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QSR EBIT margin trends continued to improve YOY in 1Q10, but compares get more difficult for the balance of the year.


Two weeks ago, I wrote about current casual dining margin trends (please refer to the June 2 post titled “CASUAL DINING – THE SQUATTERS’ INCOME IMPACT”) and QSR trends look rather similar from a YOY comparison perspective with 1Q10 having been the easiest compare of the year from an EBIT margin standpoint. 




One major difference is that the QSR industry’s comps (as measured by our QSR index shown below) get easier for the rest of the year whereas the casual dining industry’s comps get easier for 2Q and 3Q and then get more difficult in Q4, as reported by Malcolm Knapp.  According to our Hedgeye Risk Management QSR index, comps turned positive in calendar 1Q10 for the first time since calendar 4Q08, and that improvement included the significant negative impact of harsh weather in February. 


Although many QSR companies stated on their most recent earnings calls that April trends were in line with March or slightly better, more recent comments from a handful of companies point to decelerating trends in May, at least on a 2-year average basis. 


This morning Sonic preannounced its fiscal 3Q10 (quarter ended May 31) system same-store sales trends, reporting a 6% to 6.5% decline YOY.  At the low end, this 3Q10 result implies a nearly 250 bp sequential improvement in 2-year average trends from the prior quarter, but it is important to remember that SONC management attributed about two-thirds of the reported 2Q10 decline in same-store sales to inclement weather.  Excluding the weather impact, a 6.5% decline in 3Q10 implies a nearly 200 bp sequential deceleration in 2-year average trends.  SONC’s preannounced 3Q10 trends combined with its 4Q10 same-store sales guidance of -4% to -8% point to a 5% to 7% decline in the back half of the year, 200 bps worse at the low end than the flat to -5% guidance management provided three months ago.  Specifically, SONC’s press release stated, “The consumer environment continued to pose a challenge for same-store sales in the quarter, with same-store sales estimates for the system expected to decline between 6.0% and 6.5%. Though negative, same-store sales improved from March to April, but deteriorated in May.” 


MCD trends did not deteriorate in May, but the company’s U.S. trends, though still strong on an absolute basis, have slowed on a 2-year basis in both April and May when you adjust for calendar shifts.  CKR has also reported its monthly trends through May 17 and blended same-store sales decelerated slightly on a 2-year average basis in the most recent period.  Carl’s Jr., however, which has greatly underperformed Hardee’s recently, posted slightly better numbers in the most recent period on both a 1-year and 2-year basis.  That being said, same-store sales were still down 5.2%. 


Reuters reported Monday that SBUX CEO Howard Schultz said "With 10 percent unemployment continuing in America, I think this is a time for continued thoughtfulness and discipline, but we have not seen a downturn from quarters in the past. So it has been relatively the same and consistent."  This comment does provide too much insight into current trends, but it implies that trends remain at least in line with the company’s prior full-year guidance of mid-single-digit same-store sales growth as the company posted 4% and 7% growth in fiscal 1Q10 and 2Q10, respectively.


Based on this limited glimpse of current QSR top-line trends, I am not expecting trends to get better on a 2-year average basis in the second quarter as they did in 1Q; though easier comparisons will help trends on a 1-year basis. 




Food cost trends

Like the casual dining names, QSR margins were helped by declining commodity costs for most of 2009, largely in the second half of the year.  Although most companies continued to reap the benefit of lower food costs YOY in calendar 1Q10, most guided to higher costs for the balance of the year, particularly in 2H10.  Beef costs, which make up the largest food ticket item for most of the QSR names, have increased 9.6% YOY (as measured by the S&P GSCI Live Cattle Commodity Index), and the CRB Foodstuffs Index is up 6.2% YOY.


SONC:  Just this morning, SONC reported that it is expecting a 150 to 250 bp decline in 4Q10 restaurant level margin as a result of deleveraging and higher-than-expected beef costs.


MCD:  Reported a 5% decrease in its U.S. basket of goods in 1Q10 and guided to a 2% to 3% decrease in the U.S. for the full-year, which implies increased pressure for the balance of the year. During a June 2 investor presentation, CEO Jim Skinner said commodities would be flat-to-slightly down.


BKC:  Guided to a 4% YOY increase in its U.S. food costs in fiscal 4Q10 after beef costs increased 9% on a sequential basis in fiscal 3Q10.


WEN:  1Q benefited from lower YOY food costs, but the company is expecting a 2% to 3% increase in commodity costs for the full year, which will hurt margins for the balance of the year.  “Although commodities were favorable in the first quarter, they are beginning to increase earlier than we had anticipated, especially beef.”


CKR:  Management called commodity costs the “one wild card” on its last earnings call.  For fiscal 1Q11, the company guided to a 100 to 110 bp increase in food and packaging costs as a percentage of company-operated sales.  Food and packaging costs as a percentage of sales have decreased YOY for the last 6 reported quarters.


JACK: Guided to a 1% decrease in full-year commodity costs after costs declined 4.5% in the first two quarters of the year.  Specifically, management stated, “Commodity costs are expected to increase by approximately 2% in the third quarter and 3% in the fourth quarter as compared to prior year.  The increase in the third and fourth quarters is being driven by higher beef costs, which accounts for approximately 20% of our spend.”


YUM:   1Q10 U.S. operating income benefited from $5 million in commodity deflation; this benefit is expected to go away and turn inflationary as we trend through the year.  Management is expecting costs to be relatively flat for the full year. 


CMG: Food costs decreased in the first quarter but management expects food costs to increase slightly for the year, primarily in 2H, “due to modest commodity inflation enabled by increased consumer demand.”


Companies will be slow to offset these higher food costs with pricing as consumers continue to be under pressure in this economic environment and have not yet proven a willingness to spend more money.  QSR demand trends are highly tied to unemployment levels and as MCD‘s CEO Jim Skinner stated at a recent investor presentation, “We don’t have a lot of price elasticity right now.”  If MCD can’t raise prices, it leaves little room for the smaller players to do so.  On the other end, higher food costs will put increased pressure on margins as companies continue to rely on value initiatives and promotions to drive traffic.  The QSR companies on average posted higher YOY EBIT margin each quarter in FY09 even with same-store sales negative and with an increased focus on value.  These trends will not be sustainable for the remainder of FY10 if commodity costs move higher, on a YOY basis, as expected.




Labor cost trends

On average, labor costs increased as a percentage of sales for the QSR companies for most of 2009.  Based on the deleveraging of negative same-store sales and recent minimum wage increases, this is not surprising.  The tough sales environment actually caused most QSR companies to focus on increasing the efficiency of its labor and this will likely continue for some time.  To that end, management can’t cut labor costs forever without impacting the customer experience so the big cuts, even if sustainable, have already been made on a YOY basis. 


As I stated in the casual dining post two weeks ago, if the jobs picture improves, it’s only a matter of time before we hear about higher labor costs.  In an economy that is creating jobs, there is an increased incentive to quit and walk away from a lower-paying job (think restaurant server/cooks), and the restaurant industry will pay the price.   QSR Web reported on this topic on Monday, saying that QSR operators are well aware they will have to work harder to retain employees in the coming months.  Specifically, the article cited a recent Harris Interactive poll, which showed that one in five employees say they will look for a new job once the economy improves.  Employees ages 18 to 34 say they are even more likely — 26 percent — to look for new employment or expect a promotion.  A better economy will be good for top-line trends, but it will also put increased pressure on the labor cost line.




Howard Penney

Managing Director


Sentiment remains strong around the Chipotle brand.  We expect continued strength in comps but are watching for any signs of margin contraction.


CMG delivered a strong 1Q and all indications suggest that another strong quarter is possible in 2Q.  1Q comps were 4.3%, almost entirely driven by traffic, and no price has been taken in the past 12 months.  From a topline perspective, the comparisons do not get much more difficult for the remainder of the year; 2Q, 3Q, and 4Q comparisons are 1.7%, 2.7%, and 2% respectively.  Given that marketing spend in 1Q was 1.1% of sales, and management guided to marketing spend of 1.8% for the full year, traffic should remain strong for CMG in 2Q.  However, the company will feel increased pressure on the other operating cost line as it invests in its new marketing campaign.  Any pickup in other drivers of traffic will be incremental but management has stated that they will not be taking price.  The only possibility for that would come in 2H10 when some additional food with integrity will be rolled out in certain markets with “either no or very modest price increases”.  Management did point out, however, that should inflation become more of headwind than expected (guided to a low single digit increase for the full year, primarily in 2H) that they do have the ability to raise prices, but will be patient before rushing into a menu price increase.


CMG: WATCH MARGINS - cmg detail


In terms of efficiency, 1Q results were partly attributable to progress made on throughput.  On the last earnings call, management stated that they had previously taken their “eye off the ball over the last couple of years” with respect to throughput.  Assuming that the initiatives addressing these issues remain in place, store productivity should remain high.


CMG: WATCH MARGINS - EBIT Margins.xlsx 1q10


The favorable commodity cost environment enabled CMG to attain higher margins from 1Q09 onward.  The company is not locked into many of its ingredients and could see margin pressure should inflation begin to impact their commodity basket.   The few items that management has locked in include rice, soy oil, corn, and tortillas.  Traditionally, Chipotle has also kept cheese locked in but decided that the spot market was more attractive and that this enabled them to move towards more pasture-raised dairy.  Holding current cheese prices constant, the Bureau of Labor Statistics’ PPI database is showing average inflation of 7.6% for the first 5 months of 2010. Moving to the spot market, while undoubtedly beneficial during the deflationary period of 2009, could cause more volatility and uncertainty for CMG management if inflation takes hold on their cost line in 2H10 (as they expect).  During the 1Q10 earnings call, management said that the inflation outlook seemed “manageable” but having such a proportion of their basket on the spot market means that their outlook is subject to the volatility of the commodity markets.


During the first quarter, CMG posted an EBIT margin of 15.3%, up over 300 bps YOY.  This YOY growth was impressive given the fact the company was lapping a nearly 300 bp improvement from 1Q09.  Going forward, margin comparisons get increasingly more difficult on a YOY basis, particularly in the second half of the year, as the company laps the extremely favorable food costs from last year.



Howard Penney

Managing Director

Calendar Catalyst: UK Emergency Budget Meeting

Position: Short France (EWQ); Short Italy (EWI)


UK unemployment fell 10bps to 7.9% according to the latest reading from the International Labour Organization (ILO). While directionally the number is positive, the chart below points out that the rate has trended sideways for most of this year. Now PM Cameron and Co. must deliver on campaign promises to return growth to the UK economy, including greater improvements in employment. Already Cameron proposed 6 Billion Pounds in spending cuts for this year. Mark your calendar for next Tuesday, June 22nd, when the new Chancellor of the Exchequer George Osborne outlines the go-forward spending cuts in an emergency budget meeting. 


Today, the Nationwide Building Society published its UK Consumer Confidence Index .  Notably, May’s survey saw significant deterioration (below) which mirrors the slide in German consumer confidence that we saw yesterday in the ZEW survey. We believe this inflection is representative of heightened fears of the next European country to face sovereign debt default risk.


UK Consumer Confidence Index-

Index of Sentiment: 65 in May versus 75 in April

Expectations (6 months ahead): 93 in May versus 105 in April

Current Perception: 23 in May versus 29 in April

Propensity to Spend: held steady at 98


Matthew Hedrick



Calendar Catalyst: UK Emergency Budget Meeting - uk ILO

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R3: Footsteps in Asia


June 16, 2010


A couple of interesting observations out of Yue Yuen, the largest global footwear manufacturer, from Q2 results…




Here are a couple of interesting observations out of Yue Yuen, the largest global footwear manufacturer, from Q2 results. While the company reports interim 2010 results on a 6-month basis, our models, which quaterize results, highlight some rather telling trends with broader implications for the industry:


- In addition to continued strength at Retail, Q2 marked a substantial pickup in footwear sales across all categories at wholesale as illustrated in the charts below. The outperformance of Soles, Components, & Others is of particular interest as a indicator of future production suggesting positive demand forecasts across the industry.


- Geographically, Asia continues to stand out as a pillar of strength supporting our belief that Chinese footwear companies (Li Ning included) are increasingly focused on local demand.  This is best evidenced by the continued growth in Yue Yuen’s growth in retail sales as a percentage of total business, which grew to 22% of sales up from 18% last year.


- As demand builds domestically for Asian manufacturers there are potentially negative implications for pricing as capacity becomes tighter – a factor that has benefitted US-based manufacturers over the last 12-18 months.   Recall that excess factory capacity coupled with increased Chinese VAT rebates created a meaningful tailwind for sourcing costs over the past year.

- Longer term, growth in domestic (Chinese) retail by Asian-based manufacturers and brands is likely to add competitive pressure to the incumbent global brands such as Adidas and Nike.   It’s too early to worry but it’s important to note this market is not simply a “free for all”.


 R3: Footsteps in Asia - 1


R3: Footsteps in Asia - 2


R3: Footsteps in Asia - 3


R3: Footsteps in Asia - 4 





- Best Buy noted that employee retention is at an all time high, with turnover coming in under 40% for the first time. In management’s view, turnover has improved as result of employees’ being behind the company’s strategic direction. However, what BBY failed to mention is that employee turnover across all retailers is down, and in most cases at historical lows. Clearly people are staying in their jobs longer given the current state of employment across the country.


- On the heels of Calloway’s disappointing earnings announcement, Dick’s Sporting Goods CEO noted that the company has not seen any slowdown in its golf business and that they remain pleased with what’s going on in the golf area. Recall that Golf Galaxy posted a 12% same store sales increase in its latest quarter. Clearly the benefits of staying power and consolidation are beginning to accrue to one of the few well capitalized survivors.


- In the latest American Apparel soap opera, the company recently responded to allegations about questionable hiring practices for store employees. For those familiar with Abercrombie’s past troubles with only hiring “good looking” employees, this is essentially the same story all over. However, this time American Apparel responded by not only denying its potentially questionable hiring standards, but by posting CEO Dov Charney’s phone number and email for those who want to discuss the company’s hiring practices. Shouldn’t he be more focused on same store sales?




Metropark USA Withdraws IPO Plans - Specialty retailer Metropark USA Inc. has withdrawn its shelf registration for an initial public offering. The original filing was on June 13, 2008. In a Securities and Exchange Commission filing on Friday, the City of Industry, Calif.-based retailer cited “changed circumstances regarding the securities markets” as the reason for the withdrawal. Since opening its first four stores in California in 2004, the 69-unit, mall-based chain has targeted men and women ages 20 to 30. <wwd.com/business-news>

Hedgeye Retail’s Take: Another one bites the dust… as it should.


BBY to Enter Used Video Game Market - Best Buy Co., the world’s largest consumer-electronics retailer, plans to let customers trade in their used video games at more than 1,000 U.S. stores to grab sales from competitors. Shoppers will be able to exchange the games for Best Buy gift cards that can be spent on any merchandise. The program will start late in the summer.  <bloomberg.com/news>

Hedgeye Retail’s Take: This is not the first time retailers other than GME have entered the used game market.  The key here is the consumers’ opportunity to used used games as currency towards anything Best Buy sells.  With that said, GME still has a competitive advantage with core gamers as well as its systems which help to manage the unique inventory dynamics of buying and selling used product.


LIZ taps Media Firm for Juicy Couture and Kate Spade - Independent PGR Media in Boston has been tapped by Liz Claiborne brands Juicy Couture and Kate Spade New York. The brands spend about $20 mm combined annually in measured media, with Juicy backed by close to $15 mm, per Nielsen. The assignment covers media strategy, planning and buying, and fits into the shop's fashion-friendly roster that already includes Tommy Hilfiger, Bulgari, Espirit and Chico's. Kate Spade media was previously handled in-house and Juicy's media was with Laird + Partners in New York. <brandweek.com>

Hedgeye Retail’s Take:   Changes in media/pr/advertising usually mean there is a story to tell.  This also seems like it may be a cost saving measure with the consolidation of the two brands now sharing one resource. 


JCG Claims Madewell is Worth Spending On - With the official launch of its e-commerce site last week, the four-year-old Madewell brand has “arrived” and is ready for a new growth phase. CEO Mickey Drexler stated, "We feel we’ve progressed enough to commit capital and a growth plan to the business. We’ve been through four intense, creative years of putting together something we are very passionate about. The collection is ready and the way we want it to be.” Madewell.com actually quietly made its debut May 27, without any marketing, and since then, Drexler said he’s been watching it “every minute of every day, like a new baby. <wwd.com/business-news>

Hedgeye Retail’s Take:  It was only a matter of time before Madewell became a bigger deal.  This gives J Crew another growth vehicle for sure and adds confidence that the core brand will not overbuild.  Certainly seems like a good time to take advantage of some real estate opportunities while they’re still out there as well. 


Quiksilver Announces Debt-for-Equity Exchange with Rhône - Quiksilver, Inc. has entered into an agreement with Rhône to exchange $75 mm of the outstanding principal amount of Quiksilver's senior secured term loans for an aggregate of approximately 16.7 mm shares of its common stock at an exchange price of $4.50 per share. <sportsonesource.com>

Hedgeye Retail’s Take:  Another step in the balance sheet clean-up process which gradually continues to change the risk profile of the company.  Recall that the prior clean-up maneuver was to dramatically curtail inventories while at the same time sales picked up.   


Take Aways From Department Store Discussions - The take-home points, emerging through presentations and panel discussions with senior officials from some of the world’s most iconic retailers and brands including Macy’s, Selfridges, Marks & Spencer, Printemps, The Bay and Coach, were: 1) Embrace change, particularly social media, the Internet and mobile technology. “The [personal computer] is dead. It will all be on your wristwatch,” predicted Stuart Rose, executive chairman of Marks and Spencer Group plc. 2) Think small and local with marketing — tailor service and amenities to customers depending on their level of spend. “Developing local marketing plans has been transformational,” Sadove said of the Saks strategy to shift a percent of marketing dollars from national to local campaigns and install local marketing directors. 3) Work hard to “wow” the customer, go younger with the appeal and add sustainability and value-over-price to the formula. “How do we surprise her? How do we surprise her enough so she has a smile on her face and says, ‘That’s great. I really love it,’” said Lauder. 4) Speed to market of new products and trends is critical. “The biggest threat to department stores is fast fashion,” observed Myron E. “Mike” Ullman 3rd, chairman and ceo of J.C. Penney Co. Inc. Forever 21, H&M, Zara, Uniqlo and Mango are taking “a big bite” out of department stores. While Penney’s has significantly cut its product cycle time, it’s also launching Mango shops inside its stores, joining the fast-fashion bandwagon. “Retail has been a bit slow in understanding the customer,” Ullman said. 5) Think young. “The biggest challenge is attracting new, young consumers into the department store channel,” said Lew Frankfort, chairman and ceo of Coach Inc. He advised replicating the “intimacy” of the specialty store experience within the department setting by subdividing it. “Use micro marketing or laser marketing in unorthodox ways to get these young people,” he said. 6) Think local. “This whole localization has got such legs and potential,” said Macy’s chairman, president and ceo Terry Lundgren of the My Macy’s localization organization. Asli Karadeniz, ceo of Boyner in Turkey, stressed the success of her company’s marketing efforts with local cell phone carriers to target young people.  <wwd.com/business-news>

Hedgeye Retail’s Take:  Lots of focus on the younger demographic here from the one of the oldest, most outdated forms of retail.  Unfortunately the young consumer is the most informed and easily influenced consumer, which means department stores will have to embrace “real” change and not token efforts.  Creating a Macy’s Facebook page does not add instant credibility to young consumer base. 


New Brand in Men's Wellness - New York-based Deer Stags is taking a step into the men’s wellness category. Marketed under the Walkmaster label, the collection of men’s styles carries the tag line, “What Walkmaster does for your body, goes straight to your face.” The company suggests the collection’s benefits, from improving posture to putting a spring in one’s step, will bring a smile to the wearer, communicated through caricature. The shoes will retail for $60. Delivery is slated for October through independents, chains and department stores. <wwd.com/footwear-news>

Hedgeye Retail’s Take:  More toning, but this time with a male focus.  Less competition here in men’s (at least for now) but also less of a market.   


Aetrex Offers Toning Through Comfort, Pedorthic, and Running Channels - Expanding its reach into the toning sector, Aetrex Worldwide Inc. is introducing its take on wellness with BodyWorks. The series of men’s and women’s styles feature a rocker outsole designed to transfer pressure from the rear and forefoot to the mid-foot, thereby reducing pressure in those areas that absorb the most pounding. The shoes retail for $135 for women’s and $155 for men’s. Set for an early spring ’11 launch, the sneakers will deliver in November. Distribution is targeted to service-oriented comfort, pedorthic and running stores. <wwd.com/footwear-news>

Hedgeye Retail’s Take:  Hopefully the launch doesn’t come before it’s too late. 


NRF Reports Merchandise Loss Declines - The National Retail Federation on Tuesday released a survey of 75 retailers who collectively reported that merchandise losses, or shrinkage, in 2009 declined to 1.44% of $2.33 trillion in retail sales last year, down from 1.51% in 2008. Retailers lost $33.5 bn to shrinkage last year, down from $36.5 bn in 2008. The majority of the shrinkage was due to employee theft, which accounted for 43%, shoplifting 35%, admin error 14.5%, and vendor fraud 3.8%. <wwd.com/business-news>

Hedgeye Retail’s Take:  On one hand employee turnover is down which helps while on the other the economy is tough which hurts.  Net, net a focus on shrink when times are tough yields some improvement.


Online Advertising Spending Growth Estimates - eMarketer estimates that US online advertising spending will reach $25.1 bn in 2010, representing 10.8% growth over last year. Relatively healthy economic gains, along with the ongoing shift of marketing dollars from traditional to digital media, have contributed to the double-digit increase. Steady gains in online ad spending will mean an additional $11 bn flowing into the space over the next four years, increasing the Internet’s share of total media ad spending from a bit more than 15% in 2010 to over 20% in 2014. In addition, both offline and online ad spending models are being restructured by the shift toward more non-advertising marketing. In the online space, marketers are focusing more on social media and building up their Websites or brand microsites. <emarketer.com>

Hedgeye Retail’s Take:  With TV essentially moving online we wouldn’t be surprised to see adoption of online advertising move even faster.  The ability to marry interactivity and customized offers on an individualized basis is clearly a selling point vs. the old wholesale, push model.


R3: Footsteps in Asia - 5


R3: Footsteps in Asia - 6



Yesterday stocks rallied, sending the Standard & Poor's 500 Index to the highest level since May 18.  The S&P 500 climbed 2.3% to 1,115.  On the MACRO front, there is a general pickup in the appetite for risk as the growth picture continues to improve.  It was reported yesterday, that the Federal Reserve Bank of New York's general economic index showed an 11th consecutive month of growth.


This RISK dynamic seemed to help US equities look past some weaker-than-expected economic data in Europe, along with Monday’s downgrade of Greece to junk by Moody's and continued speculation that Spain will need a bailout facility.  Greek 10-year bond yields jumped 74 basis points to 9.08%.


Treasuries were weaker today with the pickup in risk, as the VIX declined 9.7%.  The DXY declined 0.65% and the Hedgeye Risk Management models have the following levels for the USD – Buy Trade (85.88) and Sell Trade (86.46).  The Hedgeye Risk Management models have the following levels for the VIX – Buy Trade (24.62) and Sell Trade (32.79).


The euro strengthened above $1.23 despite the larger-than-expected decline in German analyst and investor sentiment, as the ZEW index fell to 28.7 in June from 45.8 in May, the sharpest pullback since October 2008.  In early trading today, the euro is trading down slightly.  The inverse correlation between the euro and the TED spread weakened, day-over-day, going against the recent trend.  The TED spread narrowed this morning to 0.45.  The Hedgeye Risk Management models have the following levels for the EURO – Buy Trade ($1.20) and Sell Trade ($1.23).


Oil rallied above $77 a barrel and the Reuters/Jefferies CRB Index of commodities posted a seventh straight gain, the longest stretch of gains since March 2007. The Hedgeye Risk Management models have the following levels for OIL – Buy Trade ($73.59) and Sell Trade ($79.63).


The three best performing sectors were Industrials (XLI) +3.0%, Energy (XLE) + 2.9% and Technology +2.6%, with three sectors underperforming Utilities (XLU) +1.9%, Healthcare (XLV) +1.7% and Consumer Staples +1.0%.   The Hedgeye Risk Management S&P sector models had a positive day with 8 of 9 Sectors moving to positive on the immediate term TRADE, but still have 7 of 9 negative on TREND.


The data flow on US consumer trends and behavior continues to be negative.  After the close, the ABC Consumer Confidence Index declined to -45 from -43 last week.  Also, home builders in the U.S. turned more pessimistic in June; a sign that housing demand may be slowing even more than anticipated after a government tax credit expired. The National Association of Home Builders/Wells Fargo confidence index dropped to 17 from 22 in May, lower than all the estimates on Bloomberg and the biggest decrease since November 2008.  This data point, combined with a collapse in mortgage applications last week, augments our conviction that the housing market is going to struggle in 2H10. 


Outside of the RECOVERY/REFLATION trade, technology was one of the best performing sectors yesterday.  Most of the upside leadership for the XLK came from the semi group, with the SOX +5.5%; UMC +5.5% and TSM +4.3% were both out with positive comments regarding chip demand.   


The Financials (XLF) underperformed the most yesterday, as reform remains an overhang, particularly with talk of growing support for derivatives legislation and the Volcker Rule looking more like a sure thing.  Yesterday, the credit card names posted strong gains following the release of May master trust data, but the rally may be short lived with phase 3 of REG Z on the way.  Our Financials analyst Josh Steiner has a note out detailing what this all means. 


The retail group lagged the Consumer Discretionary Sector (XLY), with the S&P Retail Index +1.3%. Consumer electronics names underperformed with weaker-than-expected fiscal Q1 results out of BBY.


In early trading, copper is trading higher for a seventh day in a row on speculation that the economy remains robust in the U.S.  The Hedgeye Risk Management Quant models have the following levels for COPPER – Buy Trade (2.88) and Sell Trade (3.05). 


Gold is looking higher in London on concern that Europe’s sovereign-debt crisis will continue to escalate.  The Hedgeye Risk Management models have the following levels for GOLD – Buy Trade (1,217) and Sell Trade (1,246).   


As we look at today’s set up for the S&P 500, the range is 21 points or 1.3% (1,101) downside and 0.6% (1,122) upside.  Equity futures are trading below fair value ahead of today's economic release which includes May PPI, Housing Starts and Industrial Production. 


Howard Penney













Battling Bulls

“Having nothing, nothing can he lose.”

-William Shakespeare


That quote comes from the battle of all Shakespearean battles. “Henry VI”, Part 3 contains more battles than any other Shakespeare play. Yesterday was a big Bull versus Bear battle. And I lost.


No matter where I go this morning, the War of the Proverbial Roses will carry on. A battle lost doesn’t lose the war that we engaged in on the short side at April’s end. If the bulls think I am going to rollover or point fingers today - think again. I’m accountable for this team’s losses. I’m moving forward.


Before we move forward it’s important to take the time to look back. What risks are embedded in the setup for today’s battle given yesterday’s closing prices? What calendar catalysts are in front of us?


The good news is that we called for our own fall in an intraday note yesterday titled “Squeezy: SP500 Risk Management Levels, Refreshed.” Good news because it’s better to understand why you are losing than living in fear of your process. Have a plan - change the plan as prices change.


The most important part about yesterday’s price action was that the immediate term TRADE in price momentum and volatility turned positive for US Equities. We use a simple 3-factor model to measure all durations in our model dynamically: Price, Volatility, and Volume. The third leg of this stool (volume) did not confirm price and volatility, but there really are no buts – the closing price of the major indices are what matter most.


From an immediate term TRADE perspective (3-weeks or less), here are the new lines of support:

  1. SP500 = 1101
  2. Dow = 10,299
  3. Nasdaq = 2276

There are some critical strategy points to be made here.

  1. When TRADE lines of resistance become support, you need to change the immediate term plan (stop selling aggressively).
  2. TRADE lines of support can quickly become resistance again, so you need to be patient in watching prices confirm new support.
  3. TRADE lines are not TREND lines. Never confuse the immediate term with intermediate term durations.

This is where the battle becomes the war - when there is Price Momentum Mismatch between durations (i.e. the TRADE goes bullish within a bearish TREND). So the next leg of analyzing yesterday’s losses on the short side becomes looking forward to the forest of where the real risk in staying short can be found.


From an intermediate term TREND perspective (3-months or more), here are the lines of resistance:

  1. SP500 = 1144
  2. Dow = 10,698
  3. Nasdaq = 2369

Once again, no matter where you go this morning there those real-time prices are – sitting right in between a rock and a hard place of bullish TRADE and bearish TREND. I’ll be selling on rallies toward 1144 and buying on selloffs toward 1101.


How about today? What is Thunder Bay Bear who is Battling Bulls to do?

  1. Watch and wait like we did into yesterday’s close.
  2. Don’t run out there and get emotional, flailing your rifle and shooting at any bullish price that moves.
  3. Watch and wait some more…

The way I look at it is that both my fundamental Fiat Fool macro thesis and my quantitative setup continue to confirm one another for both the intermediate and long term. To a degree, some of the wins I’ve had this week (short the US Dollar, long Gold) continue to confirm the same. The US government is inching toward the Road to Perdition that the Europeans have already started to march upon – austerity.


The #2 story on Bloomberg this morning is born out of the same source of every government oriented story that ends up in your inbox – a leak – “Fed May Trim Growth Outlook”…


Make no mistake, no matter where the immediate term TRADE in this market goes, this is where the real intermediate term war between Bulls versus Bears will be decided – will US GDP growth be slower or faster than consensus expects in 2011?


We’ve been saying Bernanke and the Administration’s growth estimates for both Q4 2010 and all of 2011 are way too high. Apparently the bulls in the Fiat Fool camp have been delivered the message. Evolving the government’s forecasting process is progress for America, but that doesn’t mean this bearish TREND in the US stock market ends as a result. After all, the output of Bernanke and Co. lowering their numbers will be marked-to-market, in the end.


My immediate term support and resistance lines for the SP500 are now 1101 and 1122, respectively. Saddle up. Into the brink of Battling Bulls we go. As “Old Blood and Guts” (Patton) said, it’s time to “lead, follow, or get out of the way.”


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Battling Bulls - sp