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Investment Strategy by Jeffrey Saut

“For trading, not eating!”
August 18, 2008

“While gold was first discovered in Alaska during the 1870s, the 1890s have come to be known as the Yukon-Klondike Gold Rush days, as thousands of rugged individuals swarmed to the northern climes to find fortune and glory. Unsurprisingly, during the winter of 1896-97 the Alaskan ports were frozen solid and therefore closed to all shipping traffic. Food became very scarce and very expensive since new supplies had to be brought in over land at great hardship. Reportedly, a can of sardines that had cost $0.10 in New York could be priced at 10 times that amount by the time it reached the gold miners in Alaska. Still, there was great demand even at such inflated prices. For instance, in one remote mining town the price of a can of sardines was sold at rapidly escalating prices from $10.00, to $30.00, then $50.00. Finally, one desperately hungry miner paid $100.00 for a can of the highly sought after sardines. He took it back to his room to eat. He opened it. To his amazement he discovered the sardines were rotten. Angered, he found the person who sold him the tin and confronted him with the rotten evidence. The seller was amazed and shouted, ‘You mean you actually opened that can of sardines? You fool; those were trading sardines, NOT eating sardines!’”

... Anonymous

Similarly, “for trading, NOT for eating” has been the strategy we have employed with our recommendations on the financial and real estate groups since turning constructive on them at the end of June. Indeed, anticipating that the “selling stampede” was coming to an end, we advised accounts that at such downside inflection points you want to purchase those groups with the worst relative strength characteristics for trading purposes because those are the groups that have been “pushed down” the most. To be sure, just like when you push down too far on a spring you eventually get a “boing” bounce-back, we thought the financials and the real estate stocks had been compressed to the point where they would give us the biggest “bounce backs” off of the selling-climax “lows.” We subsequently recommended numerous exchange-traded funds (ETFs) playing to those groups and began scale-buying them into the mid-July “lows.”

Since those “lows” we have opined that the equity markets were likely involved in an upside “buying stampede,” which should last the typical 17 – 25 sessions. In last Monday’s letter we went on to state:

“Nevertheless, since July 15^th the S&P 500 (SPX/1298.20) has moved irregularly higher without so much as anything more than a one- to three-session pause/pullback with Friday’s 300+ point DOW WOW coming on day 18. If the pattern continues to play, our day-count sequence would have the equity markets topping-out sometime this week as the ‘short sellers’ run for cover into Friday’s option expiration expiation. The quid pro quo could be that the 25-session ‘selling stampede’ in indexes like the ProShares Ultra Oil & Gas (DIG/$78.59) could be nearing an end, at least on a trading basis.”

Well, last Friday’s option expiration was indeed session 23 from the July 15^th low and accordingly we followed our own advice and used strength during the week to scale-sell some more of our trading positions. Verily, we consider both the financial and real estate groups to be “trading sardines, not eating sardines” since we doubt the news surrounding them will get materially better anytime soon. And that, ladies and gentlemen, is why we just “rented” those positions for trading purposes rather than investing in them.

Speaking to the investing account, followers of these reports know that for months we have counseled accounts to reduce exposure to our beloved “stuff stocks” (energy, materials, base/precious-metals, cement, timber, etc.) even though we continue to think “stuff” remains in a secular bull market. We began recommending rebalancing (read: selling partial positions) said holdings on fears that the politicos were going to do everything in their power to drive the price of crude oil lower into the elections, for obvious reasons. Our long-standing target for the price of crude has been its 200-day moving average (DMA), which now stands at $110. With rude crude changing hands in mid-July at $147/bbl that strategy looked pretty foolish. Last week, however, oil tagged $111/bbl and our strategy doesn’t look nearly as wrong-footed. While crude oil’s recent 25% price decline looks bad in the charts, the price declines of many energy-related equities now exceeds 40% over that same timeframe. We believe the “selling stampede” in the energy complex is overdone and is therefore nearing an end. Moreover, with the recent decline in crude prices, numerous members of OPEC have been calling for production cuts. While we are not expecting production cuts in the near-term, we continue to believe that if prices fall further, OPEC will step in and defend a price near $100/bbl. Obviously, we've found a price that slows oil demand, but in our view, long-term oil fundamentals remain strong.

Consistent with these thoughts, we recommend the gradual re-accumulation of the energy stocks, particularly ones with outsized dividend yields. For fund investors there are a plethora of closed-end funds and ETFs like the aforementioned ProShares Ultra Oil & Gas, which is leveraged two-to-one on the upside. Additionally, in past missives we have mentioned a number of higher yielding names recommended by our fundamental energy analysts, like 12%-yielding, Outperform-rated Linn Energy (LINE/$20.40). This morning we offer for your consideration Strong Buy-rated Delta Petroleum (DPTR/$16.10) using its convertible bond, as well as Strong Buy-rated Chesapeake Energy (CHK/$45.53) using its convertible preferred “D” shares. As always, terms for these convertibles should be checked before purchase.

As with oil, we have been cautious on precious metals this year despite our belief that the yellow metal also remains in a secular bull market. We think the decline from $990/ounce on July 15, 2008 into last Friday’s close of $792 is overdone. The gold stocks have fared even worse, as can be seen in the charts on the next page. While many pundits are blaming gold, and oil’s, decline on the stronger dollar, we don’t see it that way. Plainly, we have been bullish on the dollar since late last year when we recommended closing down all of our anti-dollar “bets” that had been in place since 4Q01. And, at the margin the dollar’s recent strength is responsible for a modicum of the slide in “stuff stocks.” However, we think there is more afoot than just that. Indeed, the recent accelerating rotation out of “stuff” we think is largely being driven by a gathering sense that not only is the U.S. economy slowing noticeably, but so is the rest of the world. While true, we continue to believe the U.S. economy will avoid a recession and continue to muddle through (read: 0.0% – 2% GDP growth), although the odds of a recession in 2009 have clearly risen. Nevertheless, we like gold stocks at these price-points, but are again turning cautious on the U.S. dollar (see charts); and, as with energy stocks, are recommending gradual re-accumulation. Hereto there are numerous closed-end funds and ETFs, but one for your consideration is the Deutsche Bank Gold Double Long Note (DGP/$15.86).

The call for this week: Regrettably, for most of this year it has been more of a trader’s market than an investor’s market. While we are a much better investor than trader, we have attempted to navigate the volatile environment using the trading side of the portfolio. Recall that we advise using 80% of your equity portfolio for investment ideas and 20% for trading. And when we say “trading,” we DON’T mean day trading! Rather, we try to wait for a trading “set up” whereby the odds are tipped so far in our favor that if we are wrong we are going to get stopped-out quickly with hopefully small losses and live to play another day. And, that’s the way it is on session 24 since the July 15^th “selling climax” lows. Indeed, “for trading, not investing!”

“Painful Ups And Downs”
August 11, 2008

“One hour after beginning a new job which involved moving a pile of bricks from the top of a two story house to the ground, a construction worker in Peterborough, Ontario suffered an accident which hospitalized him. He was instructed by his employer to fill out an accident report. It read –

‘Thinking I could save time, I rigged a beam with a pulley at the top of the house and a rope leading to the ground. I tied an empty barrel on one end of the rope, pulled it to the top of the house, and then fastened the other end of the rope to a tree. Going up to the top of the house I filled the barrel with bricks. Then I went down and unfastened the rope to let the barrel down. Unfortunately the barrel of bricks was now heavier than I, and before I knew what was happening, the barrel jerked me up in the air.

I hung on the rope, and halfway up I met the barrel coming down, receiving a severe blow on the left shoulder. I then continued on up to the top, banging my head on the beam and jamming my fingers in the pulley. When the barrel hit the ground, the bottom burst, spilling the bricks. As I was now heavier than the barrel, I started down at high speed.

Halfway down, I met the empty barrel now coming up, receiving several cuts and contusions from the sharp edges of the barrel. At this point, I must have become confused because I let go of the rope. The barrel came down, striking me on the head. I woke up in the hospital. I respectfully request sick leave.’”

. . . The Toronto Star

Likewise, “painful ups and downs” have become a way of life to investors and traders recently, for as repeatedly stated in these missives we are experiencing the longest skein in the Dancing Dow of “up one day and down the next” since the 1940s! Still, our thesis remains intact in that the “selling stampede” ended on July 15, 39 trading sessions from the mid-May highs. From those lows, we have suggested the equity markets were likely involved in a “buying stampede” that would eventually carry the S&P 500 (SPX/1296.32) into the envisioned target zone of 1320 – 1330.

Recall that “buying stampedes,” like “selling stampedes,” typically last 17 – 25 sessions, with only one- to three-day counter-trend attempts, before exhausting themselves. It just seems to be the rhythm of the “thing” in that it takes that long to get everyone bullish enough, as well as “long” enough, in time for the ensuing downside correction. While it is true that some stampedes have lasted 25 – 30 sessions, it is RARE to have one go more than 30 days like the recent “selling stampede” we experienced into those July 15^th lows. Interestingly, when we stand back and look at a chart of the SPX since those mid-July lows, what we see is a slow-motion “buying stampede” even though it certainly does feel like one!

Nevertheless, since July 15^th the SPX has moved irregularly higher without so much as anything more than a one- to three-session pause/pullback with Friday’s 300+point DOW WOW coming on day 18. If the pattern continues to play, our day-count sequence would have the equity markets topping sometime this week as the “short sellers” run for cover into Friday’s option expiration expiation. The quid pro quo could be that the 25-session “selling stampede” in indexes like the ProShares Ultra Oil & Gas (DIG/78.86) could be nearing an end, at least on a trading basis.

As for the building sense that the “worm has turned” and things will get economically better from here; while we do believe the housing news will not get a whole lot worse, we also think it will not get materially better. We do, however, believe the news regarding mortgage delinquencies, defaults, and foreclosures will indeed get worse. And consider this; the banks still have a nearly $5 trillion dollar exposure to real estate. That exposure represents more than 50% of their total assets! By our pencil, even if housing prices stop going down, which is doubtful in the near-term, the banking complex will continue to reduce exposure to real estate as it attempts to shore-up its balance sheets. Unfortunately, as long as this sequence continues to play, CREDIT for the economy will remain lacking and/or extremely tight, as is being telegraphed in the chart below. For a finance-based economy like ours, this is troubling since it now takes $5.57 in new debt to fuel $1 worth of GDP growth. And that, my friends, is why I remain more concerned about the economy in 2009 than I have been during 2008.

As for the investment account, our fundamental energy analyst had this to say about one of our favored positions, namely Outperform-rated Linn Energy (LINE/$19.77):

“There was a lot to like in this quarter, with adjusted EBITDA increasing to $162.1 million, providing a stellar distribution coverage ratio of 1.57x, above our estimate of 1.52x. Moreover, after interest expense, distributions, and maintenance capital, the company generated $41 million in excess cash flow, or $0.36/unit. Strong distribution coverage is set to continue, providing ample excess cash flow and the potential for a near-term distribution increase. Another positive development was an improved hedging outlook. Linn took advantage of the recent run up in commodity prices, restructuring a portion of its oil hedges, cancelling some collars and raising swap prices in 2009 through 2012. After layering in the new hedges, we are raising our estimates.

Linn is attractively priced on a forward yield basis, with one of the highest yields in the E&P MLP universe (12.7%). Due to this yield, the rising distribution coverage ratio, and our confidence in the sustainability of the distribution growth curve, we believe Linn provides a highly attractive risk/reward profile. We reiterate our Outperform rating and $26.00 target price, based on a 6x multiple to our 2009 EBITDA estimate, the high end of the traditional E&P range of 4x to 6x.”

The call for this week: Friday’s date read “8-8-8,” which is considered by many to be a pretty lucky sign. Consequently, there were a plethora of Asian weddings, the likely reason why the Olympics began on Friday, and the stock market reacted accordingly with its own celebration of +302 points (DJIA). We think the “crazy 8s” will continue to party this week into our envisioned 1320 – 1330 target zone for the SPX, which is where we recommend selling your remaining trading positions and/or raising your stop-loss points. Is this the start of a new secular bull market? We doubt it because by our notes there have been 24 daily Dow Wows of 300+ points and NONE of them have been within the confines of a secular bull market. We continue to invest and trade accordingly . . .

Additional information is available on request. This document may not be reprinted without permission.

Raymond James & Associates may make a market in stocks mentioned in this report and may have managed/co-managed a public/follow-on offering of these shares or otherwise provided investment banking services to companies mentioned in this report in the past three years.

RJ&A or its officers, employees, or affiliates may 1) currently own shares, options, rights or warrants and/or 2) execute transactions in the securities mentioned in this report that may or may not be consistent with this report’s conclusions.

The opinions offered by Mr. Saut should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your Raymond James Financial Advisor.

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