The Cliffs of Insanity

“All truths are easy to understand once they are discovered; the point is to discover them.”
- Galileo Galilei


The penalties for non-consensus thinking were harsher 400 years ago. In 1610 Galileo published his observational studies of the moons of Jupiter as evidence in support of Copernicanism and a heliocentric model of the solar system. At the time, most astronomers still believed in a geocentric model and considered a heliocentric model outrageous. Galileo’s work was derided by many of his contemporaries and, ultimately, Galileo was brought before the Roman Inquisition for heresy, tried, found guilty and forced to spend the rest of his life under house arrest.


Fortunately in today’s world the penalties for having a non-consensus view generally aren’t as severe. That said, it can still take a long time for certain entrenched assumptions to change and evolve, which brings us to the subject of today’s Early Look. One such entrenched assumption in the investment community today is that home prices are unlikely to fall materially from here.


For those unfamiliar, our view on housing is bearish and our argument relies principally on supply and demand data, and the imbalances that exist between them. Our analysis has sought to both measure and quantify the effects of dislocations in supply and demand in housing and the lagged effects these imbalances have on home prices. Our conclusion is that based on the current supply and demand imbalance, prices will be 15-20% lower in 12-18 months on a national basis. This is an overly simplistic summary of a 100+ page presentation we’ve assembled on the subject, but below we present just a few of the facts worth considering.


Consider the following. There are currently 3.99 million homes on the market for sale as of the end of June. Existing home sales were 5.37 million (seasonally adjusted annualized rate) in June, which equates to 8.9 months of supply. This is disingenuous, however, as June existing home sales represent April contract activity. We know that post-April pending homes sales are down over 30% through May and June. As such, we would expect a comparable decline in existing home sales once the data rolls through on a lag later this month. In other words, existing home sales for July/August will be in the ~4 million range, which will be a wake-up call to the Panglossian bulls. Assuming inventory remains around 4 million this will equate to ~12 months of supply. The market is often considered in equilibrium when inventory is 5-6 months of supply. For reference, 12 months will be the highest amount of supply seen since the housing downturn began. This 12 months figure does not include shadow inventory, which likely represents an additional 4.2 to 6.0 million homes (according to estimates from the Mortgage Bankers Association, the Federal Government’s HAMP Program, and Lender Processing Services, the largest mortgage default processor in the country.)


Laurie Goodman, a Senior Managing Director with Amherst Securities, one of the leading providers of mortgage data analytics, recently published a paper in the Financial Analysts Journal entitled “Dimensioning the Housing Crisis” in which she submits that from the beginning of the crisis (YE06) through today there have been 1.5 million homes liquidated through foreclosure and short sale. During this timeframe, depending on which housing series you use, home prices have fallen 20-35% nationally. Using conservative assumptions, she concludes that a further 11-12 million homes will be liquidated in coming years. If 1.5 million liquidations coupled with broader supply/demand imbalances triggered 20-35% downside in home prices, consider what 11-12mn liquidations will do amid a more severe underlying supply/demand imbalance.


While the government has intervened over the past 18 months to try and arrest the rate of decline in home prices, we think their efforts have merely kicked the can down the road and have done little to alter the underlying nature of the problem. Ultimately, the pressure from foreclosures will outstrip the government’s ability to hold back the supply.


Touching briefly on the demand side of the equation, demand for mortgages as measured by the MBA Purchase Index has been steadily falling for the last five years.  After averaging 471 in 2005, the Purchase Index fell to 264 in 2009 (-44%).  2010 to date is down to 209 (-55%).  The month of July averaged just 170, a 64% decline from 2005.  For reference, 2010 year-to-date demand is consistent with demand last seen in 1, while July demand is consistent with levels last seen in 1995. 


It seems obvious to us that home prices are headed materially lower from here, yet many people – most in fact – don’t agree. There are a host of reasons we’ve had explained to us why home prices shouldn’t go down from here. The most oft-cited is the demographics argument, namely that there should be solid net new household formation over the next several years that will drive marginal demand for homes high enough to absorb existing supply, shadow inventory and whatever other pressures might come down the road.


It’s foolish to dismiss criticism out of hand without first thinking it through – especially when multiple investors are telling you the same thing. To that end, we’ve analyzed the core of the argument that household formation is set to take off, and what we’ve found is quite interesting. The chart at the end of this report shows data that we don’t think many people are aware exists. It represents real household formation rates through June 2010. We have the data monthly – not many people do. What is striking is that it shows that in the first half of 2010 the number of households in the US actually shrank. This is the first time this has happened since the data series began, and our data goes back to the 1950s. Moreover, negative growth in 1H10 follows anemic growth in 2008 and 2009.


Why is this? Normally, some 60% of net new household formation occurs in the 20-29 year old demographic. It’s typically at this age when a young person moves away from home and, in doing so, a new household is created. The catch is that unemployment is at 9.5% nationally, and the unemployment rate for this age cohort is well into the teens. Remember, household formation is a derivative of confidence, which itself is merely an extension of the employment environment. This lack of confidence must be having a profound effect across the country for the number of households to actually be shrinking.


Will this change? The relationship between the economy and household formation is reflexive, to borrow a philosophical concept from George Soros. That is to say, when times are good household formation drives the economy amid a virtuous cycle, but when times are bad the economy will suppress household formation, which, in turn, feeds back negatively into the economy in a vicious cycle. The latter is the dynamic that exists today.


Our firm is of the strong view that US economic growth is poised to decelerate meaningfully in the back half of the year and into 2011, which will keep a lid on hiring. This will in turn keep the lid on household formation, the one credible case for a pick-up in housing demand.


Josh Steiner
Managing Director


The Cliffs of Insanity - JSEL


The Macau Metro Monitor, August 5th, 2010



IM sources say that we should not expect any new visa restrictions from Beijing.  The provincial and central governments may be concerned about the American influence in Macau's gaming industry but they don't want to "start choking the golden goose". Also, the rumor about multiple-entry visas for transit visitors passing through Macau is bogus.


By the way, "silly season" is when real news is harder to find than a Macanese construction worker.



Large employers in Macau have started laying off Nepali migrant workers along with other foreign workers following the government's decision to give priority to local workers.


According to the Kantipur Daily, in recent days, Landmark Hotel has fired 53 Nepali workers, Ponte 16 Hotel--23 workers, New Century--21 workers, Grand Lapa--19 workers, Guardforce--21 workers, and G4 Securities--7 Nepali workers were laid off.  The workers were fired in short notice without compensation.


Despite JACK management having set expectations low last quarter, fiscal 3Q10 was ugly.  Earnings of $0.50 per share fell short of both my expectations and the street’s estimate of $0.53 per share.  Same-store sales at Jack in the Box came in down 9.4%, also below the street’s estimate and below management’s guidance of -7% to -9%.  Management again attributed the soft results to “high unemployment in [its] major markets for [its] key customer demographics.”


We will see what management has to say tomorrow on its earnings call, but the only obvious bright spot in the quarter was the continued improvement in same-store sales trends at Qdoba (+4.6%), which improved on a one-year and two-year average basis.  Management’s 4Q10 comp guidance for Qdoba of +3% to +4%, however, points to decelerating two-year average trends.


Two-year average same-store sales trends at Jack in the Box decelerated 110 bps from the prior quarter and better trends do not appear to be coming next quarter.  Management’s fourth-quarter comp guidance of -4.5% to -5.5%, which it said was reflective of trends in the first four weeks of the quarter, imply two-year average trends that are relatively flat to down about 50 bps from the third quarter.  So at best, we are looking at stabilizing trends. 


Restaurant-level margin declined nearly 370 bps YOY, when adjusted for the increase in workers’ compensation reserves that negatively impacted payroll and employee benefits costs by $1.8 million.  The company estimates that sales deleverage negatively impacted margins by approximately 280 bps during the quarter.


As expected, commodity costs were 2% higher during the quarter, which drove food and packaging costs as a percentage of sales up 40 bps YOY.  Declining margin, combined with negative same-store sales growth, put JACK safely in the “Deep Hole” quadrant of our sigma chart (shown below) for the third consecutive quarter. 


Based on management’s outlook for continued softness in same-store sales trends and expected increased commodity pressure, JACK will likely stay in the “Deep Hole” for at least another quarter.   Management now expects commodity costs to increase 4% in the fourth quarter, up from its prior guidance of +3%.  Full-year restaurant-level margin is expected to decline about 200 bps YOY to the low 14% range (down from prior guidance of 15% to 16%).  Full-year EPS guidance was lowered to $1.65 to $1.75, from $1.85 to $2.05.  I can only imagine what management is thinking now based on these results, given that on the last earnings call CFO Jerry Rebel said, “if we hit that [$1.85 – low end of full-year guidance at the time] God forbid...”  Earnings of $1.85 per share would sure look good now.




Howard Penney

Managing Director


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In preparation for Hyatt's Q2 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from Hyatt’s Q1 earnings release/call and subsequent conferences.


Post Earnings Call Conference Commentary  (June 7th)

  • “Approximately 70% of our rooms are in North America with 30% in International. Internationally, we have a significant and strong presence in Asia - Pacific where 15% of our rooms are located…less than 10% of our rooms are in Europe.”
  • “We reduced approximately $170 million of costs out of comparable owned hotels during 2009 and are focused on limiting cost creep as occupancies increase.”
  • “We plan selectively and opportunistically recycle assets in order to achieve our goal of driving brand preference.”
  • “Over the last 12 to 18 months, like most of the folks in the industry, we had tides of expenses largely come in the form of staffing reductions, at the hotel level as well as the management level. For example, we did restructure our overhead structure… Last year we froze salaries, we gave no merit increases, bonuses, etc cetera. As things come back, it’s going to be tough maintaining those structures. We will have wage inflation and it is our intention that over time because we’re providing authentic hospitality and get satisfaction, we don’t comprise those standards as the business recovers. I think what you’re going to see is a tight overhead structure, both at the hotel and structured overhead – in terms of actual operating expenses in the hotel, it’ll probably attract an increase in occupancy over time.”
  • “We announced plans to renovate 5 properties this year. The 2 big ones were the Grand Hyatt New York and the Grand Hyatt San Francisco…the spend is over 2 years.”
  • “Our total CapEx program this year is anywhere between $270 and $290 million. But if you look at our portfolio, we have 102 assets, 55 of them are select assets, basically Hyatt Place and Hyatt Summerfield Suites. When we acquired Marriott Suites couple of years ago, we spent a couple of years actually recreating or creating the Hyatt Place brand. So the select portfolio is largely fresh."

1Q2010 YouTUBE

  • “In North America we saw an improvement in the volume of group bookings made during the first quarter as compared to what had been booked in the first quarter of 2009, while room rates remained under pressure.”
  • “During our year-end 2009 earnings call, we stated that transient demand has started to come back, and we are happy to say this trend continued through the first quarter across all three business segments i.e. owned and leased hotels, North American managed and franchise operations, and international managed and franchise operations. Revenues from transient customers, both corporate and leisure, were up for the first quarter of 2010, compared to the first quarter of 2009.”
  • “On the group side, while revenues were down in North America as compared to the first quarter of 2009, the number of group nights sold increased by approximately 3% compared to the first quarter last year.”
  • “Over a third of the 9% (Owned/leased RevPAR) increase was driven by our international owned hotels. Results in North America were helped by the ramp-up in the performance of two hotels that were renovated 12 to 18 months ago. Results were also helped by the Olympics that benefited our property in Vancouver.”
    • “Grand Cypress, which was under renovation last year, has opened and is ramping up. We had a Hyatt at West Hollywood that we converted to an Andaz, about a little over 12 months ago, and that has ramped up nicely during the last 12 months. And then the Olympics helped us in Vancouver.”
    • “The Andaz Hotel in West Hollywood opened in January of last year, so we had no rooms out during the course of the year there. And the rooms renovation at Grand Cypress was more in the first half of the year than in the second half of the year.”
  • “Comparable owned and leased hotel margins…benefited from the two hotels ramping up from renovations that I’ve mentioned as well as our property in Vancouver. Margin improvements at these three hotels represented almost half of the 220 basis-point decrease in the quarter.”
  • “We were able to manage expense increases to approximately 5.6% even as occupancy increased by 760 basis points. However, despite focus on operating efficiently, we expect that our costs will continue to increase, driven by inflationary pressures.”
  • [North America managed and franchised hotels] First quarter comparable RevPAR for full-service hotels declined 2.2%, driven by ADR, which declined 7.9%. The number of transient room nights sold increased approximately 9% where transient rates declined slightly over 7% in the first quarter of 2010.” 
  • "While the volume of group room nights sold increased during the quarter, overall group revenues declined in the mid-single digit percentage range due to declines in average rates. Group revenue paid for 2010, as of the end in the first quarter, was down from last year, but the rate of decline of group-paid lessened over the first quarter 2010.... Group cancellations declined materially and are at pre-downturn levels.”
  • [International management franchise business] “Few special factors helped our results in the quarter, such as a lift in business in Shanghai, due to the advanced planning for the World Expo, which opened earlier this week. Overall, international fees increased 16.7% in the first quarter of 2010, excluding the impact of currency, due to higher revenues at comparable hotels and increased fees from recently opened hotels.”
  • “We are experiencing ongoing SG&A expense growth due to higher compensation costs as we restore merit increases and incur higher travel costs as the people get back on the road.”
  • “On income taxes, we are expecting that the tax rate of our U.S. income to be approximately 38%, the blended tax rate on our international income to be approximately 20%, and certain fixed charges that could be slightly higher than 2009 levels.”
  • We expected the disruption associated with these projects to reduce rooms available for sale by an average of 400 per night from July through the end of 2010.”


Heat wave + smoothies = good comps…right?


McDonald’s is scheduled to report its July sales numbers before the market open on Monday.  July 2010 had one less Wednesday, and one additional Saturday, than July 2009. 


Consumer confidence indicators in the United States, along with other factors such as unemployment, continue to bifurcate from the “recovery” theme that has manifested in equity markets.  In light of this, expectations for QSR are somewhat tempered.  However, in light of the reportedly successful smoothie launch and a favorable calendar shift, I am cautiously optimistic about MCD’s top line performance in the U.S. for July.


Turning to the bottom-line, I recently wrote a note titled, “MCD – THE MCDONALDS CONUNDRUM” (7/26).  MCD is faced with the difficult task of balancing the negative impact of TC-driving lower menu prices on margins (think Dollar Menu at breakfast) with the benefit of declining commodity prices fading in 2H10 and then potentially going away in 2011.  It will be interesting to see whether there is any hint of imminent action on the part of McDonalds to tweak its strategy ahead of time as this conundrum becomes more obvious.  However, management did state that food away from home CPI and food at home CPI would be two indicators it would monitor closely when considering taking price.


Below, I go through my take on what numbers will be received as GOOD, BAD, AND NEUTRAL, for MCD comps by region.  For comparison purposes, I have adjusted for calendar and trading day impacts.  To recall, management stated on its 2Q10 earnings call that momentum continued into July with global comparable sales trending in line with or better than second quarter sales (2Q10 global comp was +4.8% with the U.S. +3.7%, Europe +5.2% and APMEA +4.6%).



U.S. (facing a relatively easy 2.6% compare, including a calendar shift which impacted results by +0.6% to +0.7%, varying by area of the world):


GOOD:  5% or greater would be perceived as a good results because it would imply that the company was able to improve U.S two-year average same-store sales (by 35+ bps) on a sequential basis.  While this is a fairly high print by recent standards, taking into account management’s statements on global comparable sales performing in line with or better than 2Q in July, and the U.S. smoothie launch exceeding expectations, it seems reasonable to hold an optimistic view on U.S. comps this month.


NEUTRAL:  Roughly 4% to 5% implies two-year average trends that are approximately in line with those seen in June.


BAD:  Below 4% would indicate that two-year trends have deteriorated significantly on a sequential basis.  While June’s results showed a degree of resilience in the U.S. market, a decline in trends would be disappointing given management’s marginally positive commentary around global trends and, specifically to the U.S., the smoothies sales which were “blowing away high-end projections”, according to management on the 2Q earnings call.



Europe (facing a 7.2% compare, including a calendar shift which impacted results by +0.6% to +0.7%, varying by area of the world):


GOOD:  5.5% or better would be a good result for MCD’s Europe operations as it would imply a sequential improvement (of about 95 bps) in two-year average trends.  5.5% would also signal a return to the traditional “GOOD” territory of 6% two-year average trends for Europe.  Management estimates that the World Cup negatively impacted June sales by ~1%; the strong progress made by the European teams makes it likely that the impact will carry over into July.  Another important point to bear in mind for Europe is the July lapping of the VAT benefit in France.  Management stated that the lower VAT on dine-in sales in France had benefited France sales by a mid-single digit number during the year ended June 30.  Obviously for Europe as a whole this will be a smaller impact and management was aware of this catalyst when they announced guidance on July 23rd.


NEUTRAL:  3.5% to 5.5% would imply two-year average trends roughly in line with results seen in June, which had declined rather significantly from the prior month.


BAD:  Below 3.5% would imply two-year average trends that have declined sharply from June’s results.  I would point out that the street’s current estimate of 2% would fall in this range.  Management did highlight some potential issues in Europe, as I outlined above, but the street’s estimate seems very conservative, particularly given the company’s comments on global trends in July.



APMEA (facing a relatively easy 2.1% compare, including a calendar shift which impacted results by +0.6% to +0.7%, varying by area of the world):


GOOD:  A print of 7% or more would imply a sequential improvement in two-year average top line trends. 


NEUTRAL:  Comparable-store sales of 5.5% to 7% would result in two-year average trends roughly in line with trends seen in June.  Like in Europe, two-year average trends in APMEA decelerated in June.


BAD:  Same-store sales of 5.5% or less would imply a sequential slow down from June’s trends.  It is also possible, that if the number is 4.5% or below, that two-year trends may even fall lower than December’s trough two-year average number.  The street’s 4.0% estimate again falls in the “BAD” range and implies a deceleration in trends in July from the already depressed level in June.



MCD JULY SALES PREVIEW - mcd july preview


Howard Penney

Managing Director





Bull/Bear Macro-Tug

There’s a real good Bull/Bear macro-tug of war going on out there all of a sudden. There is a core constituency of bulls who want to believe that the current pattern of US economic growth is going to sustain itself and then there are the bears who remain negative on both the US Dollar and the SP500 for the intermediate term TREND.


There was plenty of economic data this morning for both bulls and bears to tug on:



  1. In the chart below we show a modest sequential acceleration in the ISM Non-Manufacturing Index (54.3 in July vs. 53.8 in June)
  2. MBA mortgage applications were up +1.5% week-over-week (barely budging demand levels not seen since 1997)
  3. ADP’s employment report came in at 42k (better than expected) 


  1. ABC/Washington Post weekly consumer confidence dropped for the 5th consecutive week to -50 versus -48 last week.
  2. II’s Bullish/Bearish Survey widened to +6 points in the Bulls favor (Bears dropped to 33% and this is a contrarian indicator).
  3. The SP500 remains below the Bear Market Macro line of resistance (1144). 

Coming up next are US Retail same store sales reports (tonight and tomorrow), weekly jobless claims (tomorrow), and Friday’s unemployment report for the month of July. My immediate term TRADE lines of support and resistance for the SP500 are now 1116 and 1131, respectively.


Keith R. McCullough
Chief Executive Officer


Bull/Bear Macro-Tug - 1

Hedgeye Statistics

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

  • LONG SIGNALS 80.47%
  • SHORT SIGNALS 78.71%