Apparel: We Just Got More Bearish

An aberrational margin lever turning a 180 should expose the ‘play nice’ posturing we’re seeing among apparel companies today for what it is – smoke in mirrors.  We’re more bearish today on the Global Apparel Supply Chain and its components than we were just one week ago. Favorite names on the short side remain CRI and JCP.


Not a conversation goes by without an investor asking about cotton. Most notably, at conferences this week management teams across the board largely downplayed the impact of higher prices on their bottom line. We’re seeing wholesalers (CRI), Retailers (JCP, KSS) and Sourcing companies (Li&Fung) all acknowledge the price pressure, but the consensus amongst them is that the consumer will ultimately pay a higher price.


There are several reasons why this absolutely will not happen. History shows how the industry has coped with circumstances like this in the past. But this time, history is history.

a)      We religiously track product spreads at the consumer level vs. import cost level. Like it or not, the positive spread between the two (due to tight inventories and low input costs) has given the industry meaningful pricing power. We are just coming off an event where input cost margin impact was 3 Standard Deviations above the mean. That’s about $10+bn up for grabs in a $280bn industry. Most CEOs don’t acknowledge this (due to no Macro process) even though they unknowingly live it every day.


Apparel: We Just Got More Bearish - 9 17 2010 9 10 00 PM


b)      While we’re talking 3-SD moves, look at the recent move in cotton. Yes, the recent spike puts it into the ‘statistical aberration’ bucket. Anomalies or not, it is an economic reality, and a 50% boost in the industry’s biggest cost input must be dealt with.


Apparel: We Just Got More Bearish - 10 Year Cotton Chart


c)       What kind of numbers? As we highlighted in our note where we outlined the bear case on CRI, the recent boost in input costs suggests that a $10 item ultimately needs to sell at retail for closer to $11.50 to keep margins for everyone even. No way that’s gonna happen.


d)      Elasticity works both ways. One thing that people often do not realize is that there’s a sea change in the basic economics of this industry. I know that ‘sea change’ sounds sensationalistic, but numbers and facts are tough to exaggerate. Consider this…

  1. This industry works in a highly elastic pricing model. As price comes down, velocity goes up. I know… that’s common sense.
  2. With few exceptions, virtually ALL of the units imported into this country are ultimately bought. It might be at a 90% discount 6 months after they hit the initially hit the floor, but they all sell.
  3. In 1992, 50% of apparel we consumer was made in this country. At that time the average American consumer 42 units per capita.
  4. In 2008, the percent of consumption that was imported hit 99%. By that time Americans purchased 64 units per capita.
  5. What does this tell us? Over nearly 2 decades, savings from outsourcing and offshoring were passed through to the consumer, and we ‘bought more stuff at lower prices.’ When demand eased, the industry still had a $3-$4bn safety net of sourcing savings to pad margin pain. This allowed the velocity to remain high without degrading margins.
  6. Now there’s no more kitty – in fact with the rise in input costs there’s a big deficit. Ideally, the industry would be controlled and rational, and would all take down orders in unison by 5-10% to maintain price. But in an industry that has thousands of brands and millions of SKUs – this would a near-impossible expectation.


e)      One of the more common themes I've heard from those in attendance at this week's conferences is that management was much more benign about cost increases than expected. Not a surprise, actually. Seriously...  Are talking heads from all facets of the supply chain going to gather at an investor conference and turn it into a battle royale as to which of their peers are going to pick up the tab on the margin deficit? No. They’ll flash their pearly whites and stand largely as a united front. The battle royale starts when the CEOs don't have to look one another square in the eye. They'll be unified until the first player with any power flinches. Then everyone else reacts.


So what have we got? An aberrational margin lever turns a complete 180. Companies are playing nice in the sandbox today, but their behavior is not genuine. We’re more bearish today on the Global Apparel Supply Chain and its components than we were just one week ago. Favorite names on the short side remain CRI and JCP.




While demand from Chinese, American, and European consumers grows for cotton, the core driver to cotton nearing $1.00 per pound is supply (though the fact that just about every commodity is on fire is a big contributing factor).  We all heard management teams talk about how they were hoping August and September crops were going to be wrong, but hope is not an investment process. Here are the issues over the last month that has kept supply well behind demand:

  • Crop quality and quantity has been negatively affected by weather across the globe
    • Low temperature and excess rain in China is dimming the prospects of a strong September harvest
    • Longer monsoon period is causing delays in Indian picking period
    • Floods and landslides destroyed Chinese crops in July and August
    • Mexican cotton output was reduced from fungus killing the crop from excess rain
    • Pakistan floods destroyed nearly 30% of the cotton crop and derailed infrastructure
    • Political/legislative pressures limiting cotton production and exports
      • India halted cotton exports in April to cool domestic prices and bolster supplies but has continued to push back the resumption of exports from September to October


Aside from the supply-demand balance we are seeing two other major issues: higher energy and wage costs for cotton production and higher shipping rates to transport finished product to consumption destinations. Cotton inputs of land rent and value of seed increased 17% since 2007 while labor costs are increasing in China and India with those inflating economies.  The shipping industry is experiencing the same supply-demand imbalance driving freight higher and higher as we've heard on numerous conferences calls in 1H 2010.


Here’s an overview of the general flow of cotton from production, to manufacture, to end market.



Apparel: We Just Got More Bearish - Production  Manufacturing  End Use


Apparel: We Just Got More Bearish - Cotton Uses


Apparel: We Just Got More Bearish - Cotton Production Tree


Apparel: We Just Got More Bearish - Cotton Price Growth



Zach Brown

Apparel Analyst

The Week Ahead

The Economic Data calendar for the week of the 20th through the 24th of September is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - c1

The Week Ahead - c2

Ugly European Chart of the Day: Italy’s Industrial Orders

We want to flash this chart of Italy’s Industrial Orders for we think it is representative of a marked inflection (see chart below). On a year-over-year compare we’d expect July orders to be up more than a mere +0.7%, especially off bombed-out levels a year ago. Clearly the demand picture for Italy’s industrial goods is not good.  As a point of comparison, we’ve also graphed industrial production in Italy and Germany. While production has slowed for both countries over recent months, the delta between the two is notable at 9.2%.


We’ve called for European fundamentals to slow into year-end as austerity picks up, which we believe should pinch the consumer (higher VAT, government job and wage cuts) and with it tame economic growth out on the curve.


While German data has also backed off over recent months, we continue to like Germany from a quantitative set-up and are long the etf EWG in the Hedgeye Virtual Portfolio. Currently the German DAX is up +4.2% YTD, outperforming many of its Western European peers such as Italy (-11.7%), Spain (-11.3%), Ireland (-9.0%), and France (-5.4%).


Matthew Hedrick



Ugly European Chart of the Day: Italy’s Industrial Orders - italy

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Another day, another grind…
Here are the bullish/bearish DATA and PRICE moves in my notebook from the last 48 hours.



INSIDE THE HEDGEYE NOTEBOOK: Sept. 17, 2010 - Notebook Image Hedgeye


1.      SP500 continues to hold its immediate term TRADE line of support = 1111

2.      The range in our 3-day probability model for the SP500 continues to tighten (46 points now)

3.      All 9 sectors in our SP500 TRADE/TREND model continue to flash bullish TRADE, confirming the index signal

4.      India raised rates by 25bps to 6%, making its 5th hike of 2010, and the BSE Sensex continued to make higher-highs

5.      Chile raised rates by 50bps to 2.5% on inflation concerns (yes, they are real) and Chilean equities are +32% YTD

6.      FTSE and DAX continue to flash bullish TRADE and TREND

7.      Netherlands reported a better than expected unemployment rate of 5.3% (down 20bps m/m) and now that stock market is bullish TRADE/TREND

8.      Russian and Norwegian stock markets have recovered their bullish intermediate term TREND lines (bullish oil signal)

9.      Both the Euro and British Pound (were long FXB) are back to bullish TRADE and TREND relative to the USD

10.  Both Brazil and Canada continue to trade bullish on both TRADE and TREND durations

11.  Commodity prices continue to be in a Bullish Formation (bullish across all 3 of our core investment durations: TRADE, TREND, and TAIL)

12.  CRB Index and soft/agricultural immediate term TRADE correlations (inverse) continue to be north of .80 across the board

13.  Gold prices continue to make higher-highs and higher lows (fear of US Congress and Japanese Bureaucrats trade)

14.  The Yield Spread (10s minus 2s) has expanded week/week by 8 basis points; bullish immediate term TRADE signal for financials

15.  US CPI and PPI inflation reports came in very much benign for august, support the storytellers at the Fed who never will see inflation

16.  Texas Instruments (TXN) buyback of $7.5B was a beast, stoking the “cash on corporate balance sheet” bull case that we heard in 2007

17.  Spanish Debt sales were both longer duration (30yr) and lower yield (5.07% vs. 5.9% last) than prior auctions


1.      SP500 continues to flash bearish from an intermediate term TREND perspective = 1144 resistance

2.      Volatility (VIX) is holding its 21-22 level of intermediate term support = sell signal

3.      US stock market breadth has deteriorated this week = 1st week it has done that in the last 3

4.      US Dollar continues to be a train wreck: down -1.8% w/w and down 13 of the last 16 weeks

5.      Short term US Treasury Yields (2s) have broken their immediate term TRADE line of support again of 0.52% = bearish US GDP signal

6.      Philly Fed survey -0.7 was another miss

7.      University of Michigan Consumer confidence drops to 66.6 here in September (from 68.9 in AUG) despite low-volume stock market strength

8.      Waxman, Weiner, Schumer all picking up the government intervention/fear-mongering from gold to china = bearish US Dollar and bond yield factor

9.      UBS comes out with their super duper “idea” list of “39 Potential M&A candidates” this week; smacks of 2007 sellside hope

10.  Chinese equities closed down for the final 3 days of the week; still bullish TREND, but bearish immediate term TRADE is as bearish does

11.  China is a “manipulator” rhetoric really turning up the volume on anti-Congress commentary in Asian publications

12.  Japanese Yen has finally broken its immediate term TRADE line of support and looks to have locked in a 3-6 month high in the rear-view

13.  Pakistan showing some equity weakness into week’s end; geopolitical risk? its certainly being priced into commodity inflation

14.  Greece continues to act like the dog of dogs after breaking critical TREND line of support at 1575 on the ATG Index (down -29% YTD)

15.  UK Retail Sales dropped sequentially to +0.4% (AUG) vs +1.0% (JUL)

On balance, still more immediate term bullish than bearish DATA and PRICE moves in my notebook and I guess that explains partly why I have the longest invested position I’ve had in our Hedgeye Asset Allocation Model in months (cash position has dropped from a peak of 79% to 46% today), but I’m getting very nervous about holding my longs here (13 LONGS, 10 SHORTS). Congress scares the hell out of me.

Enjoy your weekend,
Keith R. McCullough
Chief Executive Officer



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The note below is from Lou Gagliardi, our recently-launched Sector Head of Energy. If you'd like to trial his energy sector research, which includes access to the replay of his launch presentation on natural gas, crude oil, and opportunities in the global E&P sector, please email



Position: Short natural gas (UNG)


Conclusion: Advances in drilling technology are way ahead of the demand curve, creating excess inventory which puts downward pressure on price that could lead to a prolonged period of oversupply.


As we stated in our Energy Sector launch yesterday, we are bearish on the outlook for natural gas for three key reasons: demand, human behavior, and technology.  Today we want to focus on the technology aspect of the bear case for natural gas.


The increasing utilization of horizontal drilling and hydraulic fracturing in combination as production methods of tapping into unconventional natural gas shale plays in the lower 48 over the last several years has rocketed U.S. natural gas production. When demand re-emerges, indications are that production will chase price leading to a natural gas oversupply situation. Surprisingly, the U.S. Department of Energy (DOE) through its Energy Information Agency (EIA) is forecasting flat natural gas demand for 2011, but (surprisingly) higher prices. We obviously disagree.


Some key facts to consider as it relates to our thesis:



  • U.S. Gas production peaked in about 1974 and finally turned higher in 2005 due to increasing utilization of horizontal rigs and hydraulic fracturing (highlighted in the charts below).
  • From 2005 to 2010 (YTD), U.S. gas production increased ~20%.  In that period gas rigs declined ~20%, but horizontal rigs increased 325% (vertical rigs declined 77%).

Horizontal drilling technology

  • Horizontal rigs have increasingly displaced Vertical rigs; today roughly 65% of overall rigs in the US are horizontal rigs (highlighted in the charts below).
  • Horizontal rigs generate greater production flow rates than vertical rigs, due to greater contact area with reservoirs.
  • While horizontal drilling incurs higher costs, as much as two or three times that of a vertical well, the production factor can be increased as much as 15 or 20 times.
  • Additionally, horizontal drilling can lead to an increase in reserves in place by 2% of the original oil in place. The production ratio for horizontal wells versus vertical wells is ~3 to 1, while the cost ratio of horizontal versus vertical wells is only ~2 to 1.
  • Horizontal drilling has reduced drilling and completion costs to under $4.00/Mcf from over $5.00/Mcf. By contrast, the marginal cost of US gas production from conventional vertical wells averages ~$6.00/Mcf. 

Access to unconventional assets 

  • Today, roughly half the natural gas consumed in the U.S is produced from unconventional wells drilled within the last few years made accessible by new drilling technology.
  • Unconventional gas production accounts for nearly 50% of total U.S. gas production.
  • Reportedly breakeven costs for U.S. unconventional gas plays range from as low as $3.30/Mcfe in the Marcellus, and $3.66/Mcfe in the Fayetteville and Horn River to $4.43/Mcfe and $4.79/Mcfe in the Montey and Haynesville, respectively.
  • Drilling (horizontal) technology has enhanced deepwater exploration in areas such as Brazil (Sub-Salt), Gulf of Mexico (GOM - Lower Tertiary); and unconventional resource plays in areas besides the lower 48, as the Canadian (Oil Sands-In-Situ), Europe, China, and other unconventional plays such as Tight Gas Sands, and Coal Bed Methane.

Pent up supply

  • In a low gas price environment companies have sought to restrict flow rates, slowing production, to focus on maximizing “ultimate gas recovery”.
  • High production rates reduce a reservoir’s permeability, by slowing the production flow rate; you slow the “decline curve” and increase potential estimated ultimate recovery (EUR) rates.
  • Reducing the flow rate also defers the need for capital intensive compression, which comprises roughly a third of operating costs.
  • Restricted flow rates can likely increase the recovery factor from 30% to 40%.
  • Hydraulic fracturing enables the production of natural gas and oil from generally 5,000-20,000 feet.

In aggregate, advances in technology related to horizontal drilling and fracturing allow E&P companies to access natural gas reserves in areas that were once considered unconventional.  The impact of this is a lower aggregate cost to access the natural gas, and less steep decline curves.  As a result, production outstrips long term domestic demand growth, which we measured at ~0.5% per annum over the last thirty years.


Natural gas supply and demand facts don’t lie; DOE projections for price do.


Louis Gagliardi

Managing Director









EARLY LOOK: Deeply Disturbing





 "It is not the function of our government to keep the citizen from falling into error; it is the function of the citizen to keep the government from falling into error."
– United States Supreme Court decision in American Communications Association v. Douds




Before I start getting into one of the most critical long term TAIL risks that I am currently seeing develop in my interconnected global macro model (analytically incompetent Congressmen starting an economic war with China), allow me to paint a few mathematical lines around the core of the issue – unawareness.
1.      US Dollar: for the week-to-date = DOWN -1.8% (just another week of the same debauchery)

2.      Chinese Yuan: for the week-to-date = UP +0.90% (its best week in 28 months)


Now President Obama has been crystal clear in rhetoric on making decisions “based on facts” so we, as citizens, should hold him accountable to that in order “to keep the government from falling into error.”
To be fair, maybe our immediate term TRADE duration (3-weeks or less) is too short term for the economic sophisticates managing America’s currency risk from Washington, DC. So let’s look at currency “manipulation” on our intermediate term TREND duration:
1.      US Dollar: has declined in 13 of the last 16 weeks, and has lost over -8% of its value since early June when CNBC started begging Bernanke for QE2.

2.      Chinese Yuan: has been stable, not losing more than 0.5% of its value in any given week for the last 3 months.



If the intermediate term TREND of US Dollar devaluation and Chinese Yuan appreciation doesn’t fit your partisan politicking, let’s blow the charts out to the longest of long term so that your local politician who is gasping for the over-compensation air of re-election at the mid-terms can get “smart” on the math.
1.      US Dollar: after Nixon abandoned the gold standard (1971) and endowed both the Fed and Congress with the inalienable right to manipulate the world’s reserve currency via the US Federal Reserve Fund Rate, the US Dollar has only made a series of lower-highs and lower-lows.

2.      Chinese Yuan: since China de-pegged its currency in 2005, the Chinese Yuan has only appreciated in value. This morning’s price is the highest price ever for the Chinese Yuan. By our math, ever is a long time.


For the mathematically challenged, we’ve provided a picture of the long-term US Dollar chart so that you can forward it to Chuck Schumer (Democrat – New York) and Sander Levin (Democrat – Michigan). Before we YouTube what these professional politicians had to say on this matter, here’s what the Chinese said overnight:
1.      “Large fluctuations in the US Dollar’s exchange rate may impede the global economic recovery.” –Chinese Central Bank

2.      “The appreciation of the renminbi cannot solve the trade deficit with China and can’t fix the US unemployment problem.” –Jiang Yu

3.      “Pressure cannot solve the issue, rather it may lead to the contrary.” -Jiang Yu (spokesperson for the Foreign Ministry in Beijing)


Back to America’s conflicted, compromised, and confused:
1.      “We have to figure out ways to change behavior” –Tim Geithner

2.      “The U.S. economy is trying to pick itself up off the ground, China’s currency manipulation is like a boot to the throat of our recovery.” –Chuck Schumer

3.      “Chinese practices have led to a staggering US Trade Deficit… and it’s deeply disturbing.”  - Sander Levin


You got that right Colonel Sander Levin – the comments coming out of your mouth are Deeply Disturbing on so many levels that are obvious to any educated American on global risk matters right now that I can end with that. If your objective is to fear-monger uneducated Americans into going anti-China, shame on you.
Chuck Schumer became a member of the New York State Assembly in 1975. Sander Levin assumed office in Michigan’s 12th district in 1983. If these two characters want to point fingers at China for US government spending, deficit building, and debt incursion rather than hold themselves accountable to zero US private payroll adds in the last decade, they can go ahead and try – maybe that gets the next lemming in line to vote for them again, but in the age of the internet, I don’t think Americans are that stupid. Gentlemen, you have been YouTubed.
What do the alleged “non-partisan” people in Washington have to say about all this? Eswar Prasad, Senior Fellow at the Brookings Institute, concluded that “as the US mid-term election nears, the temptation of grandstanding on China will be irresistible to most Congressman.”
Thank you, Mr. Prasad.
The fact of the matter is that US Dollar depreciation is aided and abetted by stock market cheerleading to keep the US Federal Funds rate at ZERO percent anytime this country has an economic problem. That horse has been beaten to a dead pulp and has only equated to a high/low society whereby guys like me get paid to trade the volatility of commodity prices born out of that Dollar Depreciation as America’s poor get jammed with higher prices.
Mr. President, you tell me who is lying here, because it certainly isn’t market prices. The price of oats are up +24% in the last month alone (I eat oatmeal for breakfast). On our immediate term TRADE duration here are the highest inverse correlations to the USD Dollar:
1.      Sugar = 0.90

2.      Oats = 0.88

3.      Cotton = 0.86

4.      Corn = 0.85

5.      Oil = 0.79

*note to Chuck – these are very high inverse correlations.

According to the US Census Bureau, there were 43.6 MILLION Americans living in poverty in 2009 and the latest reading on Americans who live off of food stamps is about that same number (which is at a 15 year high). Professional politicians who are pointing fingers at the Chinese this morning get one big fat middle one from me – their fear-mongering is Deeply Disturbing. It’s US monetary policy, stupid.
My immediate term support and resistance lines for the SP500 are now 1111 and 1134, respectively. With the US stock market being immediate term TRADE bullish, I have upped my asset allocation to US Equities to 6% this week and taken my position in cash down to 46%. With US Congress imposing this kind of systemic risk to our financial system however, I’ll be a net seller all day today.



Best of luck out there today,
Keith R. McCullough
Chief Executive Officer




EARLY LOOK: Deeply Disturbing - chart1



Subscribe to Hedgeye to receive research and portfolio positions in real-time.  This note was originally published and emailed to subscribers at 8am, this morning, September 17, 2010.

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