Investment Strategy
by Jeffrey Saut
Bad Trade?!
November 23, 2009
“I asked the obligatory question: ‘How do you decide when to make a trade?’ ‘Through experience,’ he says, propping his foot up on a small fold-out seat screwed to his post. ‘Over the course of eighteen years as a specialist, I’ve had every type of experience – up market and down market, people getting shot, wars, you name it – and you learn how to react based on those experiences. I guess I’ve had everything happen, and I guess you store it in the computer in your head. You don’t have a lot of time to decide, that’s for sure. And you have to anticipate. You have to look at the tape and anticipate – two months or three months, maybe a day or so, maybe two or three seconds before someone else. That’s what makes you a good trader . . . People talk a lot about their bellies. I guess that has something to do with it too. You do feel something in your gut.’
He clears his throat with a loud harrumph and goes on: ‘You watch the tape. There’s a talent to reading the tape. Later today, either the market is going to go further down or it’s going to rally. It’s down fourteen now, at eleven-thirty. You have to anticipate when the rally will start and end. An outsider looks and sees the market down six points for the day. A student of the market looks at what the market was doing over the course of the day. Here, we live and die by the moment. The market is constantly breathing during the day. You have to breathe with it and sense its pulse. That determines whether you’re a successful trader or an unsuccessful trader.”
Do you ever hold on to a bad trade and hope for a rebound? I ask. ‘Live in hope,’ Milton says ruefully, ‘and die in despair.’ He goes on to say, ‘You try to stretch your profits and limit your losses. The worst thing you can do in this business is try to protect a bad trade. You do this and they carry you out of here. This reminds me of the kid who (poops) in bed and gets it all over his legs trying to kick it out of the crib. You see, a bad trade is like a diseased piece of meat. You don’t want it any more of it. Throw it away. Bury it. Burn it, just get the damned thing away from your mouth. When you’re breaking in a new trader, the hardest thing to learn is to admit that you’re wrong. It’s a hard pill to swallow. You have to be man enough to admit to your peers that you are wrong and get out. Then you’re alive and playing the game the next day. A lot of traders don’t learn that and they fail.’”
...“The Traders” by Sonny Kleinfield (1983)
Late last week we asked ourselves the obligatory question, “Did we make a bad trading decision a few weeks ago by recommending a ‘long’ position in the various indices because the equity markets didn’t seem to want to go down?” Indeed, since the end of 3Q09 we have been cautious, but not bearish, worried that the upside vacuum created in the charts by the July – September “melt up” (we were bullish) might get “filled” to the downside once third quarter’s window-dressing subsided. Given the fact that the stock market’s recent action belied that view, and the fact that we had entered the strongest seasonality of the year as reprised in last week’s letter, we decided the weight of the evidence suggested that a “tag in” long-position in trading accounts was appropriate.
However, that strategy appeared questionable last Thursday when the D-J Industrials (DJIA/10318.16) surrendered some 94 points, which created even more stock market divergences, which we have discussed in previous missives. The “Thursday Tumble,” at least by our pencil, was partially attributable to a report by Société Générale that stated there is the possibility of a “global economic collapse over the next two years.” While SoGen’s report offers some cogent points, we just don’t believe them. Of course, the impact of said report was likely magnified by last Friday’s option expiration, which also might be the reason that late Friday’s action almost turned stocks positive.
Nevertheless, we think the upside should continue to be driven by “game theory,” which suggests that the under-invested institutional portfolio managers have to buy stocks into year-end driven by their under-performance, their subsequent “bonus risk,” and ultimately their “job risk.” Verily, many of the portfolio managers we know remain under extreme pressure to commit their outsized cash positions in an attempt to “catch up” to their benchmarks between now and year-end (see the nearby Credit Suisse institutional cash versus retail cash on the sidelines chart).
Reinforcing that game theory point Jeremy Grantham notes:
“In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes ‘keep your job!’ (Manifestly) Career risk-reduction takes precedence over maximizing the client’s return. Efficient career-risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because they are buying.”
Jeremy goes on to note a couple of insightful points: “Refusing, on value principal, to buy in a bubble will, in contrast, look dangerously eccentric. And when your timing is wrong, which is inevitable sooner or later, you will in Keynes’ words – ‘Not receive much mercy’” – he sums up what that means to the folks who try not to go with the herd and do the right thing, “Today the challenge is not getting the big bets right. It’s arriving back at trend with the same clients you left with...”
Plainly, we agree with Mr. Grantham, which is why we continue to think the improving fundamentals, and earnings, will serve as the “carrot in front of the horse” to keep investors chasing stocks even if we do get a near-term pullback. That said, we expect the breadth of the rally to narrow, which is why we have been favoring large caps (hopefully with dividends) versus small caps for the past few months. Big cap pharma is of particular interest to us. Worth noting is that in Friday’s Fade many of the pharmaceutical stocks rallied, potentially telegraphing that the hastily conceived healthcare bill is not going to pass. In past missives we have suggested participants consider pharma for their portfolios using names from Raymond James’ research universe, like 3%-yielding Abbott (ABT/$53.64/Outperform) and 3%-yielding Johnson & Johnson (JNJ/$62.31/Outperform). We also “backed into” 3%-yielding Pfizer (PFE/$18.36) when it acquired Wyeth. Like ABT and JNJ, PFE rallied on Friday; and, all three are attempting to break out to the upside in the charts. Pfizer is followed by our research affiliates with a favorable rating.
In conclusion, there is an article in this week’s Barron’s titled “10 for the Money.” The byline reads, “Stocks that pay good dividends can ease one of retirees’ biggest fears – that they’ll outlive their investments.” Given this has been one of our major themes for the past few years, we urge you to read the article. In said article, in addition to the aforementioned Johnson & Johnson, some other Raymond James stocks were mentioned, all of which have at some time been recommended in these reports. They are: Chevron (CVX/$76.77/Strong Buy); Intel (INTC/$19.24/Outperform); and Verizon (VZ/$30.43/Market Perform).
The call for this week: As the S&P 500 traded out to new reaction “highs” in the first part of last week we heard a cacophony of crybabies. First was Meredith Whiney, banking analyst now turned strategist, who stated, “I have not been this bearish in over a year!” One-upping her was Nouriel Roubini who exclaimed, “The worst is yet to come.” Then there was Timothy Geithner’s statement that, “I can’t take responsibility for the legacy of crises you (read: Republicans) bequeathed the country.” While I think Tim Geithner has done a really good job, excuse me Mr. Secretary but wasn’t it you that resided over NY Fed as President from 2003 through January 2009, which also brings the privilege of being Vice-Chairman of the FOMC? Accordingly, it was you who served as regulator of the country’s large financial institutions. Thus, it was on your watch that the big banks ran amok. Despite such cantankerous cries, we have indeed entered the strongest seasonality of the year and we remain constructive. As the sagacious Bespoke Investment Group writes, “Since 1941, the Dow has averaged a gain of 0.50% in the week before Thanksgiving.” That said, we would not like to see the S&P 500 break below 1083. And speaking of breaking down, the Japanese stock market is breaking down and we are close to “uncle points” on those recommendations.
‘Tis the Season?
November 16, 2009
‘Tis the season . . . except in this case we haven’t quite yet entered the Christmas season. However, we have entered the best six months of the year for the equity markets. Clearly, history demonstrates that the November through April periods have on average shown superior stock market performance to that of the May through October half of the year. As our South African friend Dr. Prieur du Plessis notes, “(since 1950) the ‘good’ six-month period of the year shows an average return of 7.9%, while the ‘bad’ six-month period only shows a return of 2.5%.” This performance can be seen in the first chart on page 3.
In addition to the aforementioned seasonality, there are some equally compelling shorter-term metrics. To wit, over the past 12 years the DJIA has always shown a profit between November 11th and December 5th. Additionally, since 1976 the DJIA has posted a positive return between October 26th and January 1st every year except 2007. As for those that suggest the markets have rallied too far too fast, we offer these comments from the always insightful folks at “The Chart of the Day.”
“To provide some perspective to the current Dow rally that began back in March, all major market rallies of the last 109 years are plotted on today's chart. Each dot represents a major stock market rally as measured by the Dow. As today's chart illustrates, the Dow has begun a major rally 27 times over the past 109 years which equates to an average of one rally every four years. Also, most major rallies (73%) resulted in a gain of between 30% and 150% and lasted between 200 and 800 trading days (9.5 months to 3.2 years) -- highlighted in today's chart with a light blue shaded box. As it stands right now, the current Dow rally would be classified as both short in duration and below average in magnitude.”
To us the real question is not whether this is a counter-trend rally in an ongoing bear market, but rather is this the beginning of a new secular bull market, or a bull market within the confines of the trading range we have been in for the last nine years? In past missives we have often reminded participants that since 1900 there have been only three secular bull markets. They were from 1921 – 1929, 1949 – 1966, and 1982 – 2000. Following each one of those secular bull market peaks the DJIA has been “range-bound” for a period of years. Using the 1966 bull market peak as an example, the Dow was mired in a trading range for 16 years before embarking on the next secular bull market. Of course, those of us that lived through the 1966 – 1982 debacle know that there were a series of bull and bear markets within the confines of that trading range. In fact, there were at least ten 20%+ rallies and/or declines in that ongoing range-bound market. Accordingly, investors had to have a more proactive strategy for their portfolios, much like we have had to use for the past number of years.
While NOBODY can answer our proposed question, what we can attempt to do is position portfolios in a manner that deals with the current environment as we see it. To that point, since last April we have been using the stock market’s chart pattern from 2003 as a template for this rally. Recall that the S&P 500 bottomed in March 2003 and rallied sharply into to June. From there it flopped/chopped around for a few months, but never gave back much ground, and then it took off on the second leg of the rally, rising into the first quarter of 2004. The first “leg” of the 2003 rally was driven by liquidity, much like 2009’s first leg (March – June). The second leg of the 2003 rally was driven by improving fundamentals and earnings, just like 2009’s “July through now” rally.
To be sure, we have turned cautious a couple of times since the March “lows,” but we have never turned bearish. Most recently, we wrongfully turned cautious at the beginning of October, worried that the July – September upside vacuum created by the melt-up might get “filled” to the downside once quarter’s end window dressing was over. Obviously, that was wrong-footed because all the markets have done is work off their pretty overbought condition at the end of September into a very oversold condition a few weeks ago. We chronicled that oversold condition in our report of November 2, 2009, but regrettably didn’t act on it. Accordingly, we corrected that cautious “call” last week by adding some “long” index positions to the trading account. While we would have felt better adding those positions if the markets had pulled back, or if the S&P 500 (SPX/1093.48) had rallied above its potential double-top of 1100, in this business you have to take what the markets give you. Whatever the resolution in the short term, we continue to believe the major market indices will trade higher into the first quarter of 2010.
Plainly, we agree with the astute GaveKal organization in that the normal economic cycle is for corporate profits to increase, which drives an inventory rebuild and subsequently capital expenditure cycle, and then comes employment expansion that revives consumption. Currently, corporate profits are surging at their largest ramp rate since mid-1975. According to ISI, “profits have increased sequentially for the past three quarters at an estimated +34.8% annual rate – a record for a recessionary environment.” As of yet, however, the inventory rebuild has been muted. But with inventories plumbing record lows, we think the inventory cycle is about to begin. If correct, the aforementioned sequence should play. Importantly, consumption comes at the back-end of the cycle, not the front-end. Consequently, those arguing we cannot have a normal recovery until unemployment declines are like skiers skiing downhill looking at the tails of their skis.
We think the normal economic cycle will play once again. If so, economic reports, fundamentals, and earnings should continue to improve, putting even more pressure on underinvested participants (according to the latest surveys, hedge funds are only ~52% net long). And, that pressure should buoy stocks into the first part of 2010. It is the back half of 2010 that begins to worry us due to harder earnings comparisons, loss of the “sugar high” stimulus funds, higher taxes, an election year, increased government regulation, etc. In fact, it is the probability of further government regulation of corporate America that worries us the most, and we are not alone. As our energy analysts wrote last week:
“ENSCO International (ESV/$45.94/Market Perform) to pick up shop and head to U.K. After watching rivals Transocean (RIG/$87.31/Strong Buy) and Noble Corp (NE/$43.28/Strong Buy) move to Switzerland, ENSCO has announced its intentions to re-domesticate from Delaware to the U.K.”
ENSCO joins a growing list of companies, like Tyco (TYC/$36.50), that are moving offshore driven by worries of increased regulation and taxes. I am old enough to remember the exodus of U.K. companies, and talented people, to America in the 1960 – 1970s for similar reasons. Another example of governmental incursion came full circle last week when Pfizer announced the closing of six Research and Development facilities. One such site is located in New London, Connecticut. It was four years ago when the government used eminent domain to seize homeowners’ homes. The government (state/local) then spent $78 million to bulldoze those properties to build condos, and offices, to enhance Pfizer’s nearby research facility. The “spin” was that the project would create jobs and bring in more taxes. Now that land stands vacant, without any of those promised benefits. With Pfizer’s closing of its New London facility that land will likely remain fallow. As The Wall Street Journal writes, “Economic development that relies on the strong arm of government will never be the kind to create sustainable growth.”
The call for this week: In bull markets, be they secular or not, it is rare to get anything more than a 7% - 10% correction; while we have been looking for such a correction for more than a month, time is running out. The trick then becomes to commit some capital to areas that have good risk/reward metrics. By our pencil, the sectors displaying the best relative strength are Energy, Consumer Non-Cyclicals, Basic Materials, and REITs (real estate investment trusts). Our REIT analysts just returned from the NAREIT national conference and reiterated their Outperform rating on 3.5%-yielding Apartment Investment and Management Company (AIV/$13.48). Another way to get at the REIT theme would be via the ETF iShares REIT (IYR/$43.19). On the energy theme, our analyst upgraded American Superconductor (AMSC/$31.00/Strong Buy) this morning. As for Consumer Non-Cyclicals, the ETF that makes sense to us is the Consumer Staples SPDR (XLP/$26.72), as does Wal-Mart (WMT/$53.20). And, we still like our previous recommendations of Pfizer (PFE/$17.59) and Altria (MO/$19.26), which are both followed by our research correspondents.
I Should Have!?
November 9, 2009
“... 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 bought at Dow 8000 when the DJIA broke above the downtrend line that was formed by drawing a descending line from the May 2008 high to the September 2008 high. Now we are probing another descending trend line that can be seen by drawing a similar line connecting the October 2007 high with the highs of December 2007, May 2008 and October 2009.” So exclaimed one disgruntled portfolio manager last Friday since the senior index again continued to not surrender much ground last week. Indeed, despite all the “calls” for a correction (including ours) the Dow remains resilient. And, those “correction calls” are now legend with certain pundits trumpeting that the “bear market rally is over” and we are now going to re-test, and break, the March lows. Other mavens continue to opine that the 1937 – 1938 Dow déjà vu is the preferred pattern, which also suggests that new lows lay ahead.
To be sure, references to the 1930s abound with folks like financial historian Niall Ferguson appearing on Charlie Rose waxing that the United States will suffer the same fate as Britain following World War II. To wit, the U.K. was broke, deeply in debt, the British Pound was destined to lose its status as the world’s reserve currency, and Britain itself was in secular decline. Shortly after Mr. Ferguson’s appearance was Singapore’s first Prime Minister Mr. Lee Kuan Yew. He too opined that the U.S. was potentially at the end of an era unless the nation summons the mental fortitude, and toughness, to reverse its current course. Clearly, nostalgia is reigning on the “Street of Dreams,” causing one savvy seer to recall Vera Lynn’s 1930s song, “We’ll Meet Again.” The lyrics are:
“We'll meet again. Don't know where, don't know when. But I know we'll meet again. Some sunny day. Keep smiling through. Just like you always do. 'Till the blue skies drive the dark clouds far away.”
Plainly, this song suggests the end of something, and in fact was played at the end of the movie “On the Beach.” Said movie centers on a post World War III environment whereby the entire northern hemisphere is polluted by nuclear fallout. The only part of the earth that is still habitable is the far south of the global, namely Australia. Yet as the radiation spreads, even the Australians begin dying. The final scenes show the deserted streets of Melbourne as the song “We’ll Meet Again” plays. Indeed, the end of an era.
We, however, don’t buy the idea that our nation is at the end of an era. While the U.S. is certainly in a “hard spot,” our sense is that economist Joseph Schumpeter’s notion of “creative destruction” will play once again. One can actually see it at work as labor and capital are moving from dying industries to growing industries like electric cars, biotechnology, green companies, infrastructure, etc. We have been on the infrastructure theme for years, with particular emphasis on electricity and water. Interestingly, much of the stimulus money earmarked for infrastructure is going to go for replacing our country’s aged water pipes. Obviously, that’s good news for pipe manufacturers and we have tilted portfolios accordingly.
As for the equity markets, while we have wrongly been looking for a correction since the beginning of the fourth quarter, the S&P 500 (SPX/1069.30) still hovers around the same level it was when we turned cautious. To us that’s pretty bullish, for as stated in last week’s letter:
“While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish.”
Indeed, despite the “bad mouthing,” all stocks have done over the past month is consolidate their July – September rally by moving sideways. Moreover, that sideways consolidation has seen the equity markets work off their overbought condition into one of being pretty oversold. Ladies and gentlemen, to an underinvested portfolio manager the current environment is a nightmare, especially if you believe as we do that we are going to see an upside celebration into year-end. Manifestly, we have argued that with credit spreads below their pre-Lehman bankruptcy levels there should be no reason why the equity markets can’t “fill up” the downside vacuum created in the charts by said bankruptcy. As can be seen in the following chart, that gives the S&P 500 an upside target of 1200 – 1250. If correct, it implies that the cash rich, underinvested portfolio managers (PMs) will once again be forced to chase stocks higher. Our guess is the PMs will chase the “winners” since the March lows rather than buying the laggards. That suggests investments in emerging and frontier markets, technology, financials, base/precious metals, etc. should trade higher if the aforementioned scenario plays.
Along this “chase ‘em” theme, we have screened the Raymond James universe of stocks that have rallied more than 100% since the March lows, which were rated Strong Buys in March, and are still rated Strong Buy. If we get “melt up” stage 2, such a list should make a decent idea list. The names for your consideration are: RF Micro (RFMD/$4.02); Bank America (BAC/$15.05); Hughes Communication (HUGH/$24.60); Continental Resources (CLR/$37.17); AFLAC (AFL/$42.19); Whiting Petroleum (WLL/$61.30); ADC Telecommunications (ADCT/$6.52); NII Holdings (NIHD/$27.82); Micron Technology (MU/$7.08); JDS Uniphase (JDSU/$6.46); Motorola (MOT/$8.89); Encore Acquisition Co. (EAC/$44.74); Service Corporation (SCI/$7.55); BPZ Resources (BPZ/$6.84); and KVH Industries (KVHI/$10.99).
The call for this week: Time is running out for the bears if our year-end celebration is going to play. If the major averages break out above their recent reaction highs the party could commence. As for us, we are on the road again this week, so these will likely be the last strategy comments for the week.
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