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Investment Strategy by Jeffrey Saut

May 31, 2016

“Nothin’ from nothin’ leaves nothin’ (Billy Preston)” . . . is the first line from Billy Preston’s hit song “Nothing From Nothing” recorded in 1974 on the album “The Kids & Me.” It was a song one of my bands used to play in an era long gone by. I recalled the tune while reading one market maven’s letter last Tuesday where the author commented that, “Monday was perhaps the nothingest of nothing days.” And, he was right because on that day the D-J Industrials limped through the session only to close down by a mere 8 points. To be sure, last week began as so many weeks have begun over the past 22 months. Recall it was in August 2014 that the S&P 500 (SPX/2099.06) first breached the 2000 level, but ever since the SPX has been trading in a relatively tight range of roughly 18%. As the good folks at LPL Research write, “[That’s] one of only five times it has traded in a range of less than 20% over a period of 22 months. Looking at the chart, 2005 and 2006 were the last times to see a range this tight. Of course, that was nearing the end of that bull market, but the two times before were the mid-1990s and late 1984. Both of those occurrences were simply a break in multiyear bull markets.”

To look at the chart, and subsequent previous tight ranges, see chart 1. This range-bound stock market has frustrated both bulls and bears alike, and while Andrew Adams and I have tried to “call” the tactical moves for the SPX over the last 22 months, we have never given up on our continuation of the secular bull market “call.” As often stated in these missives, we believe what has occurred is merely an upside consolidation following a ~220% rally from the March 2009 lows into the May 2015 highs. More recently, however, it is not the 2000 level investors are focused on, but rather the 2100 level (chart 2). Indeed, the SPX has tried four times to better the 2100 – 2134 overhead resistance level, as well as the May 2015 all-time high, and has failed on every attempt. Whether this current attempt will prove successful remains to be seen, but I would note that if we do break out to new all-time highs, it would leave many investors scrambling.

To this point, the SPX took a step in that upside direction last week as it broke out above the downtrend line that has been in existence since the mid-April 2016 high (chart 2). That breakout allowed the SPX to gain 2.28% last week, and while that was pretty good, it paled in comparison to the NASDAQ Composite (+3.44%) and the Russell 2000 (+3.43%). On a sector basis, Information Technology was the star of the week with a gain of 3.60% followed by Financials (+2.62%), which caused the S&P 500 Financial sector to experience an upside breakout in the charts (chart 3). In past comments, we have argued the only two macro sectors we can find real value in are the Energy and Financial sectors. Interestingly, there is another soon to be new sector in what will then be the S&P 11 macro sectors. The new sector will be Real Estate, with an obvious emphasis on Real Estate Investment Trusts (REITs), and the new sector will begin after the closing bell on August 31, 2016 (ET). As a sidebar, there will also be a new sub-industry for copper created at the same time.

Speaking to the REITs, my friends at arguably the premier real estate money management team of Cohen & Steers recently told me there should be more than $100 billion in demand for REIT stocks from 40 Act mutual funds just to get to a market weighting when the new sector becomes effective. While nobody has done the work on how much of the REITs will be bought by international investors, I did receive this quip from one portfolio manager that traffics in this space, “With the Bank of Japan (BoJ) now owning more than 5% in 12 different REITS and also owning more than half of the entire ETF market, the ex-Vice Finance Minister from the opposition Democratic Party basically said it’s easy to get in, but how are you going to get out. ‘As with any investment, you must always think about exit, but there’s no exit when you own half of the market.’ He is not calling for selling the BoJ positions, just to stop buying more.”

The large capitalization REITs international investors will likely be buying, which have positive ratings from our fundamental REIT research team, and that screen positively on our proprietary algorithm model, include: American Tower (AMT/$106.06/Strong Buy) yielding 1.94%; Equinix (EQIX/$366.56/Strong Buy) yielding 1.93%; and, Extra Space Storage (EXR/$92.93/Strong Buy) with a yield of 2.54%. Those names with the same metrics from our mid-capitalization research universe include: Apartment Investment & Management (AIV/$42.78/Strong Buy) yielding 3.1%; American Homes 4 Rent (AMH/$18.58/Strong Buy) yielding 1.08%; Douglas Emmett (DEI/$34.03/Outperform) yielding 2.62%; Mid America Apartments (MAA/$102.35/Outperform) with a yield of 3.25%; and, Regency Centers (REG/$77.20/Outperform) yielding 2.60%. With the “wind at their back” due to the new S&P sector status, we believe the REIT complex has higher prices in store. We think you should buy some of the favorably rated REITS by our fundamental analysts.

Between the “bookends” of last week: 1) most of the economic releases were weaker than expected; 2) despite that Janet Yellen kind of confirmed a rate hike in the months ahead would be appropriate (chart 4); 3) contracts to buy existing homes, new home sales, and mortgage applications all came in higher than expected (chart 5); 4) crude oil tagged $50 per barrel; 5) the AAII Bullish Sentiment figures dropped to the lowest level in a decade (chart 6); 6) the Philadelphia Semiconductor Index broke out to the upside (chart 7); and, 7) there was no post G7 “lift” for stocks. While there were many other metrics occurring last week, these were the ones that stood out to us.

The call for this week: All of the S&P macro sectors are either neutrally configured, or overbought, on a short-term basis. Similarly, the NYSE McClellan Oscillator is overbought suggesting at least a pause to last week’s “win.” However, our internal energy indicator for the equity markets has a full charge, the lack of bullish sentiment is wildly bullish, and with headlines like this in Barron’s, “Why the Stock Market Won’t Crash – Yet,” it continues to reinforce our belief the secular bull market has years left to run. As for “crashes,” while many (like the Barron’s article) refer to the events such as: the Banker’s Panic of 1907, the Kennedy Steel Panic of 1962, the 1973 – 1974 debacle, the 2008 – 2009 Financial Crisis, etc. as “crashes,” they are not crashes! A “crash” happens over a very short period of time. By my pencil, there have only been two crashes since 1900 (chart 8). The first was the 1929 crash where the D-J Industrial Average lost approximately 25% of its value in two sessions (10-28-29 and 10-29-29). The second crash came on October 19, 1987 when the D-J Industrials lost 22.6% in a single day. Those were crashes, the various panics like the Dot-com Bubble Bust of 2000 to 2002, and the aforementioned panics, were not crashes but rather bear markets. One could make the case that the “Flash Crashes” of May 6, 2010 and August 24, 2015 qualified as “crashes” because they both occurred in one day, yet they do not qualify based on the severity (percentage) of the decline. This morning, the preopening futures are flat on no news. And, that’s how it is at session 76 in the longest “buying stampede” I have ever seen . . .

Market bubbles
May 23, 2016

“Market bubbles occur when the price of an asset significantly deviates from its intrinsic value. There have been numerous bubbles predicted in my 20 years as a professional investor. Fortunately, only two, from the perspective of U.S. investors, came to pass. The technology bubble in 2000 and the financial crisis in 2008.”

. . . Scott Kubie, Chief Strategist at CLS Investments

As many of you know, last week I traveled throughout Mississippi and Alabama presenting to our financial advisors and their clients. My message was upbeat, yet many of those investors think the equity markets are in a “bubble.” Why this “bubbleicious” sentiment is so pervasive is a mystery to me, because using S&P’s earnings estimates for this year and next (~$114 and ~$134) leaves the S&P 500 (SPX/2052.32) trading at 18x this year’s estimate and 15.3x next year’s. As written last week, “In 2000, the S&P Total Return Index was trading for more than 30x earnings (excluding negative earnings), and if one includes negative earnings, the P/E ratio was pushing 60x.” As I was attempting to explain such metrics to one of our clients last week, an email from a European account arrived. The prose was from Scott Kubie, sagacious strategist who hangs his hat at the insightful CLS Investments organization, and the first thing I saw was the equation that serves as the title for this report.

The author explains said equation by noting: 1) FCF is free cash flow one year in the future, 2) R is the required rate of return, and 3) G is the future growth rate. Scott Kubie then elaborates:

“Whether you totally grasp the equation or not, the key points are: higher cash flow and growth raise the value of the firm, and a higher required rate of return lowers the value. The last two U.S. market bubbles occurred because investors were fooled by inflated values in one of these numbers. Interestingly, the 2000 and 2008 bubbles occurred in different parts of the equation. In 2000, investors assumed Internet companies would take over every aspect of commerce. Small startups were projected to grow into behemoths down the road. The growth rates assumed far outpaced potential, and a bubble ensued. High price-earnings (P/E) ratios for technology stocks were an expression of high growth expectations. As growth (g) gets closer to the required rate of return (r), valuations can get very high. 2008 resulted from inflated cash flow. In this period, investors assumed the high profits and cash flow generated from housing loans were sustainable. Instead, those numbers were based on errant assumptions about the housing market. Those profits were restated as massive losses in the following years. In this case, the valuations looked legitimate the entire time; it was the profit numbers that were inflated. So, where should we look for the next bubble? Investors and generals are known for fighting the last war. People looking for financial decline due to increasing student loan debt or riskier car loans are looking in the wrong places. Even the optimism in Internet firms or biotech companies pales in comparison to 2000’s tech bubble. Instead, look to the variable in the equation that hasn’t caused a recent bubble. Required rates of return (r) may be too low for some assets.”

I agree with this analysis and would urge investors not to get too bearish despite the difficult stock market environment. To be sure, the past nearly two years has been one of the most challenging markets I have ever seen. As the good folks at Bespoke write, “Markets have basically gone nowhere for the last 24 months. With fixed income yields as low as they are and equity markets basically returning nothing, investors have had a very tough time generating any kind of returns since mid-2014. Sideways action is a lot better than down action, but another leg higher at some point would sure be nice.”

And that’s true; the SPX has been range-bound (~1800-2130) since October 15, 2014. During that timeframe, Andrew Adams and I have made a number of tactical trading “calls,” most of which have produced decent results. Speaking to the “bad calls” we have made, as often stated, “When you are wrong, be wrong quickly and for a de minimis loss of capital.” We had to admit to a “bad call” back in mid-April when the SPX failed to follow its brethren, the S&P Total Return Index, to new all-time highs. That action produced a “polarity flip” in our model, suggesting a move to the downside into the week of May 8 (∓3 sessions) with a downside price target of 1990-2000. So far, the timing model has been generally correct but precisely wrong given the “low print” of last week at 2025.91. Of course, that is inconsistent with our price target, yet in this business, you have to take what the markets give you. However, the past few weeks have produced another oversold condition with the SPX becoming as oversold as it was last February (chart 1). That’s interesting, because the SPX is only off ~2.4% from its mid-April closing high. At the February oversold reading, the SPX was down some 13.3% from its November reaction high.

Given this year’s non-linear (trendless) performance, it is thought provoking to look at the sector performance year-to-date (chart 2). Utilities have been the clear winner with a YTD gain of 10.85% followed by Energy (+9.86%) and Telecom (+9.21%). That sector performance is a head scratcher, because Utilities, Energy, and Telecom have not had the best earnings momentum. Maybe the equity markets are looking forward to and anticipating better earnings. That certainly is what is occurring with forward earnings guidance, which is back in the “green” for the first time since early 2014 (chart 3). This is not an unimportant point, because the performance of companies the beat their earnings estimate, beat revenue estimates, and raised forward earnings guidance has been pretty good. Some such names from Raymond James’ research universe, which have favorable ratings from our fundamental analysts and screen well using my proprietary algorithm, include: C.R. Bard (BCR/$219.74/Outperform), NVIDA (NVDA/$44.33/Strong Buy), Newell Brands (NWL/$47.14/Outperform), UnitedHealth (UNH/$130.94/Strong Buy), and Wal-Mart (WMT/$69.86/Strong Buy).

The call for this week: According to the perspicacious Jason Goepfert (SentimenTrader), “It has now been a year since the S&P 500 was at an all-time high. This is one of the longest streaks without seeing a new high, with one of the smallest losses during the streak. Other times the S&P went this long without a new high led to highly variable returns, but they were better when the maximum loss had been under 20% as it has been so far (chart 4).”

Of course, such action has left AAII Bullish Sentiment plumbing the lows (chart 5). Indeed, all the ingredients are here for a bottom. This morning, the preopening futures are down a frack as the Nikkei shed 1.63% overnight on some ugly trade data. I do find it interesting that the SPX is testing its April lows, but the Advance/Decline Line continues to trade higher. We continue to exercise the rarest commodity on Wall Street, patience…

Penultimate preparedness
May 16, 2016

The day after the market crashed on October 19, people began to worry that the market was GOING to crash. It has already crashed and we’d survived it (in spite of our not having predicted it), and now we were petrified there’d be a replay. Those who got out of the market to ensure that they wouldn’t be fooled the next time as they had been the last time were fooled again as the market went up.

The great joke is that the next time is never like the last time, and yet we can’t help readying ourselves for it anyway. This all reminds me of the Mayan conception of the universe.

In Mayan mythology the universe was destroyed four times, and every time the Mayans learned a sad lesson and vowed to be better protected—but it was always for the previous menace. First there was a flood, and the survivors remembered it and moved to higher ground into the woods, built dikes and retaining walls, and put their houses in the trees. Their efforts went for naught because the next time around the world was destroyed by fire.

After that, the survivors of the fire came down out of the trees and ran as far away from woods as possible. They built new houses out of stone, particularly along a craggy fissure. Soon enough, the world was destroyed by an earthquake. I don’t remember the fourth bad thing that happened—maybe a recession—but whatever it was, the Mayans were going to miss it. They were too busy building shelters for the next earthquake.

Two thousand years later we’re still looking backward for signs of the upcoming menace, but that’s only if we can decide what the upcoming menace is. Not long ago, people were worried that oil prices would drop to $5 a barrel and we’d have a depression. Two years before that, those same people were worried that oil prices would rise to $100 a barrel and we’d have a depression. Once they were scared that the money supply was growing too fast. Now they’re scared that it’s growing too slow. The last time we prepared for inflation we got a recession, and then at the end of the recession we prepared for more recession and we got inflation.

. . . This ‘penultimate preparedness,’ is our way of making up for the fact that we didn’t see the last thing coming along in the first place . . .

One Up On Wall Street, Peter Lynch, formerly of Fidelity-Magellan Fund

Well, this time around you can take your pick about the “upcoming menace” from: A) Recession; B) Banking Crisis; C) War in the Middle-East; D) Inflation or Deflation; E) Presidential race; F) All of the Above, and more. The consensus pick is obviously “F” All of the above, and more. Indeed, most investors believe in their hearts that we haven’t seen the stock market low, or that we are not even in a bull market. More importantly, they are also guarding their investment pocketbooks because they can’t understand how the stock market can make a real bottom before resolving the various “menaces.” What they fail to appreciate is that the Wall Street financial markets are a discounting barometer. In other words, that is what the Dow Dive from last November’s nearly 18000 “print” to the mid-January 2016 “print low” (~15450), approximately 2500 intraday points, was all about!

The problems have been so widely publicized in the financial media that they have become popular fare in the network TV circles, in the print media with everyday columnists articulating those problems, and even my 85-year old Aunt Doris called to ask if the world is coming to an end? She called asking if the banks are safe, is real estate going to crash, is ISIS going to take over the world, will there be war with North Korea or in the Middle East, etc. I reassured her that her bank was not going broke, that her house value is not going to zero, that ISIS is not taking over the world, that if there is a war it wouldn’t be anything like WW II . . . even with a new offensive option against ISIS.

My point is, if all the popular media venues know all the negatives, and the negatives are the new media feature, then 90%+ of our problems are already baked into stock prices. So, anyone waiting for the resolution of all the negatives before buying is completely ignoring the stock market’s historical role as a discounting barometer, not to mention the confirmation from my Aunt (bless her)! Speaking to this point was none other than Julieta Yung, an economist in the research department at the Fed Bank of Dallas, and Michael Antonelli. To quote them, as written in Pensions & Investments:

“Short-term fluctuations in equity prices come too fast and furious and are caused by such a multitude of inputs that assuming they’ll directly translate into changes in real economic output is an error,” Ms. Yung wrote. Michael Antonelli, a trader at Robert W. Baird & Co., says “Big swings often just reflect human emotions. The two can disconnect in the short-term because of the immediate effect sentiment has on stocks. Then that nervousness wanes, and people capitulate, and that’s when you see the market come back.”

Indeed, “Short-term fluctuations in equity prices come too fast and furious,” and that was certainly the case last week as the D-J Industrial Average (INDU/17535.32) whipsawed its way through the week with Monday – Friday gains/losses like these: -35, +222, -217, +9.38, -185, which drove the day-trading crowd nuts. By week’s end the Doleful Dow had lost more than 200 points, and in the process broke below its May and April reaction lows. That action leaves the Industrials in negative territory for the year once again, and the S&P 500 (SPX/2046.61) darn close to doing the same. While the SPX has not violated its respective May/April reaction lows, it did break below its 10-day moving average (DMA) that we worryingly wrote about in last Friday’s Morning Tack. It also broke below its 50-DMA, which suggests it has “eyes” for its 200-DMA at 2012. Of course that would fit nicely with our model, which telegraphed a decline into last week (∓ 3 sessions), with a target of 1990 – 2000, when the SPX did not follow the S&P 500 Total Return Index to new all-time highs four weeks ago.

Within the “bookends” of the week the retail sector got slammed, leaving the retail indices down some 20% YTD. In the past this has been a modest warning signal for the overall stock market. Yet the real star for the week was the energy complex with crude oil up 3.66%, natural gas better by 5.98%, and gasoline soaring some 6.23%. Surprisingly, most energy stocks did not dance higher with the surge in energy commodities. Indeed, last week was a pretty weird week, but should have come as no great surprise given what our model has been telegraphing.

The call for this week: The stock market’s recent manic depressions have been centered on the word “recession.” I have repeatedly written that I see NO signs of an impending recession. In Barron’s over the weekend, my friend Sam Stovall (S&P Capital IQ and son of the legendary keeper of the GM indicator Bob Stovall), wrote:

“Granted the current [economic] expansion is the forth longest since 1900 and lasted more than twice the median duration of the prior 21. Yet we think this worry is premature, and put the likelihood of slipping into a recession during the remainder of President Barack Obama’s second term in office at 15% to 20%.”

Plainly we agree! Worth noting is that in the past three years, paycheck income has increased by a 4.3% annualized rate, far better than the real GDP growth rate. Moreover, every other semi-truck I see has a sign on the back saying “drivers needed” (buy the trucking stocks recommended by our analyst); and, every other fast food restaurant my grandkids want to stop at has a sign reading “Help Wanted.” These are not the kind of things you see in front of a recession. Clearly, Andrew and I attempt to “call” the near-term wiggles in the equity markets. However, we have NEVER wavered in our belief that the secular bull market remains alive and well. Just look at the attendant chart on the next page and observe that every market peak has subsequently been surmounted with higher prices. We have no doubt that will be the case this time. Our model was looking for a meaningful “low” last week, or early this week (∓ 3 sessions), so stay nimble on a trading basis. Longer-term, this is still a secular “bull market.”

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