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Contemplating Turnout In The Midterms

We are on record already saying that we believe that Republicans will do much better than expected in the midterms.  The implication of much better than expected is that the Republicans could take the Senate back and will take the House by a much larger than expected margin.  In fact, we are more bullish on the chances for the Republicans than our friend and former White House Chief of Staff, Karl Rove.  Our bullishness isn’t partisan mind you, but merely based on the math.

 

As it stands today, our view is creeping more and more into consensus, and is certainly getting priced into the stock market.  The current Real Clear Politics poll averages for the Senate have the Democrats at 48 seats, the Republicans at 46 seats, and 6 seats currently “too close to call”.  In the House, the Republicans are currently at 208 seats, the Democrats are at 191 seats, and 37 seats are currently “too close to call”. 

 

If you didn’t know the Senate is in play, now you know. 

 

Currently, the “too close to call” races in the Senate are in CO, CT, IL, NV, WA, and WV.  Our view is that IL and WA will likely go Democratic, while NV, WV, and CO have a real shot at going Republican.  If this occurred, we would be at 50 – 49 for the Democrats, with CT to be decided.  Given the fact that Republican nominee Linda McMahon is willing to spend up to $50MM in advertising, this race is far from a foregone conclusion and in our estimation it is the key race to watch in the coming weeks to gauge whether the Republicans can really take the Senate.

 

The real wild card in the midterms will be voter turnout.  Our stance that Republicans could do much better than expected is based on the fact that the numbers are telling us that Republican turn out could be much, much higher than the Democrats. 

 

The supporting evidence is as follows: 

  • Reuters Ispos Poll – September 16th to 19th – 72% of Republicans said they are very likely to vote, 55% of Democrats said they are very likely to vote
  • Gallup Poll – September 20th to 26th – 48% of Republicans said they are very enthusiastic about voting, 28% of Democrats said they are very enthusiastic about voting
  • Fox News Poll – September 14th to 16th – 42% of Republicans said they are very interested in the elections, 22% of Democrats said they are very interested in the elections
  • McClatchy-Marist Poll – September 22nd – 46% of Republicans said they were very enthusiastic about voting, 30% of Democrats said they were very enthusiastic 

The differences in these numbers are outright staggering and suggest a Republican base that is ready and willing to vote, while a Democrat base that is more than likely to stay home. 

 

In midterm elections, voter turnout is typically less than 40%, so these voter enthusiasm numbers will have a significant impact.  Particularly given the context that the registered and likely voters is currently split in the country with 36.5% identifying as Democrats, 35.5% identifying as Republicans, and 24.8% indentifying as Independents (according to pollster.com), which we highlight below.  With the Republicans currently up +4% in the generic Congressional ballot, these turnout numbers may potentially add insult to injury for the Democrats.

 

Daryl G. Jones

Managing Director

 

Contemplating Turnout In The Midterms - 1


CONSUMER CONFIDENCE - WHERE IS THE PULSE OF THE CONSUMER AND THE ECONOMY?

Today's headline Conference Board consumer confidence index number declined to 48.5 from 53.2 last month.  The median estimate from Bloomberg was for a decline to 52.1.  This now puts the confidence index down 14% year-to-date.  The real story lies in the present situations Index which is only up 14% from the low set back in December 2009.  Confidence is critical for the U.S. economy and it is clear that the government stimulus has been lackluster, at best, in boosting the outlook of consumers in America.

 

In fact, there is considerable evidence to suggest that the spending could be worsening people’s confidence.  A pool released by Public Notice today suggests that 71% of people say government spending is too high and, more importantly, 68% say government spending is a factor in their own financial situation.  Consumption accounts for roughly 70% of GDP; restoring some semblance of confidence will be necessary to encourage real economic growth.

 

The Richmond Fed manufacturing survey fell to -2 from expectations of +5.  In total, 7 out of 8 Richmond Fed indicators declined, with just vendor lead-time remaining flat at 0.  The new orders index fell to 0 this month from 10 in September and shipments index fell to -4 from 11. The Richmond Fed’s district accounts for about 9.1% of the nation’s gross domestic product.

 

This morning, Hedgeye Financials sector head Josh Steiner’s read on the Case/Shiller numbers was not good.  His conclusion: “Home prices are just starting to roll, but downside will accelerate in coming months. We expect next month's number to be a wake-up call and the month after that to be a significant negative catalyst for the market generally and Financials specifically.”

 

In response to these data points, the VIX is up 1%, Gold is spiking up 8% and the dollar is down 0.4% (down 5% for the month).  The S&P is basically unchanged. 

 

The consumer is far from a picture of health, home prices are headed lower, the economy is decelerating and the S&P 500 is up 3.7% year-to-date.  The outlooks certainly seems decidedly bearish, but apparently two “big” boys think otherwise.

  • David Tepper said on CNBC yesterday that stocks are in a win-win situation.
  • From Zerohedge - “John Paulson Lecture: Bonds Are Wrong, Stocks Are Right"

The first day of the 4th quarter is setting up to be an ominous day, with the ISM manufacturing index to be reported.  The August reading of 56.3 posted a big upside surprise versus 52.8 expectations and setting off a 9% rally in the S&P 500.  Since then Factory orders, ISM non-manufacturing, Empire Manufacturing, Philadelphia Fed, Chicago Fed and the Dallas Fed have all reported disappointing numbers relative to expectations.  All of the regional FED readings, except the Empire State manufacturing reading, are showing numbers that imply economic contraction, not expansion.


A reading below 50 on the ISM is in play for the first day of October.

 

Howard Penney

Managing Director

 

CONSUMER CONFIDENCE - WHERE IS THE PULSE OF THE CONSUMER AND THE ECONOMY? - conference board present situations

 

CONSUMER CONFIDENCE - WHERE IS THE PULSE OF THE CONSUMER AND THE ECONOMY? - conference board confidence

 

CONSUMER CONFIDENCE - WHERE IS THE PULSE OF THE CONSUMER AND THE ECONOMY? - conference board expectations


THE GRIND: Sept 28, 2010

 

THE GRIND: Sept 28, 2010 - Notebook Image Hedgeye

 

Another day, another grind…


THE GRIND: Sept 28, 2010 - Notebook Bullish


1.      SP500 remains bullish from an immediate term TRADE perspective with an important line of support at 1135.

2.      The RANGE in my SP500 3-day probability model remains very tight and trade-able at 35pts

3.      Yesterday’s down day came on a weak volume study (as opposed to UP volume on DOWN days which is the TREND)

4.      All 9 sectors in our S&P Sector Risk Mgt model remain bullish from an immediate term TRADE perspective

5.      M&A continues to see more rumors than realities but Unilever for Alberto Culver yesterday was at least true

6.      China had 21 banks agree to sell loans on China’s interbank market = 1st time the govt allowed these transactions = liquidity

7.      Vietnam reported an accelerating sequential q/q GDP growth # for Q3 last night at +7.2% y/y vs. +6.4% in Q2

8.      German consumer confidence (OCT) improved to 4.9 in the GFK report vs. 4.3 last

9.      German (DAX) and UK (FTSE) stocks continue flash positive global divergences (bullish TRADE and TREND)

10.  Euro and British Pound continue to be bullish on both TRADE and TREND (we are long Pounds versus short USD)

11.  Commodities (CRB Index) continue higher in the face of a US Dollar debasement (inverse correlations on immediate term TRADE duration high)

12.  Gold is holding a very immediate term TRADE line of important price momentum of $1285

13.  Copper continues to trade in a Bullish Formation (bullish TRADE, TREND, and TAIL)

14.  Agricultural and soft commodities continue to make higher-highs and higher-lows (Bullish Formations)

15.  Israel joins an expanding list of countries who see global inflation re-accelerating for what it is and raises interest rates to 2% this morning

 


THE GRIND: Sept 28, 2010 - Notebook Bearish


1.      SP500 is broken again from an intermediate term TREND perspective (resistance = 1144)

2.      Volatility (VIX) continues to trade with an extremely high inverse correlation to the SP500 with TREND line support for the VIX at 20.96

3.      Inclusive of this morning’s weakness, the SP500 is actually down for 5 out of the last 6 trading days (market breadth deteriorating)

4.      Financials (XLF) remain the only sector in the SP500 (of the 9 we model top down daily) that’s bearish from a TREND perspective

5.      Yield Spread (10s to 2s) continues to compress this week versus last and remains a bearish headwind for US Financials earnings

6.      High Yield is trading within 7bps of its April 2010 highs at 8.25%; this is a contrarian indicator, big time

7.      Levered Loan Index at 15.13 is 5bps away from its late April early May highs; another contrarian (bearish) indicator for equities

8.      Case Shiller Prices (JUL) rollover again sequentially (month over month)

9.      US Consumer confidence comes in at a bomb 48.5 for SEP versus 53.2 AUG despite CNBC cheering the stock market higher

10.  “Republican House” finds its way onto the cover of Barron’s = consensus bullish catalyst now

11.  M&A rumors haven’t been this frothy since September of 2007 (we’ve counted 67 alleged “takeouts” that haven’t occurred)

12.  US Dollar Index continues to burn at the stake of QE hope; down now for the 15th of the last 18 weeks and Washington doesn’t care

13.  US Treasury Yields are in a Bearish Formation across the curve (2yr yield TRADE resist = 0.51%) = bearish signal for US economic growth

14.  Chinese stocks have closed down for 5 out of the last 7 days and the Shanghai Composite is now broken on immediate term TRADE duration

15.  Japanese stocks continue to be the armpit that is long term QE; Nikkei down 3 of last 4 days and down -10% for 2010 todate

16.  Japanese exports (AUG) hammered sequentially down to +15.3% y/y vs +23.5% y/y in JUL

17.  Japan’s Bureaucrats calling for another 4.6 TRILLION Yen in stimulus and proposing to pay for it by raising taxes this time?

18.  Spain’s IBEX is testing a TRADE line breakdown for the first time in months; support line could become resistance at 10,499

19.  Italy’s CDS continues to push higher at 205bps and remains the country with the most downside relative to consensus (we’re short EWI)

20.  European CDS continues to push wider on the heels of Greek Equities getting smoked (down -12% since 1st week of September with SPY +9%)

21.  Russian equities weakening in the face of Medvedev firing the longstanding (18 year) mayor of Moscow

22.  Romania’s Interior Minister resigns in the face of austerity implementation

23.  Sri Lanka is now issuing sovereign debt ($6B worth) and markets there are cheering it on?

24.  Dubai says “we are back”

 
Altogether the fundamental research DATA continues to tilt to the bearish side (as of the last 6 trading days) but PRICES are not entirely confirming how bad the DATA has become. I think a lot of this has to do with severe performance problems in the US hedge fund business into month and quarter end, so we may need to close an eye or two here for the next 72 hours before some of the smoke signals clear.
 
In the Hedgeye Portfolio we are still giving the benefit of the doubt to the bulls (LONGS = 12, SHORTS = 9), but I am increasingly concerned about October.
 
KM
 
Keith R. McCullough
Chief Executive Officer
HEDGEYE RISK MANAGEMENT

 

 

THE GRIND: Sept 28, 2010 - HE Durations


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The Grind: What's In My Notebook?

Another day, another grind…

 

BULLISH:

  1. SP500 remains bullish from an immediate term TRADE perspective with an important line of support at 1135.
  2. The RANGE in my SP500 3-day probability model remains very tight and trade-able at 35pts
  3. Yesterday’s down day came on a weak volume study (as opposed to UP volume on DOWN days which is the TREND)
  4. All 9 sectors in our S&P Sector Risk Mgt model remain bullish from an immediate term TRADE perspective
  5. M&A continues to see more rumors than realities but Unilever for Alberto Culver yesterday was at least true
  6. China had 21 banks agree to sell loans on China’s interbank market = 1st time the govt allowed these transactions = liquidity
  7. Vietnam reported an accelerating sequential q/q GDP growth # for Q3 last night at +7.2% y/y vs. +6.4% in Q2
  8. German consumer confidence (OCT) improved to 4.9 in the GFK report vs. 4.3 last
  9. German (DAX) and UK (FTSE) stocks continue flash positive global divergences (bullish TRADE and TREND)
  10. Euro and British Pound continue to be bullish on both TRADE and TREND (we are long Pounds versus short USD)
  11. Commodities (CRB Index) continue higher in the face of a US Dollar debasement (inverse correlations on immediate term TRADE duration high)
  12. Gold is holding a very immediate term TRADE line of important price momentum of $1285
  13. Copper continues to trade in a Bullish Formation (bullish TRADE, TREND, and TAIL)
  14. Agricultural and soft commodities continue to make higher-highs and higher-lows (Bullish Formations)
  15. Israel joins an expanding list of countries who see global inflation re-accelerating for what it is and raises interest rates to 2% this morning 

BEARISH:

  1. SP500 is broken again from an intermediate term TREND perspective (resistance = 1144)
  2. Volatility (VIX) continues to trade with an extremely high inverse correlation to the SP500 with TREND line support for the VIX at 20.96
  3. Inclusive of this morning’s weakness, the SP500 is actually down for 5 out of the last 6 trading days (market breadth deteriorating)
  4. Financials (XLF) remain the only sector in the SP500 (of the 9 we model top down daily) that’s bearish from a TREND perspective
  5. Yield Spread (10s to 2s) continues to compress this week versus last and remains a bearish headwind for US Financials earnings
  6. High Yield is trading within 7bps of its April 2010 highs at 8.25%; this is a contrarian indicator, big time
  7. Levered Loan Index at 15.13 is 5bps away from its late April early May highs; another contrarian (bearish) indicator for equities
  8. Case Shiller Prices (JUL) rollover again sequentially (month over month)
  9. US Consumer confidence comes in at a bomb 48.5 for SEP versus 53.2 AUG despite CNBC cheering the stock market higher
  10. “Republican House” finds its way onto the cover of Barron’s = consensus bullish catalyst now
  11. M&A rumors haven’t been this frothy since September of 2007 (we’ve counted 67 alleged “takeouts” that haven’t occurred)
  12. US Dollar Index continues to burn at the stake of QE hope; down now for the 15th of the last 18 weeks and Washington doesn’t care
  13. US Treasury Yields are in a Bearish Formation across the curve (2yr yield TRADE resist = 0.51%) = bearish signal for US economic growth
  14. Chinese stocks have closed down for 5 out of the last 7 days and the Shanghai Composite is now broken on immediate term TRADE duration
  15. Japanese stocks continue to be the armpit that is long term QE; Nikkei down 3 of last 4 days and down -10% for 2010 to-date
  16. Japanese exports (AUG) hammered sequentially down to +15.3% y/y vs +23.5% y/y in JUL
  17. Japan’s Bureaucrats calling for another 4.6 TRILLION Yen in stimulus and proposing to pay for it by raising taxes this time?
  18. Spain’s IBEX is testing a TRADE line breakdown for the first time in months; support line could become resistance at 10,499
  19. Italy’s CDS continues to push higher at 205bps and remains the country with the most downside relative to consensus (we’re short EWI)
  20. European CDS continues to push wider on the heels of Greek Equities getting smoked (down -12% since 1st week of September with SPY +9%)
  21. Russian equities weakening in the face of Medvedev firing the longstanding (18 year) mayor of Moscow
  22. Romania’s Interior Minister resigns in the face of austerity implementation
  23. Sri Lanka is now issuing sovereign debt ($6B worth) and markets there are cheering it on?
  24. Dubai says “we are back”

 

Altogether the fundamental research DATA continues to tilt to the bearish side (as of the last 6 trading days) but PRICES are not entirely confirming how bad the DATA has become. I think a lot of this has to do with severe performance problems in the US hedge fund business into month and quarter end, so we may need to close an eye or two here for the next 72 hours before some of the smoke signals clear.

 

In the Hedgeye Portfolio we are still giving the benefit of the doubt to the bulls (LONGS = 12, SHORTS = 9), but I am increasingly concerned about October.

 

KM

 

Keith R. McCullough
Chief Executive Officer

 

The Grind: What's In My Notebook? - The Grind


R3: UA, NFL, Fila, JJB, and Bedbugs

R3: REQUIRED RETAIL READING

September 28, 2010

 

A fair amount of activity in the athletic space this morning, led by a strong initial day of trading by Fila.  Keep an eye on Fleet Feet Sports and the proliferation of the NFL into the women’s apparel market.

 

 

RESEARCH ANECDOTES

 

- Expect TLC’s bridal show spin-off, “Big Bliss” to be filled with advertising from retailers looking to capitalize on the plus size demographic.  The six episode spin-off of “Say Yes to the Dress” will chronicle plus-sized brides searching for the perfect gown at Kleinfeld’s in Manhattan.

 

- Topshop continues its expansion with the announcement of the company’s second stateside location, this time in Chicago.  The British retailer is also seeking locations in additional metro areas including Las Vegas, San Francisco, Miami, LA, and NYC.

 

- Back to school was a key driver of an acceleration in web traffic to retail-related websites.  Sites seeing major increases included: Target (+6.2%), Staples (+22.8%), JC Penney (+24.8%), Kohls (+23.8%), Macy’s (+13%), Zappos (+30.3%) and Gap (+19.6%). 

 

- Keep an eye on website Sourcemap.com.  The site aims to increase transparency in supply chains, allowing consumers to know where items come from and what exactly they are made of.  With genuine concern from shoppers regarding sustainability and social responsibility, transparency is becoming a much bigger factor in the consumer’s decision making and purchasing process. 

 

- In a sign that Tommy Hilfiger is accelerating its new ‘Tommy’ concept – a new line that will be a departure from preppy basics, its Bleeker Street location is under renovation and already sporting new signage. Certainly more aggressive than initial plans to soft launch the brand in Canada, the new concepts location should give Tommy and PVH a quick read on demand as it opens in time for the holiday season.

 

- In an attempt to kickoff its new Sport Performance collection in world record fashion, Jockey rallied more than 100 players for a game of dodgeball in Chicago wearing nothing but skivvies. We hope the line is more successful than the company’s guerilla marketing attempt since it fell far short of its goal of more than 1,200 participants.

 

- Macy’s Inc. is touting Elvis Christmas tree ornaments in Tennessee and Blackhawks decorations in Illinois ahead of the holidays, tailoring goods for local markets to squeeze more out of its biggest shopping season. The company is hoping its “My Macy’s” will add as much as 3% to the chain’s holiday sales at stores.

 

- The 65th session of the United Nation's General Assembly has plagued many retailers since its open last Tuesday, driving down traffic for most stores as local shoppers couldn't access the area due to street closures and chose to steer clear of the chaos.

 

 

OUR TAKE ON OVERNIGHT NEWS 

 

Fleet Feet Sports to Acquire Phidippides Encino - Specialty Retail Development Company (SRDC), Inc., a multi-store Fleet Feet Sports franchise affiliated with Fleet Feet Sports Inc., announced the purchase of Phidippides Encino, a top running shop in Los Angeles. Change of possession will take place on Nov. 1. Phidippides Encino has served the Southern California running community for 30 years and is one of the pioneering, premier specialty stores in the United States.  <sportsonesource.com>

Hedgeye Retail’s Take: Without knowing the terms of the deal it’s difficult to speculate on its financial merits, but adding nearly 20 additional running specialty locations to its base of 90 makes Fleet Feet an increasingly more relevant player amongst athletic footwear retailers nationwide.

 

Fila Korea IPO Set for September 28th - Fila Korea Ltd., which in March 2007 purchased the Fila brand from Sports Brands International Ltd., will complete the initial public offering of its shares on the Korean Stock Exchange (KRX) on Tuesday, September 28th. Proceeds will be used to pay down debt. <sportsonesource.com>

Hedgeye Retail’s Take: After posting a 26% increase in sales in the 1H of 2010, shares doubled on its debut on the Kospi. With its re-entry into the basketball category back in April, the brand moves up in relevance on our radars in athletic footwear as it pursues further share gains.

 

NFL Launches Women-Specific Campaign - The National Football League is launching a $10 million TV campaign on Monday aimed at reaching women football fans. The effort also includes the launch of the new www.nfl.com/women microsite and is being done in concert with existing partners such J.C. Penney, Kohl's and Dick's Sporting Goods as well as new ones such as Victoria's Secret and Destination Maternity. <sportsonesource.com>

Hedgeye Retail’s Take: According to Scarborough research data on NFL demographics, only 37% of women are considered loyal fans and only 31% avid fans compared to 63% and 69% of men respectively. While a fraction of male audience, the increased spend makes sense given that women’s apparel represents the league’s fastest growing business.

 

Under Armour Signs Ravens' Anquan Boldin - Under Armour signed Baltimore Ravens wide receiver Anquan Boldin to an endorsement deal. The eight-year veteran is a three-time Pro Bowler and was the 2003 NFL Offensive Rookie of the Year.  <sportsonesource.com>

Hedgeye Retail’s Take: Just a week after signing Dallas receiver Austin Miles, Boldin is cut from the same cloth – known by fans as a physical receiver. The company is clearly becoming more visible with endorsements of professional athletes in addition to its historical stance of supporting collegiate teams – a trend that’s more costly on the margin.

 

Hundreds Queue as Bangkok Mall Opens Four Months After Deadly Riots, Fire - Hundreds of shoppers lined up to count down the reopening of Thailand’s Central World shopping mall today, more than four months after anti-government protesters torched it during deadly riots in Bangkok.  <bloomberg.com>

Hedgeye Retail’s Take:  Nothing like a shopping mall to symbolize some level of a return to normalcy in Bangkok.

 

UK Sporting Goods Retailer JJB Sports Increases Promotions to Drive Sales - JJB Sports Plc , the U.K.’s third- largest sporting goods retailer, fell the most in more than 14 months in London trading after the company added promotions following “more volatile” sales since August.  <bloomberg.com>

Hedgeye Retail’s Take:  This trend, while consistent with some back to school activity here in the U.S., runs counter to the full priced selling we are seeing across the athletic space.  Recall that JJB has been struggling for years, as has the entire UK sporting goods sector.

 

Sales and Site Traffic Jump For E-retailers - Revenue for online merchants has increased 23% so far this year, with web site traffic up 46%, according to a survey of 70 retailers. The findings could foreshadow a successful holiday shopping season. MarketLive Inc. ran a survey of its 70 retail clients finding consumers created 55.9% more shopping carts, and the number of orders grew 32.4%. Conversion rate dropped three-tenths of one percent. Company officials attribute the drop in conversion rate to the nearly 45% increase in traffic to the e-commerce sites.  <internetretailer.com>

Hedgeye Retail’s Take:  Nothing new here except the consumer continues to show interest in convenience and sharp pricing via the web.  Investments in .com infrastructure from traditional retailers have also enhanced the user experience, which in turn is helping to drive growth. 

 

Obama On Trade - The Obama administration is walking a fine line as it looks to strengthen its trade credentials. The administration is balancing a goal of doubling exports in five years to $3.14 trillion and moving forward with free trade initiatives against stepped-up enforcement of existing trade agreements. It is also reviewing the U.S. relationship with trade partners. It’s been 20 months since President Obama took office, following a long campaign leaning toward protectionism, and his trade agenda has evolved into a bifurcated strategy — emphasizing enforcement by bringing cases against illegal trade practices to the World Trade Organization, and moving slowly on free trade agreements negotiated by the Bush administration that it felt were not strong enough in areas such as labor rights on the one hand, and opening markets for U.S. exports on the other. The centerpiece of the President’s trade agenda so far has been the National Export Initiative, which aims to double exports in five years. <wwd.com/business-news>

Hedgeye Retail’s Take:  While this focus on exports will certainly be a help to the economy, we don’t expect to see any apparel or footwear production moving back onshore. 

 

More Bedbug Problems For NYC Retailers, Macy's Herald Square Flagship is this Week's Victim - New York’s bedbug problem is spreading to more retailers. Macy’s Inc. is the latest to encounter the parasites. Both Macy’s Herald Square flagship and Bloomingdale’s 59th Street flagship have reported bedbug sightings. Bloomingdale’s last week cited bedbugs but never closed and said it quickly took care of the problem. On Friday, the store distributed a memo to employees as they entered the 59th Street flagship. Other retailers recently citing bedbugs were Niketown on 57th Street, Abercrombie & Fitch in the South Street Seaport, Hollister on Houston Street and Broadway and Victoria’s Secret on Lexington Avenue and 58th Street. They were all temporarily closed and reopened after debugging. <wwd.com/retail-news>

Hedgeye Retail’s Take:  With bedbugs now discovered almost everywhere, the epidemic now shifts to retailers that actually sell solutions.  BBBY, TGT, and WMT all appear to be positioned with sprays and other extermination products.  With that said, we’re not expecting any same stores sales boost as a result of the miniscule pests. 

  


The St. Petersburg Paradox

“The mathematical expectation of the speculator is zero.”

-Louis Bachelier

 

Louis Bachelier was a French mathematician who was, well after the fact, credited with founding the Efficient Market Thesis.  In 1900 Bachelier published his Ph.D thesis titled “The Theory of Speculation.”  In his paper, Bachelier discussed the use of Brownian motion to evaluate stock prices.  Unfortunately, his thesis was “not appropriately received”, which resulted in academic black-balling and the concept being buried for more than sixty years.

 

Almost sixty-five years later Professor Eugene Fama from the University of Chicago was officially credited with developing the Efficient Market Thesis after publishing his Ph.D thesis.  His paper was titled “The Behavior of Stock Market Prices.”  The core tenet of his paper and the Efficient Market Thesis is that an investor “cannot consistently achieve returns in excess of average of market returns on a risk-adjusted basis, given the information that is publicly available at the time the investment is made.”

 

Is it not somewhat ironic that the determination of who founded the Efficient Market Thesis was not efficient?

 

Despite not having a Ph.D on staff at Hedgeye Risk Management, we have been performing our own experiment to test the Efficient Market Thesis over the past two years.  We call this experiment the Hedgeye Virtual Portfolio, and it is a culmination of our stock picks since inception.

 

In that time, we have closed 510 long positions and closed 490 short positions. 85.9% of the closed long positions have been winners and 83.5% of the closed short positions have been winners.  Obviously, these results are far from a “random walk”.  So, either we are good at our jobs, or the market is not quite as efficient as Efficient Market Theorists believe.  I would submit that it is a combination of both.   

 

Clearly, though, many stock market participants work hard, have processes, and are intelligent.  So, why do many stock market operators underperform even the basic broad market returns? Simply put, because of this little critter called Behavioral Economics that leads many market participants to act against their best interests. 

 

By way of example, let’s consider the St. Petersburg Paradox, which is as follows:

 

“Consider the following game of chance: you pay a fixed fee to enter and then a fair coin is tossed repeatedly until a tail appears, ending the game. The pot starts at 1 dollar and is doubled every time a head appears. You win whatever is in the pot after the game ends. Thus you win 1 dollar if a tail appears on the first toss, 2 dollars if a head appears on the first toss and a tail on the second, 4 dollars if a head appears on the first two tosses and a tail on the third, 8 dollars if a head appears on the first three tosses and a tail on the fourth, etc. In short, you win 2^k−1 dollars if the coin is tossed k times until the first tail appears.”

 

So, what would be a fair price to pay for entering the game?

 

I posed this question to our Research Team at Hedgeye yesterday and they came back with myriad of answers, which ranged from $1 to infinity.  This simple mathematical answer is that you should be willing to pay infinity (or your entire net worth) to play this game as your expected value is infinity.

 

 As one of our astute Analysts responded to me yesterday:

 

“Well, the series doesn’t converge …EV = (1/2)*($1) + (1/4)*($2) + (1/8)*($4) + …EV = ½ + ½ + ½ + …… the sum of which is infinite.  So, is the fair entering price infinite? Strictly speaking, I think the answer is yes – but no one on earth would take that deal (even if we cap the number of rounds such that EV = all your money, since no one has infinite money).”

 

Therein is another paradox, the paradox of the Efficient Market Thesis.  Specifically, most market operators do not make rational decision based on math.  They make emotional decisions based on arbitrary evaluations of risk. This, of course, leaves opportunities for the sneaky mathematicians to make profit.

 

So then, how do we account for valuation when considering an investment?  Surely, valuation is rational?

 

In my view, valuation is an indicator of sentiment around a security.  For instance, when a stock trades with a single digit P/E, its business is either declining, or the collection of market operators believe it is.  There are many studies that support the idea that value based strategies (i.e. buying cheap stocks) outperform over time, but I would submit that this is not because of the valuation, but rather because of the behavioral finance indicator embedded therein.

 

As we consider the stock market today, the first question many strategists try to answer is whether the stock market is “cheap”.  The simple way to make this determination is to pull up a long term price / earnings chart and look at it going back fifty years.  Today, at 15x current earnings and 13.7x forward earnings, the SP500 looks cheap versus history. 

 

The more important task though is determining what expectations are embedded in that valuation.  What is the correct earnings multiple for an economy that has crossed the Rubicon of Debt at 90% debt / GDP and has budget deficits projected for the next thirty plus years (I would say infinity, but that’s probably not fair)? Additionally, if growth rates are mired in the 1 - 2% range as a result of this fiscal situation, is the stock market “cheap”?

 

In the shorter term, setting those sneaky valuation metrics to the side for a second, what do you think is priced into the S&P500 up 8.8% in September?  Given the cover of Barron’s this weekend and the rapid rise in the S&P in the last few weeks, the catalyst of the Republicans winning more seats than expected in the midterms is likely priced in. (We called this out on our conference call with Karl Rove in early September - Could the Midterm Election Be A Major Stock Market Catalyst?)  So, what is priced in now?

 

Well, perhaps our friend George Soros said it best:

 

“The financial markets generally are unpredictable. So that one has to have different scenarios. The idea that you can actually predict what's going to happen contradicts my way of looking at the market.”

 

Or as we say at Hedgeye, the plan is that the plan will change.

 

Yours in risk management,

 

Daryl G. Jones

Managing Director

 

The St. Petersburg Paradox - PE


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 80.28%
  • SHORT SIGNALS 78.51%
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