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Investment Strategy by Jeffrey Saut

“I will survive”
... a song by Gloria Gaynor
October 13, 2008

I had so many requests to “write up” last Tuesday’s verbal strategy comments that I decided to do so this morning. Additionally, I am leaving on a speaking tour that was arranged some nine months ago and therefore these will likely be the only strategy comments for the week. And we begin this morning’s comments with a quote from an author, stock market historian, analyst, and portfolio manager, the brilliant Peter Bernstein:

“After 28 years at this post and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.”

Clearly we were wrong in thinking the lows for the year were “in” back in mid-September. That belief was driven by the sense that our elected leaders would rise to the level of statesmen and pass the original Paulson “Rescue Plan.” Silly us, we should have known better, having lived inside the D.C. beltway. Since that ill-fated Monday (9/29/08) our strategy has been one of survival. “Survival” . . . yep, that’s the right word, for in markets like these the main theme is to survive! Indeed, participants should remember that it is the second mouse that gets the cheese, not the first, since the first mouse often gets caught in the trap; or as Charles Dow lamented, “the successful investor has to be able to let two, out of every three, potential money making opportunities pass them by.” Verily, those investors/traders that have attempted to pick the “bottom” since September 29th have for the most part lost money; and that caused us to recall Saut’s rule number four. To wit, “99% of the time, when the best bargains came, I had already spent my cash!”

This rule was formulated when I began buying banks/thrifts in January of 1982. By May of that year, I was out of money when the truly “give away” prices presented themselves in June, July, and August. With this rule in mind, for the past few weeks we have been telling accounts to be the second “mouse” and conserve cash until we are more convinced of a market bottom, for if we don’t bottom soon, we are likely in “crash mode.” Clearly the setup appears right for a bottom with our proprietary oversold indicator almost as oversold as it was at the 1974 stock market low, the Volatility Index (VIX/69.95) at fear levels not seen since the 1987 crash, our downside day-count sequence long of tooth at session 29 (selling stampedes rarely go more than 30 sessions), and the coupe de gráce – the “screamer” telling investors to sell everything last week. Ladies and gentlemen, the time to sell and raise cash was at year’s end, not here. Of course, with the DJIA having just made a new all-time high in October of 2007, investors’ mindsets were clearly NOT in sell mode. That mindset was just as wrong back then as today’s ubiquitous wrong-footed mindset to selling everything. As our friend, portfolio manager Vitaliy Katsenelson, noted in the Denver Post:

“In today’s market you see some unbelievable opportunities. For the first time, in a long, long time, we can actually put a full portfolio together where we don’t have to compromise on Quality, Valuation or Growth (QVG) when we pick stocks. Until recently we carried a lot cash as we could not find enough stocks that met all the QVG criteria. So on the positive side; it is a stock picking heaven for value investors. On the negative side, unless you had cash going into this debacle you had to sell one declined stock to buy another that has declined more.”

Reinforcing Vitaliy’s comments was this quip from The Wall Street Journal (as paraphrased by me), “There are 876 companies trading below cash. In 1932 Benjamin Graham calculated there were 1 in 12 companies trading below cash, today there is 1 in 10.” No wonder Warren Buffett is opening his “checkbook” and buying stocks. Of course the Oracle of Omaha is not only focusing on “franchise” types of companies, but situations where there is a substantial dividend yield. Clearly we agree with that strategy, for over the past year our main theme has been clean balance sheets, decent fundamentals, and a dividend yield. Speaking to these points, Raymond James’ research department is publishing a report later today that highlights some of the best yield ideas compiled from our analysts. These ideas range from Master Limited Partnerships (MLPs), Real Estate Investment Trust (REITs), and convertible preferreds/bonds; to fixed income, closed-end funds and Exchange Traded Funds (ETFs). In addition to these ideas, we have our own “shopping list” using names like Eli Lilly (LLY/$31.36), and DuPont (DD/$33.40), which are positively rated by fundamental analysts at our correspondent research firm.

As for the equity markets, they became unglued last week as participants worried about Friday’s auction of Lehman Brothers’ Credit Default Swaps (CDSs), which ended up garnering only 8.625 cents on the dollar. The result left the DJIA down 18.15% on the week for its second worst weekly drubbing in its 112-year history (the worst was 18.47% the week of 7/22/33). Moreover, the senior index is down 40% over the trailing 12 months, causing one market maven to reflect on the second worst stock market crash in history. The decline began in March of 1937 and ended 12 months later for a 386-day loss of 49.1%. It was a democratic decline where stocks, bonds, and commodities all crumbled, leaving investors nowhere to “hide” (sound familiar?). Like now, the authorities tried many maneuvers to stem the slide (like lowing margin requirements, etc.), but it was all to no avail, and eventually the financial fiasco rolled into the real economy with the collapse of industrial production. Typically such a downside skein goes something like this. First, you see analysts lowering their earnings estimates for companies. Second, you see a reduction in the inventories companies are carrying. And third, there is a collapse in industrial production, causing the economy to bottom-out and subsequently recover. Unfortunately, with analysts’ operating earnings’ estimates for 2009 on the S&P 500 at an absurdly high $104.15, we have not even completed stage one.

Nevertheless, given the aforementioned metrics, and the fact that last Monday, Tuesday, and Thursday all qualified as 90% Downside Days (a very rare weekly occurrence whereby points lost, and downside volume, were both skewed 90% to the downside), we think the equity markets have a high probability of bottoming this week. That sense is also reinforced by the MACD Indicator, which is at levels not seen since the November 2002 markets lows, as can be seen in the nearby chart. The only question in our mind is how that bottom is formed. Does it come in the form of a “selling dry up,” or does it come in the shape of a “crash?” However it occurs, chance favors the prepared mind and participants should ready their “shopping lists” and map out their strategy, for as Sun Tzu wrote 26 centuries ago, “Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”

The call for this week: Appropriately, the National Debt Clock at Times Square ran out of digits this week while trying to record the country’s $10.2 trillion shortfall. A like amount of money has been eviscerated in the various markets recently, yet now is NOT the time to sell. As our friend Woody Dorsey of Market Semiotics notes in this week’s Barron’s, “This is not the time to sell. If possible, it is better to just watch and not act or even better, step away until Tuesday. Purgation can be over at any time and be followed by a reprieve rally as occurred after September 26, 2001.” Indeed, be the second mouse that gets the cheese!

“Confidence Game”
October 6, 2008

“Confidence” is defined as, “faith or belief that one will act in a right, proper, or effective way.” But, confidence can be fleeting. As Fed Governor Kevin Warsh stated:

“Confidence can be fleeting. Confidence can beget complacency. If, in liquid times, investors in structured products become complacent, they may not understand fully the value of the underlying assets. High levels of confidence, perhaps even complacency, were also observable in the behavior of many financial intermediaries. Many hedge funds, growing in size and scope, invested in less-liquid assets in search of higher expected returns. Many commercial banks increased sponsorship of structured investment vehicles to invest in long-term securities, often financing them off-balance-sheet with short-term commercial paper. Those financial intermediaries that recognized the risks of extrapolating high levels of liquidity indefinitely were threatened with eroding market share and less-impressive profit profiles. They may have hoped that robust trading markets would allow them to exit positions ahead of a crowded trade. But, to paraphrase an old Wall Street saw, they don’t ring a bell when the markets are at the top or at the bottom.”

Since the Ides of March, triggered by the collapse of Bear Stearns, confidence has clearly been waning. In September that waning turned into a “confidence crash” when the Treasury Department nationalized Mac and Mae. As stated in previous missives, it wasn’t that these GSEs didn’t need to be bailed out, they did, but it was the structure of said bailout that caused a confidence collapse. Indeed, in previous bailouts the government has left an equity stub for shareholders, allowing them to participate in the survival, and eventual recovery, of the company (think: Chrysler, Lockheed, etc.). This time, however, the equity holders were wiped-out after being told by Secretary Paulson that everything would be okay with Fannie (FNM/$1.34) and Freddie (FRE/$1.49), as well as their preferred shares. Ladies and gentlemen, the structure of this bailout is historic, as well as a game changer, causing international investors to ask us:

“Why would ANY rational investor commit capital to a situation whereby if things didn’t go the right way the government might come in and totally wipe you out?!”

Clearly a valid question, and one we can’t answer. A few weeks later another unanswerable question was raised when the Federal Reserve decided to let one of its primary dealers, namely Lehman (LEHMQ/$0.17), go bankrupt. At the time the “spin” was that at $80 – $90 billion the cost of rescuing Lehman was just too large. But, during that same week the government bailed out American International Group (AIG/$3.86) to the tune of $85 billion; AIG was not even a primary Treasury dealer! The Lehman collapse triggered a sequence of credit market events that caused certain money market funds to suspend redemptions and/or redeem funds at less than 100 cents on the dollar. When the media trumpeted the money market machinations, it sparked a “run” on select banks, causing a domino effect that toppled a number of banks.

With the confidence crisis now in full regale, the politicians sprung into action spurred by the $700 billion Paulson Plan. The original rescue plan was written on three pages. It was subsequently rewritten by the House of Representatives to some 100 pages. Still, if the plan would have been passed last Monday, our sense is the DJIA would be 1000 to 2000 points higher than where it now resides. However, our elected nimnods couldn’t rise to the status of “statesmen,” but rather played politics and defeated the bill, leading to last Monday’s 777-point Dow Dive. Shocked by that loss of more than $1 trillion in stock market capitalization, the politicos quickly reconsidered their decision as rumors swirled of a newly crafted rescue plan. Those rumors drove a 485-point Dow Wow on Tuesday. That plan materialized on Thursday with a 400-page rescue plan loaded with more than $100 billion of self-aggrandizing ornaments (i.e. pork barrel “earmarks”) for rum distillers, movie producers, wooden arrow manufactures, stock-car racers, etc., causing most of the electorate to lose total confidence in our politicians amid cries, “Our elected ignoramuses should be ashamed!”

With confidence in our financial institutions, our economy, and now our politicians in total shreds, we told accounts on Wednesday/Thursday that even if the re-crafted rescue plan was passed there would likely be only a brief rally in the equity markets followed by a subsequent sell-off. In fact, we suggested that once the markets get to this stage, they don’t usually end without a “pornographic plunge” type of hour. Regrettably, we got the brief rally when the rescue plan passed on Friday, followed the sell-off, and this morning it looks as if we will get the “pornographic plunge.” Verily, what a difference a week makes, for if the original rescue plan had been passed, our sense is the equity markets would be substantially higher than where they currently are. Yet in this business what you see is what you get and trading accounts should have been “stopped out” of remaining trading positions in last Monday’s meltdown, as noted in Tuesday’s verbal strategy comments. Clearly, we were wrong that the “lows” of two weeks ago (9/18/08) would prove to be “the lows” for the year. That error rests on the fact that we were also wrong in our assumption the initial rescue package would pass because it HAD to pass.

So where does this leave us? Well, last Monday’s “melt” (DJIA -777) turned out to be yet another 90% Downside Day (total point and volume was skewed 90% to the downside), while Tuesday’s triumph (DJIA +485) didn’t qualify as a 90% Upside Day. Moreover by the end of the week, out of the 98 sub-sectors in the S&P 500’s sector analysis, only one was positive on the week, namely the Nondurable Household Sector, on which we have been bullish. In the past such negative sector metrics have been associated with tradable stock market “lows.” Further, our proprietary oversold indicator is now more oversold than it has been in decades. Additionally, according to our “day count” thesis, we are now at day 24 in the downside skein. Historically, such skeins typically do not last more than 17 to 25 sessions before they exhaust themselves on the downside. Traders, therefore, should take heart that we are near a downside inflection point, unless this is indeed a “crash” (which we doubt). Another metric worth watching, since this is a “lending crisis,” is the Libor to Overnight Index Swap-spread (Libor/OIS-spread), which tagged an historic 276 basis points “wide” late last week. Any narrowing in this spread should be viewed as a positive since it would imply banks are beginning to lend to each other again.

The call for this week: Well, we arrived at the office at 5:30 a.m. only to see the S&P 500 preopening futures down 33 points amid news out of Europe of an expanding banking/credit crisis. This morning’s swoon comes on the back of Friday’s Flop, which turned out to be yet another Dow Theory “sell signal” like the one we wrote about last November. Meanwhile, the three-month Libor/OIS-spread is at 295 bp “wide” and with the U.S., as well as Europe, going into a recession the environment is pretty dour. However, things “felt” equally dour post 9/11/01, yet the S&P 500 (SPX/1099.23) bottomed and rallied 24% over the following three months. Consequently, once again I think we are approaching a downside inflection point; and, trading accounts should conduct themselves accordingly. More conservative accounts might wish to consider some of the closed-end funds eviscerated by this month’s hedge fund liquidation like: BlackRock Strategic Dividend (BDT/$9.95); BlackRock Enhanced Dividend Achievers (BDJ/$8.89); and Eaton Vance Tax-Advantaged Global Dividend Income (ETG/$13.79), all of which have blue-chip portfolios with yields; and, all of which are selling at substantial discounts to net asset value (NAV). Clearly, these recommendations are like buying the indices at a substantial discount, as well as in keeping with our dividend theme. As for this week, it’s kiss and tell time.

“Rollover!?”
September 29, 2008

“Never eat at a restaurant named Mom’s.
Never play cards with a man named Doc.
Never get involved with a woman that has more troubles than you.
And never, never ever, believe politicians have a clue as to the entrails of a problem.”

...Anonymous and Jeffrey Saut

I was sitting in the studio last week waiting for the producer of CNBC’s “The Closing Bell” to segue to me when I heard the congressman from Pennsylvania ask the question of Hank Paulson, “You talk about this $700 billion bailout package having to be passed because it is far superior to the alternative. So explain to us, Secretary Paulson, what is the unspeakable alternative?” While the esteemed Secretary’s response was much more subdued than what flashed into my subconscious, here is where my brain went. Recall the 1981 movie “Rollover” starring Jane Fonda and Kris Kristofferson, as paraphrased from Wikipedia:

“Jane Fonda plays Lee Winters, the widow of the Chairman and primary stockholder of Winterchem Enterprises, a chemical company, who is attempting to obtain financing of the purchase of a processing plant in Spain, while trying to determine why her husband was murdered. Apparently, her late husband discovered some damning information about a bank account number 21214, a secret slush fund involving asset transfers. Respected finance man Hubbell Smith (Kris Kristofferson) takes over as president of Boro National Bank at the request of First New York Bank chairman Maxwell Emery (Hume Cronyn), in an attempt to have Smith discover the financial status of Boro National. Smith later discovers that account 21214 is actually a slush fund where Emery is moving money belonging to the Arabs into gold as a safe haven against potential losses if the dollar collapses. The Arabs are extremely worried that if anyone finds out their assets will vanish in a public panic as American currency becomes worthless. Word of the secret account, and the asset transfers, leak out and a monetary crisis occurs. As a result of the panic there is worldwide rioting as people discover their money is becoming worthless.”

In the final scene, Maxwell Emery puts a bullet in his head, gold tracks-out over $2,000 per ounce, and lines of depositors are left lining the streets of New York attempting to get their money out of various financial institutions.

“Overstated?” You bet, but for the past two years we have opined that one of our biggest worries centered on increased government intervention and regulation. Clearly our elected officials have repeatedly “dropped the ball,” for the current situation finds its roots in “The Community Reinvestment Act of 1977 (CRA).” The CRA was liberalized under the Clinton administration whereby such “silly” questions as, “Does your income allow you to pay this proposed mortgage?” were considered discriminatory and therefore eliminated. Over the subsequent years lending standards became laxer, interest rates fell, housing prices rose, mortgages grew “fancier,” and our elected officials promoted a sort of financial carpe diem under the mantra that everyone should own a house even if they couldn’t afford it. While many bank-based mortgage officers railed at some of the mortgage loans they were making, they were encouraged to keep doing so because those questionable loans could always be sold to, you guessed it, Fannie Mae (FNM/$1.83) and Freddie Mac (FRE/$2.00). The resulting spider web of financial foolishness hit its zenith in late 2004, causing some rational folks to sound the alarm.

While there were other voices, Alan Greenspan stated it most eloquently by noting, “If Fannie and Freddie continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road.” He went on to conclude, “We are placing the total financial system of the future at a substantial risk.” Surprisingly, in 2005 the Senate Banking Committee actually “listened” and passed a reform bill that would have created a “world class regulator” for Mac and Mae, which would have cracked down on the “bobbsey twins” requiring them to eliminate many of their investments in risky assets. Unfortunately, our pandering politicians decided it was to be “party on Garth” and never allowed the bill to come up for a vote; and the rest, as they say, is history.

And here they go again, for last week many of these same politicians attempted to kill the Treasury’s rescue plan, begging the question, “Tell me Congressman, how many accounting classes have you had, how many years did you sit on a credit derivatives desk, or for that matter explain to me how a Credit Default Swap works?” Indeed, it is a disgrace that NO professional economist was even invited to speak at last week’s Congressional hearings on the rescue plan. To be sure, the pending plan was “reactively” conceived, but the politicians, as well as the public, have no idea how close the financial system came to seizing-up just two short weeks ago. Clearly, we looked into the abyss when certain money market funds stop withdrawals and/or redeemed deposits at less than 100 cents on the dollar. And that, ladies and gentlemen, is what caused the illuminati to spring into action with a reactive, rather than a thoughtfully conceived proactive, $700 billion bailout plan. Actually, it’s not really a “bailout plan,” it’s more of a “buyout plan;” but that is a discussion for another time.

While the media is replete with the notion said plan is a first, history suggests this is sophistry. Verily, back in the early 1990s Sweden found itself in a like situation and engineered a similar solution. And, it worked; except in their case it didn’t prevent a recession and rising unemployment (something we are worried about for the U.S. in 2009). In the long-term, there plainly were benefits, but it took five years before the entire situation resolved itself. With this as an example, we have supported the hastily conceived $700 billion “buyout plan” even though we have opposed most of the government’s previous rescue maneuvers. And that, friends, is the long and short of it. Either the plan is adopted, and the markets give us the anticipated “add-on” rally, or the plan is defeated and we are right back into the abyss. We urge you not to over-think the situation.

The call for this week: This morning we have the recondite rescue bill on the table, yet it is anything but transparent, creating worries that it may not pass. And that has the preopening futures sharply lower. Nevertheless, two weeks ago today we suggested another tradable “low” was being made (the fourth of the year) and suggested trading types scale-buy into weakness using the indexes of their choice (ETFs). We also stated that more conservative types should probably wait for a session that exhibited positive closing action on the assumption that would lead to a skein of better days ahead. A week ago today we said, “The lows are ‘in’ for the year” (a statement that will be tested today); to which we now add, “Provided the pandering politicians pass the ‘buyout’ plan.” Accordingly, trading accounts should be “long” half of their index positions, having sold the other half into September 19th’s 400-point Dow Wow on the premise the politicos don’t have a clue as to how to fix the problem. Still, as we enter the fourth quarter participants should keep in mind that since 1960 the S&P 500 has produced positive returns in the final quarter of the year 77% of the time; and, that Technology has tended to be the best performer. Also worth considering is that the only sector with positive net earnings estimate revisions during the past month has been Telecom Services. Additionally, we have “warmed” to stuff-stocks again (particularly the oversold energy complex) now that the Olympics/Paralympics are over and China’s factories are back “on line.” Speaking to China, the Shanghai Composite Index’s plunge has left the average price/earnings ratio of listed Chinese firms at roughly 17 times historic earnings, making China again look interesting. Ditto a number of other international markets look attractive, but not so for Europe. Looking ahead to themes for the next 10 years, we continue to embrace agriculture (farming/forestry), water (water rights, water treatment, etc.), new technologies playing to energy conservation (including alternative energy and nuclear); as well as climate change, including environmental pollution and resource limitation. Meanwhile, our political leaders continue to pander to a mis/under-informed electorate while failing to address the nation’s real issues. For example, the top 1% of wage-earners pay nearly 29% of the nation’s total taxes, while the top 5% of wage-earners pay some 48% of the total tab. This fact seems lost amid the current political blustering; or as Oscar Wilde noted, “The public has an insatiable curiosity to know everything except what is worth knowing.”

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