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Investment Strategy by Jeffrey Saut

Tired of waiting
June 20, 2016

“I’m so tired

Tired of waiting

Tired of waiting for you”

. . . The Kinks, Tired of Waiting For You (The Song)

“The American people are sick and tired of hearing about your damn emails!”

. . . Bernie Sanders on Hillary’s emails at the October 13, 2015 debate

“The American people are sick and tired of hearing about your damn Brexit!”

. . . Jeffrey Saut about this week’s (June 23rd) Brexit vote by the UK to leave the EU

I did a number of media “hits” last week, yet the question was always the same, “What’s going to happen with the Brexit vote?” As often stated in these missives, “When everyone is asking the same question it is usually the wrong question.” Moreover, I am indeed tired of hearing about the damn Brexit. To be sure there appears, at least superficially, to be some correlation (R2) with the stock market’s action, as can be seen in chart 1 on page 3. However, just as the R2 unraveled between crude oil and the direction of the S&P 500, I think the same thing will hold true with the Brexit. Besides, it’s not the snake you see that bites you. In point of fact, the “snake” nobody is seeing is what is going to happen in Germany tomorrow (21st). To wit, The German Constitutional Court is ruling on the European Central Bank’s (ECB) Outright Markets Transaction operations (OMT). The court will decide if OMT violates German law. If so, it would have important ramifications, likely putting German law directly opposed to European law. Spain also goes to the polls next week (26th) with the far-right and the far-left gaining ground at the expense of centrists. It appears, like last December, nobody will be able to put together a majority for a workable government in Spain. So put these on your radar screen along with Brexit.

Back on this side of the pond politics are also in the air, but not as dramatically. As consummate Washington insider Greg Valliere writes:

“The presidential choice is either Hillary Clinton or Donald Trump – and voters everywhere are asking: is there any other option? We were at a conference this week with over 200 savvy investors who favored ‘none of the above.’ Clinton and Trump had virtually no support with this group, and everyone asked us – is there another choice? There are only four options.”

After listing the four longshots Valliere concludes:

“Sorry, there's virtually no chance that there will be any last-minute surprises. It's the very slippery Hillary Clinton versus the cringe-inducing Trump, with a few fringe candidates lurking. When we tell this to clients and friends, many vow to write in themselves or relatives.”

Now, while there is not much R2 between our presidential election and the stock market, I did have one portfolio manager ask, “Do you think the rally off of the February low into the June high had anything to do with Trump’s rising popularity?” After I got done laughing I responded with a resounding, “No.” However, I must admit as Trump’s faux pas increased the S&P 500 (2071.22) fell some 3.3% into last week’s intraday low of 2050.37, which is the upper-end of the S&P’s 2040 – 2050 support zone. Given the manic depressive mood of Mr. Market I thought it best to “Better Call Saul.” Yet in this case it was not the TV series, but “Better Call Shad,” namely Frederick “Shad” Rowe, captain of the brainy Dallas-based Greenbrier Partners. I first encountered Shad in the 1970s when he was managing money and writing a column for Forbes magazine. His writing skills, and his investment acumen, are legendary. Coincidentally, Shad had written a column for Barron’s last week titled, “Pension-Fund Investing for Success” (Article), with the tag line, “Never mind the consultants, buy US stocks for the long term.” Some of the highlights from said article are:

  1. Have you noticed that since the stock market selloff in 2008, these folks (the consultants) have consistently advised clients that they reduce exposure to U.S. stocks? Their advice has been consistently wrong, as the tough-to-beat Standard & Poor’s 500 hit new highs last year.
  2. Pension consultants’ advice has contributed mightily to the insolvency of cities, states, municipalities, and corporations unable to meet their pension obligations because of poor investment returns on their pension funds.
  3. Let’s consider pension funds, looking at each 20-year period – roughly the typical career length of a policeman or fireman – on a rolling basis over the past 50 years. That is, we’ll look at 20 years, starting in 1965, then 20 years starting in 1966, and so on. Returns on investment in the S&P 500 stock index for each period have fluctuated between 8% and 12%. Each period contained some bad years, but there were always more good years and they outweighed the bad results for every 20-year stretch.
  4. While the actuarially assumed rate of return for most public pension systems is approximately 7.5%, the stock market has managed to climb the proverbial wall of worry and offer superior returns, compared to virtually all available alternatives – if you stayed fully invested in the index for the full 20 years.
  5. Here is a prediction. A gigantic market move to the upside is coming, as investment committees assess their costs and reach the conclusion that the stock market is their best and only hope to meet their obligations.

So despite Shad’s sage advice, the bears are convinced we are in a trading range environment at best, or a major stock market top at worse. Most of their arguments rest on valuations and a lack of earnings growth. Looking at valuations, the only metric that looks overvalued to me is Shiller’s Cyclical Adjusted Price Earnings model (CAPE), which at 26.1x earnings is about 10 points over its long-term average. Most of the other valuation tools are either marginally overvalued, or below their long-term average. Indeed, the trailing normalized P/E ratio for the S&P 500 is at 18.0x versus its average of 19.0x, while the price to free cash flow is at 23.0x versus its average of 28.1x. As for earnings, while it’s true earnings have had negative comparisons since late 2014, revisions to earnings growth estimates has been improving for nearly four months. Manifestly, the positive to negative earnings estimate revisions (EER) is now at nearly a two-year high from its long-term average. Hence, the earnings worm seems to have turned.

From a technical standpoint, the SPX has tended to be okay when it has traded above its 20-month moving average (MMA). Over the past 15+ years it has decisively fallen below that MMA, and failed to recapture it quickly, twice, as can be seen in chart 2 on the next page. That happened in early 2000, and again in late 2008, with devastating results. Currently, the 20-month moving average around 2040 for the SPX, which is one of the reasons the 2040 – 2050 support zone is pretty important.

The call for this week: Last week we mentioned a few times that the British Brexit reminds us of previous non-events like the 2014 Scottish vote, the Greece gotcha, the Italian mob job, Y2K, etc. We expect the UK to stay in the EU, which should produce a Brexit Bounce for the world’s equity markets. As for sectors, last week the only major sector that was up was the Utility sector (+0.88%), which rallied out to new all-time highs, but that paled in comparison to the rally in natural gas of more than 7%. Speaking to the other macro sectors, Consumer Discretionary is on support; the Consumer Staples sector is extended; Energy is on support; Financials, Healthcare, Industrials, and Information Technology are all neutrally configured in the short-term; Materials, Telecom, and the Utility sectors are overbought. This morning, however, stocks soar as British Brexit worries ebb with the preopening S&P futures better by 27 points at 6:00 a.m.

Baby don't go
June 13, 2016

The year was 1964 when Reprise Records released the song “Baby Don’t Go.” Written by Sonny Bono, and recorded by Sonny & Cher (Cherilyn “Cher” Sarkisian), the song became a smash hit and set the duo’s career in motion. The repeating lyric in said song is “Baby don’t go, pretty baby please don’t go.” And that’s the song playing in the various streets of the European Union (EU) as the Brits contemplate leaving the coalition on June 23 (Brexit). The latest odds I saw were those of last Friday where Predata showed 46.04% of respondents wanted to stay “in,” while 59.96 wanted “out.” The media is spinning Brexit such that an exit might cause a domino effect with other EU members following the Brits, potentially setting the stage for a complete dissolution of the EU. I think the odds of that happening are remote, but the politics of a U.K. exit could be impactful. And as long as we are skirting the realm of politics, I found this story, written by my friend Arthur Cashin, to be intriguing and pretty funny. As Arthur writes:

After the close Monday, there was the customary meeting of the Friends of Fermentation. It was far from a plenary session with only a handful of members attending. Perhaps it was the marinating ice cubes, or just the small crowd, but something prompted one of the members to weave a rather illogical but intriguing (at least to me) political fantasy. Say you are a Reality TV celebrity and you decide to throw your hat into one of the presidential races of one of the major parties. To you it's a bit of a lark, primarily a vehicle to enhance your celebrity credentials around the country. In the beginning everything goes well. You claim that the powers that be are conspiring against you and trying to rig the election. Much to your amazement, the other candidates fall by the wayside and you become the presumed nominee. In some ways this is a problem; if you run and lose, the loss may diminish your brand. Worse yet, now that you stand alone, reporters are pestering you with very specific questions on world events, and if you are not fully up to date, they begin to portray you as someone who is less than knowledgeable. That will never do. To lose could be damaging enough to your reputation, but to lose and appear not to be on top of things could wound your image, or even destroy it. In my friend's fantasy, the candidate decides that the only way out is to do many outrageous things before the convention, forcing the party leaders to block the candidate and name a substitute. That allows the candidate to claim he or she was robbed and retain their newly enhanced image. It was an entertaining story but then the peanuts ran out. Guess we're stuck with our current logical election.

While termed a political fantasy, this essay certainly would explain some of the antics being unleased by Mr. Trump. And now you understand why every chance I get I meet with my counterparts of the Friends of Fermentation. Last week, however, I met with folks in Chicago. I would like to thank all of the people at BMO, Putnam, First Trust, Nuveen, and Harris for the ideas we shared, yet the highlight of the week was having dinner with my friend Kurt Funderburg, portfolio manager for First American Bank. Kurt and I worked together in a past life when he was my Healthcare analyst. Over dinner, we talked of old times and swapped investment ideas. One of his favorite names is Dollar General (DG/$91.44/Strong Buy), which is followed by Raymond James’ fundamental analysts with a Strong Buy rating. For more on the DG story, please see our analyst’s reports.

Another portfolio manager (PM) I spoke with was CEO, CIO, and PM of Perritt Capital, namely Michael Corbett. I have met with Mike before and have found him to be a good captain of capital. Two of the funds Mike manages are the Perritt MicroCap Opportunities Fund (PRCGX/$31.90) and the Perritt Ultra MicroCap Fund (PREOX/$14.57). For the record, microcaps have underperformed for the past few years. That underperformance is likely because they did so well in 2013 that valuations got stretched. To be sure, at last February’s low, the Russell MicroCap Index was down some 27%+ from its June 2015 high. Nevertheless, while the micro capitalization universe of stocks has been out of favor, I think it’s time has come. Like Wayne Gretzky states, “I skate to where the puck is going to be;” and I believe “the puck,” at least for some of your capital, should be micro caps going forward. Over the years, many investors have asked me, “If you were going to manage money again, how would you do it?” My response has been, “I would concentrate on micro caps where there is no or little research coverage because that is where the misvalued pieces of paper are.

While we are on the subject of portfolio managers, I will remind you that some of Putnam’s “best and brightest” will be on a conference call with Andrew Adams and me to talk about strategies, discuss individual ideas, and stress the importance of incorporating alternative strategies to help reduce portfolio volatility and risk. It should be a highly interactive and productive discussion. The call is designed to be for investment professionals only, but I am sure there will be some competitors listening. The webinar will take place this Wednesday, June 15, at 4:15 p.m. EDT. To attend the webinar, please click on this link, because there is no phone number. The audio will play through your computer. If you are having any technical difficulties connecting, please contact Putnam Investments at 1-800-354-4000.

So what else did we see and/or learn in our travels last week? Well, I heard a lot of interesting investment ideas from the PMs I met with. One PM pointed out that the iShares 20+ Year Treasury Bond ETF (TLT/$134.78) is breaking out to the upside in the charts (read: lower interest rates/see Chart 1). Another complimented Andrew and me on our call for the past 10 months, that the Dollar Index (DXY/$94.66) topped last year (Chart 2), was correct and suggested select sectors that should benefit from a weaker greenback (Chart 3). Still another PM wanted to know more about the current “buying stampede,” which at session 84 is clearly the longest I have ever seen. To that point, the invaluable Bespoke organization recently wrote:

It’s been nearly four months since the S&P 500’s 2016 low on 2/11, and while it may seem like the market has just gone up every day since then, we were somewhat surprised to see that the frequency of up days over the last four months has been far from extreme relative to the rest of the bull market that began in 2009. The chart (Chart 4) shows the percentage of positive days for the S&P 500 over a rolling four-month period going back to March 2009. As of Wednesday’s close, the S&P 500 has been up in 48 of the prior 84 trading days, which works out to an average of 57.1% of all trading days. In order to compare the current reading to prior readings, whenever the line in the lower chart is red, it indicates that the percentage of up days over the prior four months was greater than the current reading, while the blue line indicates a lower reading. As shown in the chart, there is a lot of red. In fact, the S&P 500 has had a higher percentage of up days over a trailing four-month period on 38% of all trading days since the bull market began. In the top chart of the S&P 500, the red lines mean the same thing as the bottom chart. As shown, in the majority of instances, these periods of consistent up days tended to occur in bunches. Heading into this week, there was no denying that the market was overbought in the short term, and while a period of consolidation or modest declines is possible, the consistency of buying over the last four months has been far from extreme, so it’s not as though investors have been blindly buying.

And now, in addition to Friends of Fermentation, you know why I think serious investors should have access to Bespoke.

The call for this week: In last Thursday’s Morning Tack, I wrote, “Certainly this rally is extended, yet we still don’t see evidence of any ‘sell signals’ or much bearish data. In fact, one of the few cautionary ‘flags’ comes from the McClellan Oscillator, which is overbought on a short-term basis.” So while the past two trading sessions have been painful, it has indeed corrected the overbought condition (Chart 5) I spoke of and still leaves the S&P 500 (SPX/2096.07) above its 50 and 200-day moving averages. Also of note is that crude oil broke below its rising trendline last week and that we expect a decent rally attempt after the Brexit vote. This week, investors’ attention will focus on the FOMC meeting, where we have been saying for months there will be NO rate ratchet and likely no rate increase until after the November election. Many of these machinations will be discussed in this Wednesday’s 4:15 p.m. webinar with myself, Andrew Adams, and some of Putnam’s best and brightest (click here to join the webinar). As I write this on Sunday night in Charleston, SC, the S&P futures are off eight points on Brexit fears, China’s slowing fixed investment flows (15-year low), this week’s FOMC meeting, the Bank of Japan meeting, and Friday option expiration. A close by the SPX below 2078.40 would trigger a short-term trader’s “sell signal” on the daily MACD indicator.

June 6, 2016

“I try to push ideas away, and the ones that will not leave me alone are the ones that ultimately end up happening.”

. . . J. J. Abrams, American film director, producer, screenwriter, and composer

Many of you know the way that I construct portfolios. I typically begin with a base of mutual funds, but not just any mutual fund. I tend to invest in mutual funds where I know the portfolio manager (PM) and like his or her investment style. Then, because I talk to these PMs, I hear lots of good ideas. I mean really, if Tom O’Halloran, who manages Lord Abbett’s Growth Leaders Fund (LGLAX/$21.99), has purchased millions of shares of Facebook (FB/$118.47/Outperform) in the mid-twenties one has to assume he has done the fundamental work. Having been a bottom-up stock analyst myself in a past life, I then can spend a half an hour looking at the earnings estimates, financial statements, recommendations, and the chart to decide if I am going to buy the shares. This is how I try to add alpha to a portfolio (alpha).

At the mid-February lows of this year, Andrew Adams and I had a lot of investment ideas and wrote about them in these missives. Our timing and pricing models were in sink and we suggested moving back into select securities. At the May lows, however, we were not as aggressive, for as stated, while our timing model nailed the mid-May lows, we never got down to the 1990 – 2000 level our pricing model had targeted. Still, given the intensity of the rally from the May lows (S&P 500 up ~3.9%), we are currently getting “pinged” for investment ideas. Admittedly, our models are calling for new all-time highs by the S&P 500 (SPX/2099.13), but in the very near term the SPX remains very overbought. Accordingly, we are not inclined to be super aggressive right here. For those wanting to commit capital on a risk-adjusted basis, there is a relatively new product from Raymond James’ Asset Management Services department (AMS) for your consideration. To wit:

While waiting for a more definitive breakout signal from our models, clients may want to increase their allocation to attractive dividend paying stocks. The best income ideas from the Raymond James Equity Research department may be found in the latest Equity Income Report, published last week. The report features the best yielding common stocks, with a separate section for MLPs, REITs, and business development companies. For a stock to be on the list, it must be rated Outperform or Strong Buy, have at least a $1 billion market capitalization, and a dividend yield exceeding 1.5%. When an analyst downgrades a stock, it is removed from the report. The recommendations are also available as a managed portfolio through Asset Management Services, which creates a diversified portfolio of the 30 highest dividend yields.

For those wanting to be more aggressive there are two relatively new names to the Raymond James research universe of stocks that have intriguing stories, favorable ratings from our fundamental analysts, and screen well using our proprietary algorithm. The first name is Blueprint Medicines Corporation (BPMC/$20.36/Outperform). As our analyst writes:

Blueprint Medicines Corporation is a development stage biopharmaceutical company based in Cambridge, Massachusetts. Leveraging a novel target discovery engine, it is focused on the development of small molecule kinase inhibitors for the potential treatment of cancer and rare genetic diseases.

The other name is Instructure (INST/$18.04/Strong Buy). Hereto, our analyst writes:

Based in Salt Lake City, Utah, Instructure is a leading provider of software-as-a-service (SaaS) based learning management systems (LMS), which are currently gaining significant market share in the education market. In addition, the company is beginning to address learning management and human capital management (HCM) needs of the much bigger enterprise or commercial market.

For more information please see our analysts’ reports.

As for Friday’s unbelievable employment report, well it was just that . . . unbelievable! As our economist, Scott J. Brown Ph.D., writes:

Payroll growth was much lower than expected in May, with softness spread across industries. Some of this may be noise. Some of it may be weather (pulling seasonal job gains forward) – prior to seasonal adjustment, we added 2.9 million jobs between January and May, vs. 3.2 million last year. Taken at face value, this is a disappointing report. However, even considering the usual amount of noise, the trend in job growth has slowed. This is likely because firms are having a tougher time finding qualified workers (that is supported by the anecdotal evidence). This report significantly lowers the odds of a Fed rate hike in June, July, and September. A negative for the dollar and the stock market. A plus for bonds.

And it was a negative for stocks, but only for about 50 minutes, for at 10:20 a.m. the D-J Industrial Average was down ~149 points (the low of the session) when mysterious “bids” showed up leaving the senior index down only 31 points by the closing bell. Likewise, the SPX found support in its 2080 – 2085 support zone and once again had “eyes” for the 2100 level at the “bell.” To me this smacks of a stock market that wants to trade higher, which would leave many PMs scrambling to play catch up. That’s certainly what Bank of America Merrill Lynch’s “sell side” indicator is suggesting as it shows Wall Street strategists’ recommended stock allocations fell to a lower level than at the March 2009 lows!

The call for this week: Friday’s upside reversal caused one old Wall Street wag to exclaim, “When the stock market ignores bad news that’s good news!” To be sure, there is not enough data to alter our “call” for new all-time highs as of yet. On a valuation basis the forward 12-month earnings estimate for the SPX (IBES) is $124.48, giving us a nearly 6% forward earnings yield and a forward P/E multiple of 16.9x. If new highs do emerge, the market probably will be led by the healthcare and technology sectors. That should put focus on the Health Care SPDR (XLV/$72.29) and the Technology SPDR (XLK/$43.94). Looking at the chart, it is worth noting that the XLV has broken out to the upside (see charts on page 3). Today “The Street” will put on rabbit ears at 12:30 p.m. to hear if Ms. Yellen has damage control on her mind, which has left the futures flat this morning.

PS – My friend Jason Goepfert (SentimenTrader) notes in Barron’s over the weekend:

Examining data beginning in 1928 shows that in 12 out of 14 years in which the SPX posted three consecutive months of gains following a 12-month low (like now), the market rallied for the next three months. If the fourth month rose as well, future gains in the months ahead were even better, except for 1930 and 1940.

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