The Point of Collapse

“Perfection of planned layout is achieved only by institutions on the point of collapse.”

-Northcote Parkinson


Parkinson was a well known British scholar who specialized in naval history. Before he passed away in 1993, he authored 60 books, including “The Devil to Pay”, “Dead Reckoning”, and “So Near, So Far.” His writings recognized patterns of behavior in administrations and institutions in a way that makes we modern day chaos theorists proud. Patterns repeat.


The point of collapse is generally crystal clear in the rear-view mirror. Professional politicians in Japan have been telling stories for 20 years as to why they can prevent economic stagnation. In the US, the storytelling started in 2007. All the while, stock market and real-estate prices have every opportunity to rally to lower-highs, then collapse to lower-lows.


Despite all of the dissimilarities between Japan and the US, there is one similarity that continues to matter most in our risk management model – debt as a percentage of GDP. Now that the US can’t cut interest rates any lower, the “perfection of planned layout” to quantitatively ease, is also similar. We agree with Reinhart & Rogoff that crossing the 90% debt/GDP threshold is the equivalent of crossing the proverbial Rubicon of economic growth.


On July 2nd, as part of our Q3 Hedgeye Macro Themes presentation, we cut both our Q310 and full year 2011 GDP estimates for the US to 1.7%. At the time, these US economic growth estimates were about ½ the Bloomberg consensus estimate. Now we’re starting to see both the sell-side and the Fed gradually cut their estimates, but not by enough. Our estimate for 2011 is still too high.


Growth slowing, both domestically and in China, is core to our bearish views on both the US Dollar and US Equities. There will be a downward bias to our US growth estimates as long as debt-financed-deficit-spending continues to remain the answer to the Fiat Fools prayers.


Markets trade on expectations. Yesterday’s setup in the SP500 was unlike most Augusts in America. That’s because the ‘government is good’ crowd leaked an idea to the Wall Street Journal that QE2 was coming, and that Ben Bernanke was going to solve for buy-and-hope begging.


To think that we have institutionalized market expectations in this great country to this degree is downright frightening. All things rallies start and end with rumors about what a humble looking man of government will represent at 215 PM EST on an August afternoon. Sadly, this kick starts thoughts of what another thoughtful European mind, Alexis De Tocqueville, warned about American style democracy in the 19th century.


So now what?


What do we do with this big Keynesian intervention that has delivered the fear-mongering national marketing message? Have we sufficiently scared the horses? While we’ve been getting paid, has this “perfectly planned layout” of telling Americans that this is a “great depression” worked?


With 40.8M Americans on food stamps (record high) and 45% of the unemployed having been seeking employment for 27 weeks or more (record high), now what?


Should we start begging for QE3? Should we cancel the bomb of an Existing Home Sales report for public release on August 24th? Or should we get back on TV after checking our I-pads and drinking our $5 mocha-frap and tell Americans to bite the bullet on ZERO percent returns-on-savings while we pay Washington to continue to lever-up our future to the point of economic collapse?


Before the Fiat Fools run out campaigning for QE3, never mind decisions made in 1997 Japan, maybe they should analyze some real time market results to yesterday’s announcement of QE Light:

  1. The US Dollar is battling for resuscitation after 9 consecutive down weeks at $80.80 (down -9% since June)
  2. US Treasury yields are making record lows on the short end of the curve, with 2-year yields striking 0.49%!
  3. The Yield Spread (10yr minus 2yr) continues to collapse, down another 4bps day-over-day to 223bps
  4. US stock market futures are diving below the beloved 200-day Moving Monkey line of 1115
  5. US Volatility (VIX) is spiking from its intermediate term TREND range of support (22-23)
  6. QE Specialist (Japan) got smoked overnight, closing down -2.7% to down -11.9% YTD

Now what?


De Tocqueville’s answer: “The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money.”


My immediate term TRADE lines of support and resistance for the SP500 are now 1099 and 1138, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


The Point of Collapse - toc2


The Macau Metro Monitor, August 11th, 2010


According to the PBOC, new yuan-denominated lending in July fell to 532.8 billion (US$ 78.6 billion) from 603.4 billion yuan in June.  The first seven months brought 5.16 trillion yuan in loans, compared with 7.73 trillion yuan during the same period last year.


M2 supply increased 17.6% YoY to 67.41 trillion yuan by the end of July, slowing down from the 18.5% growth in June.

M1 supply climbed 22.9% in July, a decrease of 1.7% points from June's.  The Chinese government fixed this year's target for new loans at 7.5 trillion yuan. 


According to Mastercard, spending during The Great Singapore Sale (May 28-July 25) jumped 28% YoY to US$893.2 million.



PAGCOR chairman Naguiat does not believe Ramon Ang's offer of $10 billion is serious.  “They’re not even industry players,” Naguiat said of Malaysia’s Robert Kuok, Ananda Krishnan and Francis Yeoh, three of the richest men in Southeast Asia.  Naguiat noted that while Kuok owned the renowned Shangri-la chain of luxury hotels, none of them had a casino. 


A spokesperson for Kuok in Manila, Joy Wassmer, denied reports that the Malaysian tycoon was interested in PAGCOR.  Wassmer said that Kuok had never been involved in the gaming business and had “no intention of investing in the gaming industry in the future.”


Narzalina Lim, general manager of Macau Government Tourism Office-Philippines, said that Filipino tourists continue to visit Macau because of its accessibility and affordability with two Philippine-based airlines -- PAL and Cebu Pacific -- offering direct flights to Macau from Manila and Clark, at the same time offering cheap promotional packages.  With the implementation of the "open skies" policy, which will be announced soon by the Aquino administration, she believes more Filipinos are expected to visit Macau, particularly travelers from Davao Region and its nearby provinces.



As we look at today’s set up for the S&P 500, the range is 39 points or 2.0% (1,099) downside and 1.5% (1,138) upside. Equity futures are trading below fair value - disappointing data out of China and Japan has set the early tone and Europe is broadly lower. Today's focus will be trade and budget data for July.

  • ADVANCE/DECLINE LINE: -1400 (-2766)
  • VOLUME: NYSE - 980.83 (+24.14%)
  • SECTOR PERFORMANCE: 3 sectors positive - XLU, XLV and XLP - flight to safety
  • MARKET LEADING/LOOSING STOCKS: Akami +4.86, XL Group +2.68 and ADV Micro (7.95%) and Western Digital (6.12%)


  • VIX - 22.37 1.04% - The VIX now up for 2 days and bearish for equities.
  • SPX PUT/CALL RATIO - 2.49 up from 2.01 trending up (not seen since March) (low on 07/15/10 of 0.87)


  • TED SPREAD - 24.87 -0.913 (-3.541%)
  • 3-MONTH T-BILL YIELD .15% Unchanged
  • YIELD CURVE - 2.2974 to 2.2359


  • CRB: 272.28 -0.84% (down for the last 4 days)
  • Oil: 79.35 1.51%
  • COPPER: 331.25 -1.24% (currently trading at 327.25 below 332 - BEARISH for growth expectations
  • GOLD: 1,196 -0.32% (trading down for 3 days)


  • EURO: 1.3117 -0.84%  - (trading down for 3 days)
  • DOLLAR: 80.799 +0.11%) - (trading up for 3 days)


  • ASIA - Asian markets fell after the Fed disappointed saying it would reinvest money from maturing mortgage bonds in government debt.  Japan fell (2.58%) broadly - The strong yen is hurting exporters and a slowdown in the US; worries about the domestic economy also dampened sentiment as core machinery orders came in below forecasts 
  • EUROPE - European are trading sharply lower following weakness across Asian and in reaction to the Fed's comments that the US economy is slowing and took new step to aid the economy.
  • EASTERN EUROPE - Trading lower - Russia down another 1.23% and Hungary down 0.84%.
  • LATIN AMERICA - Lower but Peru trading higher for the 2nd day - Argentina down 1%
  • MIDDLE EAST/AFRICA - Mostly lower with Saudi Arabia down 1.46% 
Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends













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Giving Americans who live on fixed incomes a ZERO percent rate of return on their hard earned savings will continue to have many unintended consequences, for an “exceptional and extended” period of time


40.8 MILLION Americans, and counting…




CHART OF THE DAY: HIGH-LOW SOCIETY - Screen shot 2010 08 09 at 2.52.51 PM

EARLY LOOK: Bad to Worse

“I toil beneath the curse,
But, not knowing the universe,
I fear to slide from bad to worse.”
-Alfred, Lord Tennyson
Keith was off managing domestic risk last night taking his wife out for their anniversary dinner, so I’ve been handed the pen for the Early Look this morning.  Later today our firm will be having our annual picnic at our colleague Todd Jordan’s lake house in rural Connecticut.  It has just been over two years ago since we welcomed our first client, and the growth trajectory since has been meteoric.   On behalf of all of my teammates I’d like to thank all of our clients that have helped make this possible.  It has been a pleasure working with every one of you.
We now have close to forty employees.  We have three offices around the globe, with plans to open our fourth this fall.  And with the pending launch of Energy Sector Head Lou Gagliardi in September, we will have seven senior sector heads who cover close to 50% of the SP500.  Following our firm meeting yesterday, I can tell you this, we are just getting started.
So, as I was contemplating our firm’s growth yesterday at the Hedgeye Happy Hour following the firm meeting, I was also mulling over the future economic growth of the United States.  While I’m not in the double dip camp, I do “fear to slide from bad to worse”.  As Lord Tennyson would say.  (Incidentally, Tennyson is the second most quoted person in the English language after Shakespeare.)
Earlier this week, Keith and I presented to our clients on the topic of U.S. Sovereign Debt.  Debt and deficit issues in the United States are not exactly non-consensus as they are widely discussed and contemplated.  In fact, in the spirit of “watch what they do and not what they say”, we had the second Obama administration economic official resign today in Christina Romer, the chair of the Council of Economic Advisors.  This of course comes on the back of the July departure of Peter “The Paparazzi” Orzag, who ran the Office of Management and Budget.  Watch what they do and not what they say . . .
Undoubtedly, both Orzag and Romer have come to the same realization as us, which is that U.S. economic growth is poised to slow in coming years.  In our presentation on Tuesday, we narrowed this projection down to one key variable in our multi factor, chaos theory based model.  This factor is sovereign debt.  So if you are staffed with managing the budget or the economy in a slow growth environment, you better either wave the white flag and go back to teaching at Berkeley (Romer), or prepare your stomach for the new reality of Bad To Worse.
While many of you have read Reinhart and Rogoff’s book, “This Time is Different”, which studies the long term implications of large sovereign debt balances,  the professors also wrote a fascinating paper earlier this year, “Growth in a Time of Debt.”  This paper looks at over 210 years of data relating to sovereign debt balances and future economic growth.  The key conclusion is that as debt-as-percentage-of-GDP crosses the Rubicon of 90%, future growth slows.  And in dramatic fashion.
According to their paper, from 1790 to 2009, for 20 of the most modern economies, as debt exceeded 90% of GDP, average annual economic growth was 1.7%.  This was compared to economic growth of 3.7% at less than 30% of debt to GDP, economic growth of 3.0% with debt to GDP from 30% to 60%, and economic growth of 3.4% with debt to GDP of 60% to 90%.  In effect, as debt as a percentage of GDP passes the Rubicon of 90%, growth falls below the average by more than three standard deviations.  As the quants will tell you, that is statistically significant!
Being the industrious young analysts that we are, we actually applied this thesis to Japan.  In the attached chart of the day, we outline this point graphically. In the last three decades in Japan as we see a step up in debt, we see a corresponding step down of economic growth with the inflection point being . . . you guessed, it 90% debt-to-GDP.  Specifically,
1981 – 1989 – Japan has average economic growth of just 4.6% and an average debt to GDP balance of 64%;
1990 – 1999 – Japan had an average economic growth of 1.5% and an average debt to GDP balance of 92%; and
2000 – 2009  - Japan had an average economic growth of 0.8% and an average debt to GDP balance of 179%.
As they say, facts don’t lie, politicians do.  And the facts as it relates to debt and growth are quite clear, as debt climbs and exceeds the Rubicon of 90%, economic growth will slow.  If you don’t believe me, believe the 200+ years of data.
It is clear to me that, “The old order changeth, yielding place to new.”  With the new order being a meaningfully different growth trajectory for the United States than the prior thirty years.  
But as always, “Tis better to have loved and lost, than never loved at all.”
The Poet Laureate of Hedgeye,
Daryl G. Jones
Managing Director


EARLY LOOK: Bad to Worse - Screen shot 2010 08 09 at 2.48.16 PM

EARLY LOOK: 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 1997-1998, 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


EARLY LOOK: The Cliffs of Insanity - JSEL large

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 80.52%
  • SHORT SIGNALS 78.67%