Beware Of The Squeeze

“Study the past if you would define the future.”

Being in a fishbowl and being the guy trying to proactively predict market moves isn’t easy – that’s why I like it. Studying the past gives my macro process a fundamental base from which I can step up and take shots. Am I going to miss the net sometimes? Of course… but a better question is can my team score more often than the competition? The answer to that question won’t be a lie – the score is up on our ‘Hedgeye Portfolio’ accountability board, daily.

On October 27th, I stepped up and slapped a title on the Early Look called “Buy’em” ( , 10/27/08). No, that wasn’t in October of 2007 when I was about to leave Carlyle for being “too bearish” – that’s a 2008 print; you can ‘You Tube’ it.

Inclusive of yesterday’s -2.2% low volume selloff in the S&P500, the US market is +6% from that historical point. Not great, but not bad either. Since we have a global macro asset allocation model, which included a bullish call on China on that same date, it’s noteworthy that Hong Kong has gained +27% since 27th. No, no, no… that’s not October 27th 2007 where “they” called it “global this time!”

I’m going to keeping taking the shot here this morning and repeat that I think that a significant global trading bottom is in. Asian, European, and US indices will continue to make higher lows on down days until the facts in my macro models change. No, I am not calling this a “Trend” (intermediate term view, 3 months or more). This is a call on the “Trade” (immediate term, 3 weeks or less). Can a “Trade” morph into a “Trend”? Definitely. But I don’t have to take that shot until I see it.

Let’s strap on the “Macro” pants and take a walk down the path of my being bullish for the “Trade”. What are my 9 top factors?

1. Global counterparty risk (measured by the TED spread) has calmed for almost 6 consecutive weeks – TED is only 181bps wide this morning.
2. The US Yield Curve continues to steepen. The spread between 10’s and 2’s is now 250bps wide today. Borrow short, lend long. Liquidity is king.
3. Debtors (the levered long hedge fund community) are getting smoked out of their holes. Leverage is a disease when long rates ride higher.
4. Levered nations like Russia and Pakistan are being forced to raise interest rates this morning by 100bps and 200bps respectively. Now the USA can beat on them.
5. Access to capital is tightening and long term cost of capital is heightening – this expedites the blowing up of over-geared businesses that we don’t need.
6. Market share opportunities born out of the bankruptcy cycle are emerging (think BedBath vs. Linen’s N Things). GS, Thanks for BBBY the upgrade this morning!
7. Global Sentiment is bottoming (see Australian and German confidence readings this morning). The rest of the world actually likes Obama.
8. Inflation is deflating, domestically (CRB -47%, Oil -60% SINCE JULY!). GM’s Texas SUV plant announced they are running on overtime yesterday – huh?
9. US Consumer Discretionary stocks have been crashing for longer/further (peak to trough decline from 07’ is now -55%, and now the Street is bearish on spending!)

So where’s your head at? Is it where I made the call to leave the Street a year ago, or is it with me here and now covering and buying stocks today? Don’t get mad at me – get in the fishbowl and take a swim with me and the aforementioned facts. Consensus calls can definitely take markets higher and lower than we can all remain liquid, but so can contrarian ones. I am not being contrarian here for the sake of being on the other side of consensus. I am data dependent, and the river cards lay on the table here as you see them.

Domestically, the macro calendar is lining up for a massive squeeze. November 15th is the final date for hedge fund redemptions, so next week you won’t have to attempt to trade this market around said hedge fund “selling” or “blowing up”… guess what – they’ve been blowing up since the leverage trade has - this is not new! In conjunction with that fear morphing out of our melons will be next week’s US inflation reports (CPI and PPI) – they will be bullish for equities. Finally, earnings season will have ended, and that’s a catalyst in and of itself. Why? Well… because it’s history.

Studying history provides us context. Studying history stokes our fears and hopes. Studying markets is what I do in order to proactively prepare you for tail risks. With -2% downside left in the S&P500 (my buy level is 879) and +30% upside, the tails are growing into those books who think they have now mastered the art of short selling. I have moved our US Cash position down from 96% (September) to 51% this morning. Beware of the squeeze.

Good luck out there today,

Long ETFs

JO – iPath Coffee –The Indian Commerce Department has launched a program aimed at increasing Indian market share for US Robusta consumption.

EWL –iShares Switzerland- Swiss Life Holdings (EWL: 0.52%), the largest Swiss life insurer abandoned prior profit targets and halted a share repurchase on investment losses driving the stock price down by as much as 18%. The company can no longer guarantee that dividends will not be cut.

EWA –iShares Australia- The Bureau of Statistics seasonally adjusted wage-cost index declined for Q3 to a growth rate of just under 1% q-o-q or 4% Y/Y suggesting that wages are trending down with the cooling commodity markets.

EWG – iShares Germany – Euro zone industrial production decreased 2.4% y-o-y, the lowest level of growth since 2002. The “wise man” group recommended that Chancellor Merkel should expand a 50 billion-euro stimulus package in their annual report.

FXI – iShares China – October Retail Sales figures came in at 22% y-o-y, a slight decrease from September.

EWH –iShares Hong Kong –The Hang Seng has declined by 5.5% in the past two sessions on increasing concerns about slowing mainland industrial production.

VYM – Vanguard High Dividend Yield ETF –Pelosi’s support for a GM puts pressure on the Bush Administration -automakers had asked for access to an additional $50 billion.

Short ETFs

UUP – U.S. Dollar Index – Bank of America strategists issued a report anticipating a dollar decline into Q1 09 on lower rates and credit market concerns.

EWW – iShares Mexico - Banco de Mexico sold as much as $85 million dollars yesterday as they attempted to stem a selloff in the Peso spurred by the Fitch downgrade, which declined over 1% for the day. Since October the foreign reserves have been reduced by $13.6 billion in such transactions.

EWJ – iShares Japan The cabinet office consumer confidence survey level for October was 29.4, the lowest ever for the Index. Societe Generale issued a report stating that banks may be forced to purchase more than as $100 billion in Yen to hedge currency derivatives heavily marketed in recent years.

EWU – iShares United Kingdom – Unemployment increased at the fastest pace in 16 years in October with claims rising by 36,500 to 980,900, the highest level since March 2001. ILO Unemployment for September registered at 5.8%.

IFN – The India Fund – Industrial Production data for September showed a slight increase to 4.8% y-o-y from the prior month decade low of 1.27 on seasonal pressure as factories increase production in advance of upcoming religious holidays which curb production.

Keith R. McCullough
CEO & Chief Investment Officer

LIZ: Dismantling an Empire

In 1986 Liz Claiborne became the first woman to be CEO of a Fortune 500 company. She revolutionized an industry. The current team is making a mockery of it.

I hate having to take time out of my day to react to poor earnings reports. But for LIZ, I’m making an exception. For starters, I liked this name $5 higher. Keith and I debated this one a ton. He consistently waited for a better price. I had too much blind faith in my fundamental view and did respect the math. I welcome you to YouTube my past comments on our Portal – I’m not going to hide from them. Whenever I am wrong I’ll be my own harshest critic.

Did I like the business? The strategy? Positioning? Portfolio? No, no, no and no! I liked one simple thing -- my confidence that this management team would meaningfully reign in spending, fix an egregiously bloated SG&A structure, and cut capex to a rate that more suitable for this business.

I like the capex cuts a lot – but the rate of change has not intensified since the last call – though the positioning of the business has. I wish I appreciated sooner how flat-out bad this management team is.

One of the selling points of our model is that our content is only available to our clients. I’m tempted to send this note to the Board.

I am increasingly viewing this story as binary, and I am therefore modeling as such. Here’s what I get based on my ‘incompetent management model’ and my ‘bull by the horns management team’ models…

‘Incompetent’ Scenario: Stay the current course. Consistently play defense as $1.6bn in Partner brand business bleeds by 10% annually after a 30% hit in ’08. Direct brands grow mid single digits, but not enough to leverage occupancy cost inflation. Gross margins trend down with the industry, and SG&A cuts are to the tune of 2-3% in absolute dollars. Working capital builds after a year of improvements. Capex is down, but still runs at 2.5-3% of sales in an attempt to grow Direct business. LIZ is faced with a constant overhang of a dividend cut due to the $410mm revolver that needs to be refinanced in Oct ’09. This model gets me to EPS losses through 2012, a dividend cut in ’09, and Chapter 11 could not be ruled out. All in, the company is playing defense in a game it is destined to lose.

‘Bull By The Horns’ Scenario: Cut Capex to 2% of sales – or sub $100mm. Take remaining Partner brands and go exclusive with each one to select major retailers (i.e. Macy’s, Dillard’s, Target, etc…) and major sourcing partners (Li & Fung, etc…), thereby mitigating quarter-to-quarter volatility and start working in a true partnership fashion. Get rid of Mexx. It does not work. Fess up to a bad call and fix it. Cut SG&A across the board. Employee productivity is too low, and dollars invested over the past 2 years are not paying off. It’s time to unwind. In this scenario, despite a 20% hit in CFFO, I’m getting to Free Cash Flow of $250mm, or about 35% better than ’08. This also means no dividend cut overhang, and far less refinancing risk. At that level, 3x EBITDA and 6x earnings sounds a bit more appetizing to me.

I’m sticking with the incompetent model until I gain conviction otherwise.

S&P500 Levels Into the Close...

If you sold stocks at today's intraday low (885 SP500), that doesn't sit well with our risk management model (the tail risk now resides on the side of a massive short squeeze). The range in this market is narrowing as volume is drying up - this is not a time to dress up and play short seller.

We are buyers on red down at the 880 line in the S&P500 (see chart), and looking for this market to breakout, for a "Trade", on a close above the 945 line. Otherwise, trade the ranges.

November 15th is the final date for hedge fund redemption notices... if there is one rumor that I heard most often today (and yesterday) it's that fund XYZ is "selling" and "blowing up"... enough of the narrative fallacy already guys. Lead, follow, or get out of the way (Thomas Paine quote, not mine).

investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.

Pound/Euro: Cheap Money Getting Cheaper

We’ve been bearish on the UK and we are currently short the EWU (iShares United Kingdom) as a proxy for this thesis. The UK has one of the worst balance sheets in Europe and its economic data continues to indicate an economy that is in dire straits. Late last week we posted on British housing numbers that declined 15% y-o-y and industrial production, which contracted again in August.

In an attempt to jump start the economy, the BOE cute benchmark rates by 150 bps to take rates to the lowest level since Winston Churchill was Prime Minister. While cutting interest rates should increase money flow and hopefully revive the UK economy in time, there are, obviously, very severe implications for currency valuation.

As outlined below, the Pound as fallen to an all time low versus the Euro based on an interest rate differential that favors selling Pounds versus buying Euros. Given the extremism of the recent move by the BOE and continuing issues with the UK economy, a recovery in the Pound versus the Euro in the intermediate term seems highly unlikely and, if anything, we should expect to see continued devaluation as cheap money continues to get cheaper.

Andrew Barber

Germany: Is the bottom in sentiment in?

The German ZEW survey shows investors are becoming less negative on the economy… Since everything that matters in our macro models occurs on the margin, this is important.

The Centre for European Economic Research (ZEW) produces its benchmark sentiment indicator by surveying 300 analysts and institutional investors to capture the sentiment of Germany’s “smart money”. After declining sharply since Q1, the latest index ZEW data suggests that sentiment troughed in October and is turning less negative as the impact of government’s bailout programs start to be felt. The index level released today for November was -53 -up 10 points from last month.

While not a good indicator of the mood of the general population, the ZEW has demonstrated value as a leading indicator over the past decade. We are long German equities via the EWG (etf) and we continue to view Germany as the strongest of the major European economies on a relative basis. We expect that if domestic investor sentiment truly has found a bottom for the near term that many other investors will start to share our view.

Andrew Barber

GS: California Conflict?

Allegedly, a Goldman report advised betting against CA’s credit…

The LA Times reported this morning on a confidential Goldman Sachs research report issued in September that advised institutional investors to hedge exposure to (or establish a short on) California debt. It is no surprise that investors would receive this advice - California has been hit hard by the current financial turmoil and Governor Schwarzenegger has issued numerous dire warnings about a potential budget crisis as the credit markets began freezing up over the summer. What IS surprising, perhaps infuriating, is the source. As an underwriter and advisor, Goldman has received millions in banking fees from California bond issues and it has significant advisory and asset management relationships with pools of public capital throughout the golden state.

This conflict will likely come as a shock to California’s lawmakers who could be forgiven for assuming that, as a reputable investment bank, Goldman’s first loyalty would be to its customers and that it would avoid conflicts of interest by helping one customer profit from another’s misfortune. In this case GS apparently event tried to broker both sides of the transaction –according to the LA Times piece Goldman “regularly urged” California to trade CDS contracts on its own credit itself.

A Goldman “spokesman” was quoted saying the firm was no longer providing that advice without elaborating…

The bankers and traders that built Goldman Sachs over the first half of the last century recognized that the trust of their customers, over the long term, was worth more than any opportunity to extract a quick profit. In those days, of course, GS was still a partnership and the long term interests of the firm and those of its customers were closely aligned.

The fact that the firm’s share price is up almost 3% today on the news that they have alienated the largest municipal borrower in the nation may be an indication that the days of that kind of long term thinking is a thing of the past.

Andrew Barber

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.