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Investment Strategy by Jeffrey Saut“You Gotta Have Heart”
May 5, 2008
“. . . After the workshop, another student took us out to Claibourne, the thoroughbred farm where Secretariat was buried. He was one of the great racehorses of all time. We went to his grave. He was buried in an eight-foot mahogany coffin with a gold satin lining.
My student told me, ‘They don’t usually bury the whole horse, but he was special. Hundreds of people came to his funeral.’
‘Well, what do they bury if they don’t bury the whole horse?’ I asked.
‘Most horses they don’t bury at all. With real winners, they bury the head, the hooves, and the heart,’ she told me nodding.
‘The heart?’ I asked, astonished.
‘Yes, that’s what a horse runs with, his heart. That’s why they say, that horse has heart. If they’ve got heart, it makes up for other things, they can win,’ she explained.”
. . . Long Quiet Highway, by Natalie Goldberg
“Big Brown” was the odds-on favorite to win last Saturday’s Kentucky Derby. And he won, despite starting from the far outside 20th position, he took the lead at the top of the “stretch” and roared to the finish line. The race, however, had a tragic ending as filly Eight Belles, who finished second, had to be euthanized on the track after collapsing while breaking both front ankles. Said breakdown surfaced memories of the 2006 Baltimore Preakness, when Barbaro shattered his rear leg and had to be euthanized a few months later. Clearly, both horses had “heart!” Similarly, in the Wall Street Derby you’ve gotta have “heart.” Indeed, in this business you’ve gotta have heart, as well as experience, to give you the confidence to make the correct “bets” necessary to win the performance derby; or as one Wall Street wag put it, “Experience tells you what to do, but heart gives you the confidence to do it!”
To be sure, we have had “heart” this year having entered the year in a cautious mode, with a high cash position, worried about the potential of a “selling stampede.” As noted, we thought the selling-stampede ended on January 22/23rd (at 1270 basis the S&P 500), and said so, concurrent with recommending committing some of your cash to stocks. The ensuing rally took the S&P 500 up to 1395 in February where we turned cautious, advising participants that bottoms tend to be a function of both “price and time.” Subsequently, we suggested the averages needed to come back down and retest the January “lows” before we could get a sustainable rally that would carry them above their February highs. Almost on cue the averages peaked and slid into their respective March “lows,” which proved to be a successful retest of the January “lows” and we again recommended committing some cash to stocks. At the time “the Street” was rife with stories about the impending market disaster that awaited investors, and our sanity was questioned, except by our friend Herb Greenberg, who in a CNBC interview stated, “I don’t want to go against Jeff Saut since he is one of the smartest guys on Wall Street” (see our parting tribute to Herb at the end of this report).
From Herb’s mouth to God’s ears, for again, almost on cue, stocks gathered themselves together and re-rallied in a move that would carry them above their February highs toward our long-envisioned target zone of 1420-to-1440 basis the S&P 500 (SPX/1413.90). Interestingly, most of the folks that questioned our sanity at the March lows, and consequently would not “buy ‘em” at the time, lit up our phones last week with the question, “what do we buy?!” Regrettably, we had to reply that on a trading basis we are much less sanguine here than we were a mere month ago; and, that we would actually be scale-up sellers of trading positions on any blue-heat upside hour that took the SPX into the aforementioned zone. That move came Friday morning on the much better than expected employment numbers, with an opening salvo that left a “print high” for the SPX of 1422.72; we acted accordingly.
While we still believe the averages can extend higher into our cluster of timing-point “highs” between May 7th – May 14th, we also believe it is pretty late in the up-move and therefore are not recommending ANY new trading positions. Rather, we continue to recommend scale-up selling of trading positions into strength on the belief that come late-May it will become apparent that our economic problems are NOT behind us. That revelation should bring about a decline that will first be measured by “if” the U.S. economy spills into a recession (we still doubt it); and secondly, if that potential recession will be shallow/short or long/deep.
While that is our strategy for the trading side of portfolios, we have a different view for the investing side of portfolios. Indeed, there are many investment stocks that have not participated in the recent rally, yet afford investors attractive risk/reward ratios. One such name was added to our Focus List last week, that name being 6%-yielding Embarq (EQ/$44.06/Strong Buy). We think Embarq’s 30% share price decline from last September’s high of $63 has more than discounted this telecommunication company’s exposure to the housing debacle. Likewise, we favor 7%-yielding Alaska Communications (ALSK/$11.56/Outperform) for its exposure to the vast Alaskan natural resource reserves that should eventually be developed. Our recommendation on Schering-Plough’s (SGP/$18.90) 8%-yielding convertible preferred “B” shares remains in force; even though we lost our fundamental analyst, along with his Strong Buy rating, last Friday (the shares are still positively rated by our correspondent research affiliates). And while we have clearly been wrong on recommending scaling into 3.7%-yielding General Electric (GE/$33.34), after eight years of avoiding it, we continue to think investment positions in GE will be rewarded over the next few years (GE remain positively rated by our research correspondents).
“But Jeff,” one caller questioned us last week, “the economic news has suddenly turned for the better! So why now, after being bullish at the January/March ‘lows,’ are you now turning cautious?!” Our answer was, “while the headline numbers are indeed turning bullish, if you drill down into those numbers all is not as it seems.” Case in point, the 1Q08 GDP report, which at first blush it showed a much stronger than expected positive 0.6% growth rate. However, if you exclude the increase in inventories of unsold goods, the “final sales” number was negative by 0.2%. In other words, the inventories of unsold goods added an artificial 0.8% to 1Q08 growth. Moreover, residential investment collapsed to the tune of 26.7% annualized. Yet the GDP figures misstate this because they do not separate residential investment into true final sales of new homes, as well as into unsold inventories of new homes. Similar nuances massaged last week’s ISM Manufacturing report; and, then there were Friday’s employment numbers.
At first blush, the employment numbers looked impressive, with Nonfarm Payrolls falling by a much less than expected 20,000 (-80,000 estimated), while the Unemployment Rate edged down to 5.0% versus the median forecast of 5.2%. However, as stated in George Orwell’s book “1984” – numbers mean what we say they mean – our government’s recondite birth/death model, which adds jobs it thinks are being created but can’t actually count (read: fallacious jobs), added 45,000 construction jobs and 8,000 financial jobs. Ladies and gentlemen, given the state of real estate and financial industries, such additions are clearly a stretch! Accordingly, we think such numbers will begin to be questioned in the months ahead; and, we continue to invest and trade accordingly.
The call for this week: Last Friday we recommend scale-selling “trading positions” into strength in the 1420 – 1440 target zone (basis the SPX); and especially into our cluster of timing points between May 7th and May 14th. This view is driven by the fact that we have had the envisioned rally, as well as that 77% of the S&P 500 stocks are above their 50-day moving averages (DMAs) for the highest reading since last October (read: overbought). Amazingly, 85% of the S&P’s financial stocks are above their 50-DMAs, which is likely why the financials outperformed gold last week for the first time since last July. Meanwhile, volatility is falling, bonds have broken down (read: higher interest rates), bond spreads are narrowing, the U.S. dollar has “firmed,” and commodities have “cracked,” all of which suggests risk appetites are rising. Plainly this concerns us and begs the question, “Are we entering a new kind of investment environment?” History shows that if so, it will not be without some major dislocations, which is why we are now turning cautious.
“Where’s Herb?!”
“Where’s Herb?” except in this case we are not referring to Burger King’s failed ad campaign of the mid-1980s, but our friend Herb Greenberg. I found the answer in last week’s Wall Street Journal as I turned to “section B” only to see a picture of business journalist par excellence, Herb Greenberg. Over the years I have come to know Herb both professionally, and socially, and have always found his comments extremely insightful. Indeed, Herb unmasked many a company’s fallacious financials before Wall Street discovered them; and, Herb sounded the alarms that saved investors billions of dollars if they listened.
Consequently, I was glad for Herb, but sad for all of us as the column’s headline read, “A Columnist’s Parting Advice,” with the tag line, “After nearly 34 years as a journalist, the entrepreneur deep inside has finally won and I’m leaving to start a research firm.”
The article went on to say (as reprised from the Wall Street Journal and MarketWatch):
“But when you strip it all away, the lessons I have learned can be boiled down to five that are remarkably obvious and simple but are still often ignored in the heat of the battle:
Lesson No. 1: The numbers don't lie. They can be stir-fried, oven-fried or convection-baked, but in the end they always hold the keys to the kingdom. That is why some short sellers and forensic analysts don't like to talk to companies. They want to avoid the spin or the face-to-face meeting that can create a psychological connection that may skew what otherwise would be black-and-white analysis. Don't ever underestimate the power and influence of the human factor.
Lesson No. 2: Quality, not quantity. Ignore the "beat the Street" headlines on earnings. It is what goes into the earnings that counts. As I quoted investment legend Thornton Oglove as saying here the past week, the real story is often on the balance sheet. And let's not forget the cash-flow statement. And this tip: The more complex and convoluted the financial statements get, especially for businesses that aren't overly complicated, the more reason to worry.
Lesson No. 3: GAAP isn't the same as a Good Housekeeping seal. Generally Accepted Accounting Principles, according to which all financial statements are supposed to be prepared, include plenty of gray areas that give management enough rope to hang itself. GAAP, after all, is subject to interpretation, and some managers are more conservative than others. Remember, just because the accounting is legal doesn't mean the end results won't be lousy.
Lesson No. 4: Don't confuse stocks and companies. They sometimes go in opposite directions. Stocks sometimes really do lie. Sometimes they are pushed artificially higher by a rotation by investors from one industry group to another, because that one sector happens to be in favor. Sometimes they lie because of short squeezes, which occur when short sellers -- who bet stock prices will fall -- are for some reason forced to rapidly purchase the shares they sold short. And sometimes they lie because of momentum. Momentum can take stocks to infinity and beyond, but true believers can wind up learning that momentum has a dark side: It is called reverse momentum, and it tends to kick in when you least expect.
Lesson No. 5: Risk isn't a four-letter word. A good rule of thumb is that before you buy, instead of asking how much you can make, first ask how much you can lose. That is what the smart guys do.
Consider those my parting gifts. It has been a great ride. Thanks for sharing it.”
To which we conclude, farewell my friend . . . for those of us that listened, and acted on your sage words, you will be sorely missed.
“As long as the roots are not severed… there will be growth in the spring.”
April 28, 2008
. . . Chauncey; “the gardener”
For the past few years, as spring has sprung and market pundits have expressed conviction about a return to robust economic growth, we have referenced 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 current economic conditions Chauncey remarks, “As long as the roots are not severed there will be growth in the spring.”
Well, here we are. It’s spring again, yet this year instead of the typical cries of “As long as the roots are not severed there will be growth,” many Wall Street pundits are worried. Their worries center on the worsening housing/real-estate situation, and the resultant financial debacle, which has been magnified by the over-leveraged weaving of mortgages into a spider web of recondite “structured investment vehicles (SIVs).” As housing prices have fallen, and foreclosures have risen, said vehicles have collapsed with an attendant “hit” to the financial sector’s balance sheets that is now legend. Consequently, many financial institutions are currently in a “capital building” phase as they re-liquefy their balance sheets, implying major dilution for existing shareholders. Clearly, this is a negative backdrop for investing in the financial sector. We spoke of another negative implication for the sector in last week’s missive. To wit:
“Focusing on individual bank stocks (to buy) might be a bit myopic when the potential ‘real’ insight is that the past 28 years of financial market deregulation has reversed. Plainly something has changed, and changed materially. To be sure, the tidal wave of zaitechism began reversing with SARBOX and the reversal has been accelerating ever since. Recently the ebb tide has turned into a ‘rip tide’ as the spider web of financial engineering (our Japanese friends call it “zaitech”) was exposed by the collapse of many toxically structured investment vehicles (SIVs, SPIVs, VIEs, etc.) and punctuated by Bear Sterns’ bouleversement (BSC/$10.79). Consequently, the tide is now flowing ‘out’ after nearly three decades of financialization, which will no doubt crimp financial sector profitability with a concurrent compression in P/E multiples.”
Fortunately, we have been WAY under-weighted in the financials for years, and have totally avoided investing in the large-cap banks for nearly 10 years. Regrettably, we still feel that way despite the fact the financials could have a pretty decent trading rally as the short-sellers cover their shorts driven by the steepening yield curve. Indeed, many of the financial-related exchange-traded funds (ETFs) have broken-out to the upside in the charts, and in the process, closed above their respective 50-day moving averages (DMAs). Clearly this is a positive development. Similarly, many of the housing-related ETFs have done the same amid the near ubiquitous disbelief that this was impossible. While we agree that longer-term such rallies are likely a “bull trap,” and that the fundamentals will worsen, in the near-term we expect the price-strength to extend.
That same dis-belief is rampant with regards to the major market averages, yet hereto we are short-term positive. Manifestly, we turned bullish at the January 2007 “lows,” cautious at the subsequent February “highs,” and aggressively bullish on the March downside re-test of those January “lows” believing the re-test would be successful; and, that the ensuing rally would carry the averages above the February highs, eventually scooting into the 1400s basis the S&P 500 (SPX/1397.84). From there, if the envisioned pattern continues to play, we should see a decline. To reiterate, that decline should be measured by “if” the U.S. economy spills into a recession (we seem to be the only ones left that doubt it); and that then, the extent of the decline should be measured by if the recession is short-and-shallow or long-and-deep.
To take advantage of the aforementioned potential stock market pattern, we have recommended numerous trading and investment positions. Speaking to the trading positions, we have continued to move stop-loss points “higher” as the rally has progressed; and would look to sell many of these positions into any “blue heat” upside type of hour toward SPX 1440. As for investment positions, while some of our recommendations have been stopped-out (read: sold), due to our “sell discipline” designed to manage the downside risk, others have done just fine. One that did okay until last Friday’s earnings “hairball” is Microsoft (MSFT/$29.83). We have often spoken about MSFT since hearing its story (see previous missives) from a particularly prescient portfolio manager (PM) at our March institutional conference. At the time the shares were changing hands around $28. If participants followed our strategy of scale-buying, they should have an average-weighted cost basis of around $29. Given that our fundamental research correspondents are re-thinking their ratings, we are using a $26 stop-loss point for this investment recommendation.
Clearly this year has proven to be a difficult investing environment. Still, we continue to fare pretty well with our trading recommendations, as well as our investment names like Delta Petroleum (DPTR/$26.54/Strong Buy), Schering-Plough’s (SGP/$18.64/Strong Buy) 8%-yielding convertible preferred “B” shares, Covanta (CVA/$28.77/Outperform); and don’t look now, but Strong Buy-rated Cogent (COGT/$9.78) “gapped” above its 50-DMA last Friday on big volume. We have liked the Cogent story for the past few months, believing this homeland security “play” should do well even if the U.S. economy slips into recession. With $5.00 per share in cash, Cogent appears “cheap,” and remains one of our individual stock recommendations. Yet while we love individual stocks, we also like ETFs, closed-end funds, closed-end notes, and particularly open-end mutual funds managed by PMs that have the skill-sets to navigate ALL investing environments.
To this point, we had dinner last week with Manu Daftary, captain of the Quaker Strategic Growth Fund (QUAGX/$27.93). We “warmed” to Manu’s investing style roughly four years ago when we first encountered Quaker Strategic. What really piqued our interest was that like us, Manu does not want to be “painted” into a “style box” (large cap growth, value, etc.). Rather, he wants to invest in any sector that he thinks will make his clients money. To quote him, “If we don’t like it, we don’t own it!” Moreover, Manu is always looking to manage the downside risk and is unafraid to hold “cash.” Clearly that “foots” with our investment philosophy, for as repeatedly stated in these missives since 1999, “Don’t let ANYTHING go against you by more than 15% - 20%!” Further, like Manu, we are always re-balancing positions (read: selling partial positions as they rally to keep their weightings in-line with the portfolio’s original object). This technique allows profits to accrue and gives us cash for other opportunities as they present themselves. Indeed, to believe that the investment opportunity “sets” that present themselves today are as good, or better, than any that will present themselves next week, next month, or next quarter is naïve. To take advantage of those opportunity sets, you need to have some cash! On average Manu maintains roughly a 15% cash weighting; but at times, like in 1999, has as much as 40%. Furthermore, like us, Manu is willing to take a “stand,” as seen by the fact that he currently owns NO financials, NO consumer discretionary, and NO tech/telecom in his portfolios. He continues to search for “alpha generators” that can generate growth without balance sheet issues, as well as in any kind of economic environment. Clearly, we are a big fan.
The call for this week: For the past few months we have fallaciously suggested that interest rates were going to rise, the U.S. dollar was going to firm, crude oil was subsequently going to decline (along with most other commodities), and that the major U.S. indices, led by the financials, were going to rally; emboldened by the steepening yield curve, which implies the economy is going to recover. While we are often early, over the years we have tended to be generally correct. And last week, that envisioned sequence materialized with the financials, and early-cycle stocks, coming to the fore. Even though we believe it is a “false move,” the difference between perception and reality is where investors’ opportunities lie! Verily, we think the real surprise, going forward, may be that inflation rears its ugly head in 2009, as seen in the nearby chart from our friends at the “must have” web site, “thechartstore.com,” of how many work-hours it takes to buy a barrel of crude oil. Just yesterday, we filled the tanks of our boat to the tune of $1,000 ($4.50/gallon for regular gas); as well, we bought steaks on the way home at $27.00 per pound, yet the Fed tells us there is NO inflation! Clearly, this is sophistry, and we continue to invest/trade accordingly . . .
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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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