Thursday, September 30, 2010

Morning Note...


Happy month- and quarter-end… Futures surge ~50bps higher this morning on the better-than-expected, positive Q2 GDP revision (+1.7% vs the 1.6% prior reading) and better-than-expected Initial Jobless Claims for the week ending September 25th:  453,000 versus the 460,000 expectation.  Note the prior week’s reading was revised higher, however, to 469,000 from 465,000.  Markets are also buoyed by stability in Europe, where Ireland disclosed the terms of its bailout of AIB (~EUR35 billion) in order to restore its banking sector.  Moody’s also downgraded Spanish debt and Germany’s unemployment fell less than expected (net positive) as Europe is up ~75bps on aggregate.  Asia mostly lower overnight.  Oil +2%, gold +35bps, and the USD -35bps.  In corporate news, AIG has reached an agreement to sell two divisions to PRU for $5 billion and will use the funds to repay the U.S. government TARP.  CITI downgrades food distributor SYY.  BofAMLCO positive on “BRIC nations and equities” as global reflation takes hold; cautious on JapanChicago PMI due at 10am.  Bernanke testifies before the Senate today, but it will be a non-event because his statements will be back-looking rather than forward. 

Given the news overseas today, it’s worth checking in on some recent thoughts from The Gartman Letter:

Out of Ireland this morning is the news that the Irish government has no choice but to come to the aid of Allied Irish Bank which has had enormous trouble raising the capital it needs to meet demands upon it for increased capital by the international banking authorities. The government in Ireland had previously taken a type of “preferred shares” in the bank, and now in light of the fact that the Bank cannot raise capital itself is forced to ask the government to convert those preferred shares into common shares. Somehow we cannot see this as supportive of the EUR, but then again we’ve known that this sort of thing was going to happen sooner or later and few seemed to care previously, taking the EUR higher nonetheless. Eventually, however, harsh realities have to have harsh effects… don’t they?

He also had this to say on Gold:

Further, each request for an interview begins by asking us, generally, “How much higher can gold go?” The question is also asked enthusiastically, with a sense of gold market fever. As we’d said here yesterday, historically this level of questioning by the media has always in the past marked an interim top in gold. This sort of thing happened back in December of last year; it happened again in the late summer and it is happening again. In December, gold broke $170/ounce and in the summer it broke $100/ounce. We can imagine, given this level of media interest, that gold prices could readily break $60-$80 from their recent highs and do absolutely nothing the efficacy of the long term bull market. Indeed, a break of that magnitude would do nothing other than return the market to a sense of technical health. At the moment, it is technically over-extended and rather markedly unhealthy as a result.

To this end, we have read reports suggesting that we have suddenly turned manifestly bearish of gold and that we are suggesting being short of gold. We are recommending nothing of the sort. We note that this remains a bull market and we suggest strongly that six months hence or a year hence gold shall be demonstrably higher in price than it is now. We note that this remains a bull market and that in bull markets one can have only one of three positions: Very long; modestly long or neutral. At this point we shall suggest something nearer to the latter two positions. This, unless our language is somehow misleading, is far from being bearish. We trust we are clear on this issue.

When asked what has driven gold prices higher we’ve turned to the thesis that at the margin the world’s central banks have gone from being net sellers of gold from their reserves to being net buyers. The operative words here are “at the margin” for that is indeed what has been happening. The Central Banks had been concerted sellers of gold for years; now they are modest net buyers. We note then that in the year ending September the banks that were signatories to the Central Bank Gold Agreement have sold only 6.2 tonnes of gold in total. In previous years they were selling that much each week! Now, after a bit of selling earlier in the fiscal year, their selling has stopped completely. As The FT recently noted

the[se] sales are the lowest since the agreement was signed in 1999 and well below the peak of 497 tonnes in 2004-05. The shift away from gold selling comes as European central banks reassess gold amid the financial crisis and Europe’s sovereign debt crisis. In the 1990s and 2000s, central banks swapped their non-yielding bullion for sovereign debt, which gives a steady annual return. But now, central banks and investors are seeking the security of gold.

Remember, this Agreement was signed back in ’99, and for the decade since the Banks have been steady, aggressive sellers… until this year.

AIB -25% on EUR5 billion capital raise.  AIG to sell two divisions to PRU for $4.8 billion and use the funds to repay the U.S. Government.  RBCM ups BBY.  DBAB cuts MO, RAI.  RBCM cuts AAP.  CVD and SNY sign 10-year R&D alliance.  DB CEO makes positive comments.  MTW to refinance senior secured credit.  NEED cuts N.  NOK N8 smartphones ship.  OMN lower on earnings.  Cramer positive LLNW.  OPLK to replace LNY in S&P600.  SNX beats by 12c.  TLAB cut at MOKE.  XRTX beats by 20c.  YRCW board approves labor agreement and reverse stock split. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  According to an NPR story yesterday, who is the largest employer of musicians in America?

Yesterday’s Question:  Name the only country to have a capital named after an American president.

Yesterday's Answer:  Liberia’s capital is named Monrovia, for U.S. President James Monroe.   

Best Quotes:  From BTIG’s Mike O’Rourke… These days, the theme on the minds of traders and investors is the return of the reflation trade that was so dominant throughout 2009 as the Fed executed its large scale quantitative easing program.  Since August 10th when the FOMC put the brakes on the exit strategy but then subsequently indicated it would reverse course and open the door for a second round of quantitative easing (QE2), signs of the reflation trade materialized.  We have been hesitant to look at the market from a reflation perspective because we anticipate that QE2 will look very different from QE1.  The key way we have described QE2 is that the Fed would use asset purchases and sales in the same manner as it has historically used the Fed Funds rate.  For example, if the economic data were to weaken notably, the Fed would pick up the pace of asset purchases.  Likewise, if the economic data were to ramp up (although nobody believes that is about to happen in the near future), the Fed would start making asset sales.  Due to the obvious soft patch in the economy over the past several months, the market is widely focused upon the potential for asset purchases.  Whether or not purchases are made is conditional upon the severity of developments within the economy.  The greater the weakness, the more assets will be purchased.  The more mild the weakness, the less the Fed will do.  It will be notably different than the process during QE1 where purchases were consistent over a set time period with few adjustments.

The market's expectations for QE2 are currently fairly large due to the weak expectations about prospects for the economy.  We are in a data dependent environment.  There are only signs of the reflation trade because only certain asset classes are responding.  Theoretically, assets like Equities, Gold and Crude should rise.  Bonds will have a bid near term, pushing yields lower as players try to get ahead of the Fed.  The Dollar should suffer as the monetary base is expanded in hopes of an expanding money supply.  Since the August 10th course reversal, Gold has rallied 8.5%, the 10 year yield has dropped 25 basis points and the Dollar index has lost 2.5%.  Those are all acting as one might expect in a reflationary environment.  Equities have gained 2.1%, they are up but not even enough to offset the losses of the Dollar.  Finally, the missing link is Crude.  Even after today's rally, Crude is down 3% since August 10th.  Additionally, the solid performance from Crude today was the result of a fundamental catalyst in the form of DOE inventory data, not reflation.  Even if we expect the reflation today, the process should be different than the approach of  consistent asset purchases over the span of just over a year.  We will describe what we suspect is going on.  We know others will have a different view so please take this as simply one opinion.  We are of the view that the comfortable reflation trades are being put on in a speculative manner. In this environment, it is easy to justify buying Gold and Treasuries and selling the Dollar, so that is where the speculative momentum is headed.  Those are positions that managers can sleep with and are likely getting a little crowded, at least until we see what QE2 really looks like.  Stepping into Equities and Crude does not feel as easy or comfortable, therefore, they are not getting the attention.  If reflation is the true catalyst behind the action, than Equities and Crude should participate as well.  The divergence illustrates that either the three that are working need to consolidate their recent moves or the other two should join the party.

Wednesday, September 29, 2010

Morning Note...

Apologies, PC issues this morning.  Have not had time to craft anything of intelligence, but here’s the early morning cut-and-paste from JPM:

Morning Levels:
·         SP500 futures flattish as of 6:45amET @ 1141  
·         Europe levels: DJ Euro Stoxx dwn 0.3%, FTSE dwn 0.2%, CAC dwn 0.2%, DAX dwn 0.2%, Spain dwn 1%.
·         Europe – Europe being led lower by financials (DB, SocGen, BNP, BBVA are all off few %).  Some materials stocks also sluggish (CRH, Arcelor).  On the upside, AXA, Daimler, Alstom, FT, Schneider, and Phillips, and Anheuser.  In London, Rolls-Royce is up ~4% and leading the FTSE; Wolseley, BP, Burberry, Carnival all act well; on the downside, Vedanta, HSBC, Astrazeneca, and RBS are all off. 
·         Asia: Japan +0.67%; China -0.03%; Hong Kong +1.22%; India -0.66%; Australia -0.53%
·         European sov CDS – Greece -19bp, Ireland, Spain, Portugal, and Italy are all few BP tighter. 
·         Treasuries – pretty flattish this morning; last auction of the week today @ 1pmET. 
·         FX – DXY off 0.3% (has been falling for last 4 sessions); DXY continues to hit multi-month lows; GBP up small (up 0.16%) after Tues’ 1% ramp; EUR up small today; yen continues to climb (off 0.3%)
·         Gold up $1.5 to $1,310.5, off lows
·         Copper up 0.35%, off highs
·         Crude +30c to $76.50, off lows

Today’s Top Stories
·         In Japan, the Nikkei rose thanks to a better than expected Tankan survey and further talk of stimulus measures (the BOJ meets next week). 
·         China's HSBC/Markit Manufacturing PMI comes in ahead of expectations (the official gov't PMI will hit Thurs night); tomorrow is the last day of trading for the Shanghai market before the country’s Golden Week holidays. 
·         Ireland/Anglo Irish – Irish gov’t capital injection to be less than feared says FT - The central bank’s additional capital injection is expected to be about €5bn (£4.3bn). That would bring the bail-out costs for Anglo Irish to €30bn, shy of the €35bn forecast by credit rating agency Standard & Poor’s (FT)  
·         ECB 3-month auction demand less than expected (being viewed as a positive) - The ECB said it will lend banks 104 billion euros ($141 billion) for three months as some 225 billion euros of long-term loans mature tomorrow.  Bloomberg 
·         Spain - investors anticipating ratings cut from Moody's; Five out of eight money managers surveyed predicted in a Bloomberg survey a one- step reduction to Aa1, with the rest forecasting a two-level cut to Aa2. The decision may come this week – Bloomberg
·         Fed’s Lockhart says more Fed easing not a done deal; after the Tues WSJ article, latest sign of Fed officials trying to temper expectations; "There is growing sentiment that further accommodation through large asset purchases is coming….For me, at this moment it's not a foregone conclusion that we need to go there."   Reuters 
·         China ending ban on rare-earth exports to JapanThe Nikkei reported that China has ended its ban on rare-exports to Japan and that exports have resumed. Nikkei
·         FX wars – discussed in the WSJ – nothing really new in the article, but discusses how at least 6 countries are trying to lower the value of their currencies to maintain export competitiveness; the House on Thurs is expected to pass legislation that could make it easier to retaliate against manipulators like China and while the measure prob. doesn’t have great chances in the Senate, it could be used to pressure Beijing into action ahead of the G20 summit in Nov.  WSJ 
·         AIG – the company’s board on Wed will discuss a plan to convert Washington’s $49B preferred stock stake into common shares (FT/WSJ)
·         HPQ - Bottom Line takeaways on the HPQ meeting – overall people pretty happy w/the financial targets for ’11 and the overall tone from mgmt re the business units; however, there was no news on the CEO front, which is the key issue in the mind’s of investors. 

Catalysts to Watch
·         A lot of stuff coming up on Thurs/Fri – we will get news on the Anglo Irish wind down Thurs (which could help relieve worries around the Irish debt situation) and also the big ECB roll-over refi.  Also reports (DJ) that Moody’s will be meeting w/Spanish officials on Thurs as it makes a determination on whether to downgrade the country’s rating (that news could come Thurs or Fri).  Thurs night/Fri morning we get the key PMI manufacturing #s from China and the US.  Also – Fri is the first day of Q4.  The three big events being watched in the coming months: 1) Q3 earnings (first CQ3 earnings start next week - YUM 10/5, MAR 10/6, AA 10/7); 2) mid-terms (Nov 2); 3) FOMC (Nov 2-3). 
·         US IPOs – 4 deals looking to price today (Wed); largest IPO of ’10 to price today; busiest overall day in 8 weeks.  Bloomberg 
·         Obama will meet with families in Des Moines, Iowa, and Richmond, Virginia, Wednesday as he continues a multi-state tour to talk about economic issues (CNN)
·         Treasury auctions ($29B 7s on Wed)
·         a for-profit education hearing before the Senate HELP committee (Thurs Sept 30)
·         the House could vote on legislation that would give Congress the ability to retaliate against China for alleged currency manipulations. 
·         Bernanke is going to be testifying before the Senate on Thurs Sept 30 (10amET), although the focus of his commentary will be on fin reg reform (not monetary policy). 
·         In Europe, the first ever pan-European strike is planned for Sept 29.  Unions throughout Europe are pushing hard to get millions out on the streets of several cities. 
·         China’s “Golden Week” holidays run Oct 1-7. 
·         Eurozone banks face major refinancing this week - On Thursday, some €75bn in one-year loans and €18bn in six-month loans will return to the ECB. In addition, €132bn in three-month liquidity will mature on the same day; analysts would view as a victory if less than EU175B is rolled over (FT)  
Corporate Events Calendar
·         Tues Sept 28: earnings before the open (MAN Group trading update, WAG); earnings after the close (MLNK, ZZ); analyst meetings (HPQ, DT/FTE, CGNX, KNOT, TLS); shareholder meetings (BKS). 
·         Wed Sept 29: earnings before the open (ATU, FDO, AM, Misys trading update, FirstGroup trading update, London Stock Exchange trading update); earnings after the close (WOR, SNX, XRTX); analyst meeting (FDX, KMT)
·         Thurs Sept 30: earnings before the open (MKC); earnings after the close (ACN, CBK, SMOD, DMAN, RECN, LWSN); analyst meetings (DHX, MMC, WU, VCI, LRCY)
·         Fri Oct 1: sales (auto companies will report their Sept sales). 
Economics Calendar – daily view
·         Wednesday, Sept 29th: no major US releases today
·         Thursday, Sept 30th: US (Core Personal Consumption Expenditure, GDP, Initial Jobless Claims, Personal Consumption); Eurozone (n/a) Other (Canada - GDP).
·         Friday, Oct. 1st: US (Personal Consumption Expenditure Core, Personal Income, Personal Spending, U. of Michigan Confidence, Construction Spending, ISM Manufacturing); Eurozone (Switzerland-Retail Sales, PMI; Germany – PMI; UK – PMI, Eurozone Unemployment Rate) Other (China-PMI Manufacturing).

Tuesday, September 28, 2010

Morning Note...


Futures slightly higher (+35bps) on an overnight rally across the pond.  U.S. markets remain somewhat quiet, however, and it’s unclear if recent action represents a simple respite after a +10% month, a near-term calm before the potential GDP revision Thursday, a medium-term calm ahead of Q3 earnings season, a longer-term calm ahead of midterm elections, or all of the above.  There is a bit more action overseas, as Europe rallied from down 1% to now stand slightly positive.  U.S. futures followed this action, and rallied significantly at ~5am on speculation that the ECB was stepping in to buy Irish & Portuguese debt (for the moment).  In corporate news, Walgreen’s (WAG; +7%) beat estimates by 5c and reported revenues that were in-line with expectations.   Blackberry-maker RIMM announced a new “Playbook” for 1Q2011 to compete with Apple’s iPad.  In economic news, the July CaseShiller home price index data was in-line to slightly lower than expected, but has not had much market impact.  Asia weaker across the board overnight.  Gold remains near $1300/oz.  Oil -33bps.  USD down slightly.  Many mutual fund’s fiscal year-end is this Thursday the 30th.  For the purposes of “window-dressing,” (which is clearly unnecessary after this month’s action) some use T+3 as year-end (which was yesterday), and some use September 30th – I admittedly have never been able to get a firm answer on that question. 

Worth noting that the Wall Street Journal posted an article just after yesterday’s close that hints at a watered-down QE2, which might in fact disappoint the market (and perhaps helped futures trend weaker late yesterday afternoon and overnight before catching a bid on the European rally):

Fed Mulls New Bond Approach By JON HILSENRATH

Federal Reserve officials are considering new tactics for the purchase of long-term U.S. Treasury securities to bolster a disappointingly slow recovery.

Rather than announce massive bond purchases with a finite end, as they did in 2009 to shock the U.S. financial system back to life, Fed officials are weighing a more open-ended, smaller-scale program that they could adjust as the recovery unfolds.

The Fed hasn't yet committed to stepping up its bond purchases, and members haven't settled on an approach. After its meeting last week, the Fed's policy committee said it was "prepared" to take new steps if needed.

A decision on whether to buy more bonds depends on incoming data about economic growth and inflation; if the economy picks up steam, officials might decide no action is needed.

The Fed's internal debate about a bond-buying strategy is emblematic of the challenging position in which it finds itself. In normal times, it simply raises or lowers short-term interest rates to guide the economy.

But having pushed short-term rates to near zero, it now has to devise new, untested approaches at almost every turn. A misstep could lead to unintended consequences, one factor that makes officials wary and investors jittery about its every move.

In theory, buying long-term bonds pushes other interest rates down because it reduces the supply of debt available to investors, pushing up the price of this debt and the yield down.

In March 2009, the Fed said it would buy $1.7 trillion worth of Treasury and mortgage-backed securities over a six to nine month period—known inside the Fed as the "shock and awe" approach.

Most Fed officials believe that helped to drive down long-term interest rates and spurred the economy.

Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.
     
Most economists at the Fed and outside, though not all, believe that the Fed's decision to embark on what's known as "quantitative easing"—buying bonds—after cutting its target for short-term interest rates to near zero helped prevent an even deeper recession.

A move to resume the purchases would be a big step for the Fed, which just a few months ago was talking about how to reduce its portfolio.

In deciding how to resume its large-scale purchases, if it opts to do so, the Fed is considering both the potential benefits of pushing down already-low long-term interest rates and the potential risks, particularly to its credibility in financial markets about its ability and willingness to reverse course if the economy rebounds or inflation accelerates.

Fed officials have done little to dissuade investors that they might do more.

Fed Chairman Ben Bernanke last week reiterated his dissatisfaction with the recovery, saying the economy has failed to grow "with sufficient vigor to significantly reduce the high level of unemployment."

Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at lest another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.

A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.

"The shock and awe approach is rarely the optimal way to conduct monetary policy," he says. "I really do not think it is the right way to go except in really exceptional circumstances."

In the heat of the crisis it made sense to jar frozen markets back to life with a big attention-grabbing program, he says. Announcing another big program with a finite end date now, he says, would lock the Fed into a policy that might not prove appropriate several months from now.

Moreover, a large commitment could destabilize markets by unhinging the dollar or creating fears of a big inflation uptick, he says.

Under a small-scale approach, Mr. Bullard says, the Fed might announce some still-undecided target for bond buying—say $100 billion or less per month. It would then make a judgment at each meeting whether continued action was needed, he says, based on whether "we're making progress toward our mandate of maximum sustainable employment and inflation at our implicit inflation target."

There are many open questions. One is size. Mr. Bullard says doing more than $1 trillion of purchases per year would give him "pause" because that's how much net debt the Treasury will issue this year, meaning the Fed would be financing it all. There is also a question of whether the Fed might tie further action to movements in the unemployment rate, inflation or other metrics.

Mr. Bullard currently is among 12 regional Fed bank presidents with a vote on monetary policy, along with the four current Fed governors in Washington. He has been arguing for this kind of approach to Fed policy for several months, but only began to get traction with other officials as the economy slowed down this summer.

The Fed is not of one mind on the issue, though. Some officials are reluctant to resume bond buying to, as they put it, "fine tune" the economy. Others are more inclined to be bold to resuscitate the recovery.

A small-scale approach could be a path to compromise among officials.

"Given the disagreement about the need for additional easing within the FOMC, retaining some flexibility might be critical to the adoption" of more quantitative easing, Goldman Sachs analysts said recently.

The Goldman economists estimate that an open-ended, small-scale approach would have less impact on bond markets than a large one-time approach, because investors wouldn't be certain about whether such a program would continue.

"The more you commit to large amount of purchases up front, the bigger effect you're going to get," says Jan Hatzius, Goldman's chief economist.

The Fed concluded its $1.7 trillion purchases of mortgage and Treasury bonds in March. Researchers at the Federal Reserve Bank of New York estimate that the program reduced long-term interest rates by between 0.3 percentage point and 1 full percentage point.

The Fed took a step toward new purchases in August. It said it would begin replacing maturing mortgage bonds by purchasing Treasury debt to keep the overall level of its securities holdings constant.

Here’s something else interesting from the Journal, as per Bloomberg:

Americans Think Recovery Will Take Years, Survey Shows, WSJ Says 2010-09-28 10:20:48.564 GMT

Sept. 28 (Bloomberg) -- Some 46% of Americans think it will take until at least 2013 for the economy to recover to “normal times,” while 36% expect it will take sooner, WSJ reports, citing survey by AlixPartners…39% plan to spend less on non-essential items in next yr, 48% to keep spending the same. 

AEC to offer 8M shares.  AGNC to offer 10M shares.  ANAD cut at STFL.  CGNX raises guidance.  DLB cut to Neutral at GSCO.  ENTR to offer 10M shares.  JBL beats by 3c and guides in-line.  GSCO ups PHM to Neutral.  RAX to replace ACF in S&P400.  Cramer loves LULU.  TGT cut at CSFB.  CITI cuts HSP.  GSCO cuts KBH.  JPHQ cuts AAI.  UBSS cuts AAI. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  Name the only country to have a capital named after an American president.

Yesterday’s Question:  You may know that Al Capone was born in Brooklyn and spent most of his “career” in Chicago…but where did he die?

Yesterday's Answer:  Al Capone died on Palm Island, which lies just off the MacArthur Causeway in Biscayne Bay, between downtown Miami and Miami Beach.   

Best Quotes: 
EARLY LOOK: 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

Monday, September 27, 2010

Morning Note...

Futures slightly higher this morning (+25bps) as “Merger Monday” comes back in vogue:  Southwest Airlines (LUV) is buying Air Tran (AAI; +56%) for $1.4 billion and Unilever (UNA NA or UL) is buying Alberto Culver (ACV; +18%) for $3.7 billion.  Asia was higher overnight as markets play “catch up” with our action Friday.  Also, Japan announced roughly $50 billion of new stimulus.  Looking ahead, China’s PMI data is due Thursday night for Friday morning, and note that China closes October 1st to 7th for the “Golden Week” holiday.  Europe flat to slightly lower this morning, as the ECB apparently considered unlocking rescue funds for Ireland but has yet to act, and Anglo Irish Bank is set to release restructuring details on Thursday and Moody’s cut the bank’s senior debt rating three notches.  A pan-European strike is set for Wednesday, September 29th, and will surely generate some major media headlines.  In other corporate news, the WSJ reports that takeover talks between Santander (STD) and M&T Bank (MTB) have broken down.  Economic data is a bit back-end loaded this week, as revised U.S. GDP is also due for Thursday morning and the ISM manufacturing index will be release Friday along with U.S. auto sales.  Barron’s was cautious on Technology & Semiconductor stocks. 

Worth noting two interesting stories from the New York Times and the Wall Street Journal.  According to the WSJ, the bulk of Q3 earnings pre-announcements have been negative, with a count of 77 downside warnings vs. 34 upside revisions.  The 2.3 ratio of “negative-to-positive preannouncements for Q3 is up sharply from 1.1 in Q2.”  According to the NYT, “The conventional wisdom is that gridlock is good for the stock market, but there’s no evidence that that’s been true over the last 84 years.”  The article goes on to point out that from 1926 through last year, an index of large-capitalization stocks returned about 7 percent, annualized, when there was gridlock, compared with about 12 percent when there was not.

Also, there was an insightful survey conducted by CNBC in light of David Tepper’s commentary Friday morning.  The survey results indicated that investors anticipate $500 billion of new stimulus from the Fed to be lasting roughly one year.  As a result, one wonders how “baked in” Tepper’s “Don’t fight the Fed” commentary actually is (bold emphasis mine):

Fed Will Boost Balance Sheet by $500 Billion: Survey
Published: Monday, 27 Sep 2010 | 7:00 AM ET
By: Steve Liesman, Senior Economics Reporter

The Federal Reserve will boost its balance sheet by about half a trillion dollars over a six-month period beginning in November and keep it inflated for up to a year, according to a survey of leading markets participants by CNBC.

About 70 percent of the 67 respondents, which include economists, strategists and fund managers, believe the Fed will begin quantitative easing again.

Of those, 80 percent believe the Fed will start before the end of this year. November is seen as the most likely month for the Fed to restart asset purchases by 38 percent of those who took the survey, but December was a close second with 32 percent.

“The trigger for the resumption of quantitative easing late this year will be an increase in unemployment back into double-digits,” wrote Mark Zandi, of Moody’s Economy.Com. He thinks the Fed will act in December and ultimately purchase an additional $1 trillion in assets.

The survey is among the first efforts to quantify market expectations for when and by how much the Fed will restart quantitative easing, or asset purchases, as is widely expected. Before the Fed Funds rate was lowered to zero, the Fed futures markets served as a proxy for market expectations for actions by the central bank.

The Fed has made clear that the size of the balance sheet is now a major tool for aiding the economy yet there is no obvious proxy for gauging market sentiment. CNBC will conduct the survey periodically to gauge how market expectations for the Fed change with incoming economic data and statements by Fed officials.

There is a wide range of answers surrounding the key unknown of how much the Fed will buy in assets. The average for the survey put the portfolio at $2.35 trillion by Feb. 1, growing to $2.5 trillion by August 2011. The Fed is expected to remain around that level through November, 2011. The Fed’s portfolio is currently targeted at $2.054 trillion, meaning market participants expect the portfolio to grow an average by about $500 billion by August.

At their September meeting, Fed officials hinted strongly that they would restart asset purchases, saying the Federal Open Market Committee “is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

But Fed officials have not so far offered any guidance for how much they would add to the portfolio. The Fed kept its balance sheet at about $800 billion before the financial crisis but raised it by nearly $1.5 trillion through the purchase of treasuries and mortgage-backed securities along with toxic assets it took on its balance sheet through the rescues of AIG and Bear Stearns.

The lack of guidance, along with differences over the economic outlook, results in a wide range of estimates from respondents for the size of the balance sheet through November 2011. In fact, 22 percent believe the balance sheet will be smaller by then than it is now, with the low coming in at $1 trillion, meaning a reduction in the portfolio by $1 trillion from the current level of $2 trillion.

Nearly 30 percent think the portfolio will be more than $1 trillion dollars larger, with the high at $4.1 trillion.

“If the Fed pulls the trigger, they will go big,” wrote Stephen Stanley of Pierpont Securities. He sees the balance sheet hitting $3 trillion by August.

Market participants believe the move will help lower interest rates, with 57 percent saying it would be totally or somewhat effective. About 38 percent think it will be ineffective and 6 percent unsure.

David Resler of Nomura Securities said lowering interest is not the principal goal of additional QE. Rather, he said will purchase assets to ward off deflation and boost inflation expectations.

Mark Vitner of Wells Fargo said: “There will only be a modest impact on interest rates… because the move is more widely expected and interest rates are already so low.”

Others were skeptical of the impact. Mark Elenowitz of TriPoint Global Equities wrote that he sees little impact because rates are already low. “My fear is that instead of prompting economic activity through sustained low interest rates, the Fed may provoke a debilitating bout of inflation,’’ he said. Others thought the Fed will have some impact, but at a cost of a very painful exit strategy.

Purchasing assets is just one of the actions the Fed could take. It has also said it could lower the interest rate paid on excess reserves, now at 25 basis points, and can make an even firmer commitment to keep rates low for longer. 

BEN upgrade at FBRC.  MSCO ups DRYS.  HNR to explore strategic alternatives.  GSCO cuts INFN.  Barron’s positive JBLU.  UBSS ups NUAN.  YRCW announces tentative agreement with Teamsters.  GSCO ups BDX.  WEFA ups ARI.  GSCO cuts ESRX, ZMH.  OPCO cuts RDWR.  Barron’s positive BBY. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  You may know that Al Capone was born in Brooklyn and spent most of his “career” in Chicago…but where did he die?

Yesterday’s Question:  Who am I?  Born on this date in 1936 in Greenville, Mississippi…winner of 18 Emmys, 17 Grammys, and 4 Peabody Awards…died in 1993…every kid surely knows his work without knowing who he actually is…

Yesterday's Answer:  Jim Henson, of Sesame Street and Muppet Show fame.   

Best Quotes:  From BofA/MLCO desk... “Good Morning - Fourth straight week of gains for the markets.  The market is up 10% in less than a month on light volume.  Three out of every four stocks are now trading above the 50 day mva.   S&P 500 companies have bought back 77.6 billion of stock in the second quarter.  Heavy week of economic data for the week ahead.  Case Shiller tomrrow. GDP on Thursday, and PPI on Friday.   Auto sales also due out on Friday.    M&A still alive and well.   LUV for Airtran, and Unileverr for Alberto Culver on the tape this morning.     1147.50 is the eighteen week high, 1132 was Fridays low.   I saw Wall Street II, it is horrible.   Have a great day”

From BTIG’s O’Rourke… “Friday’s rally was more equine than bovine.  In a rare media appearance, hedge fund manager David Tepper of Appaloosa provided a bullish outlook for Equities.  After the summer of popular pessimism as highlighted by the NY Times last month, and themes like deflation going mainstream, such comments from someone with a track record suddenly makes optimism acceptable once again.  The market received an added boost from a better than expected Durable Goods report with healthy upward revisions to the July report.  The way we like to define bull and bear tapes is as follows.  A bull tape is one where during selloffs, stocks don’t stay down long enough to afford the opportunity to buy and a bear tape is one in which stocks don’t stay up long enough in the rallies to afford the opportunity to sell.  As we all know, the equity market has been consolidating, not only in the trading range of the past 4 months, but actually for an entire year.  It has been positive that throughout September, down days have been scarce, but the quick and easy manner in which this week’s 3 day selloff was erased is a good indication that we are likely in the early stages of a bull tape.”