Investment Strategy by Jeffrey Saut

“Being Right or Making Money”
August 25, 2014

“Apparently, Barry Bannister has raised his 12-month S&P 500 price target from the lowest on the Street to the highest price target, an increase of 450 S&P points in his forecast from 1850 to 2300. Bannister was, not surprisingly, self-confident in view. [However] never did I hear the words, ‘I was wrong, or I don’t know.’”

... Doug Kass, Seabreeze Partners

So wrote my friend Dougie Kass in his blog of last Friday referencing Stifel Nicolaus’ strategist Barry Bannister. Now I grew up sailing on the Chesapeake Bay and one of the old watermen’s axioms is, “You can’t change the direction of the wind, but you can adjust the sails!” As with sailing, you can adjust your “sails” in the stock market because if you do not adjust for the changing causal relationships you are doomed. Hence, I have no trouble with Barry Banister adjusting his price target. However, like Doug, I find it disingenuous that there is no mention of being wrong. As Doug further scribes, “When I am wrong, I try to say/write that I have been wrong (as I have been on my market call this year). When I don't know, I say it. I have learned to never be self-confident in view and to worry about what or who lies over my shoulder (especially of a Cossack kind!). As Grandma Koufax used to say, ‘Dougie, honesty is the best (insurance) policy’.” Doug’s prose reminds me of another Wall Street icon, namely Peter L. Bernstein, who wrote:

After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.

As stated in previous missives, I am wrong, and wrong a lot, but being wrong comes with the franchise of an activity whose outcome depends on an unknown future. My redeeming feature is that I am unafraid to admit to being wrong. As well, when I am wrong I am usually wrong quickly and for a de minimis loss of capital. Case in point, around the beginning of July, for a plethora of reasons chronicled in these reports, I began looking for a pullback. As events unfolded it felt more and more like we were finally going to get the 10% - 12% decline the historical odds call for some time this year. Indeed, first the S&P 500 (SPX/1988.40) broke below the 1940 – 1950 support, bringing into view the secondary support zone of 1890 – 1900. But as we approached that 1890 – 1900 zone the decline was arrested by some encouraging geopolitical news; and when the SPX traveled above the now 1940 – 1950 overhead resistance zones, I had to admit to being wrong and embrace the “call” of testing the highs and maybe more.

At the time I suggested three potential trading patterns. First, the SPX rallies up to either its all-time closing high of 1987.98, or its all-time intraday high of 1991.39, and then fails to make a higher high, leading a pullback attempt. Second, the SPX rallies slightly above its all-time highs with a peak-a-boo “look” to new highs enough to get everyone excited about another new leg to the upside just in time to get a pullback. That would be the reciprocal pattern of the bottoming sequence that saw a peak-a-boo “look” to new lows on October 4, 2011. At the time I was comparing that pattern with the similar patterns of 1978 and 1979 that saw those “undercut lows” end the decline, which is why we were bullish on October 4, 2011. As a sidebar, I continue to believe that was the “valuation low” launching this current bull market, not the “nominal price low” of March 2009. The third scenario is that this is for real and we are set for another leg up in the ongoing secular bull market. And to that secular bull market theme, while I have been wrong a number of times on the magnitude of various pullbacks, I have never wavered on the fact that I think we are into a bull market. In the attendant chart (chart 1) the nominal price lows of December 1974 and March 2009 are delineated by the blue arrow. Worth noting is that nobody measures the 1982 to 2000 secular bull market from the December 1974 low, but rather the valuation low of August 1982. When you measure this bull market from its respective “valuation low” of October 4, 2011, it is not nearly as long-of-tooth as the bears would have you believe.

Given last week’s action obviously the first negative scenario has been eliminated. This week should tell us if this is just a peak-a-boo “look” to new highs, or something more. Surprising, at least to me, is that the 11-session straight-up move has not resulted in a massively overbought condition in the NYSE McClellan Oscillator (chart 2). It also begs the question, “Are we in a buying stampede?” Recall “buying stampedes” tend to last 17 to 25 sessions, with only one- to three-session pauses/pullbacks before they exhaust themselves on the upside. Hereto, this week should tell us if this is a stampede. If it is, today is session 12. However, I am still worried about the topping formation coincident with the 64-65-66 month sequence often referenced in these missives that has “topped” a number of rallies. This month is month 65.

This morning worries about the “humanitarian aid” from Russian convoys, Chinese jets dangerously close to our surveillance planes, Iceland’s volcano, and the earthquake in Napa Valley are being offset by hints of further monetary easing by the ECB, more Monday merger mania, and better geopolitical events. The result has left the 5-year to 30-year U.S. yield curve the flattest it has been since the 2008 financial crisis, so the bond market is worried about something. Stock pickers at the Bank of Montreal, however, are betting on improving growth in the U.S., and a decline in the euro currency, which should be bullish for U.S. equities. I agree and continue to believe we are in a secular bull market that has years left to run.

The call for this week: The title of this report is “Being Right or Making Money,” which is the title of a book by Ned Davis that resides on my desk. I would certainly rather make money than “be right!” But, “Being wrong comes with the franchise of an activity whose outcome depends on an unknown future.” So yeah, I was wrong and all we got was yet another ~5% decline. But, again I wasn’t wrong for long because when the SPX broke above the 1940 – 1950 overhead resistance zone I said we were going for the all-time highs; and here we are with the preopening futures up by 6 points at 4:30 a.m. Meanwhile the U.S. dollar is sharply higher on Kuroda and Draghi’s dovish comments and don’t look now but gasoline has declined from ~$3.30 per gallon to $2.70 basis the futures market. That is obviously consumer friendly, which is why the Consumer Discretionary sector was up by more than 2% last week. Indeed, last week the equity markets seemed to be driven by better economic news (existing home sales +2.4%, building permits +8.1%, housing starts +15.7%, LEI +0.9%, Philly Fed 28.0, etc.). To the Philly Fed report, I don’t understand (there’s that phrase again) how a 3.5 pop in Inventories and a 0.8 rise in the Average Workweek offset declines in seven other components (see chart 3).

Chart 1

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Chart 2

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Chart 3

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Lucid Dreaming!
August 18, 2014

“Experts in the phenomenon known as lucid dreaming, where sleeping people are aware that they’re in a dream, say dreamers should look for reality checks, or details that look different in dreams than in real life. . . . Some lucid dreamers are able to control elements of their dreams once they realize they’re dreaming. They do what’s impossible or unlikely in real life, like fly or meet famous people. ... Others use the technique to solve problems, spur creativity, overcome nightmares or practice physical skills, says Daniel Eracher, a professor at the University of Bern’s Institute for Sport Science, who has conducted surveys of lucid dreamers. ... [Researchers] found that people with frequent lucid dreams are better at cognitive tasks that involve insight, like problem-solving. Other researchers have shown that people who dream of practicing a routine can improve their abilities in that activity in real life.”

... The Wall Street Journal, by Shirley S. Wang (8-12-14)

Evidentially, the “lucid dreamers” on Wall Street practiced their skills two weeks ago as professional traders were sneaking large “buy orders” into the equity markets on the closing bell. Simultaneously, the Commitment of Traders’ Report showed those same traders were dramatically reducing their “short sale” bets. At the time I was writing that the inference of such actions suggested the “pros” were betting the anticipated decline, which began in July, was going to be just another 5% - 7% pullback before the uptrend resumed. Last week, that strategy looked like the correct call with the S&P 500 (SPX/1955.06) having bottomed the previous week at a ~4.3% decline before accelerating to the upside last week. As written, I thought said acceleration was driven by the week’s option expiration, which felt like an upside squeeze into Friday’s “witch twitch.” And, it looked like that was the way it was going to play, until Friday’s Russian Roulette.

I warped in around 6:00 a.m. on Friday to find the alleged humanitarian aid convoy, of some 240 Russian trucks, had stopped short of the Ukrainian border, but 23 Russian military vehicles had snuck past the border guards during the night. Evidentially the equity markets thought nothing of such shenanigans as the preopening futures were printing higher with the “pros” still wanting to be “long” going into the afternoon option expiration. However, things changed dramatically at 10:30 a.m. when news stories swirled around the world’s trading desks that the Ukrainian army had engaged the Russian convoy with shots being fired. At the time, nobody knew if body-bags were necessary, so equity markets swooned and bonds rallied. The Dow Dive typified the world’s markets with the senior index losing ~138 points from the previous session’s close, and an eye-popping 200-points from that session’s intraday high. The consternations continued into the 2:30 p.m. “pivot.” (The equity markets tend to have two pivot points. One occurs at 11:30 a.m., when traders “square” their positions and leave for lunch. The other is at 2:30 p.m. when again they square position going into the final hour of trading.) After Friday’s 2:30 p.m. “pivot point,” however, there was no second-shoe to fall on the Ukrainian/Russian situation and a rally attempt ensued into the close. In a pre-interview with my friend Susie Gharib, for last Friday’s CNBC Nightly Business Report, she asked me, “What is going to happen in the markets next week?” I replied, “It all depends on geopolitical events over the weekend.”

For the week the D-J Industrials (INDU/16662.91) gained 0.66%, the economically-sensitive D-J Transports (TRAN/8264.12) improved by 2.12%, the D-J Utilities (UTIL/548.81) were up 1.13%, but the big winner was the NASDAQ 100 (NDX/3987.51) at a +2.56% gain. The week’s biggest winning sectors were Healthcare (+2.32%), Information Technology (+1.75%), and Consumer Staples (+1.41%), while by my work the only two sectors currently oversold are Energy and Industrials. On the commodity front, all of the ones I monitor were down for the week save Corn (+4.01%) and Palladium (+2.31%). Yet within the bookends of the week there were some pretty interesting events. Japan’s economy contracted at an annualized 6.8% rate; the U.S. Treasury noted that our budget deficit was “only” $95 billion; the EPA intends to close another 200 coal-fired electricity generating facilities; Libya’s recently-appointed leader (Col. Mohammed Suwasysi) was assassinated leaving effectively no government operating in Tripoli; in the course of the last six months more jobs have been created in the U.S. than at any time since 2006 (but while U.S. job creation has soared, pay is 23% less); German 2Q GDP fell 0.2% causing German Bunds to briefly travel below 1%; French 2Q GDP was flat leaving France teetering on recession, France’s finance minister warned that his country would no longer attempt to meet EU deficit targets; U.S. new mortgage loans fell to their lowest level since 2000; U.S. 2Q preliminary figures suggest further decline in Personal Income Taxes; Saudi Arabia and the U.S. are using crude oil as a weapon; Bill Gross is reducing his holdings of U.S. Treasuries; Iraq’s Maliki stepped down; the NFIB Small Business optimism index recorded its second highest reading of the economic recovery; there are only 11 countries in the world that do not have some form of conflict; and the list goes on.

Susie also asked me about the message from the T’bond market, “Does the bond market have it right (recession), or does the stock market have it right (economic expansion)?” I told her that IMO the rally in U.S. treasuries is a flight to quality, as well as a relative yield play with the German Bunds at 1% and the U.S. dollar improving against the world’s currencies. The other thing I related was that with the European economy appearing to be “slipping,” and with the euro weakening vis-a-vis the U.S. dollar, it should drive European investment dollars into U.S. equities for multiple reasons. As well, most European accounts remain massively under-invested in U.S. stocks given that the benchmark they are compared to, the MSCI All Country World Index, has about a 48% weighting in U.S. equities.

For whatever reason, the SPX finally broke out above its 1940 – 1950 overhead resistance zone that has served as a ceiling for the past few weeks. While it was not a decisive upside breakout, and it was reversed on Friday’s geopolitical gottcha, a breakout is still a breakout and has tilted the weight of the evidence towards my sense that a sustainable low happened on August 7th. Moreover, a trader’s “buy signal” was triggered last week when the 14-day Stochastic traveled above its moving average. Also of interest was that despite Friday’s Fade, “they” could still not break the SPX back below 1940. Accordingly, as I told Susie, this week we will put “rabbit ears” on for the world’s geopolitical events, as well as four different housing reports, the CPI, PMI, LEI, Philly Fed (see chart 1), and the all-important Jackson Hole confab where Ms. Yellen will discuss the employment situation.

Turning to earnings, with the earnings season almost over, it’s proven again to be better than the bears have suggested with 58.6% of ALL reporting companies beating estimates, while 60.7% bettered revenues estimates. As for sectors, Technology fared the best with a 68.3% revenue beat and 66.7% earnings beat rate. Healthcare was a close second at 66.7% and 63.0%, respectively (see chart 2). Drilling down into the Raymond James’ Research Universe saw five companies beat earnings/revenue estimates and guide forward earnings expectations higher. These five have positive ratings from our fundamental analysts and screen positively on my proprietary algorithms. We offer them for consideration on your “shopping lists.” They are: Advance Auto Parts (AAP/$131.47/Strong Buy), AmerisourceBergen (ABC/$76.33/Outperform), Monolithic Power (MPWR/$44.06/Outperform), Skyworks (SWKS/$54.39/Strong Buy), and UnitedHealth (UNH/$81.47/Strong Buy).

The call for this week: I am in Boston seeing portfolio managers and speaking at a couple of events, as well as a national conference. If past is prelude, my Boston sojourn will see some kind of dramatic action in the equity markets. My hope is that a sustainable low has been achieved on 8-7-14 and the subsequent action will be on the upside. If so, the rally that began a week ago should gain “legs” from the option expiration upside “squeeze” and the de-escalation of the Ukraine situation. A decisive breakout above 1950 would suggest at least a test of the all-time highs and likely more.

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A New York State of Mind
August 11, 2014

I was a kid, with only a few years of experience, in this business. My mentor was a savvy-seer with decades of experience on the floor of the New York Stock Exchange (NYSE) and was willing to share that knowledge as long as I was willing to buy him glasses of scotch. I learned a lot from him over the years, and many glasses of scotch, at Harry’s Bar & Grill in New York City. I thought my business acumen was advancing pretty well, and when some particularly bad news arrived in 1963, I searched around quickly for a cheap “put” to buy, or a low priced stock to sell short. Later that day, I met my mentor at the bar. After buying him yet another scotch, I told him what I had done to take advantage of the negative news. His response was, “Kid, when the bad news hits you ‘buy ‘em, you don’t ‘sell ‘em!” They don’t teach things like that in college.

... Art Cashin, Director of Floor Operations for UBS

I met Arthur, as well as a host of other friends, last Thursday afternoon during my NYC sojourn to see institutional accounts and do media events. Over a scotch, he related the aforementioned story to me. The timing was propitious because another one of our friends had just telephoned to tell us the President was authorizing air strikes against ISIS. After a dinner at Mr. Chow’s, I went back to my hotel to find the preopening S&P 500 futures printing down roughly 11 points. The next morning when I warped in at 5:30 a.m. the futures had pared those losses to a mere minus 3.60 points. Wow, I thought, how fortuitous was Art’s story from the night before! Yet, that comment was to pale as rumors swirled down the canyons of Wall Street that Putin was deescalating the Ukrainian Uprising by withdrawing Russian troops from the border. By Friday’s closing bell the senior index was up 185 points and the S&P 500 (SPX/1931.59) was sporting a 22-point gain. The set up for a rally attempt was certainly in place with the NYSE McClellan Oscillator oversold and with the SPX holding its 100-day moving average (DMA), a moving average that has proved to be support for the last few years. Bolstering the oversold condition, the SPX had traded into the bottom of its 3% trading envelope (see chart 1). Further, last Thursday I wrote about the mysterious on-the-close buy orders that were showing up in each of the week’s sessions. Concurrently, the Commitment of Traders’ report indicated a noticeable reduction in professional traders’ short-sale positions, suggesting the pros were betting that this was just going to be another 5% - 7% pullback. And at its nadir, the D-J Industrials (INDU/16553.93) was down 4.5% from its recent high, while the SPX had lost 3.9%, in one of the most whipsaw two sessions in recent memory (see chart 2). Here, however, is the rub. The NYSE McClellan Oscillator is now fully overbought (see chart 3) and the SPX is within 9 points of its 1940 – 1950 overhead resistance zone often referenced in these reports. Accordingly, I continue to exercise the rarest commodity on Wall Street, patience!

While last Thursday with friends at Bobby Van’s across from the NYSE was the highlight of the week for me, there were some other very cool high points. The week began with a presentation at the Piedmont Club in Spartanburg, South Carolina for our financial advisors. The next morning I had breakfast with some portfolio managers (PMs) followed by speaking at a lunch in Greenville, South Carolina’s Thornblade Country Club. That night I did another well-attended presentation at the same club. I don’t know how long ago, and who made the decisions for the city of Greenville, but those decisions have left Greenville as one of my favorite places to visit. The next morning at 6:00 a.m. I flew to NYC for a 10:00 a.m. meeting with a hedge fund. My next meeting was with the sagacious folks at Baron Capital. I always enjoy the company of Ron Baron, one of “The Street’s best stock pickers, but on this visit I had the privilege of talking with his energy-centric PM, Jamie Stone. He began by saying oil prices are likely “range bound” for the foreseeable future, between a band of $80 - $85 and $105 - $110 per barrel. He explained that production costs are not going down, we are capacity constrained, there is an upward shift in capital intensity, and that the “majors” are outspending their cash flows; so, it’s tough to see oil prices having a big decline. He also opined that the success of the U.S. oil shale bonanza is “pulling capital from the rest of the world.” He added that shale has low resource risk (tons of shale oil), but high execution risk. He worries that the energy space is going to run out of skilled people because everyone is scrambling for labor. One of the names he liked from Raymond James’ research universe was Concho Resources (CXO/$133.33/Outperform). He noted that Concho is drilling 600 wells per year, yet has some 20,000 resource prospects left to drill. The other name mentioned was Oasis Petroleum (OAS/$47.54/Strong Buy), which recently “missed” on two key volume metrics, but is trading at 5x cash flow and is growing production by 45% per year.

Next on the docket was Baron Capital’s real estate PM, Jeff Kolitch. He began by noting the amount of houses that are selling per year is way below the country’s population growth of 3 million folks per year. He also said that the commercial sector is clicking “across all sectors.” Another very interesting data point came from the CEO of Hyatt (H/$56.57/Market Perform), when he said (as paraphrased) – I have been visiting our various properties around the country, and despite the fact we are near occupancy capacity without a bubbling economy, I don’t see any new hotel construction around our properties – and that, ladies and gents, brings us to a stock mentioned by him. Starwood (HOT/$79.66/Outperform), he said, is moving toward an “asset light” business model. That would be shifting the company from total ownership of hotels to more of a management of hotels model. To wit, the company is selling roughly $2 billion worth of hotels, and using some of that money to buy back 10% of HOT’s stock, and then probably returning excess cash to shareholders. That Baron’s duo was followed by none other than Ron Baron, who while discussing favored positions like Iridium Communications (IRDM/$8.22/Strong Buy), which I own, and Tesla Motors (TSLA/$248.13), pronounced (again as paraphrased) – the stock market tends to grow at about 7% - 8% per year plus dividends, but we attempt to grow our accounts by 14% - 15% per year, and Baron Capital has the track record to prove it! Ron further offered-up that the value of the U.S. dollar falls by half every 20 years and that the stock market is a good hedge against that.

The rest of Wednesday was spent with the good folks at JP Morgan Asset Management, and two of its premier PMs, but I will have to continue this discussion in tomorrow’s Morning Tack. Regrettably, Mary Edroes, the head of JP Morgan’s asset management division, was in Brazil and therefore unavailable to meet with me this time, but I got a rain check.

The call for this week: Until Friday’s Fling, the Russell 2000 (RUT/1131.35) outperformed the SPX every day last week. That was a distinct change of trend and is consequently worthy of note. It is also interesting that the RUT’s PEG ratio (price to earnings growth) was below 1, which seldom happens, and implies that small caps are cheap. Last week the Street experienced record junk bond redemptions ($7.1 billion), as U.S. economic growth trumped the rest of the world. Also of interest is that Darrell Issa said more than 20 governmental officials lost/destroyed emails after Congress launched its investigation. This morning, however, all sins are forgiven as Iraq is close to naming a new Prime Minister, Russia has “stepped back” from the borders of the Ukraine, Ukrainian forces are about to recapture the city of Donetsk, and Israel agrees to a new cease fire with the Palestinians. Such events have the pre-opening SPX futures up 8 points at 6:00 a.m. That said, we will not be out of the woods until the SPX surmounts the 1940 – 1950 overhead resistance zone.

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