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EARLY LOOK: Don't Eat Yellow Snow



“Even if you are on the right track, you will get run over if you just sit there.”

-Will Rogers



EARLY LOOK: Don't Eat Yellow Snow - Will Rogers




Oklahoma’s favorite son, Will Rogers, probably didn’t know it at the time but he made a very important contribution to modern day risk management with the aforementioned quote.


Rogers was our kind of guy. Multi-factor, multi-duration, and not afraid to put his thoughts out there for everyone to criticize every day. He was transparent and didn’t feel compelled to live a professional life of opacity. He lived his life out loud.


By the time he passed away in 1935, Will Rogers penned more than 4,000 nationally syndicated newspaper columns and produced 71 movies. He also traveled across the world 3 times. This gave him a unique perspective on the interconnectedness of human behavior.


The most important thing we can acknowledge about human behavior when we buy or sell something is that we are human. By nature, we are more likely to think something we own is worth more than it’s worth. Ultimately, the market’s last sale decides the price.


Another critical acknowledgment in modern day risk management is that the game is changing at a rate that’s representative of global economic imbalances, fund flows, and geopolitical risks. Never before has the US government sponsored so much market volatility. Never before has the hegemony of US economic power been such a question mark. Never is a long time.


My son Jack is barely 3 years old, but as winter approaches he will be old enough to learn his first few rules in risk management. Never eat yellow snow, and never trust a professional politician.


Whoever chooses to trust Greek, Irish, or US politicians who are telling us that they’ll never have to default on any long term liability because they have figured out how to print short term debt-upon-debt-upon-debt subscribes to a belief that the history of sovereign debt cycles doesn’t support.



EARLY LOOK: Don't Eat Yellow Snow - Flags



If you choose to trust what you see, recognizing this globally interconnected game of risk is always “risk on”, you are most likely going to see this Fear of Government trading environment plainly. You don’t have to “just sit there” and suck it up. You can keep moving.


There are two ways that I’ve applied this basic strategy of motion to express my investment views: 

  1. Hedgeye Asset Allocation Model: Managing the gross exposure of my CASH position dynamically.
  2. Hedgeye Virtual Portfolio: Managing my LONG versus SHORT positions, aggressively, on a net basis. 

I don’t run a hedge fund anymore. So far, this is the best I can do to communicate what it is that I am trying to recommend you do out there. I know that other people don’t do it this way. I also know that I’ll need to keep changing what it is that I do or I’ll get “run over.”


Back to explaining what it is that I’ve been doing this week…


1. Dynamic Asset Allocation to CASH:

  • On Tuesday when I “Walked The Line” (title of Early Look note that morning) and the SP500 was testing a breakout above my intermediate term TREND line of 1144, I moved to 64% CASH = selling strength.
  • On Thursday, after the SP500 closed down for the 3rd day in a row, I reinvested 6% of that CASH position into Commodities (DBA) and German Equities (EWG), taking my CASH position down to 58% = buying weakness.
  • This morning my Hedgeye Asset Allocation is as follows: Cash 58%, Int'l FX 21%, Bonds 9%, Int'l Equities 6%, Commodities 3%, US Equities 3%.


2.  Aggressively Managing Risk Around My Net LONG/SHORT position:

  • On Monday morning at SPX 1125 I had 13 LONGS and 10 SHORTS.
  • On Wednesday morning at SPX 1139 I had 8 LONGS and 10 SHORTS.
  • This morning at SPX 1124 I have 11 LONGS and 7 SHORTS.  


Naturally, some “fully invested” asset managers are going to look at this and say a few things: 

  1. You can’t hold a cash position like that.
  2. You can’t time markets like that.
  3. You can’t … 

But, yes I can.


Rather than just sit here and accept that at any given moment in my day the government can either squeeze me or displease me, for now I’m going to keep moving with an explicitly large amount of cash on the sidelines to deploy whenever I see the opportunity to do so.


My immediate term support and resistance levels for the SP500 are now 1113 and 1143, respectively.


Enjoy your weekend and best of luck out there today,



Keith R. McCullough
Chief Executive Officer



EARLY LOOK: Don't Eat Yellow Snow - 1


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The Economic Data calendar for the week of the 27th of September through the 1st of October 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.





Over the past number of quarters, top line numbers have taken precedence over food cost trends in determining investor sentiment.  With food costs continuing to increase, when are investors going to shift their focus?


Looking at the restaurant space, it is difficult to know which factors are driving the space.  The health of the consumer, commodity costs, and government policy are all important and interconnected.  As I outlined on 9/20 in a post titled, “NO MORE ROOM AT THE TROUGH”, regulatory action has been a cause of food inflation and remains a potential cause today.  With the topline results of many restaurants remaining robust, it seems that any investor concerns on inflation are assuaged by same-store sales growth.  It is only when the tide goes out that the rocks beneath the water line can be seen. 


The narratives that we can spin around current stock moves are legion.  Perhaps consumers are defaulting on their debt and splurging on discretionary items.  Perhaps the prospect of more quantitative easing, and lower mortgage rates to refinance to, are boosting spending.   Or perhaps we are burning brightly just before we plunge into a dark depression.  Rather than bother with these anecdotal hypotheses, we prefer to look at some data.  The chart below shows clearly that some restaurant and agriculture stocks have been performing strongly of late, with several exceptions (particularly the agriculture stocks). 




Many of these price moves are confirmed by top line trends.  CMG and MCD have been outperformers from a sales perspective, while EAT and WEN have been softer on that same metric.  Looking at the possibility that commodity costs have played any role in these recent price moves, it is instructive to observe the agriculture stocks’ price action.  I will allow readers to decide for themselves, but one thing that stands out to me is that Monsanto (MON) is a beneficiary of higher corn prices but has been underperforming.   Given a number of factors alluded to in the aforementioned note from 9/20 (Dollar down=corn up, ethanol blend in gasoline, strong demand), we believe that corn prices are set to move higher with the inverse relationship with the US Dollar being our main focus.   While TSN, CAG, and SAFM have been going down, as one would expect, MON would be expected to perform strongly with high corn prices.  See the table below for some correlation data (stock to corn).




Due to contracts or other hedging mechanisms, the impact of higher commodity costs may be somewhat staggered versus price performance in the restaurant space but it seems that CMG, BWLD, YUM, CBRL, and CAKE stand out as being impervious to commodity cost increases.  We know that BWLD has outlined lower year-over-year chicken wing prices as being earnings accretive over the next few quarters but other largely uncontracted  (CMG) stocks are also unimpeded, thus far, by the threat of rising costs. 


RESTAURANTS – DOES INFLATION MATTER? - correlations commodities


At Hedgeye we are currently short the US dollar and have a very bearish view for the intermediate term.   As the table above suggests, this stance implies a bullish view on corn prices.  When planning for the next fiscal year, many companies begin to lock in their commodity needs late in Q3 and early Q4.  I was surprised earlier this week to learn that DRI management have left themselves exposed to certain commodities given the recent spike in commodities.  Management believes that current levels of some commodities the company uses are unsustainable.  I am not sure I would be so confident.  The table above outlines the correlation between the USD and certain commodities. 


Howard Penney

Managing Director

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Revisiting Brazil

Conclusion: Favorable consumer trends have been positive for Brazilian credit expansion and growth. Also the real is likely to continue appreciating from here, despite accelerated intervention efforts from the Brazilian central bank.


We’ve been admittedly quiet on Brazil over past couple of weeks for the simple fact that there haven’t been any meaningful inflection points to report. We remain favorably disposed to the Bovespa due to Brazil’s defensive consumption growth which is supported by near all-time lows in unemployment, inflation that has slowed sequentially to an eight-month low in August (4.49% YoY), and a favorable interest rate environment that is fueling domestic credit expansion (no Selic rate hike expected through year-end).


 One data point that caught our eye was homebuiler debt offerings backed by homebuyer contracts and retail lease payments  that are on pace to reach 6 billion reais ($3.5B) this year, up 87.5% YoY, according to the Sao Paulo-based Capital Markets Corporation. Currently, YTD issuance is at 4.7 billion reais, up 47% from full-year 2009.


Demand for these bonds has been quite strong due to low vacancy rates driven by Brazil’s domestic growth. According to Jones Lang LaSalle, the office vacancy in Sao Paulo, Brazil’s largest city, is at a record low of 8.5%. That compares to 12% in Midtown Manhattan, up from 5.3% in June 2007. While we don’t support the idea of Brazil’s households and private sector levering up on real estate, we do remain confident in Brazil’s ability to grow and fuel the underlying demand needed to sustain robust growth in this segment of the Brazilian economy.


To tune of cautious optimism, a few “not-quite-red” flags have surfaced recently regarding the Brazilian consumer: 

  • Brazilian retail sales dropped sequentially in July (+10.9% YoY vs. +11.3% in June).
  • Consumer delinquencies rose 11.5% in August – the highest August reading since 2005.
  • While the headline FGV Consumer Confidence reading rose 70bps MoM in September, the future outlook index dropped 1.1% MoM to 111.6. 

Clearly, we’re nitpicking here, so we’ll take these marginal deteriorations with a grain of salt. Growth on the ground in Brazil remains strong, which caused the government to revise up their growth and inflation estimates recently (GDP up 70bps to 7.2%; and CPI up 13bps to 5.1%). We don’t put too much weight on government projections, as they are typically lagging or wrong, but we do agree this revision is warranted based on the recent string of positive economic data.


It remains to be seen, however, how the recent ascent of the real will affect Brazilian growth going forward. On one hand, the strong real restricts on the margin exports of manufactured goods. On the other hand, dollar debasement has fueled parabolic up-moves in the prices of many agricultural products and commodities. Roughly 50% of Brazil’s exports are commodities/basic materials, so they’ve been riding the recent wave of Fed-sponsored dollar debasement. Some of Brazil’s key commodity exports have benefited (three-month % change): 

  • Orange Juice – up 11.6%
  • Coffee – up 14.5%
  • Soybeans – up 18.4%
  • Copper – up 22.3%
  • Sugar – up 52% 

Clearly, these prices moves are positive for Brazilian farmers and miners. Despite this, the Brazilian central bank remains committed to slowing down appreciation of the real, which is up 10.2% versus the U.S. dollar since its May 25th low. The commitment stems from Brazilian Finance Minister Guido Mantega’s resolve to maintain favorable repatriation rates for Brazilian exporters. His commitment has been backed decisive action: in the YTD through August, the central bank has purchased $18.6 billion dollars – up 155% YoY though the same period! He’s even gone on record to suggest Brazil can use its sovereign wealth fund and/or issue debt to fund incremental dollar purchases.


Unfortunately for Mr. Mantega, we don’t think the Brazilian government checkbook is nearly as boundless as Mr. Bernanke’s printing press, so his efforts will likely do nothing more than to marginally slow the rate of real appreciation driven by fund flows to the country (see: Petrobras’ $70 billion share offering).


Darius Dale



Revisiting Brazil - 1


Revisiting Brazil - 2


The note below is from our recently-launched energy Sector Head, Lou Gagliardi. 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 .


Conclusion: We believe that historical levels of the crude oil to natural gas ratio will not be revisited. Crude oil will remain in the new normal range versus natural gas of 14 – 18x, and thus not return to the historical average of ~10x, which would imply $40/barrel oil at current natural gas prices.


We looked at the historical relationship of oil to gas prices since 1994, on oil to gas “fundamental” multiple basis based on the historical average, oil would be trading at an average price of ~$40/bbl. But we don’t think the probability of that occurring is high, particularly since crude oil’s emergence as a “trading” financial asset over the last few years, and the willful, or not, of the debasement of the U.S. currency through extraordinary liquidity injected into the U.S. monetary system and the ensuing ballooning of our fiscal deficit.  In effect, a weak U.S. dollar equals higher oil prices.


 From 1994 to today, the price of WTI (West Texas Intermediate) crude oil and HH (Henry Hub) natural gas has averaged ~$40.70/bbl, and $4.55/Mcf, or at an average oil to gas multiple a shade over 9 times, which is close to the Btu equivalent of 6 times oil to gas. In contrast, the average multiple for 2010 year-to-date is about 17 times, as natural gas has dropped and oil has remained above $70/bbl, whilst the U.S. dollar has remained weak relative to the Euro. The average standard deviation for each year since 1994 has been just under 2 times, year-to-date for 2010 it is 2.3 times. So it appears that the volatility in the relationship has returned to its historical mean.


Over the last few years, we have seen crude oil traded increasingly as a financial asset, which has created incremental demand for crude oil.  In addition, the general decline of the U.S. dollar over the last few years has led to an increase in crude oil since it is priced in U.S. dollars.  But not all of the price increase in crude oil is attributable to its relationship to the U.S. dollar, or financial demand.  In fact, a fair portion of its meteoric rise in price is due to fundamental structural imbalances and deficiencies in the supply/demand equation.


There are many fundamental factors from rising Resource Nationalism across the globe, to the acceleration of the developing world’s industrialization, i.e., China, India, Brazil, Russia, to insufficient energy infrastructure, to geopolitical instability, to rising lifting and finding & development costs, to insufficient excess supply capacity, which all have fueled crude’s rise upward. Indeed, increasing supply constraints due to declining production from major oil producing regions from Mexico, Venezuela, Alaska North Slope, North Sea, to Canadian Conventional, and the lower U.S. 48, have exerted upward price pressure on crude prices. While there does not appear a high probability of oil prices returning to $40/bbl for a sustained period, it does appear that the price of oil pegged to supply and demand has shifted higher on an energy equivalent basis vis-à-vis natural gas. This is in line with our long-term TAIL bullish outlook for oil.


A counter weight to the oil to gas multiple remaining higher could be the price of natural gas. Our outlook is bearish for natural gas over the intermediate term trend, driven by drilling technology ahead of supply needs; we believe that increasing natural gas supply will compete away some crude oil usage in areas where oil is used as a commercial fuel source. Increased switching to natural gas as a commercial fuel source away from crude oil due to its low gas price could exert some modest downward pressure to crude prices from a fundamental basis in the intermediate term.  But, in the long term, crude oil supply constraints will continue to pull crude prices higher. The wild card in the oil to gas multiple will remain the U.S. dollar driven by U.S. monetary policy and global deficit spending. So watch the multiple, long-term we expect it to stay wider than historical levels as we enter the new normal of natural gas and crude oil energy equivalency.


From the Oil and Gas Patch.


Lou Gagliardi 

Managing Director





Bull/Bear Battle: SP500 Levels, Refreshed...

You’ll notice a welcomed change in the title of this risk management product – we change as prices do and, unless we see a breakdown through 1144 before today’s market close, we can’t call this an intermediate term Bear Market anymore.


What we’ll call it is a Bull/Bear Battle however. With Q3 performance problems in the hedge fund industry capitulating into month and quarter end, I see no reason to make a decisive move yet in the SP500 – that’s why I am neither long nor short SPY in the Hedgeye Portfolio.


Where would I consider taking a position? From an immediate term TRADE perspective, the 1148 line is the most interesting spot on the short side and 1131 is support. The range in my 3-day probability model is as tight today (30 SPX points) as it has been in all of 2010. A tight range of probabilities (on a very short term duration) simply gives me a higher confidence interval in trading around my gross exposure and in/out of long/short positions.


May the Battle begin,



Keith R. McCullough
Chief Executive Officer


Bull/Bear Battle: SP500 Levels, Refreshed...  - S P

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