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Investment Strategy

Investment Strategy by Jeffrey Saut

I think Icahn
May 2, 2016

Last Thursday was session 53 in the “buying stampede” and it was going along swimmingly. Well, I guess the surprise “no stimulus” announcement out of Japan caused an early morning stutter-step, but the equity markets seemed to stabilize after a somewhat weak opening. In fact it caused one market wizard to comment, “I love this market. Bad earnings can't take it down. Remember, the move most people least expect is the DJIA going right through all of that overhead supply and making all-time new highs. I'm in the minority camp, expecting major new highs. Buy in May and don't go away!”

And that was pretty much my feeling as well, since I too was expecting the S&P 500 (SPX/2065.30) to notch a new all-time high. However, last Thursday, when Carl Icahn appeared on CNBC, he said he no longer owned Apple and stocks “stopped!” Further, when he stated that unless there is more economic stimulus, a day of reckoning is coming, and then stocks swooned. The result left the SPX lower on the week by 1.26% and resting on its 40-day moving average (DMA). In past missives I have suggested there were two scenarios going into the month of May. My preferred scenario was for the S&P 500 to make new all-time highs, which would have used up its remaining internal energy, leaving the SPX susceptible to a pullback. The alternate scenario was for an immediate pullback into mid-May, which should actually set the stage for higher prices over the next few months. Yet Icahn’s CNBC comments seemed to derail my preferred path for stocks. Still, the Thursday/Friday downside two-step leaves the near-term directionality of the equity markets inconclusive (IMO). We should get a better read on direction this week.

Adding to last week’s downside drama was the government’s report on real GDP, which rose at an annualized rate of just 0.5%. In said report, consumer spending slowed (+1.9%), business fixed investment fell (-5.9%), University of Michigan Sentiment Index was lower (89.0 vs 91.0 in April), new home sales fell (-1.5%), the Fed dropped the phrase “global economic and financial developments continue to pose risks,” and maybe that was dropped because the flash GDP estimate for the Eurozone was better than expected (+0.6%). That caused me to re-read this quip from the managing director of the IMF, Christine Lagarde:

The good news is that the recovery continues; we have growth; we are not in a crisis. The not-so-good news is that the recovery remains too slow, too fragile, and risks to its durability are increasing. Certainly, we have made much progress since the great financial crisis. But because growth has been too low for too long, too many people are simply not feeling it. This persistent low growth can be self-reinforcing through negative effects on potential output that can be hard to reverse. The risk of becoming trapped in what I have called a “new mediocre” has increased.

Read that paragraph again. She just as easily could have been talking about the U.S.! This week we will get a slew more of economic reports with eyes focused most closely on the ISMs, Durable Goods, non-farm productivity, and the all-important Employment Situation Report for April. I continue to believe last week’s economic reports will mark the low water point for the economy and look for things to strengthen going forward (chart 1).

Speaking to earnings, the EPS season is now half over with roughly 1,100 companies reporting. As expected, at least by us, the percentage of companies beating estimates stands at 64.2%. That’s the strongest “beat rate” since mid-2010. While at 55.5%, revenues are not as strong as the earnings “beat rate,” hereto they are the strongest we have had over the trailing 12 months (chart 2). Even the forward earnings guidance is strong. As my friends at the must-have Bespoke organization write, “The forward expectations coming out of corporate America this earnings season are definitely stronger than what the narrative is in the financial media” (chart 3). Of the 10 S&P macro sectors (on September 1st there will be an 11th macro sector as REITs debut), the strongest “beat rate” comes from (in order of strength): Consumer Staples, Materials, Healthcare, and Consumer Discretionary. The weakest “beat rate” sectors are: Telecom, Utilities, and Energy. And as long as we are on the subject of sectors, after a ~16.6% rally by the SPX from its February 11, 2016 intraday low (we were bullish) into the intraday high on April 20, 2016, and the subsequent 2.8% pullback, the only sector that is even remotely oversold is Technology (chart 4). That’s very interesting since Technology is trading at a price to estimated growth (PEG) ratio of 1.27x, while Utilities trade at a PEG ratio of 3.34x. If you think Utilities are going to grow 2.5x faster than Technology, I have a few yards of swampland here in Florida I would like to sell you! As for this season’s earnings reports, ISI’s eagle-eyed Ed Hyman writes, “The biggest development last week was the dollar's 2% decline, which helped push up commodity prices including gold, oil, corn, and lumber. The yen's surge was very disturbing. But the combination of a lower dollar and higher commodity prices has significantly improved the outlook for S&P earnings. Earnings probably bottomed in 1Q.”

Obviously we agree, and regarding the earnings theme, we often talk about companies that have beaten their earnings estimates, beaten revenue estimates, raised forward earnings guidance, and are favorably rated by our fundamental analysts. Screening the companies that have done this so far, and using our proprietary algorithm trading system, shows six companies that qualify. We offer them to you for consideration on your potential “buy list” if the SPX does indeed pull back into mid-May. They are, in no particular order: Abbott Labs (ABT/$38.90/Outperform), Advance Micro (AMD/$3.55/Outperform), Gigamon (GIMO/$32.59/Outperform), Manhattan Associates (MANH/$60.54/Outperform), Newell Brands (NWL/$45.54/Outperform), and RingCentral (RNG/$19.08/Strong Buy).

The call for this week: Well, I will be in Denver this week seeing portfolio managers and presenting at events for our financial advisors. If past is prelude, something important will occur in the equity markets, just like happened late last week when I was giving a keynote presentation at Raymond James Financial’s national conference in Nashville where the music was GREAT. One of our advisors told me he loved the RingCentral (RNG) story since he has been using it with great results! I will be demoing it in the weeks ahead. This morning all is quiet on the western front with the pre-opening futures flat. But this week’s action should be a “tell” about how we play into mid-May . . .


Wait until you get a pitch right where you want it!
April 25, 2016

One of the most successful investors in history received the only A+ from Professor Benjamin Graham (of Graham and Dodd “Security Analysis” fame) at Columbia: the chairman and chief executive officer at Berkshire Hathaway, Inc., which traded as low as $38 per share in the early 1970s and now trades around $219,000 per share. If you haven’t guessed who by now, it’s Warren Buffett. How does he do it? Well, the following are excerpts from financial media interviews back in the late 1980s:

“The most important quality for an investor is temperament, not intellect. You don’t need tons of IQ in this business. You don’t have to be able to play three dimensional chess or duplicate bridge. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd. You know you’re right, not because of the position of others, but because your facts and your reasoning are right. . . . Most investors do not really think of themselves as owning a piece of the business. The real test of whether you are investing from a value standpoint or not is whether you care if the stock market opens tomorrow. If you’ve made a good investment, it shouldn’t bother you if they close down the stock market for five years. You own a piece of business at the right price and that’s what’s working for you. . . . In 30 years of investing I have never bought a technology company. I don’t have to make money in every game. There all kinds of things I don’t know about—like cocoa beans. But, so what! I don’t have to know about everything. The securities business is the perfect business. Every day you literally have thousands of the major American corporations offered you at a price, and a price that changes daily, and nothing is forced upon you. There are no called strikes in the business. The pitcher just stands there and throws balls at you and you can let as many go by as you want without a penalty. In real baseball, if the ball is between the knees and the shoulders, you either swing or you get a strike called on you. If you get three strikes, you’re called out. In the securities business, you stand there and they throw U.S. Steel at $28 and General Motors at $80, and you don’t have to swing at any of them. They may be wonderful pitches, but if you don’t know enough, you don’t have to swing. And you can stand there and watch thousands of pitches, and finally you get one right there where you want it, something that you understand and is priced right – and then you swing . . .”

On many occasions I have said, “The rarest thing on Wall Street is patience!” That quote is akin to Buffett’s quote, “If you don’t know enough, you don’t have to swing.” For most of last year, we didn’t “swing.” Then, in late August, our model told us to “swing” and we did. That was the week of the August 24, 2015 “lows” around 1800 on the S&P 500 (SPX/2091.58). The next time we “swung” was on December 11, 2015 when our model called for a “rip your face off” rally. About a week and a half later, we had to admit that was a bad “call.” In this business, when you are wrong, you admit it quickly for a de minimis loss of capital. So we came into 2016 with a defensive stance. But on Friday, February 5, CNBC’s Becky Quick asked me what the model was “saying” now. I responded, “It is saying we bottom next week” and we are tilting accounts according. It was during that week (February 11 to be exact) the SPX retested its August 2015 “lows” and the rest, as they say, is history. So where does this leave us now?

Well, the consensus “call” is that we are either making a “top” followed by a big decline or we are at the top of the trading range that has been intact since October 2014 (~1800 - ~2130) and now the SPX is headed back down. That view is reflected in this excerpt from our friends at the Boston-based Fidelity organization: “While this rally may continue to play out, the stock market may not break out of its year-long trading range until earnings growth stabilizes and the policy divergence between the Fed and other central banks ends.”

We are not of that view. Our work suggests the SPX will break out to the upside of the over-one-year trading range. As stated in prior missives, “To me, this feels very much like 2013 where the markets ground down every short seller into the May timeframe before a near-term top arrived. If that pattern plays here, it would fit nicely with my internal energy indicator, whose energy would be totally used up by mid-May. It still feels like new highs to me.”

And maybe, just maybe, the S&P Total Return Index is pointing the way higher as it traded to new all-time highs while the D-J industrials notched new reaction highs (INDU/18003.75). Now, if the D-J Transports (TRAN/8085.98) can better its November 2015 closing high of 8301.80, we will have a Dow Theory “buy signal.” If not, it will be an upside non-confirmation and likely lead to a pullback in stocks. If the Trannies are going to make a new reaction high, it will have to come quickly, because as stated, by mid-May, the equity market’s internal energy should be totally used up.

As for earnings season, while it is still a small sample of the S&P 500 companies that have reported 1Q16 earnings, 78.3% have beaten their lowered estimates (as of last Thursday). That is the best showing since 3Q09 and much better than the past few quarters. There have been some high-profile company “misses,” but the operative word (at least so far) for this earnings season is “beat.” Perhaps the better-than-expected earnings season is telegraphing stronger GDP numbers in the months ahead, although last week’s economic reports were on the softer side. This week, we get a slew of economic reports (Durable Goods, GDP, Core PCE, etc.) as well as the FOMC meeting. As I have repeatedly stated, IMO, if the Fed doesn’t raise rates this week, I doubt if they raise rates until after the election. However, the bond markets seem to think something’s afoot as the Roll-Adjusted Ultra Long Bond Future has broken down in the charts suggesting higher interest rates (chart 1). And, that could be what caused the Bloomberg US Dollar Index to try and reverse it downtrend (chart 2). Or maybe the interest rate complex is anticipating stronger GDP growth in China where energy and electricity consumption is strengthening and things like the Shanghai Steel Rebar Futures are surging (chart 3). It is also worth noting that, last week, Schlumberger said the crude oil surplus would be gone by year’s end and Caterpillar sees its business bottoming globally.

The call for this week: Well, today is actually session 50 (I miscounted when I said last Friday was session 48, because I failed to account for one of the holidays) in the second-longest “buying Stampede” I have ever seen. As SentimenTrader’s cerebral Jason Goepfert writes, “The S&P 500 has gone 10 weeks since trading below a prior week's low. This is the longest such streak since 2011 and among the most impressive since 1928.” That skein has left most of the macro sectors overbought. We are also within a week of the month of May where the market’s internal energy wanes. We have been steadfastly bullish since our model telegraphed the SPX would bottom the week of February 8; however, while we do expect an upside breakout by the SPX to new all-time highs, we are not real excited about adding to the many stocks featured in these reports since those February lows. In fact, according to one particularly brainy colleague, “Everything is expensive except emerging markets.” This morning, futures are flat as participants await the Fed meeting.


Shad Rowe
April 18, 2016

For years, when I was living in Virginia, I attended the annual Shad Planking. As described by Wikipedia (paraphrased):

The Shad Planking is an annual political event in Virginia, which takes place every April near Wakefield, Virginia. It is sponsored by a chapter of the Ruritans, a community service organization. Ostensibly the event is to celebrate the running of shad where the oily, bony fish are smoked for the occasion, nailed to wood planks, and then stuck in the ground around an open flame wood fire. The event began after WW II, and was long a function of the state's Conservative Democrats, whose political machine dominated Virginia politics for about 80 years (from the late 19th century until the 1960s). However both Virginia, and the Shad Planking, had evolved into a more bipartisan environment by the 1980s. In modern times, would-be candidates, reporters, campaign workers, and locals gather to eat shad, drink beer, smoke tobacco, and kick off the state's electoral season with lighthearted speeches by the politicians in attendance.

This morning, however, I am not referring to Virginia’s “Shad Planking,” but rather my friend Frederick “Shad” Rowe, captain of the Dallas-based money management firm Greenbrier Partners. Back in the 1970s/1980s I used to read Shad’s sage comments in Forbes Magazine, but regrettably he is no longer a contributor. He now writes an insightful letter to investors in his partnership every month, which I very much look forward to. This month’s letter was no exception. To wit:

Investing has always been a game of alternatives. What do we do with our money? Cash is not a reasonable answer because it is depreciating all the time. Bonds are not the answer either – with a 1.8% yield, a 10-year U.S. government bond trades at roughly the equivalent of a stock selling at more than 80x after-tax earnings. In comparison, the S&P 500 trades at approximately 18x expected earnings with a current dividend yield of 2.2%. It is worth noting that the bond’s interest payments are fixed, while S&P 500 earnings and dividends are likely to increase over time. The nature of real estate has changed – a new world is unfolding with people shopping online and working from home – and you still have limited liquidity. Sometimes the obvious answer is also the correct answer. The stock market is the obvious answer. It has generated superior returns over time. But the volatility scares most investors. Ultimately we believe that a broad spectrum of investors will reach the same conclusion that we reached long ago. After seven years of generally rising stock prices, we still have not seen the broad, enthusiastic participation that generally indicates market tops. For investors of most stripes, the stock market remains the only viable game in town – a game which many natural participants may have forgotten, but we trust will remember soon enough. And while stocks may not be cheap relative to where they trade at stock market bottoms, they remain very cheap relative to the other outlets for our hard-earned cash.

Obviously I agree with Shad and if S&P’s earnings estimates are close to the mark the S&P 500 (SPX/2080.73) is in fact trading at 17.6x this year’s estimate of ~$118. Yet if next year’s estimate of ~$136 is correct, the SPX is trading at 15.3x earnings. So as Shad eloquently points out, “while stocks may not be cheap relative to where they trade at stock market bottoms, they remain very cheap relative to the other outlets for our hard-earned cash.” Speaking to “cheap” stocks, last week the Financial sector soared with a weekly gain of 3.95%, and why not, for it is truly the cheapest sector out there. Indeed, the Financials trade at an earnings yield of 9.89% (earnings/price), possess an enterprise value to earnings before interest and taxes (EBIT) of 10.28, with an aggregate P/E multiple of 10.11x (see chart 1 on page 3). While most folks want to talk about the major banks, some of the names mentioned to me by various portfolio managers in NYC recently were more obscure. EverBank Financial (EVER/$15.19/Outperform) was one, as it provides a diverse range of financial products and services directly to clients nationwide through multiple business channels. A quick trip to EverBank’s website shows some of their unusual products, like CDs denominated in foreign currencies. The shares trade near book value, at roughly 10x our fundamental analyst’s earnings estimate for 2016, and with a 1.6% dividend yield. Other financial names mentioned, and with favorable ratings from our fundamental analysts, include: Pacific Premier Bancorp (PPBI/$20.85/Strong Buy); Q2 Holdings (QTWO/
$23.74/Outperform); BOFI Holdings (BOFI/$17.25/Strong Buy), which has sold off recently on a negative story from a salacious source; and Carolina Financial (CARO/$18.23/Outperform).

So the Financial sector “painted the tape” higher last week, potentially resolving the question I have heard from the negative nabobs for over a month, that being, “The overall stock market can’t rally without the financials rallying.” To be sure the consensus “call” has been for either a big decline for stocks, or the ubiquitous “call” for a continuation of a trading range. Ladies and gentlemen, I can make a cogent argument that the SPX has been trapped in a trading range since April 2014 between 1800 and 2130 (see chart 2). That’s over two years, which is about as long as a consolidation period lasts within a secular bull market. And yes Virginia, I still believe we are in a secular bull market that has years left to run!

Our model “called” the low of February 11, 2016 and at the time we featured numerous stocks for your consideration in these reports. Since then, the SPX has gained ~15%, which has left the SPX testing its downtrend line in the charts that began last May (chart 3 on page 4). Of interest is that the economically sensitive D-J Transportation Average (TRAN/7978.23) has rallied a large ~20% from its January 20, 2016 low and may be pointing the way higher for the overall stock market. The Trannies’ rally is impressive given crude oil’s ~55% rally from its mid-February low. That “crude climb” has lifted the S&P 500 Energy Index ~22% (chart 4) with many of our energy stocks rallying significantly more than that. Ladies and gentlemen, such actions are not typical of what precedes a recession. Meanwhile, the cumulative Advance/Decline has broken out to new highs (chart 5 on page 5). As for the economic data, most of it has been on the softer side recently, implying interest rates should remain low. The exception to the economic malaise was last week’s Empire Manufacturing Report, which showed its third straight month of improvement (chart 6). China also showed renewed economic strength with iron ore and crude oil imports at all-time highs (chart 7 on page 6). Meanwhile, the dearth of bullish sentiment suggests a bottom for stocks is at hand (chart 8) and our proprietary measurement of the equity market’s internal energy has rebuilt to nearly a full charge, suggesting an upside breakout to new highs is likely in the cards. As for the alleged horrible earnings season, while it is a small sample, of the 49 companies in the S&P 500 that have reported 34 (69%) have exceeded estimates, eight have matched estimates, and seven have missed. Obviously, we will have a better sample by this Friday.

The call for this week: Today participants in the Boston Marathon will race for the finish line. Hopefully, the S&P 500 will race for its respective all-time high “finish line” of 2130.82 as well. The setup is certainly right given the aforementioned metrics and the historical precedent that stocks tend to do pretty well with the SPX gaining ground over 70% of the time the week, and month, following “tax day.” And as SentimenTrader’s perspicacious Jason Goepfert writes:

Stocks enjoyed a rare kind of breakout this week. As volatility compressed over the past month, the S&P 500's Bollinger Bands started squeezing together, and this week the index broke out above its upper Band. That was the first time in nearly 400 days it was able to do so, the 2nd-longest streak in its history. Generally, stocks did well after triggering a breakout like this after having gone a long time without one. The small-cap Russell 2000 is nearly above its 200-day average. The last of the four major stock indexes to climb above its long-term average, when the Russell ended a streak of at least six months below its average, it tended to continue to rally going forward. A new high in the Advance/Decline Line tends to lead to gains. In response to some questions regarding Thursday's Report on the A/D Line, when it moves to a multi-year high, the S&P 500's maximum loss at its worst point over the next year has averaged -3.9%.

Indeed, as we have been saying, “Buy the dips!” And this morning you are going to get another opportunity to buy the dips as there was no oil production cut at the Doha meeting, leaving oil down 4%, the preopening S&P futures off 6 points, and an earthquake in Japan has investors shaken, not stirred.


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