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Professionally Speaking
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Investment Strategy by Jeffrey Saut
“Toto, this certainly isn’t Kansas anymore?!”
... Dorothy from the “Wizard of Oz”
November 17, 2008
The holiday season officially began at the Saut household last weekend, for as I sat down in front of the TV to catch up on some overdue reading, the movie “The Wizard of Oz” appeared. Followers of our work know that three movies really put us in the holiday mood. “The Wizard of Oz” is always first, as well as prior to Thanksgiving. Following Turkey Day comes Frank Capra’s 1946 Christmas classic “It’s a Wonderful Life,” whose theme of a collapsing bank threatening to leave its president George Bailey destitute should resonate with participants as well today as it did in 1946. Finally, usually a few weeks before Christmas, comes George Seaton’s 1947 movie “Miracle on 34th Street.” This morning, however, we focus on “The Wizard of Oz.”
While most people know “The Wizard of Oz” as one of the most popular films ever made, what is little known is that the book was based on an economic and political commentary surrounding the debate over “sound money” that occurred in the late 1800s. Indeed, L. Frank Baum’s book was penned in 1900 following unrest in the agriculture arena due to the debate between gold, silver, and the dollar standard. The book, therefore, is supposedly an allegory of these historical events, making the events easier to understand. In said book, Dorothy represents traditional American values. The Scarecrow portrays the American farmer, while the Tin Man represents the workers, and the Cowardly Lion depicts William Jennings Bryan. Recall that at the time Mr. Bryan was the official standard bearer for the “silver movement,” as well as the unsuccessful Democratic presidential candidate of 1896 who gave the “Crucified on the Cross of Gold” speech at that year’s Democratic National Convention. Interestingly, in the original story Dorothy’s slippers were made of silver, not ruby, implying that silver was the Populists’ solution to the nation’s economic woes. Meanwhile, the Yellow Brick Road was the gold standard, and Toto (Dorothy’s faithful dog) represented the Prohibitionists, who were an important part of the silverite coalition. The Wicked Witch of the West symbolizes President William McKinley; and the Wizard is Mark Hanna, who was the chairman of the Republican Party and made promises that he could not keep. Obviously, “Oz” is the abbreviation for “ounce.”
Plainly, the turmoil following the “1873 Coinage Act,” the “Sherman Silver Purchase Act of 1890,” and the subsequent panic, and depression, of 1893 left the phrase “time for a change” swirling across the country as citizens struggled to correct the numerous wrong-footed plans/schemes that were so hastily conceived by the country’s then elected “nimnods.” If that sounds familiar, it should, because as repeatedly noted in these missives following the Bear Stearns bailout a similar series of hastily conceived reactive, rather than thoughtfully conceived proactive, “plans” have been enacted only to subsequently find that they should have been constructed better. That happened again last week as Treasury Secretary Hank Paulson abandoned the Treasury’s plan/scheme to buy toxic assets under the original TARP legislation in lieu of “capital injections.” Ladies and gentlemen, this is a stunning reversal by “stammerin’ Hank,” who made “toxic asset” purchases the centerpiece of the $700 billion Troubled Asset Relief Program (TARP). His switch-and-bait tactics caused “howls” from Congress about how ANYONE can be rational when the “powers that be” change the rules of the game at whim?!
Change the rules indeed, for eliminating the short-sale “uptick rule” was one of the dumbest decisions I have seen in 38 years in this business. Of course it would not have been so bad if “they” would have strictly enforced the no “naked shorts” provision; but alas, for while there was much lip-service paid to this dirty little secret of Wall Street, not much has been done to correct it. Adding insult to injury, overnight “they” eliminated the ability of participants to sell-short nearly 800 different companies’ shares, some of which were NOT even financials; and then there was the $140 billion tax break for financials that “they” snuck by under the TARP legislation. Adding to the manipulative environment was the billions of dollars worth of pork-barrel spending, as well as “earmarks,” which also missed the radar screen. Or how about this game changer – according to The Wall Street Journal, “The New York Stock Exchange has begun allowing floor traders known as specialists to place orders for 30 minutes after the market closes in an unprecedented effort to deal with the wild swings in stock prices that have been occurring in the last minutes of trading.” Blatantly, this “game changer” is designed to manipulate stocks to show higher closing prices. No wonder the volatility has increased as participants are uncertain what “rules of the game” will show up tomorrow.
The ever changing rules have left retail investors disgusted, and liquidating positions, the hedge funds have been eviscerated, having lost half of their assets and likely to lose more, the mutual funds are getting net redemption, which leaves the buyers of last resort only those folks with “permanent capital,” namely pension funds and Warren Buffett. No wonder the volatility is legend; and, last week was no exception as we lost 660 points over the first three sessions of the week, rallied 552 points on Thursday in what looked like a one-day upside reversal, only to give much of Thursday’s triumph back in Friday’s last hour of trading where the senior index shed 449 points in just 45 minutes. While much of the final hour machinations were attributed to rumors that Congress was not going to bail out Detroit, the late-day dive was pretty disconcerting. Still, we are sticking with the view that October 10th represented the capitulation price lows when of the 3130 stocks that traded on the NYSE, an unbelievable 2901 of them made new yearly lows combined with 16-to-1 downside over upside volume. We also opined that the psychological lows were made on October 24th. That said, we have never given up on a full downside retest of the October 10th lows, which is why we have tended to use a hedging strategy for trading and investment positions. As often stated, in downside retests 60% of the time the previous lows hold; the 40% of the time they don’t stocks go lower, but not by much.
Obviously, we thought that was the case last Thursday when the S&P 500 (SPX/873.29) breeched its October 10th intraday low of 839.80 and went lower, but not by much. Reinforcing that view was the fact that the DJIA (8497.31) did NOT breech its respective October 10th intraday low of 7882.51, setting-up the potential for a huge downside non-confirmation. Moreover, of the 3268 stocks that traded on the NYSE, only 776 of them made new yearly lows in Thursday’s session. Interestingly, the DJIA/SPX’s pricing action since October 10th has traced out a spread triple-bottom in the charts. Often a strong move “up” from a third downside test, like we saw last Thursday, tends to develop into a strong rally as participants are caught in a “bear trap.” Stockcharts.com defines “bear trap” as, “A situation that occurs when prices break below a significant level and generate a sell signal, but then reverse course and negate the sell signal, thus ‘trapping’ the bears that acted on the signal with losses. A bear trap in another form of whipsaw.” Hopefully, that is what we experienced last week. This week should resolve that question.
The call for this week: The stage version of “The Wizard of Oz” begins at the Warner Theater in Washington D.C. on December 2nd. If past is prelude it will be a sellout. Why is Frank Baum’s play so popular in the nation’s capital? Our sense is that it’s because people inside the Beltway easily relate to fantasy! That’s why “they” continue to proffer reactively considered “schemes” rather than thoughtfully crafted proactive “plans.” Given the ever-changing “rules of the game,” no wonder the equity markets are having such a tough time gaining any upside traction, which is why we continue to employ a hedging strategy, as well as the strategy of being the “second mouse that gets the cheese.” Nevertheless, we are treating October 10th as the capitulation panic low (until proven wrong) and remain hopeful that last week represented a triple-bottom in the charts for the DJIA and SPX. Further, the Commodity Research Bureau Index (CRB) recently registered a similar “capitulation low” reading. According to the institutional service “Chartworks,” “There have only been five instances (of this) since 1956. In each occurrence, once prices reversed up by producing a week with a higher high the index took no more than six weeks to reach the 20-week moving average.” Obviously, if the CRB is ripe for a rally, it would benefit the high-yielding commodity-centric convertible securities we have been recommending, as well as the Canadian dollar.
“Unprecedented”
November 10, 2008
At a recent Bank Credit Analyst (BCA) investment conference titled, “Inflation and Deleveraging: A Turning Point In The Debt Supercycle?,” a BCA “Special Report” paraphrased some of the presenters beginning with this prose:
“Martin Barnes opened the proceedings with the unenviable task of reminding participants just how bad the damage to the financial markets has been, yet just how little we have come in the deleveraging process. In setting the scene, he told of a client who had recently mentioned how annoyed he was becoming on constantly hearing the word ‘unprecedented.’ Many of the guest speakers who followed could not help themselves and used the word repeatedly in their presentations. And with good reason – these have been truly unprecedented times. Every asset class and region has been affected by the process of financial sector deleveraging. From the collapse in equity prices to the blowout in credit spreads and equity premia, there has been no place to hide.”
“Unprecedented” indeed, for as repeatedly stated in these missives, investing correlations that have worked for years ceased working in June/July of this year, leaving brilliant investors like Marty Whitman and Ken Heebner both down some 43% year-to-date. While the month of October was not entirely unprecedented, it was close as it registered the second worst stock market month in history. Said decline also triggered certain indicators close to unprecedented levels, as can be seen in the chart on page 3 from our friends at Riverfront Investment Group, which shows that the one-year price rate of change for the DJIA has only been more severely depressed three times in the past 100 years (1974, 1938, and 1932). Interestingly, in past reports we have likened the current decline to that which began in March of 1937 and culminated in March of 1938 with the DJIA losing 49% of its value. Like now, EVERYTHING collapsed (stocks, bonds, commodities, etc.) leaving investors nowhere to hide except for cash and Treasuries. Also like now, the government pulled out all the “stops” and implemented game-changing rules like lowering margin requirements and instituting the “uptick rule” for short sellers, but it was all to no avail; stocks sank until the sellers were exhausted.
Speaking to downside exhaustion, we have noted that a fairly unprecedented event took place on October 10, 2008. On that date 3130 stocks traded on the NYSE. Of those 3130, an unbelievable 2901 (or 92.7%) of them made new yearly lows! Concurrent with that 92.7% “new year lows” reading was a near 16-to-1 downside over upside volume reading, causing a rare signal from the Capitulation Indicator, which had not “spoken” since 1966. Accordingly, we deemed October 10th as the capitulation-price low and October 24th as the psychological price low when the S&P 500 failed to break below its October 10th price of 839.80. And then there was last week’s “unprecedented” two-day 929-point Dow Dive, which was the largest two-day point decline in the 112-year history of the Dow! Still, both the DJIA and the S&P 500 didn’t even come close to breaking their respective October 10th intraday capitulation price lows, eliciting this commentary from the website “The Sentiment Trader:”
“Going back to 1994 we have never had two consecutive TRIN (or the Arms Index) readings of greater than 3.0. Yesterday and today we saw readings over 4.0 and this has bullish implications over the short term. This reading, coupled with the lower volume over this dramatic 10% selloff, argues for this being part of the month long bottoming process. It is vital that the October lows of 850 hold in the S&P but based on our readings this should be part of the bottoming process and not the beginning of another significant leg down for the stock market.”
Plainly we are hopeful that the October 10th “lows” hold and we are using them as our “uncle point” both for investment and trading positions. Yet, it just isn’t the various equity markets that are “unprecedented.”
To be sure, U.S. Consumer Confidence readings fell to a record low recently, the Bank of England lowered its key lending rate by 150 bp to a 54-year low of 3% from 4.5%, the IMF said the “advanced economies” (31 nations) would contract by 0.3% in 2009, the first year these economies will have contracted since the IMF was founded in 1945, inflation-adjusted U.S. consumer spending fell at a 3.1% annual rate in 3Q08 for its largest drop since 2Q80, Thomson Reuters’ index of 34 retailers showed a comparable-store sales decline of 0.7% in October to its lowest level ever, friends of ours at one of NYC’s trendiest retailers told us business is off more than 50%, our “black car” chauffeur in NYC told me the black car industry in Manhattan is doing 50,000 fewer assignments a week, auto sales have collapsed, and the list goes on.
Yet by far the most unprecedented event of last week was President-elect Barack Obama’s victory. I had actually thought there would be a celebratory equity market rally Wednesday morning on this unprecedented election, but alas it was not to be. Evidently, “the Street” was worried about an Obama regime that will increase long-term capital gains taxes, raise taxes on dividends, increase the size of government, increase the size of entitlement programs, well you get the idea. As stated in last Thursday’s verbal strategy comments – If the Obama administration moves toward larger government, like Franklin D. Roosevelt (FDR) did following the Great Depression, then we are in trouble, for after the Depression there was a huge backlash against business, and business leaders, amid calls for the government to fix ALL of life’s inequities. And if you don’t believe me, Google FDR’s 1933 and 1937 inaugural addresses, which read like they could have been written yesterday. Indeed, if Barack moves toward the 1930s model that focuses on the “right to healthcare, the right to own a home, the right to everything,” he replaces the “rights” of the individual (that founded this country) with the government’s “granting” of said “rights” in true socialistic fashion, leaving our country in trouble (in my opinion).
If, however, he moves to the center, providing a stimulus package not designed to give “checks” to EVERYBODY, which historically has provided only a short-term shot of heroin to the economy, but rather injects funds into infrastructure projects like bridges, roads, etc., the multiplier effect for the economy would be significant. Combine this with a thoughtfully conceived plan to stabilize housing prices and the economic impact could be significant. More importantly, as the astute GaveKal organization opines:
“Probably most important economic transformation which is about to occur is the transformation in personal leadership. Suppose you believe, as I do, that the financial meltdown triggered by the bankruptcy of Lehman Brothers was not a divinely ordained retribution for decades of greed and profligacy, but simply a bizarre accident, caused by the incompetence of the Bush Administration, particularly of Mr. Paulson. In that case, the arrival of a credible new economic team in Washington, led by respected figures such as Messrs Volcker, Summers and Geithner, could transform psychology in global financial markets. With house prices stabilizing and an inspiring new leader replacing the doltish President Bush, American consumer and business confidence could enjoy a similar resurgence.”
The call for this week: We are hopeful that President-elect Barack Obama will move to the “center” and take the aforementioned path. If so, the October 10th “lows” should hold. Moreover, our studies of past elections show that the first “move” by the equity markets following Presidential elections have typically been a wrong-way move. We are hopeful that is the case this time. It is also interesting that many of the indices have traced out in the charts what could be a reverse head-and-shoulders bottom. However, the path is not certain, which is why we have recommended downside “hedges” on most trading, as well as investment, positions. As recommended last week, those trading positions include: ProShares Ultra S&P 500 (SSO/$29.60); ProShares Ultra Financial (UYG/$8.53); ProShares Ultra Real Estate (URE/$9.41); and ProShares Ultra Basic Materials (UYM/$18.49), the first three of which were recommended with a hedge. As for many of the convertible preferreds recommended for investment accounts, given the rally in some of these shares the idea of hedging partial positions hereto makes some sense.
“Devastation”
November 03, 2008
“We’ve seen the wholesale destruction of wealth on an unprecedented size and the best we can say is that it will end when it ends and not a moment before. Idiotic though that might seem, it is true wisdom borne of thirty plus years of doing this every day. It was only a year ago that our Global Index traded upward through 10,000; it is now down nearly 45% from its high. This is, by any stretch of the imagination, a fully stretched bear market. A bounce . . . and perhaps a material, violent bounce lies straight away, but it shall be a bounce that is again sold by those who are too long . . . too exposed . . . too frightened of their economic futures and have the need to reduce their exposure on strength.”
. . . Dennis Gartman of “The Gartman Letter”
Gosh, I thought as I read Dennis Gartman’s prose, that almost sounds like me because since June of this year investing correlations that that have worked for years have ceased working, leaving investors very few places to hide from the downside devastation. As stated, the asset devaluation has been ubiquitous with all asset classes, other than cash and Treasuries, being sold off in equal measures regardless of their fundamentals. For reference, between 10/09/07 and 10/10/08 the S&P 500 (SPX/968.75) shed some 42.5%. October was particularly unkind for many individual stocks, for while the SPX lost nearly 17%, certain select stocks slid a lot more than that. To be sure, the SPX’s trailing 12-month performance pales in comparison to the 1929 – 1932 experience whereby the S&P 500 fell 86.2% over 33 months; still, participants are going to be shocked when they get last month’s brokerage account statements and actually see how October was.
Nevertheless, we have been telling accounts that the time to raise cash, and hedge your portfolio, was some time ago – not here! Indeed, over the past few weeks we have suggested that a bottoming process was at work in the short/intermediate-term with the capitulation “price low” recorded on October 10th (839.40) and the “psychological low” recorded on 10/24/08. Interestingly, the “psychological low” never even came close to breaching the intraday “price low” of October 10th. Accordingly, for investment accounts, we have been recommending various attractively yielding convertible preferreds that play to companies with clean balance sheets and decent fundamentals. Additionally, last week we “dialed in” the trading account (for the first time in weeks) by recommending a number of exchange-traded funds (ETFs) and in some cases employing a hedging strategy to reduce trading risk. Our trading/investment vehicles of choice were ANY asset that has been slaughtered over the last three months. Of particular interest were the materials and energy complexes, with particular emphasis on the unloved natural gas stocks, all of which are rated Strong Buy by our fundamental analysts, like Petrohawk (HK/$18.95), Goodrich (GDP/$27.76), and Chesapeake (CHK/$21.97). However, the real trick from here is to figure out which assets collapsed due to simply the liquidity crunch; and, which ones collapsed because of not only the liquidity crunch, but the slowing economy. As the astute GaveKal organization notes, “In the first category are Asian and U.S. credits, U.S. non-cyclical large-caps and exporters, Japanese equities, deposit-taking banks, etc. In the second category, we would leave Eastern and Southern Europe.”
In addition to the massive oversold readings (see chart), and other “bottoming” metrics so often mentioned in these reports, last week the Federal Reserve made the unorthodox decision to grant “swap lines” of credit to Korea, Singapore, Brazil, and Mexico. This seminal maneuver will likely ease the worldwide U.S. dollar shortage that has been hurting economic growth in emerging markets. Consequently, we would expect not only a rally in our markets, but a rally in emerging markets and commodities. Moreover, our bullish stance on the dollar since this time last year is now waning, at least on a short/intermediate term basis. Indeed, the weakness in the “carry trade” currencies, combined with the recent reduction in credit spreads, should permit the equity markets to gain traction at least into Thanksgiving. From there, the market should further ponder how severe the recession is going to be.
Speaking to the upcoming recession, Volvo (VOLVY/$5.30) reported last week that orders swooned 99.63%, which left Chief Executive Officer Leif Johansson exclaiming, “We’re heading toward the sharpest downturn I’ve ever seen in Europe.” Meanwhile, the Baltic Dry Shipping Index fell below 1000 for the first time in six years, suggesting it is now 90% cheaper to ship goods over the ocean than it was at the beginning of 2008. Further, ISI’s Auto Dealer Survey fell to a record low 27.5, consumer spending for 3Q08 will likely be -3% for the biggest drop in 30 years, air freight traffic dropped 7.7% in September, U.S. consumer confidence collapsed to a record low in October, the default rate among sub- investment grade borrowers is surging to 7.9% from just 1.3% a year ago, and the nation’s debt rose $506 billion between September 30 and October 30, causing one Wall Street wag to sigh, “What a mess!”
Despite the lousy news backdrop, the SPX spurted over 10% last week; and when stocks ignore bad news that’s good news! We think, after a Presidential Pause early this week, the equity markets will continue to trend higher into our targeted Thanksgiving date. Yet while last week’s SPX gains were spiffy, the real winners of the week were things like lead and nickel, which soared 28%, consistent with our bullish near-term “call” on commodities. Accordingly, we are “long” ETFs playing to our aforementioned themes, some of which are hedged.
The call for this week: The durability of the current advance is rooted in the ability of credit spreads to stabilize and continue to contract. Meanwhile, all eyes will focus on tomorrow’s election. As our economist Dr. Scott Brown notes, “No one could get elected campaigning on a balanced budget platform since that would entail tax increases or large cuts in entitlements. But is it too much to ask that our candidates realistically address the budget issue? Does it have to be about personality? The sad truth is that we get the government that we deserve.” We continue to invest, and trade, accordingly.
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