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TODAY’S S&P 500 SET-UP - August 24, 2010

As we look at today’s set up for the S&P 500, the range is 23 points or 0.8% (1,059) downside and 1.4% (1,082) upside.  Equity futures are trading below fair value ahead of the housing data.

  • PERFORMANCE ONE DAY: DOW (0.38%), S&P (0.40%), Nasdaq (0.92%), Russell (1.33%)
  • PERFORMANCE MONTH-TO-DATE: DOW (2.79%), S&P (3.11%), Nasdaq (4.22%), Russell (7.41%)
  • PERFORMANCE QUARTER-TO-DATE: DOW +4.1%, S&P +3.56%, Nasdaq +2.39%, Russell (1.12%)
  • PERFORMANCE YEAR-TO-DATE: Dow (2.43%), S&P (4.28%), Nasdaq (4.83%), Russell (3.63%)
  • ADVANCE/DECLINE LINE: -786 (-284)
  • VOLUME: NYSE - 865.17 (-23%) - no massive selling
  • SECTOR PERFORMANCE: 4 sectors positive on the day - XLU positive on TRADE AND TREND
  • MARKET LEADING/LAGGING STOCKS YESTERDAY: Washington Post +6.07%, Micron Tech +3.65%, and Avon +2.72%. Titanium Metals -4.5%, Flir -4.25%, and Intuit -3.97%


  • VIX  - 25.66 +0.67%
  • SPX PUT/CALL RATIO - 1.78 down from 2.03  


  • TED SPREAD - 16.94 0.203 (1.210%)
  •  3-MONTH T-BILL YIELD .16% +.01%
  • YIELD CURVE - 2.11 from 2.13


  • CRB: 266.03 -0.37% down 5 of the last 6 days
  • Oil: 73.10 -0.98% looking to be down 10 of the last 11
  • COPPER: 331.25 +0.03% - Not following oil on the down side
  • GOLD: 1,218 -0.17% - looking to be down for 3 days


  • EURO: 1.2668 -0.35% - headed lower for the 4th day
  • DOLLAR: 83.123 +0.08% - headed higher for the 4th day


  • ASIA - Most Asian markets followed Wall Street to the downside. China rebounded to black in late morning trading, helped by recoveries in exporters and resource firms.
  • EUROPE - European markets fell in a broad based retreat; concerns about the economic outlook and poorly received corporate news are not being well received. 
Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends














Honesty is the best policy – when there is money in it.
-         Mark Twain

What reserve price Justice?



COMPLIANCE: SEC-Bay? - Screen shot 2010 08 24 at 6.59.19 AM


On Wednesday, US District Judge Emmet G. Sullivan held his nose and approved a $298 million payment by Barclay’s Bank to settle criminal charges of violating US financial sanctions against Iran, Cuba, Libya, Sudan and Burma.  Noting that the charges were brought after Barclays itself reported internal findings to US officials, and that the bank cooperated in the investigation, the Justice Department disputed the Judge’s criticism that they had accorded the bank special treatment.
According to the settlement document, Barclays acknowledges that bank employees cooperated with requests from foreign banks to delete from funds transfers information identifying the originating banks, and that between 1995-2006 the bank processed more than $500 million of transactions that were prohibited under the Treasury’s Office of Foreign Assets Control (OFAC) rules.
We commented last month (30 July, “Quotations From Chairman Mary”) on the $160 million paid by Wachovia to settle liability for processing over US$ 420 billion in transactions from Mexico – including at least $4 billion in bulk cash – with no anti money laundering procedures in place.  The Justice Department identified $110 million in drug proceeds laundered through Wachovia, including money that went to purchase cargo planes and load them with cocaine.  Wachovia agreed to pay dollar for dollar the amount of drug money identified as being laundered through their neglect, plus a $50 million fine, for a total of $160 million.
Details of the cases differ.  Wachovia, says the Justice Department, “admitted failure to identify, detect, and report suspicious transaction in third-party payment processor accounts.”  Barclays, according to Justice spokesman Lanny Breuer, deliberately circumvented OFAC sanctions and “stripped vital information out of payment messages that would have alerted US financial institutions about the true origins of the funds.”  Each step of this process is potentially a separate criminal act.  Bank employees were allegedly asked by Iranian and other banks to remove information identifying the issuing bank and country of origin on some $500 million worth of transfers.  Failure to report such a request to internal Anti Money Laundering (AML) personnel is potentially a crime.  And if Barclays employees cooperated with these requests, each transfer was a separate criminal transaction.

On the other side, Barclays self-reported to Justice, and has spent $250 million improving their internal AML procedures.  Breuer said “we will take their disclosure, cooperation and remedial efforts into consideration.”
That’s some “consideration.”  Wachovia was dinged dollar for dollar on the illegal transfers, plus made to pay a fine of 45% of the total.  Barclays has negotiated a steep discount, paying only 60 cents on the dollar of the amounts processed, with no additional fine.  The government points out that both institutions have spent large sums of money to improve compliance – as though that were part of their punishment.
As far as anyone is telling – and we will never know the truth, because a settlement blocks any further information being divulged – Wachovia’s illegal transfers were the result of negligence on the part of the bank, while  Barclays’ transactions appear to be the knowing facilitation of criminal activity.  We do not care to offer an opinion as to which is “worse” – we don’t believe that no one inside of Wachovia knew what was going on, nor that nobody profited from turning a blind eye.  And given the terms of the Barclays settlement, we shall never know how widespread the crimes were, nor how high in the corporate structure they reached.  All we know is that Barclays has successfully negotiated down the price of major financial fraud – and for that, many in the shadowy world of not-quite-banking should be grateful.
Were we a senior executive or shareholder of either institution, we would make damn sure that people went to prison.  As taxpayers we believe we are entitled to that outcome.
Instead, it’s Welcome to the Homeland Shopping Network, where it’s All Money Laundering, All The Time!  It may be that Wachovia never had sufficient clout to get a better deal for itself.  Meanwhile Barclays, still a darling of the financial sector, is featured both above and below the fold on the front page of the FT’s Companies & Markets section (19 August).  The lead story quotes BarCap’s capital markets group’s estimate “that the 35 largest US banks will have to come up with half as much new capital as had been expected” under the new Basel rules, as compromises were reached on the structure of tier one capital.
Below the fold on the same page, the headline reads “Judge Accuses Barclays Of Paying For Justice In Sanctions Settlement,” quoting Judge Sullivan as saying the proceedings raised questions, such as “Why are the financial institutions being treated like this?”
Good question.  Under the settlement, Barclays is not permitted to dispute the charges that the bank knowingly stripped identifying information from funds transfers to avoid OFAC sanctions.  In other words, the bank’s employees knowingly committed crimes and were directly responsible for funneling at least half a billion dollars of illicit funds through the US banking system, and the bank would make sure that all the employees, and the executives on whose watch it happened, would stand in the dock and plead guilty, and go to jail for a long time, where they would be deprived of their Ferraris and their freedom, and not to mention the other unpleasant stuff that happens On the Inside… so yes, Barclays would be happy to do all this, except the DoJ decided they didn’t have to because after all the bank was so forthcoming five years after they found the crime in their midst…
This is why crime runs rampant.  It is encouraged.  It even has a price schedule.  And now, it’s negotiable.  Tired of overpaying for those nasty money laundering sanctions?  Come on down to DJ’s, where your crime is our dime!
Financial regulators publish sanctions guidelines that tell what you should expect to pay for any of a large number of violations.  In fact, managements confer with their lawyers, comparing sanction guidelines and established precedent to determine whether or not to break the rules.  Trust us.
Like a CDS or a simple listed option, the pricing requires inputs, based on assumptions.  What is the likely return if we break the rules?  What is the likelihood we will get caught?  How many people do we have to cut in on this to make it happen, and how much do we trust them?  What’s my piece of the action?  This can be mapped into a simple equation and run across a variety of scenarios.  Decisions to violate the rules are always based on a calculation of the low likelihood of getting caught (A), paired with a low likelihood of being successfully prosecuted (B), less probable legal fees (if B).  Reputational damage rarely factors into the equation because let’s face it, we already work on Wall Street...
The love affair between Washington and Wall Street marches on with a new round of settlements.  As long as no one goes to jail, the world will go on seeking new and untried forms of Bad Behavior – and the authorities will charge for the privilege.  Justice, despite Judge Sullivan’s demur, may not be for sale.  But clearly, you can rent it.
SEC boosters say they have substantially raised the price of corporate fraud – Judge Rakoff expressed his disgust with the B of A settlement, even as he signed off on the deal, decrying the fact that no one was held to account.  And the “record” Goldman settlement merely shows that the arrogant rich have to pay more for the privilege of renting the law.
It all seems to come down to popularity.  While the unloveable B of A gets a sharp uptick in the cost of lying to shareholders, Barclays managed to drive down the price of a ten year pattern of laundering money for the Iranian Revolutionary Guard.  Mark Twain said the efficiency of our justice system “is only marred by the difficulty of finding twelve men every day who don’t know anything and can’t read.”  The SEC and DoJ appear to have unearthed the mother lode.
As for Goldman, paying a half billion dollar fine for unloading fugazy paper on the Europeans looks like poetic justice.  Who do they think they are, Alan Greenspan?




Moshe Silver

Chief Compliance Officer

COMPLIANCE: An Epiphanous Moment

COMPLIANCE: An Epiphanous Moment - Screen shot 2010 08 24 at 6.55.37 AM
Amid jealous barbed praise and a certain amount of heartfelt respect, hedge fund great Stanley Druckenmiller has announced he is taking his marbles and going home.  Druckenmiller was George Soros’ investment strategist when they famously “broke the pound sterling” and generated over a billion dollar profit.  After he struck out on his own, Druckenmiller became widely known as one of the finest risk managers in the business, and his Duquesne Capital Management has long been a top performer.  Now Druckenmiller has decided to call it a day, announcing that Duquesne will return its outside investors’ money.  His announcement is seen as a bellwether “as many of his far less illustrious peers in the hedge fund world are suffering” (Financial Times, 19 August, “The Letter That Shook World Of Hedge Funds.”)
We wonder at the FT’s use of the word “peer,” which our dictionary defines as someone “who has equal standing with others…”  We are aware that inexact common usage (“peer pressure,” “a jury of one’s peers”) means anyone else in the room, though they may not share the critical characteristic that sets a person apart.  Such as the fact that Drunckenmiller’s hedge fund has averaged about 30% annual return going back to 1986.  “Peers”?  We think not.
The FT article quotes a prime brokerage executive as saying Druckenmiller “probably had an epiphanous moment” – a usage we are positively drooling over.  Indeed, it is clear that there have been fundamental changes in the financial markets.  It was just such an “epiphanous moment” in the life of hedge fund manager Keith McCullough that led to the creation of Hedgeye Risk Management.  Whatever has driven Druckenmiller’s decision, with his track record he has earned his peace and quiet and need apologize to no one.
As we never tire of pointing out, the art of managing money is the art of having other people’s money to manage.  According to the Journal, Druckenmiller “has some $8 billion of his own money to invest,” which makes him no longer a “money manager” by our definition.  If lesser managers – Druckenmiller’s “peers” – are not having epiphanous moments of their own, it is likely because they can not afford them.


Moshe Silver

Chief Compliance Officer

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TGT: Multiple Targets

Is TGT teeing itself up as one of the best large cap growth stories in consumer discretionary, or is this setting up as the mother of all ‘Ackman Assault Hangover’ sucker punches? Our best ideas often stem from internal debate. We’ve got plenty of that here. Here’s the Bull vs. Bear…


Eric’s Bull(et) Points

  • Topline has more drivers now, ex-macro, than it has had in some time.  The company’s focus on rolling out the 5% rewards/loyalty program and the continued rollout of P-Fresh is accretive to sales.  Management says each could be worth 1-2 pts of comp on an annualized basis.  Clearly there is something they are seeing in the Kansas City test market (loyalty) and in the P-Fresh remodels to give them confidence.  Either way, both company led initiatives offer internally generated sales drivers that others (i.e. WMT) don’t appear to have.
  • Traffic is the key here, an TGT clearly has momentum.  More food and consumables=more traffic.  This also leads to opportunity, which in this case may mean a customer picks up an additional non-food item on any given trip.  Probably works.
  • Management disciplined about opening new units in this environment, instead using capital to fund .com infrastructure and P-Fresh remodels.  We like the conservative approach and discipline in not growing for the sake of growth.  Yes international is still on the table, but we suspect that means Canada first.  There is no rush here and this is a positive for cash flow.
  • Aggressive pricing activity from Wal-Mart seems to be a perpetual thorn in the side of traditional grocers and now BJ’s.  However, TGT has clearly found a way to compete effectively.  The introduction of the “Up and Up” private label brand and differentiated store and merchandise assortment seems to be keeping Target relatively insulated from pricing pressure issues.  Perhaps this past quarter is the best example of this, where core retail gross margins were up 5 bps while WMT and BJ both saw pressure as they took prices down.  We don’t need to remind anyone of the trend in grocery margins.  The bottom line here is Target’s success away from commodity consumables affords better margins.
  • Credit card portfolio risk gradually dissipating for two reasons.  One, the overall credit environment is improving leaving opportunity to reduce reserves.  Secondly, Target is shrinking its receivables base as tighter credit restrictions and increased government restrictions no longer allow for unabated growth.  Target also discontinued its co-branded Visa program, which leaves future receivables growth entirely tied to store sales. 
  • Expense pressure from investments in dot.com will remain through 2011 as the company carries duplicative costs during the transition away from Amazon (TGT’s outsource partner).  The flip side here is we should see leverage on such investments begin to materialize in 2012, the year in which Target.com becomes fully operated in-house.
  • Management has clearly articulated the benefits of adding incremental food/consumables sales into their boxes via the P-Fresh remodel.  However, the result over time will be lower gross margins and commensurately lower SG&A.  Net, net EBIT rate should remain unchanged.  While in theory this makes sense, we know that investors are not fully onboard with trading margin for expense savings.  Over time, this will become more clear.  In the nearer term, headline gross margins could remain under pressure from this mix issue alone.
  • While TGT offers a more discretionary play vs. WMT, it also offers greater visibility over the intermediate term in my view.  The two strategies currently underway to drive topline results have been tested.  We already know that inventory management coupled with differentiated product helps Target to drive a higher EBIT structure than WMT.  While the Street may be excited to learn that WMT has dialed back rollbacks (after they didn’t work to drive demand elasticity), the non-consumables part of the story is still very much in limbo.  This is the single biggest wild card in the WMT story and one that in our view, has not been answered by a few mid-game personnel changes. 


Brian the Bear

One factor I can’t shake is the Ackman Attack. Let’s look at the timeline.


Oct 07-Mar 08: As the credit bubble implodes and sets the stage for the worst economic downturn since the Great Depression, Bill Ackman buys 20.5mm shares of TGT at average price of about $50. By the end of 2009, Ackman owns 3.55% of shares outstanding.


Wanna hear some irony? Ackman’s activist stance was focused on 1) TGT’s outsized risk in credit operations, and 2) lack of accountability and responsiveness in addressing TGT’s valuation. As of latest filings, Ackman has 28.7% of his fund’s assets in TGT (even after having sold down to 2.81% of s/o). Over a third of one fund’s assets on one security???  C’mon Bill. I’ll give you the benefit of the doubt and assume that you aren’t even levered. How ‘bout holding yourself to the same risk management and accountability standards you demand from companies  in your ’50-year model’?  Give our Macro team a call. They can help you there.


This is more than McGough ranting. I actually do have a point there…

On Target’s May 7 sales release last year, comps were in-line, but more importantly TGT noted that tight expense controls and better gross margins (markups better, markdowns fewer) will lead EPS to be “well above First Call estimates".  Credit quality also came in line vs. a trend of coming in slightly below plans. Then, four days later, TGT issued a press release titled “Questions That Attendees May Want To Ask At The Pershing Town Hall.’ In other words, TGT started to pull out all the stops to make Billy go away.


Ultimately, Billy took it on the chin, and lost his proxy battle on May 28 of 2009 after it was clear that the momentum of the business was going against him. The ‘strong cost control’ is particularly notable to me. Being cost-conscious is great – I tell my wife and kids that all the time. But this is a company that has added $1.5bn in revenue (2.5% over 2 years) since The Ackman Assault, but has held SG&A dead even. And yes, that’s despite 9.5% square footage growth over that same period. Last I checked, a new store requires a few bucks.


Yes, TGT is great retailer. No doubt. But my point this is a company where working capital is eroding on the margin, and starting next quarter, the Gross Margin compares get very tough at the same time Target will need to actually start to spend real SG&A dollars to support the much-touted growth initiatives that prompted positive press and sell-side upgrades.


In fact, there’s a sell-side consensus “Buy Ratio’ of 82%. For those of you counting, that’s the most favorable since April of 2000. Yes, 2000.  The short interest is down by a factor of 2-3x from the beginning of the Ackman Assault.


If it were not for context that Eric Levine adds to the equation, I’d have the bear claws out big time.


We’ve got more work to do on this puppy.



Keith’s factor models suggest that TGT is bearish TREND with resistance = 53.63.


TGT: Multiple Targets - tgtss


TGT: Multiple Targets - tgtbs


TGT: Multiple Targets - tgtsgma


Comps have accelerated through the summer for MCD and I wouldn’t bet on them slowing down in August.


Sales of frappes and smoothies at McDonald’s restaurants have performed well throughout the summer and continue to do so.  Smoothies in particular have created tremendous noise in the market.  Earlier this month, the release detailing July sales underlined frappes and smoothies as top contributors to the month’s 5.7% print in the U.S. market.  Based on current sales trends for frappes and smoothies, I expect two year average sales trends in the U.S. to accelerate in August on a sequential basis.  Taking calendar shifts into consideration, I would not be surprised to see McDonald’s USA print a 6 to 7% comparable restaurant sales number for August.  Globally, there is a chance that July’s 7% figure could be exceeded in August.




Additionally, news has emerged that McDonald’s is testing a new line of products – Chicken Flatbread Sandwiches – in the Baltimore market.  If successful, this product could provide needed support for sales trends in the lagging lunch day part.






Howard Penney

Managing Director

Sticking With Our Short on Dr. Copper

Conclusion: As the global economy slows sequentially, we expect the price of copper to decline as inventory builds and currency tailwinds unwind.


Position: Short Copper (JJC).


Refined copper imports by China (the world’s largest consumer) grew in July for the first time in four months. The 6% M/M increase reflects May and June demand for imports (it takes one to two months for the imports to arrive in Shanghai), which was high, as higher prices in Shanghai prompted arbitrage trade. A recent report out of Orient Securities Futures suggests the window for arbitrage may be closed, which is bearish for Chinese copper imports going forward.  Also, it is important to note that this important number is down -23% on a Y/Y basis.  So, while copper inventories are low in China, the culprit is really low imports rather than accelerating end market demand.


Admittedly, we were early shorting copper from a timing perspective, but we continue to have conviction on the short side – despite current low inventories. Copper stockpiles as measured by the London Metals Exchange hit the lowest levels since November 11th and are down 2.8% this month after declining 8.3% in July. Since the YTD high of 555,075 tons on February 18th, copper stockpiles on the LME have declined 27.6%. We have seen a similar decline in stocks on the Shanghai Futures Exchange, down 42% since the high of 189,441 metric tons in the week ending 4/29.


Sticking With Our Short on Dr. Copper - 1


Sticking With Our Short on Dr. Copper - 2 


Interestingly, and despite these bullish fundamentals, copper is only up 0.2% since Feb. 18th and down 1.3% since April 29th. On a two and three month basis, however, copper is up 14.1% and 11.8% respectively, which is supported by dollar weakness (the Dollar Index is down 3.1% and 2.9% over the same durations).  The fact that the price of copper has barely moved in a declining inventory environment is a bearish indicator for us as it relates to the future direction of price.


Normally, we look to the price of copper as a leading indicator for global growth, but with the mixed signals we have been receiving from a price perspective as a result of prolonged periods of dollar strength and weakness, we must turn to our outlook on global growth to forecast where we think Dr. Copper is headed. As a reminder, we are bearish on global growth in 2010 and we have a 1.7% estimate for 3Q10 and 2011 U.S. GDP growth (roughly half of consensus estimates), which is largely driven by our forecast for housing prices to fall 15-20% in the next 12 months and rising structural unemployment. In addition, we have been bearish on Chinese growth since January 15th, and with consumer price inflation hitting a 20-month high in July, we don’t expect China to loosen its tightening measures anytime soon. Additional factors supporting our bearish stance on global growth are austerity in Europe and slowing end demand from Western consumers which may serve to reduce industrial production and trade internationally.


With the looming global growth backdrop, we expect copper inventories to build, or at least see a deceleration in the rate of declines. Either result is incrementally negative for price. Furthermore, we could see dollar strength from accelerated dollar purchases by central banks globally as exporting nations from Asia to Latin America look to increase their slice of the contracting pie that is global trade in 2H10.


Managing Risk


As always, our style of investing requires a prudent risk management approach that is duration agnostic. We will continue to analyze and interpret the near-term risks to our short position in Copper. Those risks include further dollar weakness from here and reduced production in China, the world’s largest smelter of the material.


We expect tomorrow’s existing home sales to be a bomb, in the range of down 20%-30% M/M. Obviously, this will come as a shock to investors (consensus estimates are for a 12% decline), which will likely serve to conjure up more calls for increased stimulus in order to avoid a pending double dip in housing. If Bernanke and Co. give in to market pressure, we expect the dollar to resume its decline after closing up on a weekly basis for the previous two weeks. Further dollar debasement from here is positive for copper prices (r-squared = 0.69 on a two-month basis).


 Sticking With Our Short on Dr. Copper - 3


With regard to supply, the latest rumors out of China claim that the government may shut smelting plants that violate environmental rules as it looks to tighten regulation after a series of industrial accidents led to waste spilling into rivers and seas. The latest data (2008) show that China accounts for nearly one fourth of total world copper smelting output, so a reduction in production there will provide support for the price of copper. Accidents are running at an annualized rate of 204 in 1H10 compared with 171 in all of 2009, according to China’s Environmental Protection Ministry.


Absent the development of these risks, we expect the price of copper to decline from here as the fundamental and currency tailwinds look to unwind. For now, copper is bullish from a TRADE ($3.25/lb) and TREND ($3.14/lb) perspective with TRADE resistance at $3.31/lb. 


Darius Dale