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Investment Strategy by Jeffrey Saut

“It’s tough making predictions, especially about the future.”
January 5, 2009

In December 2007 Barron’s published an article titled ‘A bullish call — Wall Street’s seers forecast more gains for stocks next year’ (see Barron’s Online, December 17, 2007) where 12 well-known strategists listed their 2008 earnings estimates and year-end 2008 price targets for the S&P 500. The earnings’ estimates ranged from a high of $101 to a low of $85.65, while their price targets were scattered between 1525 and 1750. None of the strategists predicted a recession and Tobias Levkovich believed that stocks were “screamingly cheap relative to bonds.” Similarly, Abby Cohen noted that the S&P 500 was trading at just 15.6 times average 2008 estimated earnings. For 2009, these “experts” now expect the S&P to increase to around 1100. I confess that I have no idea where the S&P 500 will be in a year’s time, but given the catastrophic economic conditions, I am convinced that governments around the world will increase the intensity with which they will attempt to save the world with monetary and fiscal measures.

. . . Dr. Marc Faber, “The Gloom, Boom and Doom Reports” (as paraphrased by me)

I have read the insightful Dr. Faber for a long time and have always found him thought-provoking, and extremely helpful, because he is an out of the box “thinker,” which is why I HIGHLY recommend his news letter. Like him, I have no idea where the S&P 500 will be a year from now. Still, the media calls every December to ask, “Where do you think the S&P 500 will be a year from now; and, what are your earnings projections?” My standing answer is found in the first paragraph, of the first chapter, in Ben Graham’s legendary book “The Intelligent investor.” To wit, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. ” Therefore, while predicting/forecasting the future may be fun and exciting, it is by default, according to Dr. Graham, “speculation.” Nevertheless, in December 2007 the media countered my “Grahamism” argument by asking, “Well, the consensus operating earnings’ estimate for the S&P 500 in 2008 is $102; and, the consensus target price is 1620. What do you think about those numbers?” My response was, “I think they are both way too high.”

That said, I was still shocked at how bad last year turned out to be, even though I was somewhat prepared for it. What we got right was raising a lot of cash in November/December of 2007 and entering 2008 in a very defensive mode. What we got wrong was not raising enough cash and not being defensive enough. Going into 2009, however, we actually have a more positive spin than most. Indeed, we continue to think the capitulation, and/or psychological “low,” was recorded on October 10, 2008 when roughly 93% of the stocks traded on the NYSE made new yearly “lows.” Meanwhile, at least so far, it appears the “price low” was recorded on November 20, 2008. Accordingly, we have positioned accounts, using a “scale in” and “hedged” approach, for a short/intermediate-term rally into mid-January. From there, we believe the major averages should be due for a pause/pullback as they contemplate the new administration and when the recession will end. Our sense remains that the GDP numbers will have seen their nadir in the 4Q08, but that GDP will not turn positive until the 4Q09. If correct, and if past is prelude, the equity markets will have bottomed the perfunctory six months prior to the end of the recession. As history shows – when a recession becomes a fact acknowledged by all, the worst of its effects have already pretty much run their course.

Moreover, an old Chinese proverb suggests, “In the management of affairs, people constantly break down just when they are nearing a successful issue. If they took as much care at the end as at the beginning, they would not fail in their enterprises.” Plainly, we agree and have opined that the time to be cautious was at this time last year, not after a 52% decline in the S&P 500. Indeed, just like participants were conditioned in 1999/2000 that declines would not gain much traction, participants have now become conditioned to believe rallies will not gain much traction. We don’t believe it and would ask investors to consider what could actually go right in 2009. To be sure, the equity markets are now well off of their respective November “lows.” Risk appetites are returning. Policy “easings” have accelerated almost everywhere. The U.S. dollar rally has abated. And, China has taken measures to keep its economy from slipping further into the abyss.

Clearly, our equity markets have responded favorably to these events since November. And, last week that response continued with the DJIA (9034.69) and the D-J Transportation Average (DJTA) (TRAN/3651.00) closing above their respective December 2008 closing “highs.” While this is NOT a Dow Theory “Buy Signal,” by our method of interpreting Dow Theory, it is a step in the right direction. If, however, the DJIA and the DJTA can close above their respective November 4, 2008 closing “highs” of 9625.28 and 4071.81, it would render the first Dow Theory “buy signal” from inexpensive valuations in decades. While we are hopeful, we remain worried about the trillions of dollars of CDOs/CLOs/etc. coming due this year. Yet, for the past few months the equity market has shown an amazing resilience to bad news, a trait we hope extends in the new year. Ladies and gentlemen, when markets turn a deaf ear to bad news that’s good news!

As for the “here and now,” our hedged “long” positions in the major market exchange-traded funds (ETFs) are now showing decent gains and we are raising stop-loss points appropriately. Meanwhile, our unhedged long positions in the iShares MSCI Japan (EWJ/$9.63) and the iShares MSCI China (FXI/$31.11) have not only broken out above their respective December closing “highs,” but their November closing “highs” as well, and hereto we are raising stop-loss points. As for the closed-end municipal bond funds recommended three weeks ago, both BlackRock MuniHoldings Insured (MUE/$9.60) and Nuveen Insured Dividend Advantage (NVG/$11.60) have experienced rallies that have reduced their discounts to net asset value by nearly 50%. While we continue to like the strategy of buying distressed debt, we would now be more price sensitive given the fact that the Treasury Bond complex broke down last week, implying higher interest rates. Interestingly, while we don’t own it, the Market Vectors Agribusiness ETF (MOO/$29.46) has closed above its November/December closing “high,” which should help our recommendation on 8%-yielding Archer-Daniels convertible preferred “A” shares (ADM+A/$38.27). We continue to like the agriculture theme and in addition to Archer-Daniels offer for your consideration Bunge’s 7%-yielding convertible preferred (BGEPF/$68.00); both issues are followed by our correspondent research affiliate.

The call for this week: It has been said that, “So goes the first week of the new year, so goes the month and then so goes the year.” While there is statistically some truth to this old stock market “saw,” we prefer combining it with the December Low Indicator, which we will write about next week. Our strategy remains to favor the upside into mid-January where a pause/pullback should be in order. What happens to the stock market’s “internals” (advance/decline, selling pressure, etc.) in that pause/pullback should tell us a lot about the market’s future direction. Our official stance for the year is that it will be a “stock pickers” year where companies with lots of cash on their balance sheets (so they don’t need to go to the credit markets), decent fundamentals, and dividends will provide outperformance. A company like Strong Buy-rated Intel (INTC/$15.20) is just such a company. Nevertheless, 2009 should be a better year than 2008, for as noted in the December 30th issue of “The Economist:”

“If 2008 was the year of systemic risk (systemic risk is the risk of collapse of an entire system or entire market and not to any one individual entity or component of that system. It can be defined as ‘financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries.’ It refers to the risks imposed by interlinkages and interdependencies in a system or market; systemic risk by definition is systemic or universal and thus this risk cannot be diversified away but is borne by all assets in the entire universe), particularly in the financial sector, 2009 seems likely to be a year dominated by the more usual ‘specific risk.’ (Specific risk is the risk that affects each asset uniquely. This is sometimes referred to as ‘unsystematic risk.’ Unlike systematic risk or market risk, specific risk can be diversified away.)”

“The Bezzle”
December 29, 2008

“In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man, who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the Bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”

“Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.”

. . . “The Great Crash of 1929” by John Galbraith

Mark Twain once opined, “History doesn’t repeat itself, but it often rhymes.” Nowhere is this truer than in the stock market because the stock market is mainly a combination of fear, hope, and greed only loosely connected to the business cycle. As Nobel laureate George Akerlof argues, “Individuals can act irrationally and for non-economic reasons.” Indeed, at the margin, stocks are driven by human emotions; and over the years human emotions have not changed all that much, as can be gleaned from the Galbraith quote. To wit, “Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery.” Those who go on to read the book find that following the 1929 crash came the most spectacular “bezzle” of the period. It was the looting of the Union Industrial Bank of Flint, Michigan. “The gross take, estimates of which grew alarmingly as the investigation proceeded, was stated in The Literary Digest later in the year to be $3,592,000 (December 7, 1929).” Regrettably, following the discovery of this initial bezzle came a string of bezzles that created a negative feedback loop in crowd behavior and human psychology that impacted the various financial markets.

Fast forward to present day. While there is no specific definition of a stock market crash, the term commonly applies to a double-digit percentage decline in a stock market over a few days. For example, in 1987 the DJIA lost 22.6% in just one day; and in 1929 it lost 23% in two days. Therefore, by our pencil, we have not experienced a stock market crash, but rather a series of mini-crashettes. Still, it certainly feels like a crash, and as MFS Investment Management writes, “100 days ago the S&P 500 was down 14.1% YTD (total return). As of last Friday (12-12-08), the S&P 500 is down 38.7% YTD. Thus the S&P 500 has fallen 28.6% in the last 100 days, a performance that would rank as the 6th worst bear market of the last half century.” Unsurprisingly, following such a downside skein, comes news of “the bezzle” whereby Bernie Madoff’s ponzi scheme came unraveled to the detriment of many investors. Manifestly, only when the tide goes out does one discover who’s been swimming naked. Unfortunately, if past is prelude, like in the 1930s there will be more “Mr. Madoffs” in the coming months, which should lead to increased negative investor psychology combined with massive Congressional hearings resulting in more wrong-footed regulations like the Sarbanes-Oxley Act. While this is likely the course we are steering over the coming quarters, the real question becomes, “Have the equity markets already discounted such events?”

In past missives we have suggested that the equity markets have been in a bottoming process since the October 10th capitulation “low.” We have given numerous metrics for that view, but in this week’s Barron’s the always insightful Stephanie Pomboy makes our prose pale in comparison when she states:

“In the very near-term, there are a variety of reasons to anticipate a rally in risk. First is the massive destruction witnessed to date. Our dogmatic [insistence] that markets needed to give back all the gains built on the housing-bubble lie have largely come to pass. Virtually every market is at or near pre-bubble lows, from stocks to bonds to commodities . . . [so] the financial deleveraging may largely be complete (see the nearby crude oil chart). Most notably, yields on corporate credits have climbed to multidecade (and in the case of junk, record) extremes. At the same time, cash [must be] burning a hole in investors’ pockets with 0% yields before inflation and dollar debasement.”

Obviously we agree with our friend Stephanie, which is why we have been recommending the scale buying of distressed debt situations like BlackRock MuniHoldings Insured (MUE/$9.36) and Nuveen Insured Dividend Advantage (NVG/$10.75), both of which sell at discounts to their net asset value and have over 6% tax free yields. We also have been recommending Lord Abbett Bond Debenture Fund (LBNDX/$5.70) with a near 9% yield. Moreover, even though we have avoided the financial complex for years, for those wanting exposure to said complex our vehicle of choice remains the iShares S&P U.S. Preferred Shares (PFF/$28.12), which is yielding over 10% and has a 78% exposure to the financial complex’s preferred shares (see the attendant chart). Additionally, during the past few weeks we have added the iShares MSCI Japan (EWJ/$9.17) and iShares FTSE China (FXI/$28.06) to the ETF portfolio.

The call for this week: We will be doing reviews on analysts and general “housekeeping” over this holiday-shortened week, so these will be the only strategy comments of the week. Nevertheless, while there will likely be more negative news, we think the worst of the economic news is at hand. Meanwhile, the world’s stock markets are well off their “lows,” risk appetites are slowly returning, and the central banks are aggressively easing. Indeed, as MaroStrategy’s Bob Parenteau notes, “The prime monetary policy operation becomes the Fed’s ability to use its infinitely expandable balance sheet to purchase longer maturity Treasuries, GSE debt, mortgage backed securities, and in the extreme, even equities and corporate bonds with the objective of getting private market interest rates down and asset prices up.” We continue to think the Fed will be successful. Happy New Year everybody.

“Turning Point?”
December 22, 2008

Winter officially began yesterday morning with the arrival of the Winter Solstice. Recall that solstice means “standing-still sun;” and on December 21^st at 7:04 a.m. (EST) the sun “stood still” over the southern Pacific Ocean (Tropic of Capricorn). At that time the sun’s rays were directly overhead, giving the impression that the sun was truly standing still. This phenomenon occurs twice a year (winter solstice and summer solstice), for as Earth orbits the Sun the north-south position of the Sun changes due to the Earth’s changing “tilt.” The dates of maximum tilt to the Earth’s equator correspond to the winter and summer solstice, while the dates of zero tilt are termed the vernal and autumnal equinox. In these latitudes most people “frame” the winter solstice as the shortest day of the year. We, however, have always liked the French version, which avers that it is rather the longest night of the year. In the northern “climes” this will mean roughly nine hours of sunlight, and 15 hours of darkness, and that light-to-dark ratio tends to produce “Seasonally Affected Disorder Syndrome” (or SADS) in certain folks.*

SADS is attributable to a lack of melatonin in the brain, which can lead to depression. Since sunlight produces melatonin, when temperatures drop, the skies grow grey and the days get short, individuals afflicted with SADS are often heard lamenting, “I can’t get into the Yuletide spirit, I’m just too depressed.” Interestingly, the ancient peoples seemed to suffer from this same affliction and consequently made the Winter Solstice a time of year for festivals, which even superseded Christmas, in an attempt to boost the spirits and keep the year alive. As poet Susan Cooper scribed in her poem “The Shortest Day:”

“So the shortest day came and the year died.
And everywhere down the centuries of snow, white, world
came people, singing, dancing, to drive the dark away.
They lighted candles in the winter tress;
They hung their homes with evergreens;
They burned beseeching fires all night long
To keep the year alive. ...”

No one is quite certain how long ago humans recognized the winter solstice, and began heralding it as a turning point, but a turning point it is since the sun will set a minute or two later each day from here into the summer solstice (June 21^st), which just happens to be the shortest night of the year. We paid tribute to this year’s “turning point” by facing the sky and screaming at the top of our lungs. It was one of many such screams emitted over the past year as we watched the S&P 500 (SPX/887.88) lose nearly 52% of its value since October 2007. However, our sense is that the economy, and the various markets, are near/at a turning point.

That “turning point” sense is driven by last week’s decision from the Federal Reserve to change its approach to interest rate targeting by allowing the Fed Funds rate to “float” between zero and a quarter of one percent. The operative word here is ZERO as the Fed is effectively offering the banks “free money.” With the Fed Funds target rate now down to the 0-25 basis point level, the Fed is “out of bullets” with regards to conventional monetary policy. Consequently, the Fed felt compelled to announce that, “The Federal Reserve will employ all available tools to . . . preserve price stability.” As Bloomberg Television put it, “The Fed is All In!” “All In” indeed, for it now appears the Fed is moving to influence other interest rates. As MaroStrategy’s Bob Parenteau notes:

“The prime monetary policy operation becomes the Fed’s ability to use its infinitely expandable balance sheet to purchase longer maturity Treasuries, GSE debt, mortgage backed securities, and in the extreme, even equities and corporate bonds with the objective of getting private market interest rates down and asset prices up.”

To be sure, this Fed is being much more aggressive than the Bank of Japan following Japan’s “bubble bust,” as well as more aggressive than the Fed of this country’s Depression years; and, we think the Fed will be successful in getting private market interest rates down and asset prices up.

Accordingly, we think last week’s Fed action will mark a “turning point” for the real economy and would argue the equity markets tend to lead economic turning-points by roughly six months. Since the typical recession lasts 18 months, a six-month economic “turn” from now would “foot” with the NBER’s recent revelation that the current downturn began in December 2007 (12 months ago, even though we still have not experienced two negative quarters of GDP). Moreover, in addition to our often mentioned metrics for a better equity market since the October 10th capitulation “low,” the ensuing downside devastation recently left the S&P 500 (at its nadir) a massive 34% below its 200-day moving average (DMA). Ladies and gentlemen, the last two occasions that the S&P 500 exceeded the gap of 25% below its 200-DMA was in October 1974 and October 1987, both of those readings were at major market lows for the indices. Their subsequent advance was more than 50%! Given all the previous mentioned reasons for our “call” to gradually re-accumulate stocks, in some cases using hedge strategies, we now add Kiplinger’s “Six Reasons to Buy Stocks Now”:

1) Stocks are battered and cheap.
2) Stocks are overdue for a rally.
3) The low risk alternatives are pathetic.
4) It’s not the 1930s.
5) The market shows signs that the worst is over.
6) If not now, when?

Plainly we agree, and would note that even though the flow of news has become materially worse over the past few months, the DJIA is not much changed from mid-October. Basically, the major market indices have gone sideways despite the news, including news of fraud and manipulation. Such pricing action suggests participants have capitulated, and that much of the “selling” has already been done. In past missives we have opined that just like investors were conditioned to believe that any decline would not gather much traction back in 1999 and 2000, they are now being conditioned to believe that any rally will not sustain. Meanwhile, last week the Volatility Index (VIX/44.93) closed below its November closing low of 47.73 and the Russell 2000 (RUT/486.26) tracked-out above its 50-DMA (at 481.45). If the DJIA (8579.11) can likewise break out above its 50-DMA at 8702, the Dow’s November 4th reaction “high” becomes the next upside target. Bettering that high, with a like move from the D-J Transports, would register a Dow Theory “buy signal;” the first such signal that would come from “cheap” valuation levels in more than a decade.

In conclusion, Dire Straits was playing on the Street of Dreams last week as the Fed lowered interest rates to zero. Indeed, “your money for nothing and your chicks for free!” Unsurprisingly, given interest rates, the Dollar Index lost 2.8% on the week; yet we think the worst of the dollar’s recent decline is over since the ECB will likely have to lower rates as the European economies sink deeper into recession. Surprisingly, given the dollar’s weakness, crude oil fell a shocking 26.8% last week. Hereto, we are of the view that oil is bottoming as these prices should cause China to increase its strategic reserves. Still, Asian asset classes are the real beneficiary of a falling U.S. dollar and low oil prices, which is why we are long the iShares MSCI Japan (EWJ/$9.14) in the ETF portfolio. And, this morning we are adding iShares FTSE China (FXI/$30.55).

The call for this week: We are leaving for the Nation’s capital, so these will be the only strategy comments for this holiday shortened week. Nevertheless, as our friends at Bespoke note, “The S&P 500 remains in a short-term uptrend that formed off of its 11/20/08 lows, although it’s walking a tightrope to maintain it.” Obviously, we agree; and conclude with this quip from the Stock Trader’s Almanac – “Santa Claus comes to Wall Street nearly every year and brings a short, sweet, respectable rally. The rally occurs within the last five days of the year and the first two in January.” Merry Christmas everybody.

*Unknown author

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