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Bear Market Macro: SP500 Levels, Refreshed...

“It happened just as I figured.  The traders hammered the stocks in which they figured would uncover the most stops, and sure enough, prices slid off.”

-Jesse Livermore, Reminiscences of a Stock Operator


No matter where the bulls go now, here we are. The Pain Trade is finally to the downside as a lot of players in this game are caught off-sides. This morning’s release of the II Bull/Bear Survey tells you most of what you need to know from a sentiment perspective. Bears dropped from 33% last week to 27.5% this week and that, my risk management friends, is not Bearish Enough.


In the US stock market, the inverse correlation to watch most closely here is SPY/VIX. We have been talking about this 22-23 support zone for the VIX and our Bear Market Macro line of resistance for the SP500 (1144) in meetings from Boston to Chicago and back again through NYC yesterday. As of 130PM EST, both have once again confirmed our bearish intermediate term stance on US Equities.


All that said, the SP500 is immediate term oversold anywhere south of the 1093 line and we’d be covering some shorts and buying some longs here for the immediate term snap back TRADE to 1111. This isn’t a time to freak out and sell everything. Do that when the VIX is at 23 again.



Keith R. McCullough
Chief Executive Officer


Bear Market Macro: SP500 Levels, Refreshed... - 1

Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash?

Conclusion: Chinese demand continues to decelerate. An analysis of the fundamentals suggests we could be headed for a global correction across a variety of asset classes.


I’ve said it before and I’ll say it again: as risk managers, it is our job first and foremost to help our clients protect capital. To do so, we have to take a duration agnostic approach to our research – which is exactly what we are doing in this report. Even though we have a long term bullish bias on China, we understand there will be a lot of money made and lost along the way (the Shanghai Composite, down 21%, is the 2nd-worst performing major equity market globally). To that tune, we dive deeper into Chinese trade and property data released over the past 48 hours to help decipher what it may mean to equity markets and asset classes globally.


China’s trade surplus grew to an 18-month high in July on the heels of weak exports and an even larger slowdown in imports. Exports rose 38.1% Y/Y to $145.5B, down from June’s 43.9% Y/Y increase. Imports fell off the table: up 22.7% to $116.8B vs. an increase of 34.1% in June. This is the smallest Y/Y gain in Chinese imports since growth resumed in November ‘09.


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 1 


So what does this all mean? The Chinese deceleration story is nothing new to global markets, but what is new is the REFLATION we’ve been seeing in commodities absent Chinese demand. In 2009, REFLATION worked because of a simple two-factor model: 1) dollar down; and 2) Chinese demand accelerating. Now, one of those factors has been removed from the engine, yet we’re still seeing the same result.


On yesterday morning’s Daily Macro Call (available to our institution subscribers at 8:30 am each day – email us at if you need a live dial-in), I asked Keith: “Chinese demand continues to decelerate, yet we’ve seen commodity reflation over the last several weeks. How long could this continue to happen in spite of waning Chinese demand as investors look to commodities for yield and inflation hedging?” His response, in short, was simple: “until it stops. Then the crash comes.”


In further detail, a combination of treasury yields at or near all-time lows and a bearish intermediate term outlook for U.S. growth (and likely U.S. equities), suggests we are in a period of heightened yield seeking and once prices start to deflate, we could see an expedited move to the downside across commodities and equities globally (fearful selling). The catalyst for this move, as it was in summer of 2008 could be a sharp appreciation of the dollar. The dollar, which has been down for nine consecutive weeks, is likely oversold in the near term. If the dollar rallies, it could trigger a massive down move in many commodities – an asset class that is becoming increasingly autocorrelated with more and more speculative interest from money managers globally. Furthermore, U.S. equities are also near historical peaks in autocorrelation (see chart below), so an expedited up move in the Dollar Index could spell disaster for 3Q fund performance.


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 2 


In the table below, we show correlations between commodities and select equity indices and the Dollar Index across multiple durations:


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 3


In the table below, we show correlations between commodities, the dollar, and select equity indices and the S&P 500 across multiple durations:


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 4 


While we understand that no two crashes are the same, we are in a similar precarious setup as 2008. Then, the accompanying catalyst (alongside a sharp ascent in the dollar) was a freezing in the credit markets. In our view, that catalyst could be the private equity reliquefication pipeline. In 2007, there were a plethora of L.B.O.’s priced at peak multiples that are now looking to get liquid as debt ratios rise and interest coverage declines. To do so, they’ll either have to IPO increasingly at the low end of the range or hold tight for bankruptcy. Either result (more equity supply at lower prices or rising unemployment) is negative for U.S. equities.


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 5 


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 6


So why might the dollar rally? The answer is quite simple: if the Fed shies away from any further meaningful quantitative easing, the dollar will likely get a boost from a much-needed dose of fiscal austerity (mid-term elections could also prove to be a catalyst with Republicans gaining steam nation-wide). If the current administration finally realizes that QE2 and MEGA Refi. won’t fix our structural, 10 percent unemployment, then U.S. equity investors could be in for quite the surprise.


As with any investment thesis, there are risks embedded in these conclusions. The main risks are: Chinese demand reaccelerating and the Fed opting to pursue further stimulus. While both very valid, we stand counter to both – particularly Chinese demand reaccelerating. Chinese property prices slowed sequentially on a Y/Y basis in July (10.3% vs. 11.4% in June), but, much to the dismay of the Chinese government, they held flat on a M/M basis. This suggests that they will continue to enforce tightening measures, which is bearish for Chinese demand over the intermediate term.


Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 7


Another data point which affirms this is yesterday's news leak that China’s banking regulator has ordered banks to transfer off-balance sheet loans back onto their books and to make provisions for those that may default. Furthermore, because large and small Chinese banks have to maintain capital ratios of 11.5% and 10%, respectively, there will likely be less lending on the margin – particularly to property developers. Before, banks were able to circumvent the tightening measures by repackaging loans into CDO’s. Fitch estimates these assets to be worth 2.3 trillion yuan ($339 bil.), so in the event they are unable to raise enough capital to cover the load (only $60 billion planned for 2010), they will be forced to clamp down on lending even further – which may wind up sending Chinese demand for raw materials and energy to new lows within this current cycle - which are already depressed. July data (released overnight) affirms this: Chinese Industrial Production came in at the slowest growth rate in 11 months (+13.4% Y/Y); July crude oil imports dropped 14.7% from June; and crude steel production fell to a five-month low - down 3.9% from June.


As for further stimulus, we’ll rely on 200+ years of data to suggest that the U.S. government does not want to cross the Rubicon of Sovereign Debt. As Reinhart and Rogoff’s 2009 study shows, there is a sharp slowdown in average growth once advanced economies breach 90% debt-to-GDP. Sure, the Fed could decide to continue to bail out the markets in the near future, but that will come at a steep cost for the not-too-distant future growth prospects. The is no question U.S. economic data will continue to slow from here, so Bernanke will have plenty of chances to keep firing the QE gun going forward, but at what cost to global growth?


Darius Dale



Chinese Demand Continues To Slow . . . Could The Correction Turn Into A Crash? - 8 

Buying the Pound Today

Position: Long the British Pound via FXB


With the pullback in the GBP-USD today towards our TRADE line of support at $1.54 we bought the British Pound via the etf FXB (see chart below). As we’ve noted in recent work, we expect an economic slowing in Europe beginning in the second half of the year. Specifically in the UK, we’re cautious on the housing market. 


The UK’s unemployment picture has yet to greatly excite in either the positive or negative direction over the last months (see chart). However, employment data out today showed that the number of people unemployed in the UK fell by -49K to 2.46 Million in the three months to June, the biggest drop in three years, yet the overall rate of unemployment remains unchanged from the previous month at 7.8%. Jobless claims dropped -3.8K versus consensus expectations of -17K.


Following our bearish outlook on the US Dollar, we believe that currencies like the Pound stand to gain on the other side of the trade. Below, we provide our TRADE (3 weeks or less) and TREND (3 months or more) lines for the GBP-USD. Notably, our models don’t see resistance until the $1.61 level.


Matthew Hedrick



Buying the Pound Today - FXB


Buying the Pound Today - ILO

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Contemplating Slow Growth . . . Bad for Equities and Natural Gas

Conclusion: The math is pretty simple – debt at extreme levels equals slow growth which negatively impacts equity and natural gas returns.


While we are encouraged to see a savvy firm like Goldman Sachs take their GDP estimates down closer to our street low estimates for 2011 GDP growth of 1.7%, it is likely that our estimate continues to have negative bias.  The key current factor driving our view of slowing growth is debt on the balance sheet of the United States.


The future downward risk to our GDP growth estimate will likely hinge on two key factors: housing prices and inventory.  If housing prices unravel quicker than we expect, it will have a direct impact on consumer spending, which is ~70% of GDP.  Additionally, if inventory building were to slow, which was a major contributor to last quarter’s GDP growth number, it would create a major economic growth headwind on a reported basis.


Currently, our estimate for debt-as-a-percentage of GDP for 2010E is 93.2% and 96.1% for 2011E.  The wild card variable for this number is that it assumes no further stimulus (though with yesterday’s “quantitative easing light” this ratio will grow), which would obviously step up the ratio dramatically in the short term.  Leaving future stimulus out of our projections is appropriate given the momentum that Republicans have in polls, and the potential austerity measures that are associated with such.


In our 40+ page sovereign debt presentation from early August (email us at if you want a copy), we highlighted a piece of long term analysis from Professors Reinhart and Rogoff from their recent paper titled, “Growth in a Time of Debt.”  In the paper they look at 220 years of data comparing debt levels of countries to their underlying growth.


The key take away from their paper is that as sovereign debt balances accelerate and eventually reach the 90% debt-to-GDP level, which we have coined the Rubicon of Sovereign Debt, growth slows dramatically.  In fact, the analysis of 2,317 observations has a statistically significant 352 observations at, or above, 90% debt as a percentage of GDP.  Collectively these observations show us that growth averages at 1.7% beyond the Rubicon of Sovereign Debt , which is almost three standard deviations below the collective growth rates at lower debt levels.


The second derivative of this analysis is, of course, equity returns.  In effect, how do equities perform in periods of slower growth?  We looked at the annual returns for the S&P500 for the last 30-years versus the GDP growth in each period.  The conclusion was that in low growth periods, equity returns lag.  The key conclusions of the analysis were as follows: 

  • In the five years with the lowest GDP growth of the past 30-years, the average return of the S&P500 was 2.5%; and 
  • In the five years with the highest GDP growth of the past 30-years, the average return of the S&P500 was 19.8%. 

The question of course is: what else is impacted by slow economic growth? 


We also took a quick look at the returns of natural gas, the commodity which is priced domestically and most directly impacted by U.S. economic growth.  Not surprisingly, the results were very similar.  For this analysis we were only able to look at the past 10-years of data, but in the four years with the highest GDP growth in that period the average year-over-year price gain for natural gas was +16.8%, while in the four years with the lowest GDP growth prices declined an average of (-3.4%) year-over-year.


The math is pretty simple – debt at extreme levels equals slow growth, which negatively impacts equity and natural gas returns.


Daryl G. Jones
Managing Director


Here is a look at 2Q guidance ahead of earnings on Thursday.


The trends at MCD are making it nearly impossible for any of the big (mature) hamburger chains to post better that expected results.  In addition, higher commodity prices (especially beef and pork) will make it difficult to maintain margins in 2H10.


The recent introduction of salads has been well received, but not enough move the needle at this point. 


The stock trades at a significant discount to its assets values, but being “hopeful” that the majority shareholders can create value (by spinning-off Arby’s) is not an investment process.  The $1 menu at Arby’s helped transactions, but will penalize margins for the time being.


I look forward to the day when Wendy’s can just be Wendy’s!



  • Wendy’s - To maintain or sequentially improve two-year average company-owned same-restaurant sales trends for the Wendy’s concept must see same-restaurant sales grow by at least 1.7% in 2Q.  Per StreetAccount, the Street estimates that company-owned same-restaurant sales for Wendy’s will come in at -0.1%, which would result in a 91 bp sequential decline in two-year average trends.
  • Arby’s - To maintain or sequentially improve two-year average company-owned same-restaurant sales trends for the Arby’s concept must see a same-restaurant sales number of at least -13.8% in 2Q.  Per StreetAccount, the Street estimates that company-owned same-restaurant sales for Arby’s will come in at -7.6%, which would imply a 310 bp sequential increase in two-year average trends.



  • For the year, we continue to expect positive same-store sales and further margin expansion at Wendy’s, and negative same-store sales at Arby’s but improving on a year-over-year basis.
  • Expecting adjusted EBITDA growth in the low to mid-single digits for 2010. This excludes the effect of the 53rd week in 2009 of approximately $14 million and incremental investment spending to expand breakfast menu in 2010.
  • We believe that the new salads will drive transactions and sales.
  • In 2010, we plan to remodel up to 100 company-owned Wendy’s restaurants
  • We will begin to introduce the new menu into our three existing breakfast markets in the second and third quarters, expanding in the fourth quarter (franchise and additional company markets) and finally a national rollout in 2011.
  • Internationally, we expect franchisees to open 35 to 45 new international Wendy’s restaurants.
  • We would expect the Wendy’s system unit growth to be flat this year.
  • For Arby’s we plan on having 75% of system as Pinnacle Image restaurants by the end of 2012 – stronger sales and margins.
  • On track to remodel 100 Arby’s company-owned restaurants in 2010.  Investing $100 million over the next three years.


Howard Penney

Managing Director

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AD: More blue moons managed - Image1




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