Users: rabbi_geoff: Raymond James Financial | Investment Strategy by Jeffrey Saut

“1-800-GET-ME-OUT?!”June 4, 2012

The “S” word makes most investors uneasy. They find the “B” word, “buying,” much more pleasant. Why is perhaps best explained in a book written by Justin and Robert Mamis titled “When to Sell.” Following are several poignant excerpts from that book:

“Stocks are bought not in fear but in hope. No matter what the stock did in the past it assumes a new life once a purchaser owns it, and he looks forward to a rosy future – after all, that’s why he singled it out in the first place. But these simple expectations become complicated by what actually happens. The stock acquires a new past, beginning from the moment of purchase, and with that past comes new doubts, new concerns, and conflicts. The purchaser’s stock portfolio quickly becomes a portfolio of psychic dilemmas, with ego, id, superego, and reality in a state of constant battle.”

“The public is most comfortable when they are sitting with losses. Because if their stocks are down from where they bought them, they don’t have to worry about them. Once he’s got a loss, the typical investor is sure he isn’t going to sell. He bears the lower price because in his mind it is temporary and ridiculous; it’ll eventually go away if he doesn’t worry about it. So selling at a loss becomes absolutely out of the question. And since it is out of the question, and his mind is made up for him, the struggle of any potential decision vanishes and he is able to sit comfortably with the loss.”

“To the public mind, selling is never sound. It always conveys the possibility of being wrong twice: first, admitting that they’ve made a buying error; second, admitting that they might be wrong in selling out. And if the stock has actually gone up, they are tormented; should they take a profit or hold for a bigger one? That creates anxiety, and anxiety breeds mistakes. But as long as they’ve got losses, and never have to decide, they can sit back comfortably and dream instead.”

“Through the entire market cycle lurks the fear of finalizing the deed, of taking it from dream to reality by selling. By not selling, by tightly holding on to his stocks, the investor never has to face reality.”

Yet, “selling” seemed to be on the market’s mind late last week punctuated by Friday’s Dow Dive of ~275 points. Said decline left the senior index down 8.74% from its May 1st closing high (13279.32) into Friday’s close (12118.57). While not all that big of a decline, it brought back memories of the past two years’ May – July corrections of 17% and 20%, respectively. Yet, investors should keep in mind that since 1928 there have been 294 pullbacks of 5% or more. Ninety four of them have been moderate (>10%), 43 have been severe (>15%) and 25 have been bear markets (>20%). What is interesting to me is that since last October 4th’s “undercut low” the chant from most investors has been, “We want a pullback to become more fully invested.” Now that we have the pullback everyone is in panic mode (again). To borrow a line from George Bernard Shaw – There are two tragedies in life; one is not to get your heart’s desire, the other is to get it! The “heart’s desire” for the bulls since last October has been the fact the markets have ignored all of the bad news. Verily, the senior index has turned a deaf ear to the worsening Euroquake situation, Iran, softening economic trends, deflationary dives in commodities, etc. Of course that “deaf ear” stance has changed over the past four weeks.

Indeed, the Dow’s decline is now 22 sessions long. Such “selling stampedes” typically last 17 – 25 sessions before they exhaust themselves; it just seems to be the rhythm of the thing. This has been my observation over the years in that it takes this long to get participants bearish enough to finally panic and throw in the towel by selling their stocks. While it is true some stampedes have lasted more than 25 sessions, it is rare to have one run more than 30 sessions. Today is session 23 on the downside. Obviously Friday’s Fade took out my failsafe point of 1290 on the S&P 500 (SPX/1278.04), leaving the DJIA (INDU/12118.57), the S&P 500, and the NASDAQ Composite (COMP/2747.48) all below their respective 200-day moving averages (DMAs). The bears will be quick to point out this is what happened right before the crashes of 1929 and 1987. However, the bullish argument is that over the past 20 years a break below the 200-DMA by the SPX, after it has stayed above it for three months, has typically led to a rally. Also worth noting is the decline has left most of the oversold indicators I rely on pretty oversold. Nevertheless, I told “callers” on Friday that when markets get into one of these selling squalls they rarely bottom on a Friday. What tends to happen is participants go home and brood about their losses over the weekend and “show up” on Monday in selling mode, which often leads to “turning Tuesday” (read: recoil rebound). Accordingly, the SPX needs to quickly recapture 1290, and stay above that level, if a rally is to commence. On the other hand, if the SPX merely bounces back up to 1290, and then falls sharply back, I would view that as a bearish sign requiring more downside hedging and/or the raising of some more cash. Fortunately, we recommended raising cash in February – April. Unfortunately, we recommended judiciously putting some of the cash back to work (but not much of it) into somewhat more defensive names like 3.8%-yielding Rayonier (RYN/$42.18), which has a Strong Buy rating from our fundamental analyst.

While Euroquake has been on center stage for weeks, Friday’s shockingly weak employment report brought the focus back to the economy and jobs. The 69,000 private sector payroll growth figure was well below the estimate of 150,000 and just to add pain to injury the unemployment rate ticked up to 8.2% from 8.1%. Still, investors should remember unadjusted private-sector payrolls have risen by 1.983 million over the trailing 12 months for roughly a 165,000 monthly average jobs gain. As our economist, Dr. Scott Brown, notes, “That’s not bad, but it is far short of what’s needed to make up ground lost during the economic downturn.” Now for weeks I have been discussing the weakening economic reports. That string of weakness continued last week given that of the 21 economic releases, 18 were weaker than expected, two were in line, and only one exceeded the estimate (that would be Continuing Claims). This softening trend could still just be a weather-related issue combined with skewed seasonal adjustments; the next few months will decide.

The call for this week: Friday was the first day of hurricane season here in Florida, yet the storm didn’t hit our beaches but rather blew onto the Street of Dreams with a 275-point “storm surge.” The media attributed Friday’s Flop entirely to the disappointing employment numbers, but the truth was the market was already headed down before the release of those numbers. And when the SPX’s 1290 level was breached, the rout was on. The result left all of the indexes we monitor near their lows of the day and the three major market indices (INDU, SPX, COMP) below their respective 200-DMAs for the first time in about five months. The bears will be quick to point out this is what happened right before the crashes of 1929 and 1987. However, the bullish argument is that over the past 20 years a break below the 200-DMA by the SPX, after it has stayed above it for three months, has typically led to a rally. And despite the break below my 1290 pivot point I can’t shake the feeling that all of this is just part of the bottoming process.

P.S. – I am on the road again this week seeing accounts and speaking at conferences.

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Being ThereMay 29, 2012

“As long as the roots are not severed ... there will be growth in the spring.”

... Chance “the gardener” in the book Being There

With the recent slowing of economic momentum, grumbles have surfaced again from various stock market gurus about another recession. To those groans this morning I reference the book “Being There” by author Jerzy Kosinski. The story revolves around a simple-minded man named Chance “the gardener,” who knows only gardening and what he sees on television. Indeed, for his whole adult life Chance has not ventured outside the grounds of his employer’s Washington D.C. manor. Eventually, however, the employer dies and Chance is cast out onto the streets, where through a mishap he encounters the wife of a D.C. powerbroker. Thinking her car was the reason for the mishap, she insists that Chance “the gardener,” who she interprets to be Chauncey Gardiner, come with her to her husband’s estate. Benjamin Rand (the husband) is completely taken with Chauncey’s simple, direct approach, and mistakenly attaches profundities to Chauncey’s ramblings about gardening. Viewing him somewhat as a savant, Rand introduces Chauncey to Washington’s elite, including the President. In one verbal exchange regarding the current economic condition Chauncey remarks, “As long as the roots are not severed there will be growth in the spring.”

To be sure, it’s spring again and instead of the typical shouts of “As long as the roots are not severed there will be growth in the spring,” many Wall Street pundits are worried about economic growth. Their worries center on our dysfunctional government, the housing/real-estate situation, and Euroquake. Speaking to the government, since the mid-term elections I have suggested the Tea Party surfaced what Adam Smith wrote about in the book “The Wealth of Nations.” My prose read, “The Tea Party has surfaced what Adam Smith described as the ‘political corruption that prevents prosperity’.” And that’s exactly what we’ve got; the best Congress (Senate and House) money can buy. However, my sense is this is changing because if you parse the backgrounds of the newly elected members of Congress you find that many of them are not professional politicians. Moreover, if you speak to them they will tell you they really don’t want to be in Washington, but they think our country is off course and they want to fix it. I think this is one of the reasons the S&P 500 (SPX/1317.82) rallied 16% following the 2010 mid-term elections into its May 2011 high. This year the SPX is also following the presidential-year script, as can be seen in the chart on page 3. Hopefully, this correlation will continue, driven by the bullish theme of more practical leaders.

As for housing, our fundamental real estate team writes:

“Last month, we shifted our tactical investment position on the homebuilders in a positive direction following trips to key homebuilding markets in Florida and Arizona. We believed (and have since confirmed) order results for the public builders would reflect surprising strength and a sharp acceleration in activity. We believe demand has remained strong in recent weeks as MDC (MDC/$28.87/Outperform) recently reported that April orders rose ~30% y/y (moderating from +51% y/y in 1Q), even as it lapped a big promotion event from last year. Also of note, Ryland (RYL/$22.83/ Outperform) reported that net orders (from continuing operations) increased 37% y/y in April. [Further] the average home price rose 5.1% to $282,600 from $268,900 last year. Relative to March, sales increased in three regions, with the breakdown as follows: Northeast (up 7.7%), Midwest (up 28.2%), South (down 10.6%), and West (up 27.5%).”

Of course, such improving metrics have been telegraphed for months by the S&P 1500 Homebuilders and lumber futures, as can be seen in the attendant chart on page 3 from Ed Hyman’s sagacious ISI organization, whose mutual funds we embrace. Then there was this quip from Fiserv, “Average U.S. home prices – down by a third since 2006 and still falling – will rise almost 4% a year for the next five years.”

Last week, however, those two worries were again overshadowed by Euroquake as rumors swirled that Greece was going to pull out of the EU and Spain’s second largest mortgage lender, Bankia, was on the verge on insolvency. To those apprehensions I repeat my belief of the past 12 months. To wit, having worked in Washington I have a good understanding of politicians, bureaucrats, and bankers. Unsurprisingly, they are the same in Europe as they are here in that they do not want to lose power; and if the EU fails they all lose their power. So my hunch is, and has been, the powers that be will continue to “paper over” the Euroquake situation and hope that time will provide a solution. That said, I can envision a scenario whereby the weakest countries could leave the EU while the stronger members stay. In fact, such a “partial break-up” might just be part of the solution and not the total disaster many expect. If so, not only could this prove positive for the EU, but the rest of the world as well.

Such worries continue to leave investors profoundly underinvested in U.S. equities, as well as why the SPX trades at a P/E multiple of less than 13x this year’s estimate. With consensus earnings estimates centered around $103, and $119 for 2013, a return to the SPX’s mean P/E ratio of 16.2x implies decent upside from here. Further, this is one of the longest periods of time equities have been below their 50-year average valuation levels since 1973 – 1974. Back then the worries du jour were about the OPEC Oil Embargo and the resulting oil prices, Watergate, President Nixon’s resignation, the collapse of Franklin National Bank, the near bankruptcy of New York City, well you get the idea. From that grim news backdrop, the D-J Industrial Average (INDU/12454.83) made its nominal price low in December 1974 at 577.60. While the Industrial’s valuation low didn’t arrive until August 1982, at 776.92, most stocks made their generational low prices in December of 1974.

Fast forward and recall that on March 2, 2009 we stated the stock market would bottom that week and likened said bottom to the nominal price low of December 1974. Since October 4, 2011 we have additionally opined that “low” was probably the valuation low, which bring us to 2012. Our work suggested the “buying stampede” ended on January 26th and subsequently we recommended raising cash in anticipation of a 5-8% correction. While it took longer than expected, the correction finally arrived in April – May, culminating on May 18th with an intraday low of 1291.98 for the SPX. At the time ALL of the oversold indicators we use were at/near historic readings and we recommended judiciously recommitting some cash to select stocks. Regrettably, since then the SPX’s action has not been all that impressive. Indeed, the SPX has not even been able to claw its way back to our first target level of 1338, much less into the critical 1356 – 1366 zone. Yet, there is still time for this recovery to occur provided the SPX does not break decisively below 1290, for that would trigger a danger signal for further price erosion.

The call for this week: I am out of the country seeing institutional accounts, so these may be the only strategy comments for the week. In my absence the stock market will likely resolve its near-term directionality because the “selling stampede” is now 18 sessions long and such stampedes tend not to last for more than 17 to 25 sessions. Despite the decline, by my work there has been no Dow Theory “sell signal,” although there are some Wall Street wags who are using very short-term pivot points and believe otherwise. Still, the downside skein has left all of the indicators I monitor extremely oversold, suggestive of at least a near-term bounce. Such a rally would tell us a lot about the health of the market going forward in time, but if 1290 is violated I will need to rethink my bullish stance. Interestingly, all of the indices I track were up on the week with the economically sensitive D-J Transports (TRAN/5079.84) fairing the best with a 4.23% gain. Likewise, all of the macro sectors improved for the week with best being Materials (+3.72%). Surprisingly, the upside surge in Corn and Wheat stopped, but the driver of this duo’s rally remains as temperatures soared into the 90s across the corn and wheat belt accompanied by the Iowa’s lowest rainfall in 40 years. That caused the U.S. Agriculture Department to lower its rating for wheat in Kansas by nine points for the sharpest one-week ratings drop since 2007. This weather point is not unimportant, for if the warmest winter on record is followed by the hottest summer on record there are all kinds of investment ramifications for water stocks, fertilizer stocks, air conditioning stocks, utilities, etc.

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“I Should Have?!”May 21, 2012

“... A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door that he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back into the box, which would scare away any turkeys lurking on the outside. One day he had a dozen turkeys in his box. Then one walked out, leaving eleven. ‘I should have pulled the string when there were twelve inside,’ he thought, ‘but maybe if I wait, he will walk back in.’ While he was waiting for his twelfth turkey to return, two more turkeys walked out. ‘I should have been satisfied with the eleven,’ he thought. ‘If just one of them walks back, I will pull the string.’ While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return ... ”

... Why You Win or Lose, by Fred C. Kelly

“I should have sold when the S&P 500 broke below its rising trendline on April 9th at 1397” (see chart on page 3). “I really should have sold on May 11th when the S&P 500 (SPX/1295.22) traveled below its April 10th intraday reaction low of 1357.38.” So exclaimed one disgruntled portfolio manager last Friday since the SPX continued to surrender ground. Plainly, the “I should have” crowd surfaced again last week as the SPX knifed through my envisioned support zone of 1320 – 1340, causing one savvy seer to exclaim, “Markets always go further than most pundits believe, both on the upside and the downside.” Yet the recent downside dive from May 1st’s 1415 level into last Friday’s close of 1295.22 has caused many of my indicators to register readings not seen in a long time. For example, the McClellan Oscillator is now at oversold readings not seen since the recent April 10th trading bottom (see chart on page 3). Then there is the CBOE Equity Put/Call Ratio, which is flashing a “buy signal” that has proven profitable at every downside inflection point since 1994; or, as the astute folks at Bespoke write:

“Following today’s 0.44% decline (5/16/12) in the S&P 500, the 10-day Advance/Decline line for the S&P 500 has now dropped down to –1,930. This is an extreme oversold reading based on historical standards. For those unfamiliar with the indicator, the 10-Day A/D line is simply a rolling 10-day total of the daily net number (of similar readings) shows that equities have historically rebounded after hitting such extreme oversold levels. Over the next week, the S&P 500 averages a gain of 1.21% with positive returns two-thirds of the time. Over the next month, the S&P 500 averages a gain of 5.58% with positive returns 83% of the time. Going out three months, the S&P 500 averages a gain of 7.68%, and over the next six months the index averages a gain of 13.35%.”

Adding to the litany of downside inflection-point indicators is the AAII (American Association of Individual Investors) survey that recorded its lowest bullish reading (23.6% bulls) since August 2010. Moreover, my parade of short/intermediate-term indicators shows a composite reading that is at historic levels. To wit, there have only been only four other times when my indicators have combined to show such negative inclinations. More than seventy percent of the time, given such readings, the major market averages have been higher a week later, while 92% of the time they have been higher a month later. Accordingly, unless we are in “crash mode,” and I don’t believe that, it is time to ready your “buy list” and begin judiciously recommitting some of that cash to stocks; and, that is what I have been recommending. Indeed, over the past week I have been recommending recommitting some of the cash we suggested raising in February – April. One of the techniques we have used to accomplish this at similar inflection points was first proffered by our friends at Riverfront Investment Group back in 2009. As stated:

“First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And six, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.”

I think Riverfront’s strategy is appropriate since the SPX is probing its next downside energy level. Further, the stock market’s internal energy level is totally exhausted on the downside, implying a tradable bottom is likely at hand unless we are involved in a mini-crash. The real question thus becomes, “If we get a rally from this oversold condition is it the start of a new “up leg,” or is it just a compression rally that will be brief followed by still lower prices?” Speaking to that point, it is worth considering the SPX is currently trading at a P/E ratio of 13.1x earnings. Since record keeping began there have only been five occasions when a bear market began with the SPX’s P/E ratio below 15x. Another timely question is, “Will the recent Dow Dive trigger QE3, Operation Twist II, or targeting GDP?” While equity markets can clearly do anything, at worst we should at least get a relief rally from here and at best it could be the start of a new “up leg.” Therefore, I think the gradual re-accumulation of investment positions is the correct strategy. For those participants not wanting to try and “catch a falling knife” by purchasing the exchange-traded product of your choice, a more conservative approach would be to accumulate dividend-paying stocks. Some that screen well technically, and have a Strong Buy rating from our fundamental analysts, for your potential shopping list include: 3.0%-yielding Automatic Data Processing (ADP/$51.98); 3.8%-yielding Rayonier (RYN/$42.08); 4.3%-yielding Digital Realty Trust (DLR/$68.48); 5.2%-yielding Enterprise Products Partners (EPD/$48.48); and 8.2%-yielding Linn Energy (LINE/$35.24).

The call for this week: The brilliant Lee Cooperman, captain of hedge fund Omega Advisors, quoted Joe Rosenberg on CNBC last week, “You can have cheap equity prices, or you can have good news, but you can’t have both!” Clearly, we currently have “bad news,” which in my opinion has resulted in “cheap equity prices.” Playing to that quote, my father always told me, “Good things tend to happen to cheap stocks.” So, unless we are involved in a “mini crash,” my sense is at least a short-term bottom is due. As stated, the real question is, “If we get a rally from this oversold condition is it the start of a new ‘up leg,’ or is it just a compression rally that will be brief followed by still lower prices?” And now that the Internet distraction is behind us, the stock market’s focus should turn to the declines last week of 4.3% for the SPX and 5.3% for the NASDAQ, marking their worst weekly performance since last November, leaving the markets severely oversold. Indeed, most of the major indices I follow are down 13 out of the last 14 sessions, while Technology is down 12 days in a row. Such downside skeins are at historic proportions since markets tend not to go more than 11 sessions in any one direction. Interestingly, the big winners last week were wheat (+15.2%) and corn (+9.3%), possibly because the Intercontinental Exchange (ICE/$123.59/Strong Buy) began trading grain future contracts for the first time. To celebrate, pop the top on a box of “The Breakfast of Champions” and enjoy!

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