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“Throw Deep?!”
May 12, 2008
Back in the late 1980s a newspaperman visiting the Oakland Raiders football training camp in California had just returned from the Jack London Historic Monument. He read a sample of London’s prose to the colorful Raiders’ quarterback, Ken “The Snake” Stabler:
“I would rather be ashes than dust! I would rather that my spark should burn out in a brilliant blaze than it should be stifled by rot!
I would rather be a superb meteor, every atom of me in magnificent glow, than a sleepy and permanent planet. The proper function of a man is to live, not to exist. I shall not waste my days in trying to prolong them. I shall use my time.”
The newspaperman asked the quarterback, “What does this mean to you?”
“Throw deep,” said Stabler!
Throwing Deep, the Long Bomb, the Hail Mary, are all phrases usually associated with football. It is the spectacular play with the possibility of a quick score, as opposed to the Woody Hayes three-yards-and-a-cloud-of-dust “grind it out” strategy. Throwing Deep is also an attitude, and emotion, that has recently reappeared on Wall Street. Indeed, a mere seven weeks ago the S&P 500 (SPX/1388.28) retested its January 2007 “low” of 1270, traumatizing participants into inaction as the threat of “financial contagion” echoed down the canyons of Wall Street. We, however, were bullish, opining that said retest would be successful and the ensuing rally would carry the averages above their respective February “highs” into mid-May, where a “trading top” should occur in the 1420-1440 zone (basis the SPX). From there, we suggested, a decline would commence that should be measured by “if” the U.S. economy spills into recession (we still doubt it); and then, by if the recession would be short/shallow, or long/deep.
And, isn’t it amazing how fear has morphed into greed in a mere seven weeks, for now the cry on the “Street of Dreams” is about the new bull market that has emerged! We, on the other hand, have turned cautious. Our caution centers on the belief that our economic problems are NOT all behind us, the Dow Theory “sell signal” of November 21, 2007, the double-top chart configuration of the SPX at 1560-1570, and “The Snake;” except in this case we are not referring to Kenny “The Snake” Stabler, but rather the 20-month moving average (MMA) (aka “The Snake”) that has often represented the demarcation line of bull and bear markets. As can be seen in the nearby chart, the 20-MMA tends to mark the difference between the “bull” and the “bear.” When the SPX is above its 20-MMA stocks are in an “up” phase. Even when “the snake” is marginally violated to the downside, but then quickly recaptured to the upside, the bull trend remains in force. However, when it is violated decisively to the downside, and stays there, caution is warranted.
Clearly, the “snake” has been decisively penetrated to the downside. Even the past seven-week rally has done nothing more than bring the SPX back toward the “belly” of “the snake.” While we are certainly hopeful this will be a false technical breakdown, for the past eight years, whenever the “hair” on our neck has been standing up, like it is now, we have tended to err on the side of caution, consistent with Warren Buffet’s two rules of investing: 1) Don’t lose money; and rule number 2) Don’t forget rule number one!
Yet another observation has us worried, that being the price action in crude oil. We are old enough to remember a similar sequence of events that occurred in the 1990-1991 timeframe. As like now, the price of crude oil was surging and smart money was selling crude oil short around its then double-top of $24 per barrel. Fundamentally those short sellers were right; oil was clearly overpriced. But then the Persian Gulf War began and in a mere two months oil spurted from $17/bbl. to more than $41/bbl. Long-time readers of these missives know that we are ALWAYS respectful of price action. And while crude is currently fundamentally overpriced, its price continues to elevate. Whether this means another geopolitical event is in the works is unknowable, but crude oil should not be doing what it is doing and it worries us!
Consistent with these thoughts, we are recommending rebalancing energy positions in portfolios (read: selling partial positions to bring weightings back in-line with the portfolio’s original objectives). While longer-term we remain bullish on energy, crude oil is currently 37% above its 200-day moving average, a level that has historically suggested it is well overbought and due for a correction barring some unforeseen geopolitical event. That said, we are increasingly bullish on the oilfield services complex, believing that the huge cash flows accruing to the exploration & production oil companies (E&P) will result in increased capex spending. Bolstering that view has been unusually bad weather in the Gulf of Mexico this spring, where high winds and choppy waters have curtailed contract awards. Over the past week ocean winds have “laid down,” however, and our sense is contract awards will start to flourish. We think this will make pleasant reading for oilfield services companies like Cal-Dive (DVR/$14.00/Outperform) and Superior Energy (SPN/$52.60/Outperform), both of which broke out to the upside in the charts last week.
As for the recent “financials fascination,” like the E&P complex we are currently shy of financials after their spectacular rally, driven by the belief that their problems are all in the rearview mirror. We don’t believe it; hello AIG (AIG/$40.28), whose Friday revelations shocked Wall Street participants. As repeatedly stated, we think that after 28 years of financial deregulation the financials are now being re-regulated, which implies a crimp in their profit margins with an attendant P/E multiple compression. And that, ladies and gentlemen, is why we have avoided the financials.
So what should we do? Well, our trading strategy has been to sell trading positions into strength on any rally above 1420 (basis the SPX). This is especially true now that we have entered our cluster of trading-top “timing points” in the May 7th – May 14th timeframe. If you followed that advice, you have “lost” (read: sold) two-thirds of your trading positions and raised stop-loss points on the remaining one-third. As for the investment account, we remain opportunistic buyers of fundamentally sound, favorably rated, dividend yielding, hopefully non-economically sensitive situations on price weakness as they approach support levels in the charts. In past missives we have recommended names like 7.7%-yielding Alaska Communications (ALSK/$11.11/Outperform), 6.3%-yielding Embarq (EQ/$43.59/Strong Buy), as well as Schering-Plough’s 8%-yielding convertible-preferred “B” shares (SGP+B/$181.79); SGP is still favorably rated by our correspondent research affiliates, as is 3.8%-yielding GE (GE/$32.27). And this morning we offer for your consideration, even though it is currently rated Market Perform by our fundamental analyst, 11%-yielding LINN Energy (LINE/$22.59) with a stop-loss point of $18.57, which is its recent reaction low. Additionally, the dry bulk shipping complex is worthy of consideration given the recent strengthening shipping surveys, and rising Baltic freight rates, which suggests emerging markets remain strong. Verily, our favorite “country play” over the past few years has been Brazil, whose bourse has broken out to the upside in the charts. Yet for bulk shipping ideas, we defer to our correspondent research affiliates along the lines of DryShips (DRYS/$91.96).
The call for this week: Sometimes you “throw deep,” and sometimes you “grind it out.” We were cautious entering 2008 fearful of a “selling stampede,” but turned bullish at the late January “lows.” Again we were cautious at the February “highs,” suggesting that a re-test of the January “lows” was in order, but became aggressively bullish at the subsequent downside re-test of those January “lows” in March, believing said re-test would be successful. And that the ensuing rally would carry the major averages above their respective February “highs.” Regrettably, once again we are “grinding it out” (read: cautious) now that we have rallied 12%, entered our cluster of topside “timing points,” and traveled into our upside target zone of 1420-1440. Indeed, it’s not the snake you see that bites you!
P.S. – We are in Vancouver, Canada, and then off to Europe, so these will likely be the last strategy comments for a few weeks.
S&P 500 with 20-month Moving Average
Source: Reuters.
“You Gotta Have Heart”
May 5, 2008
“. . . After the workshop, another student took us out to Claibourne, the thoroughbred farm where Secretariat was buried. He was one of the great racehorses of all time. We went to his grave. He was buried in an eight-foot mahogany coffin with a gold satin lining.
My student told me, ‘They don’t usually bury the whole horse, but he was special. Hundreds of people came to his funeral.’
‘Well, what do they bury if they don’t bury the whole horse?’ I asked.
‘Most horses they don’t bury at all. With real winners, they bury the head, the hooves, and the heart,’ she told me nodding.
‘The heart?’ I asked, astonished.
‘Yes, that’s what a horse runs with, his heart. That’s why they say, that horse has heart. If they’ve got heart, it makes up for other things, they can win,’ she explained.”
. . . Long Quiet Highway, by Natalie Goldberg
“Big Brown” was the odds-on favorite to win last Saturday’s Kentucky Derby. And he won, despite starting from the far outside 20th position, he took the lead at the top of the “stretch” and roared to the finish line. The race, however, had a tragic ending as filly Eight Belles, who finished second, had to be euthanized on the track after collapsing while breaking both front ankles. Said breakdown surfaced memories of the 2006 Baltimore Preakness, when Barbaro shattered his rear leg and had to be euthanized a few months later. Clearly, both horses had “heart!” Similarly, in the Wall Street Derby you’ve gotta have “heart.” Indeed, in this business you’ve gotta have heart, as well as experience, to give you the confidence to make the correct “bets” necessary to win the performance derby; or as one Wall Street wag put it, “Experience tells you what to do, but heart gives you the confidence to do it!”
To be sure, we have had “heart” this year having entered the year in a cautious mode, with a high cash position, worried about the potential of a “selling stampede.” As noted, we thought the selling-stampede ended on January 22/23rd (at 1270 basis the S&P 500), and said so, concurrent with recommending committing some of your cash to stocks. The ensuing rally took the S&P 500 up to 1395 in February where we turned cautious, advising participants that bottoms tend to be a function of both “price and time.” Subsequently, we suggested the averages needed to come back down and retest the January “lows” before we could get a sustainable rally that would carry them above their February highs. Almost on cue the averages peaked and slid into their respective March “lows,” which proved to be a successful retest of the January “lows” and we again recommended committing some cash to stocks. At the time “the Street” was rife with stories about the impending market disaster that awaited investors, and our sanity was questioned, except by our friend Herb Greenberg, who in a CNBC interview stated, “I don’t want to go against Jeff Saut since he is one of the smartest guys on Wall Street” (see our parting tribute to Herb at the end of this report).
From Herb’s mouth to God’s ears, for again, almost on cue, stocks gathered themselves together and re-rallied in a move that would carry them above their February highs toward our long-envisioned target zone of 1420-to-1440 basis the S&P 500 (SPX/1413.90). Interestingly, most of the folks that questioned our sanity at the March lows, and consequently would not “buy ‘em” at the time, lit up our phones last week with the question, “what do we buy?!” Regrettably, we had to reply that on a trading basis we are much less sanguine here than we were a mere month ago; and, that we would actually be scale-up sellers of trading positions on any blue-heat upside hour that took the SPX into the aforementioned zone. That move came Friday morning on the much better than expected employment numbers, with an opening salvo that left a “print high” for the SPX of 1422.72; we acted accordingly.
While we still believe the averages can extend higher into our cluster of timing-point “highs” between May 7th – May 14th, we also believe it is pretty late in the up-move and therefore are not recommending ANY new trading positions. Rather, we continue to recommend scale-up selling of trading positions into strength on the belief that come late-May it will become apparent that our economic problems are NOT behind us. That revelation should bring about a decline that will first be measured by “if” the U.S. economy spills into a recession (we still doubt it); and secondly, if that potential recession will be shallow/short or long/deep.
While that is our strategy for the trading side of portfolios, we have a different view for the investing side of portfolios. Indeed, there are many investment stocks that have not participated in the recent rally, yet afford investors attractive risk/reward ratios. One such name was added to our Focus List last week, that name being 6%-yielding Embarq (EQ/$44.06/Strong Buy). We think Embarq’s 30% share price decline from last September’s high of $63 has more than discounted this telecommunication company’s exposure to the housing debacle. Likewise, we favor 7%-yielding Alaska Communications (ALSK/$11.56/Outperform) for its exposure to the vast Alaskan natural resource reserves that should eventually be developed. Our recommendation on Schering-Plough’s (SGP/$18.90) 8%-yielding convertible preferred “B” shares remains in force; even though we lost our fundamental analyst, along with his Strong Buy rating, last Friday (the shares are still positively rated by our correspondent research affiliates). And while we have clearly been wrong on recommending scaling into 3.7%-yielding General Electric (GE/$33.34), after eight years of avoiding it, we continue to think investment positions in GE will be rewarded over the next few years (GE remain positively rated by our research correspondents).
“But Jeff,” one caller questioned us last week, “the economic news has suddenly turned for the better! So why now, after being bullish at the January/March ‘lows,’ are you now turning cautious?!” Our answer was, “while the headline numbers are indeed turning bullish, if you drill down into those numbers all is not as it seems.” Case in point, the 1Q08 GDP report, which at first blush it showed a much stronger than expected positive 0.6% growth rate. However, if you exclude the increase in inventories of unsold goods, the “final sales” number was negative by 0.2%. In other words, the inventories of unsold goods added an artificial 0.8% to 1Q08 growth. Moreover, residential investment collapsed to the tune of 26.7% annualized. Yet the GDP figures misstate this because they do not separate residential investment into true final sales of new homes, as well as into unsold inventories of new homes. Similar nuances massaged last week’s ISM Manufacturing report; and, then there were Friday’s employment numbers.
At first blush, the employment numbers looked impressive, with Nonfarm Payrolls falling by a much less than expected 20,000 (-80,000 estimated), while the Unemployment Rate edged down to 5.0% versus the median forecast of 5.2%. However, as stated in George Orwell’s book “1984” – numbers mean what we say they mean – our government’s recondite birth/death model, which adds jobs it thinks are being created but can’t actually count (read: fallacious jobs), added 45,000 construction jobs and 8,000 financial jobs. Ladies and gentlemen, given the state of real estate and financial industries, such additions are clearly a stretch! Accordingly, we think such numbers will begin to be questioned in the months ahead; and, we continue to invest and trade accordingly.
The call for this week: Last Friday we recommend scale-selling “trading positions” into strength in the 1420 – 1440 target zone (basis the SPX); and especially into our cluster of timing points between May 7th and May 14th. This view is driven by the fact that we have had the envisioned rally, as well as that 77% of the S&P 500 stocks are above their 50-day moving averages (DMAs) for the highest reading since last October (read: overbought). Amazingly, 85% of the S&P’s financial stocks are above their 50-DMAs, which is likely why the financials outperformed gold last week for the first time since last July. Meanwhile, volatility is falling, bonds have broken down (read: higher interest rates), bond spreads are narrowing, the U.S. dollar has “firmed,” and commodities have “cracked,” all of which suggests risk appetites are rising. Plainly this concerns us and begs the question, “Are we entering a new kind of investment environment?” History shows that if so, it will not be without some major dislocations, which is why we are now turning cautious.
“Where’s Herb?!”
“Where’s Herb?” except in this case we are not referring to Burger King’s failed ad campaign of the mid-1980s, but our friend Herb Greenberg. I found the answer in last week’s Wall Street Journal as I turned to “section B” only to see a picture of business journalist par excellence, Herb Greenberg. Over the years I have come to know Herb both professionally, and socially, and have always found his comments extremely insightful. Indeed, Herb unmasked many a company’s fallacious financials before Wall Street discovered them; and, Herb sounded the alarms that saved investors billions of dollars if they listened.
Consequently, I was glad for Herb, but sad for all of us as the column’s headline read, “A Columnist’s Parting Advice,” with the tag line, “After nearly 34 years as a journalist, the entrepreneur deep inside has finally won and I’m leaving to start a research firm.”
The article went on to say (as reprised from the Wall Street Journal and MarketWatch):
“But when you strip it all away, the lessons I have learned can be boiled down to five that are remarkably obvious and simple but are still often ignored in the heat of the battle:
Lesson No. 1: The numbers don't lie. They can be stir-fried, oven-fried or convection-baked, but in the end they always hold the keys to the kingdom. That is why some short sellers and forensic analysts don't like to talk to companies. They want to avoid the spin or the face-to-face meeting that can create a psychological connection that may skew what otherwise would be black-and-white analysis. Don't ever underestimate the power and influence of the human factor.
Lesson No. 2: Quality, not quantity. Ignore the "beat the Street" headlines on earnings. It is what goes into the earnings that counts. As I quoted investment legend Thornton Oglove as saying here the past week, the real story is often on the balance sheet. And let's not forget the cash-flow statement. And this tip: The more complex and convoluted the financial statements get, especially for businesses that aren't overly complicated, the more reason to worry.
Lesson No. 3: GAAP isn't the same as a Good Housekeeping seal. Generally Accepted Accounting Principles, according to which all financial statements are supposed to be prepared, include plenty of gray areas that give management enough rope to hang itself. GAAP, after all, is subject to interpretation, and some managers are more conservative than others. Remember, just because the accounting is legal doesn't mean the end results won't be lousy.
Lesson No. 4: Don't confuse stocks and companies. They sometimes go in opposite directions. Stocks sometimes really do lie. Sometimes they are pushed artificially higher by a rotation by investors from one industry group to another, because that one sector happens to be in favor. Sometimes they lie because of short squeezes, which occur when short sellers -- who bet stock prices will fall -- are for some reason forced to rapidly purchase the shares they sold short. And sometimes they lie because of momentum. Momentum can take stocks to infinity and beyond, but true believers can wind up learning that momentum has a dark side: It is called reverse momentum, and it tends to kick in when you least expect.
Lesson No. 5: Risk isn't a four-letter word. A good rule of thumb is that before you buy, instead of asking how much you can make, first ask how much you can lose. That is what the smart guys do.
Consider those my parting gifts. It has been a great ride. Thanks for sharing it.”
To which we conclude, farewell my friend . . . for those of us that listened, and acted on your sage words, you will be sorely missed.
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