EARLY LOOK: Bad, Bad Risk

// April 28th, 2010 // No Comments » // Keith

“And the giant beside him about to fall, they will try to make you crawl.”
-Sly Stone

There all kinds of risk. Good risk, medium risk, and bad risk. (Some investment bankers even say no risk.) Bad risk is also the name of a song by the U.S. funk band Sly and the Family Stone. Growing up in the era of psychedelic drugs and music, it is likely that Sly Stone knew a few things about bad risk.

As Risk Master Brother McCullough is discussing on Bloomberg this morning, we are waking up to some funky news. Suffice it to say, in the world of global investing , potential sovereign debt defaults be some Bad, Bad Risk.

Greek credit default swaps have been blowing out for the last few weeks and yesterday the culmination was a downgrade of Greek and Portuguese sovereign debt, the former to junk bond status. That be bad.

As is often the case in global macro risk management, geopolitics matter. In 1998, the United States and a few other nations came to the rescue of Mexico in her inability to roll over short term loans. Sho’nuff, the United States actually made a profit of some $500MM on this bailout. Ironically, the architect of this bailout was Treasury Secretary Robert Rubin.

Even the most eminent of Perceived Experts, like Brother Rubin, make funk predictions. As it relates to sovereign debt defaults, we’ve quoted former Secretary Treasury Robert Rubin from a presentation he gave at Yale Law School last year in which he said, “he did not forsee any sovereign debt defaults.” Now to be fair to Brother Rubin, in the same lecture he indicated a Greek Philosophy that he took in his freshman year at Haw-havd was the underpinning of his risk management philosophy. No math, brother?

(We’d just be piling on Goldman if we mentioned that Brother Rubin was also the former CEO of Goldman Sachs and that Goldman had a very substantial long position in Mexican bonds, and thanks to his bailout they got out whole. But no need to kick a firm when it’s down!)

The simple math associated with Greece suggests that risk is accelerating. This morning the spread between Greek bonds and their German counterparts is 800 basis points (8%!). That be wide! In addition, and we’ve highlighted this in the chart below, Greek credit default swaps continue to blow out. By our last measure, they were at 842 basis points. That would be funky, if it weren’t dang expensive insurance.

Yesterday, S&P downgraded our Greek Brothers to junk status. The implications of this go far beyond one country. This is the first time any nation in the Eurozone has been downgraded to junk since the introduction of the Euro in 1999. Incidentally, Greek debt is now on par with the economic stalwarts of Azerbajian and Egypt. According to S&P, in a restructuring Greek debt could be worth as little a 30 percent of face value. Dang!

The question is: When is Germany going to get down with it? It is time to put some stank on it in the Eurozone!

This morning Sister Merkel, also known as the Chancellor of Germany, is going to be giving a statement regarding Greece at 10:45 a.m. eastern. Mark that one in your Outlook calendar. This will be a catalyst for the market. And while it is earnings season . . . at the moment Macro Matters more than the EPS miss of Buffalo Wild Wings. Ain’t that the truth?

While it was an easy decision for the United States to bail out Mexico in 1998 (setting Goldman’s long exposure aside), it is a much more nuanced decision for Sister Merkel in regards to Greece. As our European Analyst Matt Hedrick wrote yesterday:

“ While we believe Germany’s “contribution” is inevitable, what we’re currently seeing from Merkel is political posturing. On May 9th, Germany’s largest state by population and the industrial heartland, North Rhine-Westphalia (NRW), holds a state election. Merkel’s Christian Democratic Party (CDU) along with her coalition partners the Free Democrats (FDP) need a win to retain the majority in the Bundesrat (upper house of parliament), which is critical for her party to carry out scheduled reforms, including tax cuts and health care reform.

Recent polls suggest that Merkel’s opposition, the alliance of the Social Democrats-Greens, has a slight advantage. With government spending a hot topic in the election, Merkel must show that she’s not writing a blank check to the Greeks, and will continue to drive a hard line.”

Like any astute geo-political, analyst Brother Hedrick has ascertained an important point, even in the face of a spiraling economic crisis in the Eurozone, politics still matter. To summarize this in the wise words of Sly Stone: “And the giant him about to fall, they will try to make you crawl.” Now that’s a groovy realization.

Last month we did an in-depth presentation of sovereign debt and the risks associated with potential defaults. The conclusions of this historical analysis was simply that defaults or restructurings are rarely one-off issues, and certain nations, not surprisingly Greece, tend to be leading indicators.

Rumors yesterday out of Europe suggested that Europe would convene a “Greek Aid” summit on May 10th. By that time, Sister Merkel’s elections will be one day behind her. If that date don’t speak the truth . . .

Keep groovin’

Daryl G. Jones
Managing Director

EARLY LOOK: Begging Blankfein To Speculate

// April 27th, 2010 // No Comments » // Keith

“Bernanke is, in fact, begging us to speculate.”
-Jeremy Grantham

Jeremy Grantham is one of the most important thought leaders in modern day finance. After seeing the forest beyond the trees in the early 1970’s when he started one of the first index funds, he has successfully realized the art of managing money – having money to manage. With $107 Billion in assets under management from his perch in Boston, the investment world is a better place with his hedgeye for risk management in it.

Grantham’s Quarterly Letter for April 2010 was titled “Playing With Fire” and, as usual, it didn’t disappoint. There is actually an addendum to his letter titled “Friends and Romans, I Come To Tease Graham and Dodd, not to praise them” that is one of the better contrarian (and quantified) analyses of some of the Perceived Wisdoms associated with value investing that I have read. I highly recommend studying his conclusions.

Studying what we know is easy. In fact, it gets easier and easier to understand what we know if we choose to wake up every morning focusing on those certainties. Unfortunately, those who use VAR models (Value at Risk) have recently learned the hard way that managing risk in an ever increasingly interconnected world doesn’t start with certainty. Real-time risk management starts with accepting uncertainty.

Now, Grantham doesn’t spend as much time on interconnectedness as I do, but he certainly took some time in his letter to address the realities of the societal risk associated with a government sponsored Piggy Banker Spread (marking the short end of American savings rates to model so that the banks can borrow there and beg you to speculate on stocks/bonds). Without going through his entire note, here were some of his best quotes:

1. “The Fed’s promises look good and, as long as you’re not a small business, you can borrow to invest or speculate at no cost.”

2. “Collectively, we forego hundreds of billions of potential interest, but at least we can feel noble because we are helping to restore the financial health of the banks and bankers, who under these conditions could not fail to make a fortune even if brain dead.”

3. “The urge to weasel and own a little more emerging is a direct result of the lack of clearly cheap investment alternatives.”

Over the short 12 years I have spent in this business, I have come to realize that the only people worth respecting are those who have the mental malleability to change. Markets and the risks embedded in them are constantly changing and we, as a profession, have a special duty to change with them. Grantham does a great job of calling it like it is, and shunning the Glaring Groupthink that ultimately gets investors run over.

Today, Lloyd Blankfein is going to get run-over by the populist madness of crowds. He’s already released his proactively predictable defense. He’s once again proclaimed his mystery of faith that he is smarter than you and Goldman “managed our risk as shareholders and regulators would expect.”

That’s actually a very appropriate summary of what Goldman did. They did exactly what the likes of Grantham and I would expect. They bought the 2006-2007 leverage top, saw in-house funds like “Goldman Alpha” get annihilated by “6 standard deviation events”, then asked their friends to bail them out as they “hedged” the final stage of the selloff, ultimately perpetuating a bottom.

Having their ex-CEO (who signed off on using VAR (Value at Risk) as a risk management tool as they levered themselves up the wazoo in 2004 and beyond) twilight as the US Treasury Secretary is risk management in and of itself. Gotta have the inside man if you want to get anything done in Washington folks. No wonder why Hank Paulson puked as the entire narrative fallacy what these guys call “risk management” blew up in their face.

We have a lot of friends at Goldman. Our call on the stock isn’t personal. It is what it is – right. We took plenty of heat for saying the stock would go to $151/share, but it went there and that’s all I have to say about that.

The point here is to hold certain actors of the new era of Goldman leadership accountable. Blankfein was a corporate tax lawyer and then a precious metals salesman, not God. He’s made his way to the top the good old fashioned American way. Now he’s looking over the precipice of history’s lessons. Real leaders take the fall.

There are $63B reasons (his derivatives book) and a huge ownership stake that will give the likes of Warren Buffett the opinion that Blankfein should be saved. Or are there? Maybe the stock is telling us something folks. At 7x earnings, value investors must be calling it “cheap”, but that doesn’t mean the Blankfein leadership discount won’t remain. The cheap gets cheaper – until it doesn’t.

In front of his shareholders, employees and Americans alike, Mr. Blankfein will be interviewing for his job today. We’ll see if he can detach his emotion and ego from the kind of risk management “shareholders and regulators” should “expect.”

On a breakdown and close through $151/share, our immediate term TRADE line of support for GS is now $142.29. The intermediate term TREND line of resistance that we signaled on Friday April 16th ($165.59/share) remains broken.

Mr. Blankfein, “value” investors around the world, are “begging you to speculate” that you are indeed smarter than the collective wisdom of the crowd. However populist these winds blow for or against your case today, Godspeed.

My immediate term lines of support and resistance for the SP500 are now 1207 and 1221, respectively.

Best of luck out there today,
KM

EARLY LOOK: The Forgotten Truth

// April 26th, 2010 // No Comments » // Keith

“It is a simple but sometimes forgotten truth that the greatest enemy to present joy and high hopes is the cultivation of retrospective bitterness.”
-Robert Menzies

Retrospective bitterness might be the last way to describe how Australians have regarded their former leader. Born in 1894, Sir Robert Menzies founded the Liberal Party of Australia and, after winning his second election in 1949, he went on to become the longest serving Prime Minister in Australian history.

In 1942, Menzies delivered one of the most important speeches of his career. It was called “The Forgotten People.” Current Australian Prime Minister, Kevin Rudd, often referenced this generation of Australians ahead of the 2007 federal election. Here’s an excerpt from that historical Menzies speech:

“I do not believe that the real life of this nation is to be found either in great luxury hotels and the petty gossip of so-called fashionable suburbs, or in the officialdom of the organized masses. It is to be found in the homes of people who are nameless and unadvertised, and who, whatever their individual religious conviction or dogma, see in their children their greatest contribution to the immortality of their race.”

Nameless and unadvertised, officialdom in America today is not. If we didn’t reach the record heights of political hubris in 2007, we are going to blow up this Bubble in US Politics as big as we can here in 2010. Unfortunately, Crocodile Dundee himself may not have a knife large enough to pop it, until it’s too late.

Today, we are going to grope around for answers as to whether or not this stock market rally is sustainable and whether failed politicians continue to perpetuate our long term issues. Our problems don’t start with asking ourselves whether American capitalism is dead, but where our principles went in trying to define it.

Australian central bank Chief, Glenn Stevens, isn’t going to win a popularity contest at the G-whatever meetings. Nor does he care. He is a realist and a risk manager who reminds the people of Australia that “present joy and high hopes” for their country shouldn’t be solely measured by the ticks of their stock market. To have sustainable prosperity, everything starts with The Forgotten Truth that inflation crushes the forgotten people.

Between new home sales exploding to the upside for the month of March (+23.8% year-over year growth) and US Producer Prices (PPI) for March coming in at new sequential high of +6% year-over-year, last week’s growth and inflation data in the US was a lot higher than the “double-dip” crowd has been forecasting. When money is free, it’s amazing how much higher demand for things you can buy with those moneys can go.

Although this was March data, the real-time price data for April continues to inflate as well. Never mind that the SP500 has inflated +80% from its March 9th, 2009 low. This stock market is still -22.2% cheaper than the most levered up price (based on the most levered up domestic consumption and housing numbers), in US history. What a deflation deal!

There isn’t an inflation chart in my entire global macro playbook that hasn’t V-bottomed at this point, so I guess if you are going to be bullish and dovish all at the same time up here, you better be taking the government’s word for it because the forgotten people of America don’t buy it. Despite the SP500 being up a monstrous +15.1% since February the 8th, last week’s ABC/Washington Post consumer confidence reading registered a new low at minus 50. Oh damn that Forgotten Truth.

For those of you who believe that some levels of inflation are marked-to-market in the commodities that you either pump into your cars or children’s mouths, you saw the leading indicator for anything that needs to be moved around in this world shoot up another +3.2% week-over-week to close Friday’s trading to $85.12/barrel. At the same time, Gold is starting to bust an inflationary move to the upside again, adding another +1.5% week-over-week as well.

All the while, US Treasury bond yields continued higher last week with the short end of the curve moving up to 1.07% on 2-year yields. As much as Ben Bernanke wants you to believe that he’ll never raise interest rates, Mr. Macro Market is seemingly trying his best to move rates higher on his own.

There is only 1 week left in April and we are on the record with a call for April Flowers bringing May Showers to the US stock market. While that might irritate the odd perma-bull who still truly believes in buy and hope (that the Fed never stops purging its citizenry’s savings for the sake of the selected ones), I’m ok with that. My topside intermediate term overbought target for the SP500 is 1214, so I will be shorting the SP500 (if it’s up) sometime in the coming days.

That doesn’t mean I don’t love America. It just means I love my family, my firm, and the capital I have preserved for them. I am proud to be part of “The Forgotten People” who never had to fire anyone, point fingers, or ask for a bailout. We were the bears turned bulls of 2008-2009 who won’t chase the SP500 up here. We are now more comfortable being long Germany, Oil, and Aussi dollars.

The last time the bearish side of the US Institutional Investor sentiment survey was this low (17%) was 1987. I guess that means The Forgotten Truth is only another one of those days that “no one could see coming” away – except from New Haven and Australia.

My immediate term support and resistance lines for the SP500 are now 1205 and 1220, respectively.

Best of luck out there today,
KM

EARLY LOOK: Come On Into The Water

// April 23rd, 2010 // No Comments » // Keith

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. ”
-John Maynard Keynes

You’d think with all the Keynesian government people running the world today that they might from time to time consider some of Keynes thoughts about inflation. What you’d think a politician should do and what they actually do are often two different things. It’s sad; it’s unfortunate; and it’s all part of the Bubble in Politics.

If you combine a Big Bailout Keynesian spender with local inflation of the borrowing cost of money, you get a politician who has a serious problem. After all, politics are local. Finally, that’s what the Prime Minister of Greece is admitting in front of YouTube cameras worldwide this morning. He is tapping the EU and IMF for immediate help. In the Kubler-Ross Model of Five Stages of Grief, they call this the “Acceptance” stage.

My friend Todd Harrison, who runs Minyanville, has been using The Five Stages of Grief as a metaphor for the storytelling your local politicians and investment bankers alike gave you in May of 2008. It’s two years later and it’s almost May again. Like the Bear Stearns credit default swaps that were blowing out to the upside back then, politicians and levered long only managers alike want you to believe that Greece is just a “one-off event.”

This morning, Greece’s PM George Papandreou will remind the world of a long standing saying that we Hedgeyes have here in New Haven, CT: markets don’t lie; politicians do. Yesterday we saw credit default swaps in Greece rocket higher by 158 basis points to 644, and this morning you are seeing yields on 10-year Greek bonds spike to over 9%, which is a massive spread of 575 basis points relative to German bunds of the same duration.

No matter what European and Western politicians tell you about short term resolve, we want to remind you that these are the very early innings of a long and protracted sovereign debt default cycle. Borrowing an old Goldman 2007 saying, “it’s going to be global this time”, indeed.

In the face of attempting to fund long term debt obligations with marked-to-model short term government paper, we are also seeing global spikes in inflation. Yes, I realize that every portfolio manager in America who bought the 2007 top, crashed, then sold the 2009 low, wants to tell you that your 401k is still 30-40% underwater because we are going to “double dip.” I guess all I have to say about that is swim in these incompetent Street macro forecasting waters at your own risk. As Quint said in Jaws, “The cage goes into the water… you go into the water… the shark is in the water…”

My favorite central banker in the world sees these waters for what they are – dangerous. This morning, this is what Glenn Stevens at the Reserve Bank of Australia had to say about monetary policy: “Our task is now to manage a new economic upswing… this will be just as challenging, in its own way, as managing the downturn.”

Interestingly, this global macro man made this comment at the University of Southern Queensland, in Toowoomba, Australia. Maybe that’s how far away you need to be from the Greenspan Groupthink ideologies of Washington, DC to have read South Korea’s announcement for a +25% price hike for hot rolled coil (steel prices) by May 3rd for what it is – inflationary.

South Korea’s Posco is Asia’s 3rd largest steelmaker and they, like most manufacturers, must mark its prices to market so that they can earn a spread. In the good ole USA, Ben Bernanke has a different ideology on that. He price fixes the rate of return on my savings account at ZERO percent and makes that the marked-to-model borrowing cost of his cronies in the US banking system. Nice!

Bernanke continues to miss the inflation that he missed in 2008 that absolutely crushed the US Consumer. He is a good natured historian, so we can’t get upset about this anymore. When it comes to being a proactive risk manager of global interconnectedness, he is simply incompetent.

It’s actually quite amusing to watch some of the sell-side analysts who work for the banks that get paid the Piggy Banker Spread tag along with Bernanke’s compromised and conflicted message that he sees no inflation.

Yesterday’s Producer Price Index (PPI) report gives us one more chance to reiterate one of our three Q2 Macro themes – Inflation’s V-Bottom. In an intraday note to our macro subscribers yesterday, this is what Howard Penney wrote about the report:

“Stagnating consumer confidence figures suggest that most consumers don’t trust the direction the country is going in. We are in agreement with that sentiment and think that most politicians lie and Washington’s free money man, Ben Bernanke, can’t see inflation. Or, at least, he doesn’t want to — until he has to.

The PPI rose 6% year-over-year in March and was up 0.7% sequentially – more that the 0.5% consensus estimate on Bloomberg. The PPI report recorded its largest annual gain since September 2008 and was up on the back of a 2.4% rise in food prices, its sixth straight monthly increase. The increase can be attributed to a 49.3% increase in prices for fresh and dry vegetables (meats and eggs also contributed to the increase in prices for finished consumer foods.)”

Now, we understand that Captain Sell-Sider doesn’t get paid as fat a margin on that Piggy Banker Spread if Ben Bernanke raise interest rates. That’s the joke about this entire inflation story. The stock market inflates every other day and “by a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. ”

If you are waking up in America this morning, and standing in the food stamp line like 11% of your countrymen, just look on the bright side. At least this isn’t Greece, yet… “come on into the water” and buy yourself some government paper.

My immediate term lines of support and resistance for the SP500 are now 1203 and 1214, respectively.

Best of luck out there today.
KM

EARLY LOOK: Ocean Day

// April 22nd, 2010 // No Comments » // Keith

“How appropriate to call this planet Earth, when clearly it is Ocean.”
-Arthur C. Clarke

Today is Earth Day. For those that didn’t know, Earth Day was founded 40 years ago by Senator Gaylord Nelson as a day to inspire awareness and appreciation for the environment. That’s pretty simple, and, to use an overused phrase, it is what it is.

Personally, I’ve never really studied environmental issues, so I’m willing to admit what I don’t know. Maybe Al Gore is a story teller. Maybe he is not. One thing I am willing to accept, though, is that respecting the environment is ultimately a good thing. To that end, I drive a hybrid. Yes, this right leaning, hockey playing, Alberta born, thirty something bachelor drives a hybrid. There it is.

Just as in Arthur Clarke’s quote above, sometimes we just have to call things at face value. Ultimately, I think that is the issue that Goldman Sachs is facing. I don’t need to scrutinize the SEC’s case against them to know that they probably did something wrong, nor do I need to hear their high priced New York lawyered excuses to know that they can probably justify what they did.

Warren Buffett famously said that it takes a life time to create a reputation and 10 minutes to destroy it. Time will tell whether this is the 10 minutes of reputation destruction for Goldman. My guess is it probably isn’t. There are too many fine people that work at Goldman, some of whom we are honored to call friends, for the firm not to endure.

In the short term though, as we’ve outlined in the chart of Goldman Sachs below, there is an impact on the company’s valuation, and currently there is limited support for Goldman Sachs’ stock. More critically, the Political War on Wall Street will accelerate with an enduring impact on Goldman and its peers. As point in fact, and highlighted by NPR’s Planet Money blog, a “Google search” of Goldman Sachs SEC provides an advertisement for www.barackobama.com and “financial reform that protects main street”. We’ve posted a picture of this below.

It is unlikely that Goldman Sachs will come out and admit wrongdoing in this instance, but being forthright and transparent may well be their most effective tool for taking the political momentum out of the sails of those who will now be focused on reforming Wall Street. Imagine if Lloyd Blankfein stood up in front of Congress and said: “We failed our clients in this instance. And we will work to repair that trust.” His stock would probably be on its way back towards $200 per share.

Financial reform is a topic that will impact your investments over the coming month, so we want to highlight a few key dates as it relates to financial reform, which starts today:

1) Today (4/22/10) – Senate likely to begin debate on Senator Dodd’s (D-CT) Financial Reform bill.
2) Today (4/22/10) – UK general election debate between PM Brown and Conservative Candidate Cameron will likely focus heavily on the GS/Financial Reform issue. US politicians may watch closely to gauge voters response to different posturing around this issues.
3) Today (4/22/10) – President Obama will visit Manhattan to deliver a speech on the importance of Financial Reform at Cooper Union; an interesting choice of location, for it was there that President Abraham Lincoln galvanized New Yorkers for the first time in his quest to become President with one of his most famous speeches decrying slavery.
4) Thursday (5/6/10) – UK general election for Prime Minister.
5) Memorial Day (5/31/10) – This is the Date President Obama has given to Congress to have a Financial Reform bill on his desk. After Memorial Day, Congress will go into full swing campaign mode, and passing any meaningful legislation will become difficult.
In completely non-sequitur fashion, I’m going to give one of our analysts, Howard Penney, a tire pump this morning. He nailed his long call on Starbucks. Since he recommended the stock, the unrealized return in our virtual portfolio is up ~120%. Last night, Starbucks reported same store sales that were +7%, which is the highest level in 4-years.

Like most large multinational companies, Starbucks also provides Macro analysts with some interesting nuggets. As it relates to consumer spending, Starbucks’ comps were driven by a 5% increase in ticket prices (the amount spent per purchase). In the year ago quarter, ticket prices declined by 3%. The simple point as it relates to the consumer spending is that based on this Starbuck Proxy, consumers are willing to spend more and accept marginally higher prices. Clearly, there are some inflation implications here.

If you don’t have access to our stock picks or Howard’s fine research, email us at sales@hedgeye.com . While our research isn’t free, we’ll let you trial it for a few weeks and are confident you will be impressed.

We would be remiss this morning if we didn’t also mention Fitch’s warning on Japan’s credit worthiness. While ratings agencies are typically lagging indicators, the reality is that Japan is a lesson for those nations that continue to Pile Debt Upon Debt. While Japan is not at imminent risk of a default, the unintended consequence of its massive government balance sheet was long term deflation, and hence its equity market has done nothing for more than 20-years. That’s not good.

Enjoy Ocean Day!

Keep it real,

Daryl G. Jones
Managing Director

EARLY LOOK: Next Gen Mathematics

// April 21st, 2010 // No Comments » // Keith

“Do not worry about your difficulties in Mathematics. I can assure you mine are still greater”
-Albert Einstein

The good news about the difficulties associated with applying chaos theory to financial markets is that it’s getting less difficult as access to information expands. That said, everything is relative. These are still very early days in terms of how governments, institutions, and individuals apply Next Gen Mathematics to managing risk in a globally interconnected marketplace.

One of the main roadblocks to successfully applying chaos theory to asset allocation models and cross-country analysis is that many fixed income and derivatives markets do not trade transparently. That is, unlike most natural systems where chaos theory is applied (like the weather), only a select group of buyers and sellers of derivative securities know whether it is sunny out or raining.

I have heard many people argue over the course of the last 72 hours that allowing derivatives to trade over-the-counter is going to “hurt liquidity.” In the short run, for the narrow marketplace of players interacting, that may very well be the case. In the long run, arguing against an expansion of markets and the subsequent reduction in costs to transact in those markets is basically arguing against transparency. In principle, and in science, I don’t buy it.

Having lost the odd toe attempting to trade everything from currencies in swap to making short sales in illiquid Chinese shell companies, I can at least tell you that one of the main reasons why a buy-sider might argue for not regulating markets is that you can make yourself a ton of money by picking off the monkeys out there who not only don’t know what they don’t know, but they can’t see someone who is supported by a multi-billion dollar cost structure.

I have worked with some hedge fund portfolio managers who are not mathematically oriented, but by trading markets have a form of chaos theory embedded in their practitioner’s experience. They learned by doing. This is good, for them. But not for our economic system. If an asset manager finds an edge, the last thing she is going to do with that is share it with a world of wannabes looking to evolve.

Let’s consider this as a practical matter and look at how different people I have worked with consider “earnings season”:

1. You start with a market narrative that “earnings season is going to be great”

2. Stocks start to discount this positive expectation (SP500 up 78.6% since last year’s low)

3. Earnings season hits, and there is price action that follows the “news”

So, a really good risk manager will consider the driving part of the Street’s story line (“earnings are going to be great”) and score that, quantitatively, relative to the price action born out of the “news.” I have seen some managers build a base of “hot” inventory that measures price moves on a 1-3 day basis into/out of news. I have seen others overlay that with volume and volatility studies. I have seen some people ignore all of the aggregated data and only focus on the stock they own.

The upshot of how all of these different personalities measure different kinds of data is the definition of chaos theory – “studying the behavior of dynamical systems that are highly sensitive to initial conditions” (Wikipedia). As opposed to waking up thinking you know exactly what is going to happen, you should wake up accepting that everything is grounded in uncertainty.

Back to the real-time example…

1. The SP500 has rallied +15% since the initial February Freakout about Greece.

2. The Street’s narrative is “earnings season is going to be great”

3. Coke and IBM report earnings before yesterday’s open, and both stocks close down almost -2% on the day

So now what? What if you only follow AAPL and you are right convinced that the company is going to be the largest on the planet and that yours is a differentiated thesis that you should be paid 5 and 50 for? What if you didn’t see GS have a huge intraday reversal to the downside on big volume after a monster earnings report? What if you did see all of this and you are waking up to the following price reactions to earnings reports from last night?
A) Trading up on earnings: TPX +10%, AAPL +5%, ALTR +5%, TUP +4%, STX +3%, TCK +3%, TSS +3%

B) Trading down on earnings: VITC -31%, TSFG -29%, CSIQ -9%, SNV -8.%, JNPR -8%, CREE -6%, NUVA -6%, YHOO -4%, GILD -3%, PLXS -3%.
Now everything, of course, should be scored relative to the last trading price. No, that’s not the calculus the US Government uses when inflating your property taxes relative to marked-to-market trading prices of homes. It’s certainly not the ideology that Tricky Dick Fuld upheld as the written gospel of marked-to-model at Lehman Brothers. It’s just real-time math, and you need the Next Gen of Mathematics to solve for what to do.

How you interpret these real-time prices in your mathematical models relative to the one-factor we have briefly addressed (earnings season) is up to you. To me, chasing a market that has responded this poorly to earnings news because AAPL was “great” is plain reckless.

When we overlay the degradation in the earnings narrative with global risk factors like sovereign debt (Greece 10-year bond yields blasting to all time highs this morning) or the rise of short term US Treasury yields to 1.02%, this really starts to get interesting.

Don’t worry about the difficulties associated with evolving. There is much work to be done out there on the proverbial ice of market transparency, and I can assure you that my team’s issues are still greater. We know what we don’t know.

My immediate term support and resistance levels for the SP500 are now 1199 and 1214, respectively.

Best of luck out there today,
KM

EARLY LOOK: Pasteurized Ignorance

// April 20th, 2010 // No Comments » // Keith

“No matter how busy you may think you are, you must find time for reading, or surrender yourself to self-chosen ignorance.”
-Confucius

According to the Pew Research Center’s latest study on “Teens and Mobile Phones”, more than half of teens in America send 50 or more text messages a day (33% send more than 100 messages a day) and almost 75% of 12-17 year olds in America have cell phones. If you didn’t know we live in a crack-berry culture of sound-bites, now you know.

While Americans are definitely finding time to read, the question remains one of focus. What are you reading? When are you reading it? How do neurological factors in your brain affect the emotional side of decision making based on what you just read?

Adults in the investment business do their fair share of headline reading as well. Unfortunately, the pressures that have been institutionalized by short term performance measurements have rendered the historical context behind what we think we are reading into a collective warm boil of Pasteurized Ignorance.

On this day in 1862, French chemist Louis Pasteur created the first successful pasteurization test. Per our friends at Wikipedia, “pasteurization aims to reduce the number of viable pathogens so they are unlikely to cause disease… the process was originally conceived as a way of preventing wine and beer from souring.” This sounds like something that the world’s $80 Trillion derivatives market might need.

Since 2000, when Congress released the derivatives/leverage hounds, financiers have been getting plenty punch drunk on the profits that came along with the ignorance associated with Opacity’s Child (derivatives). All the while, American tax payers have been battle scarred from a decade of booms, busts, and dry heaves.

When I think about Goldman, Lehman, or Bear selling the Street this stuff, I just think of it for what it is. Heck, I’m a “sophisticated investor”, and I should know that derivatives don’t trade over the counter. They do not uphold the principles of transparency that a “free” marketer is sauced up on. And, given that everything else in our society is being posted to Twitter, there is no reason to believe that the rules of a conflicted and compromised derivatives market won’t be changing.

That’s it. That’s my take on Goldman Sachs. I really could care less about incompetent analysts at the SEC voting 3-2 on this being fraud. I really don’t care about Goldman’s EPS report this morning either (they crushed the number, reporting $5.59/share in EPS vs. $4.14 expected… and yes, they made a lot of money in fixed income and derivatives trading). I currently have no position in GS. I’ll short it when I am not being asked to 100x an hour. I’ll short it when it’s up and I see my price.

All I really care about is the history of the derivatives market in America and whether or not this mega-phone sound-bite provides the political capital for re-regulation of Pasteurization’s Ignorance. There is a long history of required reading here. A lot of it started with ex-Goldman Co-Chairman, Robert Rubin, being the Treasury Secretary. In the end, numbing it down to a French dude named Fab’s trade isn’t going to be the real public debate.

So onto the next…

Pasteurizing the Washington/Wall Street concept of risk management is the more important task for today. In less than 48 crack-berry hours, the Manic Media has completely forgot about sovereign debt, inflation and, well, pretty near everything! Because people ignored the microbial growth in their drink prior to 1862, certainly didn’t mean that the worms ceased to exist.

Here’s the grind on what our Hedgeyes are seeing globally this morning:

1. Despite a recovery day in the USA, Japanese and Chinese stocks didn’t rally last night and are now both broken from an immediate term TRADE perspective

2. India sees the ‘V’ in Inflation that we talked about on our Q2 Themes call. India went ahead and raised rates for the 2nd time in a month last night.

3. Thailand has been getting tagged, dropping 10% in a straight line since April 7th on domestic unrest, and finally had a big up move last night, closing +4.6%.

4. German ZEW (confidence) hit a 6 month high this morning and German stocks continue to outperform the likes of Spain which is trading down again this morning.

5. UK inflation zoomed higher to +3.4% y/y growth in their CPI report for March. Yes, at Hedgeye we call this Inflation’s V and its born out of countries with fiat currency.

6. Greek bond yields are shooting to record wide spreads versus German Bunds (472 bps wide for 10yr paper) after the Germans reminded us they don’t trust the Greeks.

7. Brazil’s stock market broke its immediate term TRADE line of support on the Bovespa yesterday (that line = 70,006).

8. Gold is starting to flag bullish again (bullish TRADE line of support = $1124/oz) in the face of sovereign debt and inflation risks mounting, globally.

9. The IMF is proposing a new “bank tax” at the G-20 meetings that started last night.

While we can certainly suck Pasteurized Ignorance from the vacuum of headlines about Goldman that are on the tape this morning, that’s not going to do us a whole heck of a lot of good where it matters. Goldman being regulated will matter, but that’s not just something that’s going to affect Goldman.

While he testifies on Capitol Hill today, Tricky Dick Fuld will remind all Americans that we cannot run this country like a Lehman trader would his P&L. Thankfully, those days and ideologies will soon be gone. Or at least I hope they are. Hope, alas, is not an investment process but all that I have left that the 75% of this country’s 12-17 year olds who text one another are going to find a better way.

My immediate term support and resistance lines in the SP500 are now 1177 and 1214, respectively.

Best of luck out there today,
KM

EARLY LOOK: Opacity’s Child

// April 19th, 2010 // No Comments » // Keith

“Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”
-Alan Greenspan

Some of the financial ideologies born out of the Clinton Administration’s second term are something for sore eyes this morning. With ex-Goldman CEO and czar of all things Greek Philosophy, Robert Rubin, at the helm of the US Treasury, there was no stopping Alan Greenspan and Larry Summers from de-regulating us into oblivion.

Now some may argue that is too aggressive a stance to take on America’s Wizards of Oz (after all, they are “professionals”), but one of those people isn’t President Bill Clinton. Clinton made 3 explicit comments about his Treasury Secretaries (Rubin and Summers) on ABC’s “This Week” program yesterday:

1. “I think they were wrong and I think I was wrong to take their advice.”

2. “Their argument was that derivatives were expensive and sophisticated and only a handful of people will buy them and they don’t need any extra protection.”

3. “Sometimes people with a lot of money make stupid decisions and make it without transparency.”

Now whether you are political or not doesn’t matter this morning. This Tiger Woods like PR nightmare for Goldman Sachs is political in principle and global in reach. In the UK, Gordon Brown is staring down an election on May the 6th, so don’t think his rushing out to the cameras to call this a “moral bankruptcy” was ironic in its timing.

Don’t think for one second that the Clintons don’t have a plan here if President Obama fumbles on the opportunity either. Hillary’s husband admitting he was wrong in the face of Blankfein reminding the world that he thinks he is smarter than you, opens the fences for one of the biggest political softball pitches in US history.

History is what matters this morning, not the semantics of a Goldman VP and the volcanic ash that has become him. On December, the 15th of 2000 Congress took Robert Rubin and Larry Summers word for it and declared law that derivatives and swaps were free and clear from regulation and/or oversight by the CFTC (Commodities Futures Trading Commission). Then in 2004, Hank Paulson and Dick Fuld lobbied hard to have the SEC removed their leverage ratios (great for a derivatives business, if you have one).

Taking a step back, most people in America are becoming familiar with the name Brooksley Born. She was the chair of the CFTC who tried to regulate the swaps market early in Clinton’s second term. This was after Orange County’s derivatives bet blew up (1994) and before Long Term Capital Management imploded (1998).

I know, how dare she try to regulate the Goldman boys (she was elected President of the Stanford Law Review in 1963) when, according to my favorite financial historian Roger Lowenstein, “most of the women in law firms were still pouring coffee.”

Brooksley Born resigned in 1999 and the rest, as they say, is history. In Lowenstein’s latest book, “The End of Wall Street” you can get up to speed on the history of derivatives de-regulation in literally 7 pages (pages 57-63). On page 62, Roger quotes Greenspan when he was asked about the topic of derivatives regulation again in 2002: “Regulation is not only unnecessary in these derivative markets, it is potentially damaging.”

What’s really going to be damaging here is the deepening global perception of American financial markets being opaque. When the President of the United States pipes his message of ‘Transparency, Accountability, and Trust’ into CNN, some people out there actually take his word for it.

I think this Goldman case is going to be much larger in scope than those who “bought GS on the dip” on the technical merits of the SEC fraud case on Friday think. This is going to be a global debate about transparency versus opacity. Goldman will be opacity’s poster child.

The risk manager in me obviously asks about the downside before I start accepting the narrative fallacy of perpetual upside; particularly after Thursday’s closing YTD high of 1211 in the SP500 (which was +79.1% higher than where most of people were right freaked out by the fears that the likes of another Goldman beauty, Hank “The Market Tank” Paulson, helped perpetuate).

Not unlike Hank Paulson’s grossly miscalculated risk that Lehman filing for bankruptcy was going to equate in a “cleanup day” (Lowenstein’s “The End of Wall Street”, page 198), the idea that re-regulation of the entire swaps and derivatives market is going to equate to a 1-day selloff in stocks from their nosebleed highs is reckless in its historical assumptions.

We shorted the SP500 on Thursday April 16th, then issued a slide presentation on Friday outlining why our Hedgeyes see the risk outrunning the reward at SP500 1214 as we head into May. No, we didn’t know that the SEC was going to make this move. No, we didn’t purport to not know how opaque our financial system was prior to the announcement either. Managing risk doesn’t happen in the vacuum of Opacity’s Child. If you are going to play this game, just know who you are playing against.

My immediate term support and resistance levels for the SP500 are now 1175 and 1214, respectively.

Best of luck out there today,
KM

EARLY LOOK: High vs. Low Society

// April 15th, 2010 // No Comments » // Keith

“We took a perfectly useless psychopath like Valentine, and turned him into a successful executive. And during the same time, we turned an honest, hard-working man into a violently, deranged, would-be killer! Now, what are we going to do about taking Winthorpe back and returning Valentine to the ghetto?”
-Randolph Duke from the movie Trading Places

When thinking about some of the topics that have been discussed in our morning meeting recently, the topic of a HIGH vs. LOW society has come up several times. I joked that it’s like working at Hedgeye Risk Management where you have the Ivy League educated vs. everyone else. All kidding aside, as a firm, we have some of the most talented young people working at Hedgeye, thanks to our ties with Yale University.

That being said, the first thing I think of when talking about the HIGH vs. LOW society is the highly entertaining movie Trading Places. (Sadly, our talented young group from Yale is too young to remember the movie.) The storyline is that of a HIGH vs. LOW society and the movie has been called a modern take on Mark Twain’s classic 19th century novel The Prince and the Pauper.

Fast forward to yesterday’s press briefing by White House Press Secretary Robert Gibbs and Treasury Secretary Tim Geithner; Mr. Gibbs commented that the market is going up because of Obama’s Administrative policies. Mr. Gibbs is correct to a degree, and Mr. Obama gets full credit for the market’s performance under his term as president. In fact, the President even gets credit for calling the bottom in the market when on March 3rd he offered some advice on the market saying stocks are “potentially a good deal for those willing to think long term.” Great call!

Obama’s policies have created a V-shaped recovery and a 78% return in the market since he nearly called the bottom perfectly. In many respects, his policies have created this HIGH vs. LOW society which might be very difficult to get out from under.

Yesterday, the S&P 500 rallied 1.1% (now up 8.6% YTD) on the back of the earnings calendar, with better-than-expected results out of the Financials (XLF – up 18.4% YTD) and Technology (XLK – up 4.4% YTD). The Financials led the way yesterday, thanks to JP Morgan, and is the most striking example of the HIGH vs. LOW society.

FOOD STAMPS VS PIGGY BANKERS SPREAD – The most recent statistics from the NY Times are that one in eight Americans rely on food stamps; one in four children in the United States rely on food stamps; and one in 50 Americans live on nothing but food stamps. Contrast those disturbing facts against JPM’s reported earnings, which is a company that is printing money because of the Piggy Banker Spread.

To quote the CEO of JPM – “China’s growing, India’s growing, Japan is growing, home prices have stopped going down, consumers income is up, consumers are spending, service and manufacturing indexes are up, inventories are still low, I could go on and on.” Yet, according to the FED, we still have the need for interest rates to stay at exceptionally low levels.

President Obama’s campaign promised “Change” and to help the middle class. Unfortunately, his policies that have helped drive the V shape recovery in the S&P 500 are only making the rich feel richer.

RICH vs. POOR – Back in early 2009, the spread in confidence levels, as measured by the Conference Board, between those people making more than $50,000 per year and those making less than $15,000 was 2 points. As of the most recent reading the spread stands at 17 points.

YOUNG vs. OLD – The Millennials were often cited as a strong political force that helped the Obama administration get elected. It’s also the Millennials that are being hurt the most by the current recession. Unemployment levels among the youngest demographic of our society stand at 25% versus 9.7% for the national average.

BULLISH BEARISH SURVEY vs. CONSUMER CONFIDENCE – The most recent Institutional Investor survey shows one of the widest spreads between “bulls” and “bears” since 2007. This, contrasted against the most recent ABC consumer confidence index, which fell to -47 in the week ending April 11, down 4 points from a week earlier, highlights the Wall Street vs. Main Street disconnect. As an aside, today it was reported that the UK Nationwide consumer confidence fell to 72 in March vs. 81 in February. We are not alone!

We have a chart book of MACRO data points that has only one relevant shape to describe the current economic recovery and that is a V and the signs of “over stimulation” continue. China’s economic growth accelerated to the fastest pace in almost three years in 1Q10 – GDP rose 11.9%. The market reaction to the news was muted as the case for continued policy tightening is clear.

We are short the S&P 500 and “fighting the Fed” which makes us wrong, for now. Right now, it’s more prudent to manage risk around the excessive stimulus measures that are unsustainable and inflationary.

As for Billy Ray Valentine and Louis Winthorpe III – they’re not just getting rich… They’re getting even!

Function in disaster; finish in style

Howard Penney
Managing Director

EARLY LOOK: Miles High

// April 14th, 2010 // No Comments » // Keith

“I’ve experienced the highest of highs and lowest of lows. I think to really appreciate anything you have to be at both ends of the spectrum.”
-John Elway

I was flying from Denver to Kansas City last night and had one of those nights where nothing went my way. This is the game and nothing teaches you how to play it better than the game itself.

Over the last few years plenty has gone right for my family and firm. For that, I am plenty grateful. No matter where I want to go this morning, the best place is to get right back to where I have always been – feet on the floor, starting from the lowest of lows.

Mile High Stadium stood in Denver, Colorado from 1948 until 2001. That’s where legendary quarterback, John Elway, played his entire career. It’s also where Denver Broncos fans sustained the world’s loudest roar for 10 seconds (October 1st of 2000 with a reading of 128.74 decibels). Interestingly, the hearts and minds of Broncos fans registered loudest after John Elway was gone. I’d say that’s because the image of the man and his teams never left.

Not many players in this game of life win at the highest level in what is their last game. John Elway did. After beating the Atlanta Falcons 34–19 in Super Bowl XXXIII, Elway was voted MVP in one of this world’s biggest games. That proved to be the last game of his career. He decided his fate. No one else. That’s something I can believe in.

This morning you are waking up to a US stock market that is Miles High relative to the lowest of lows in expectations. While this game tends to oscillate between both ends of the spectrum of greed and fear, the expectation of what is coming next is really what its all about.

To understand where to go in the market or in life, you truly need to understand where you’ve been. Otherwise you will have learned nothing and will not evolve. The SP500 closed up +0.07% last night at 1197. That’s what we call a higher-high. That’s also what we call bullish, until it isn’t.

This morning’s Institutional Investor survey (weekly) shows one of the widest spreads between “bulls” and “bears” since 2007. After the SP500 is miles higher than most would have expected, this is what we call a contra-indicator.

Before markets correct, institutional investors get either too bullish or not bearish enough. After markets rally, institutional investors fear missing the next leg up or getting squeezed. Most great players in this life don’t wake up living in fear. They wake up with a repeatable process that they can trust, and they carry on.

On a week-over-week basis, “bulls” in the Institutional Investor survey moved from 49% to 51%, while bears remained completely depressed at 18.9%. I measure the spread between bulls and bears across multiple durations, and anytime the spread in this data set exceeds 30 points, it’s significant contrarian indicator. This morning’s spread between bulls and bears, of course, is 32 points.

The only sad parts about being on the road is missing my wife and kids and having to endure watching CNBC. While I have the manic media channel on mute, the body language of it all can make any accountable American want to leave this stadium of conflicted one-way players for good. After cheering the market right off a cliff in 2007, then calling for a Great Depression at the bottom, right before a +77.1% rally – and getting bullish up here again, after the move… well, its just sad to watch.

This morning’s ABC/Washington Post consumer confidence reading confirms that our high-low society is indeed what Americans won’t cheer for no matter what CNBC pipes into their homes. This week’s confidence reading dropped from minus 43 to minus 47. This too, is just sad. This is the new America we have created.

The US stock market may very well be Miles High relative to the fear-mongering expectations of some who never saw the crash or the recovery coming, but it never forgets. I won’t either. Today is a new day, and everything starts from this price.

My immediate term support and resistance lines for the SP500 are now 1186 and 1204, respectively.

Best of luck out there today,
KM