenic due to accelerating sovereign debt concerns.  Even if this was a simple “error”, the timing was far from random.


In fact, this event is likely a catalyst for more market volatility in the coming weeks, rather than a return to complacency and the upward trend in the market.  This view is based on signals from a number of the key factors that we monitor in our risk management model, which include: credit spreads, volatility and sovereign debt credit default swaps, which are outline in the attached chart.  Collectively these factors had been signaling to us the potential for an equity market correction, and continue to signal further turbulence ahead.


Credit spreads widening in conjunction with a declining stock market typically indicate a dramatic shift away from any type of risk by institutional investors.  More specifically, they also signal bond investors getting increasingly concerned about fundamentals and cash flow.   Over the course of the past few days, corporate high yield yields widened dramatically from 8.2% to 8.6%.  This morning yields continue to climb.


The VIX is one of a few measures of volatility that we use, and it has been accurately called the fear index.  As investors get scared and sell assets, volatility spikes, which increases the potential intraday moves of asset classes.  Similar to credit spreads, equity volatility had been increasing over the past few weeks and is up another 14% this morning, signaling increasing fear and volatility ahead.


On the final point, credit default swap spreads widened for many European countries over night.  In fact, many are approaching all time highs, specifically Greece's five-year CDS rose 10 basis points to 950 basis points, while those of Portugal rose 60 basis points to 495 basis points, and Spanish CDS rose 17 basis points to 290 basis points.  If this market action is telling us anything, it is that any proposed bailout that is on the table is insufficient and there are more European sovereign debt issues ahead of us.


While we support the adage that the time to buy is when there is blood in the street, that strategy needs to be framed with the understanding that equity markets can stay irrational, and usually do, for longer than investors expect.  In early 2009, very few investors predicted that the market would climb over 75% in the ensuing 15-months.  Conversely, the correction, when it occurs, will likely be of longer duration than the consensus group-thinkers believe as well.  And perhaps the correction is only the beginning.


Daryl G. Jones

Managing Director


Correction or Contagion, What’s Next for Equity Markets? - 1





The Week Ahead

The Economic Data calendar for the week of the 10th of May through the 14th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - cal1

The Week Ahead - cal2

BBBY: KM Buying – Our Fundamental Backdrop

In the midst of the current correction, Keith continues to look towards quality names with stability in earnings momentum, proactively-driven top line growth, and plenty of cash to boot. In other words, Bed Bath & Beyond.


Here’s a reminder as to why we like this one…


  1. Long-term: Combine a remarkably consistent management team, steady unit growth, outsized market share gains regardless of the economic climate, and you get one of the most predictably efficient growth models in retail. We don’t buy the ‘growth is maxing out’ argument – the fact is that there’s still 85% of this industry that BBBY does not own. Sprinkle on underappreciated/undervalued non-core concepts and call option on putting $1.7bn cash hoard to work, and this is a tough story not to like at face value.
  2. Intermediate-term: Earnings guidance calls for 10-15% growth in 2010. We’re looking for 25% and that may be conservative.  Yes, expectations have risen, but 4Q was just the third quarter in a row (after 10) in which gross margins improved.  Sales are accelerating, as they should when a macro recovery is underway and the company’s biggest direct competitor is now gone for just over a year.
  3. Near-term considerations: The catalyst here should continue to be earnings. BBBY is not scheduled to report until the back half of June, but our degree of confidence in the model is high. Management finally putting the cash hoard to work would be a welcomed bonus.


Valuation: At 8x EBITDA and 15x P/E, we ‘get it’ that it is not exactly the cheapest name in retail. But its been a long time since I’ve seen a name in retail where more people say “it’s too expensive…I missed it.”  That’s a tough argument to stick to when you have a quality name that’s got growth, earnings momentum, market cap, and cash.



Early Look

daily macro intelligence

Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.


March is a tough act to follow.


Mc Donald’s is expected to report its April sales before the market open on Monday.  On a year-over-year basis, April 2010 has one less Wednesday, and one additional Friday, than April 2009.  The impact from the Easter shift in school and business holidays from March 2008 to April 2009 positively impacted Europe’s comparable sales by approximately 2%. 


Below, I am providing my view on comparable sales ranges for each of MCD’s geographic segments as indicators of what I would rate as GOOD, NEUTRAL, or BAD results based largely on 2-year average trends.


To recall, MCD management made the following comments about April trends on its 1Q10 earnings call:

  • “Our momentum is continuing into April with comparable sales trending positive across all of our geographies.”
  • “I think that the consumer is starting to feel a little bit better. We see consumer confidence scores getting better over the last couple of months. We see a little more spending in the marketplace and yet the stubborn unemployment being at 9.7% still is a factor, I think, relative to that overall spending and net confidence.”
  • "For April, what we said in the release was that we expect April to be at least as strong as the quarter on a global basis. So what we’re setting there is a floor, saying that it won’t any lower than 4.2 is what our expectation is.”



U.S. (facing a 6.1% compare, including a calendar shift which impacted results by 0.0% to +0.4%, varying by area of the world):


GOOD:  Any result greater than approximately 4% would be perceived as a good result because it would imply that the company was able to sustain its U.S. sales momentum from the outstanding print in March.   Last month’s number resulted in a 2-year average trend of 4.9% (or 5.4% if you adjust for the negative calendar shift in March 2009), which was the best 2-year number since February 2009.  In order for April’s number to imply a 2-year average trend in line with what was seen in March, the comparable store sales figure will have to be approximately 4%. 


NEUTRAL:  Roughly 3% to 4% implies 2-year average trends that are about even with March to slightly lower, but still remain above prior month trends, confirming a real rebound in MCD’s U.S. business. 


BAD:  Any comparable store sales number below 3% would imply a sequential slowing from March on a 2-year average trend basis.  While this would not be a disaster in the context of the trends over the last couple of years, it would fail to confirm the resurgence that was seen in March.  Given that many management teams have been making positive comments on April trends, I think it would be a disappointment to see 2-year average trends slow sequentially (especially given the run that the stock has been on since March trends were reported).



Europe (facing a 8.4% compare due to Easter holiday shift, which positively impacted April ’09 by 2% and a calendar shift which impacted results by 0.0% to +0.4%, varying by area of the world):


GOOD:  Above 4% would signal a sequential improvement in 2-year average trends; despite improving last month, the 2-year average trends are still at historically low levels.  A +4% trend would imply a return to 2-year average trends in the region of +6%.


NEUTRAL:  +3% to +4% would signal that 2-year trends are roughly even with March levels.  While this level is neutral with respect to sequential trends, it would indicate continued softness in the Europe business compared to the most part of 2009 when 2-year average trends were consistently in the 6.0% to 8.0% range.


BAD:  Below +3% would indicate that trends have sequentially deteriorated further from March levels. 



APMEA (facing a 6.5% compare, including a calendar shift which impacted results by 0.0% to +0.4%, varying by area of the world):


GOOD: Better than 6.0% would signal that 2-year average trends have rebounded strongly from last month’s (adjusting for the calendar impact on March) dip after a strong showing in the first two months of the year. 


NEUTRAL:  Roughly 3.0% to 6.0% would indicate that 2 year-trends were stable-to-slightly better on a sequential basis from March. 


BAD: Below 3% would imply 2-year average trends that have either stagnated or slowed further from the level seen in March.  Below 1% would point to trends in line with the trough 2-year average trends indicated in December.




Howard Penney

Managing Director

UK Undertow

Position: Long Germany (EWG)


Per Wikipedia, undertow is defined as “a strong subsurface flow of water returning seaward from shore, often as result of wave action.”  If the strong subsurface flow in the UK is the threat of stagflation as the UK economy is forecast for meek growth alongside expanding inflation and a looming double-digit budget deficit to GDP ratio, more surface waves could result, including those from yesterday’s general election result.


Number 10 Downing Street


Yesterday’s election yielded no clear majority government, or the 326 seats needed (of the 650 seats in the House of Commons) to gain an overall majority in Parliament. Although Cameron won the most seats with 291 versus Gordon Brown (251) and Nick Clegg (51), the inability of one party to form a majority sets the stage for three likely outcomes:

  1. Gordon Brown and his incumbent government may continue to govern because no party won parliamentary majority, perhaps with a hand-shake agreement with another party for support like the Liberal Democrats.
  2. Brown may offer his resignation to the Queen and suggest a new government, likely David Cameron.
  3. The Queen could overthrow Brown’s minority government in her "Queen’s Speech” on May 25th in favor of another party (the Conservatives).

While a hung parliament was largely priced in, the uncertainty on the political and economic direction of the UK could likely put further downward pressure on the Pound, which is down -9.2% versus the USD year-to-date (or flat versus the EUR) and also on the equity market (the FTSE is down 5% YTD).


Inflation Popping


The UK’s Producer Price Index for April was released today and the figures remind us why we want to steer clear of this economy. The Input Price Index jumped 13.1% in April year-over-year and output rose 5.7% versus the previous year and suggest that producers will pass on higher input costs to consumers.  The most current reading of CPI is 3.4% in March Y/Y.


UK Undertow - UK PPI APRIL


Clearly, whoever emerges as the winner in the UK will have the challenge of righting an ailing economy.  The UK has a hefty budget deficit that will likely reach ~13% of GDP this year with gross debt climbing to some 73% of GDP which would force the government into a very difficult position of cutting the deficit (expediently) while not smothering growth (think Greece, Portugal, Spain, USA...).  While the UK debates spewed idealism on the country’s future, the reality of the country’s anemic fundamentals is formidable.


Matthew Hedrick


I wouldn’t say we’re bullish, LVS actually missed our estimate, but we were way above the Street. Here’s what we found interesting.






  • Mass table drop (8%) and VIP RC (16%) both declined while the market exploded.
  • Gross gaming revenues were 2% below our estimate--spread among slot win, VIP and Mass.  Net win was $26MM below our estimate due to higher rebates.
  • Rebates were $100MM or 34% of VIP table hold compared to 30.8% of VIP table hold in 2009.  Going forward we will use a 32% of VIP win rate to calculate rebates for Venetian.
  • Better hold helped the quarter:
    • $14MM on Mass revenues using the company’s 4 quarter average of win of 23.6% and flow through to the bottom line at a 60% rate
    • $7MM on VIP assuming a normal hold of 2.85% and should flow through to the bottom line at roughly 50% since Venetian’s junket VIP volumes are 80% turnover based (1.25%)
  • Non gaming revenues, especially the room revenues, were a little better than we estimated.


  • Slot handle was up 31%; RC drop increased 25%; BUT non-rolling drop decreased 4%.   As a point of reference for the whole Macau market, VIP RC volumes (Junket only) grew 75% y-o-y in 1Q2010.
  • Non-rolling chip drop has declined 14.4%, 25.5% and 8.1% in 2007, 2008, and 2009, respectively.  Despite the huge growth in gaming revenues, this is a competitive market.  To put things in perspective, Mass table revenues grew 37% y-o-y in 1Q2010 while Sands Mass win only grew 4% despite a 1.5% increase in Mass hold.  Sheldon’s characterization of the property as a mature “cash cow” is fair.
  • Better hold also helped the quarter:
    • $5MM on Mass revenues which has roughly a 35% gross margin
    • $21MM on VIP, assuming a normal hold of 2.85% with a gross margin of roughly 18%
  • Gross gaming revenues were 3% below our estimate--spread among slot win, VIP and Mass; however, net win was $19MM below our estimate due to higher rebates
  • Rebates were $68MM or 33.2% of VIP table hold compared to 31.7% of VIP table hold in 2009. Going forward we will use a 33% of VIP win rate to calculate rebates for Sands
  • Commission at Sands are 50/50 turnover based (i.e. 1.25%) and Rev Share, so high hold at this property doesn’t flow through quite as well as at Venetian and FS
  • Fixed costs look like there were up around $5MM y-o-y and promotional expenses also look a little higher y-o-y
  • Direct play at Sands was 10% of VIP volume compared to a 11% 4 quarter average.



  • Table drop was better than we thought, by $85MM but casino revenues were $3MM below our estimate.  The player rebate on tables games went up to 4% this quarter, which isn’t surprising given the strength of the baccarat play.  Obviously the correct way to calculate the rebate would be on the VIP volumes which we just don’t know.  If the strong Baccarat trend continues, we will need to model both net and gross revenues for Vegas going forward, just like Macau.
  • Non-gaming revenues were $10MM better than we expected – which was pretty much entirely driven by better RevPAR results.
  • Cost cutting looks like it’s essentially done.  Total operating costs were down 3.3% y-o-y after 3 quarters of double digit declines.   1Q09 was actually an easy comp as costs were essentially flat from the prior year.  We expect costs will be up year over year going forward.
  • The Palazzo had a monster quarter while the Venetian suffered.   Win per table was $9,282 vs. $2,729, respectively.  This is partly due to the massive divergence in luck between the 2 properties.  Our guess is that Venetian held at 13% and suffered roughly an 8% decline in drop while Palazzo got most of the Baccarat volume and held at 30% with drop increasing over 55%.
  • Palazzo is commanding a 6% rate premium over Venetian; not a surprise since the property is newer and rooms are nicer
  • Promotional expenses decreased to 33% of casino revenues from 36% last year.
  • Slot hold % was up materially but some of that should be sustainable given:
    • Shift to penny games from quarters.  Penny games have much higher hold % - mid teens.
    • Pruned video poker mix which has very low hold.  Particularly, they removed IGT “Jacks are Better” full pay games which have hold percentages as low as 50bps.
    • Table win of 23.4% compares to 2009’s table hold of 17% and 2008’s table hold of 20% - so it’s definitely not “normal”.  If we use the company’s 4 quarter trailing average of 17.3%, then casinos revenues would have been $33MM lower.

Attention Students...

Get The Macro Show and the Early Look now for only $29.95/month – a savings of 57% – with the Hedgeye Student Discount! In addition to those daily macro insights, you'll receive exclusive content tailor-made to augment what you learn in the classroom. Must be a current college or university student to qualify.