Investment Strategy
by Jeffrey Saut


March 27, 2017

“Pull” is a term used in shooting sporting clays, which are supposed to represent real birds and sharpen the shooter’s ability to actually hunt live birds. The term is yelled by the shooter to tell the person operating the trap to launch a sporting clay. “Pull” comes from an era long gone by when they actually had real birds in cages and the shooter would say “pull” to have the cage cord pulled and release the bird. The term “pull,” however, took on a whole new meaning last Friday when Speaker Ryan “pulled” the Republican healthcare bill (H.R. 1628) from consideration. I had literally said on CNBC earlier that day (as paraphrased): I lived in Washington D.C., and still have a pretty good network on Capitol Hill and typically what happens, if they don’t think a bill will pass, they pull it (read: withdraw it). But, there is NOTHING typical going on in D.C. these days! I also opined on the same show that – I was hearing that H.R.1628 was a few votes short of the ability to pass. Even if it had passed there would have been major revisions to it in the Senate. I guess it was once again the Russians that influenced the death of H.R. 1628, since they are being blamed for just about everything else. The question now becomes, “How will the various markets view Friday’s Foil?”

Speaking to many media types late Friday afternoon I suggested that a lot of technical damage has been done to the charts during the week. The S&P 500 (SPX/2343.98) broke down from its trading range of 2350 – 2400 that has existed since mid-February. The SPX has also closed decisively below its 20-day moving average (DMA) that has served as a support level since last December (Chart 1). Clearly, the gap in the price chart created by the Fed Fling (March 15, 2017) on the rate ratchet has now been filled raising the question, “Will the upside gap that occurred on February 10, 2017 to February 13. 2017 between 2311.08 and 2311.10 be filled?” Moreover, will the Trump agenda disappointments lead to a 0.328 Fibonacci retracement of the recent rally toward a downside target price of 2278? To be sure, smart money is “betting” that way given the divergence between the CBOE SKEW Index and the Volatility Index’s (VIX) SKEW (Chart 2). As defined by the CBOE:

The CBOE SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "SKEW".

Ladies and gentlemen, the current CBOE SKEW is around 145, and well above what the CBOE website describes as, “As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant.” Further, the VIX SKEW has diverged with the CBOE SKEW suggesting something BIG is getting ready to happen in the equity markets. Additionally, there is still plenty of “internal energy” to foster such a move, but unfortunately our internal energy indicator does not tell us if that energy is going to be released on the upside or the downside. Our hunch remains that it will be released on the downside for the aforementioned reasons.

Accordingly, we have assembled a potential “buy list” since we think any decline will be contained. Names for your consideration that screen positively on our models, play to some of our themes, and are favorably rated by our fundamental analysts, include:

Applied Optoelectronics (AAOI/$55.02/Strong Buy) develops and manufactures optical devices, including laser diodes, photodiodes, related modules and circuitry, and equipment for applications in Fiber-to-the-Home, cable television, point to point communications, and wireless.

Athenahealth (ATHN/$108.60/Outperform) works to achieve faster reimbursement from payers, reduce error rates, increase collections, lower operating costs, improve operational workflow controls, and more efficiently manage clinical and billing information for its ambulatory clients.

DexCom (DXCM/$82.62/Outperform) is a leading provider of continuous glucose monitoring (CGM) systems that enable people with diabetes to more frequently and conveniently manage their blood glucose levels.

ICU Medical (ICUI/$155.65/Strong Buy) is a provider of disposable medical connection systems, custom IV sets, and accessory devices used in vascular procedures and critical care settings. Its devices prevent catheter-related bloodstream infections and protect healthcare providers from accidental needle sticks.

Flexion Therapeutics (FLXN/$27.27/Strong Buy) is a specialty pharmaceutical company focused on the development and commercialization of novel sustained injectable pain therapies. The company’s primary focus is osteoarthritis (OA),

Mylan (MYL/$40.96/Strong Buy) is a leading global pharmaceutical company engaged in the development, manufacture, and marketing of prescription generic, branded generic, and specialty pharmaceuticals offering one of the broadest product portfolios in the pharmaceutical industry.

Premier, Inc. (PINC/$30.10/Outperform) is a collaborative healthcare alliance of 3,750 U.S. hospitals, 130,000 alternate sites, and 400,000 physicians. The company operates through two segments: 1) supply chain services, including a group purchasing organization (GPO), direct sourcing, and specialty pharmacy; and 2) professional services: informatics and advisory services.

Texas Capital Bancshares (TCBI/$80.25/Outperform) is an $18.9 billion asset bank holding company with 13 full-service branches in the business centers of Austin, Dallas, Fort Worth, Houston, Plano, and San Antonio.

Trimble Navigation (TRMB/$31.32/Outperform) applies technology to make field and mobile workers in business and government more productive. Its solutions are focused on location/position based applications for use in agriculture, construction, fleet management, and more.

The call for this week: It is interesting that the Advance/Decline Line peaked coincident with the S&P 500 (SPX) on March 1, 2017 (Chart 3). Also of interest is that the SPX has bounced off of roughly the 2340 level for three consecutive sessions and has had a cluster close around the 2345 for those same three sessions. In the process the daily candlestick chart has been a “doji” pattern in each of those sessions (Chart 4). According to Investopedia, “A doji is created when the open and close for a stock are virtually the same. Doji tends to look like a cross or plus sign and have small or nonexistent bodies. From auction theory perspective a doji represents indecision on the side of both buyers and sellers. Everyone is equally matched, so the price goes nowhere; buyers and sellers are in a standoff. Some analysts interpret this as a sign of reversal.” And don’t look now, but the average Russell 3000 stock was down almost 18% from its 52-week high and 30% are down more than 20%. This morning, it’s bombs away with the Spoos off 20 points . . .

The Climb

March 20, 2017

“The Climb”

“There's always gonna be another mountain
I'm always gonna wanna make it move
Always gonna be an uphill battle
Sometimes I'm gonna have to lose” (Climb)

. . . Miley Cyrus

I spent last week climbing the mountains of Idaho and Utah, seeing accounts and doing presentations for our financial advisors and their clients. In my absence, the stock market did some climbing of its own as the S&P 500 (SPX/2378.25) came within five points of its all-time closing high (on an intraday basis), causing one old Wall Street wag to comment, “Can you spell double top?!” The challenge of the all-time highs came on last Wednesday’s “celebratory climb” following Ms. Yellen’s rate ratchet of 25 basis points, which occurred amid a string of softening economic statistics (sidebar: The Taylor Rule suggests the Fed is behind the curve by over 260 basis points). Despite last “Wednesday’s Win”, the SPX had no upside follow-through on Thursday, or even in Friday’s “quadruple witch twitch,” leaving it trapped in its 2350-2400 trading range that has existed since mid-February. Interestingly, given said rate rise, the 10-year T’note’s yield actually fell from Wednesday’s pre-FOMC announcement of over 2.6% into Friday’s close of ~2.5%. Almost on cue, the U.S. Dollar Index (DXY) declined from Tuesday’s intraday high of 101.79 to close the week at 100.31. Over that same timeframe, crude oil prices rose from $47.09 to $48.78, and gold rallied from $1196.80/ounce to $1229.80. On a very short-term basis, using NO fundamental analysis and just looking at the price charts, the 10-year T’note’s yield appears to have peaked (Chart 1 on page 3), crude oil looks to have bottomed (Chart 2 on page 3), gold has the appearance of a bottom (Chart 3 on page 4), and the S&P 500 looks toppy (Chart 4 on page 4).

Speaking to our models, and the stock market’s “internal energy,” our long-term proprietary model flipped positive in October 2008 and has NEVER turned negative since then. In recent history, our intermediate model turned positive the week before the presidential election but flipped negative at the end of January and remains in cautionary mode. Likewise, the short-term model turned positive the week prior to the election and turned negative the last week of January; however, it flipped positive around the beginning of March. Obviously, our short and intermediate models are in conflict, which is why Andrew and I have often said that this is a confusing time in the equity markets. In the past, when our models have been conflicted, we have exercised patience, a strategy we are currently embracing. Certainly the large commercial hedgers are somewhat confused, because, with the stock market trading towards new all-time highs, they are “short” (betting on the downside) holding the second largest short position in the equity index futures in history. Meanwhile, there are some pretty weird breadth readings. According to the sagacious Jason Goepfert (SentimenTrader), “Advancing securities on the NYSE accounted for only 43% of all volume, while more than 60% of the issues actually rose. Since 1965, there was only one other day with a divergence like this. With lesser divergences (less than 45% Up Volume but more than 55% Up Issues), stocks struggled over the shorter term, with the S&P rising over the next seven days nine out of 24 times, averaging -0.7%.” The eagle-eyed Jason goes on to note, “One of the major reasons we were expecting volatility to rise in January (which likely meant stocks would also fall) was the fact that options traders were betting on an outsize moved, but it was being masked by what everyone was seeing in the VIX. We've looked at the ratio of the SKEW to VIX indexes for years as a way to get a little more information as to how traders are pricing in volatility expectations. In January, traders were pricing in a relatively high probability of a "black swan", or large, sudden move, in the next 30 days. That was a complete failure. Now it's even more extreme.” (Chart 5 on page 5)

Of course, this concurs with our “internal energy” model, which while not having a full charge of energy, has almost a full charge. This, too, implies a big move is capable of happening in the short run. If that energy is released on the downside, it is a long way down to even a shallow 0.382 retracement of the rally off of the pre-election lows with a target downside target of 2278 for the SPX. The ideal set-up for a pullback would be an early week rally attempt that either fails to exceed 2400 or marginally exceeds 2400, followed by steady stock market price erosion. Plainly, it is not required for the equity market to pull back, but our models suggest it should be difficult for the SPX to make meaningful upside progress from its current position. We guess it could grind away in a churning fashion, allowing the SPX to re-energize, but in our view, that is a low probability “bet.”

As for the sectors, excluding Real Estate, because it was not a sector back in 1990, weightings have changed dramatically since 1990, and even since 1999, as can be seen in Chart 6 on page 5. Of note is that four cyclical sectors currently have weaker breadth readings than the broad S&P 500: Energy, Materials, Industrials, and Consumer Discretionary (a tip of the hat to Bespoke Investment Group). That mix is likely due to the softening economic statistics and has caused some pundits to cry “a recession is coming.” We, however, believe the underlying economy is much stronger than the government’s figures suggest. To examine that “stronger economy” viewpoint, we are having a conference call with our pal Joe Brusuelas, who is the Chief Economist at RSM US LLP (formerly McGladrey LLP).

Sticking with the economy, and parsing President Trump’s proposed budget, shows the winners and losers. The winners: Defense with an increase of $52.3 billion (+10%), Veterans Affairs an increase of $4.4 billion (+5.9%), and Homeland Security with an increase of $2.8 billion (+6.8%). The losers: Health and Human Services (-17.8%), State (-28.7%); Education (-13.5%), Housing and Urban Development (-13.2%), Agriculture (-20.7%); Labor (-20.7%), Transportation (-12.7%), Energy (-5.6%), Commerce (-15.7%), Interior (-11.7%), Justice (-3.8%), Treasury (-4.1%), and the EPA (-31%). Moreover, President Trump’s proposed budget would eliminate: Community Development Block Grants, the Weatherization Assistance Program, the Low Income Home Energy Assistance Program, the National Endowment for the Arts, and the Corporation for Public Broadcasting. And don’t look now, but the House Budget Committee voted 19 to 17 to advance the Republican healthcare bill. Amid the cacophony of last week’s “political noise”, almost unnoticed was this Department of Commerce request: The Department of Commerce is seeking information on the impact of federal permitting requirements on the construction and expansion of domestic manufacturing facilities and on regulations that adversely impact domestic manufacturers.

Ladies and gents, this is HUGE, because fewer regulations will unleash the entrepreneurial spirts of America’s free enterprise system.

The call for this week: The SPX has experienced two “inside days”, meaning Thursday’s intraday high/low was “inside” Wednesday’s intraday high/low, and Friday’s action was “inside” Thursday’s range. According to Investopedia, “An ‘Inside Day’ is a candlestick formation [in the charts] that occurs when the entire daily price range for a given security falls within the price range of the previous day. Inside day often refers to all versions of the harami [chart] pattern and can be very useful for spotting changes in the direction of a trend.” We would also note there is a small upside gap in the SPX chart that occurred in last “Wednesday’s Win” between 2368.55 and 2368.94. Recall that gaps tend to get filled. Interestingly, the SPX’s 20-day moving average has proved to offer buying opportunities and it is now at 2371.64, so watch those two levels. This week’s trading action is key . . .

Being wrong and still making money

March 13, 2017

The brilliant Peter Bernstein (author, historian, and economist) once 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 winningest 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 then 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.

I was a mere “pup” in this business when my father would tell me, “Son, if you think the market is going up be bullish. If you think it’s going down be bearish, but for gosh sakes make a call. And when you make a ‘call’ you are going to be wrong at times. The trick, however, is to be wrong quickly for a de minimis loss of capital.” Wow, that sounds a lot like Peter Bernstein’s “Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect.”

I came across Bernstein’s cogent comments while culling through reams of material, and reexamining my models and investment method, to see if I would have done anything differently given my too cautious stance over the past four weeks. The answer is “not really” because for the past few weeks there have been some pretty noticeable divergences. As Robertson Thomson & Associates’ eagle-eyed portfolio manager Mick St. Amour notes, “Small caps, transportation stocks, and financials have been good indicators of risk appetite for equities, as well as leadership groups, but now they are lagging” (see charts on pages 2 and 3). So from Andrew’s and my perch, if we have lost anything it has only been “opportunity costs” and not real money. Indeed, better “to lose face and save skin!” I also came across another piece I have written about in the past that divides investors into three categories: Assassins, Hunters, and Rabbits. The article was written by Lee Freeman-Shor and titled “Being Wrong and Still Making Money.” The author asks, “The investment ideas of some of the greatest investors on the planet today are wrong most of the time, and yet they still make a lot of money. How can this be? How can the world's best investors get it wrong and still make millions?" The author continues by noting:

My findings suggest the odds are that an investor's great ideas will lose money. As such, before you invest a cent into an investment idea, it is imperative to have a plan of action as to what you will do if you find yourself in a losing position. When losing, the successful investors I worked with planned to become either Assassins or Hunters. Assassins sold losing investments that fell by a certain percentage or that declined by any amount and showed no signs of recovery after a certain period of time. Hunters invested a lesser amount at the outset and with a plan of buying significantly more shares if the price fell. Hunters were also unafraid to sell if it became clear that they had made a mistake. The bad investors didn't have a plan and consequently turned into Rabbits. When losing money, Rabbits neither bought more shares nor sold their holdings. Once forming an initial perception, Rabbits were achingly slow to change their opinion of a stock. Which tribe will you become a member of?

I don’t know about y’all, but I tend to be a “Hunter.” Case in point; a little over a week ago, when the D-J Industrial Average “popped its top” and leaped some 300 points, that Dow Delight looked a lot like an upside blow-off to me. Therefore, I studied one of my accounts only to find roughly 15 stock positions that really had not performed all that well in the ~13% rally by the S&P 500 (SPX/2372.60) since the presidential election. Subsequently, I sold those positions and said so in these letters. Some took that action to mean that I am out of the market, which is patently untrue. All I did was raise a little cash in one particular account with the strategy of putting that cash back to work in either the pullback my models have been looking for, or in some fresh ideas from last week’s Raymond James 38th Annual Institutional Investors Conference.

While there were many names at our institutional conference, the ones I saw that I wanted to buy and are also rated positively by our fundamental analysts are: Hilton (HLT/$56.48/Outperform); Flexion Therapeutics (FLXN/$20.73/Strong Buy); Nvidia (NVDA/$99.12/Strong Buy); Iridium (IRDM/$8.45/Strong Buy) and its preferred, which I own; and, Texas Capital Bancshares (TCBI/$86.45/Strong Buy). I offer these names for your consideration for future purchases in any pullback in the major market averages. Please see our fundamental research on these names for more insight.

The call for this week: I am in Sun Valley Idaho speaking at an event, and then in Boise, from there I am in Salt Lake City speaking at another conference. My sagacious friend, Mick St. Amour concludes his comments by writing, “Putting it all together, the main and bigger move for equities remains higher given an economy that in general continues to improve and a Fed that remains net accommodative. But in the short term there are some divergences when we look at credit markets, breadth, and perhaps evidence of early rotation out of more cyclical groups into more defensive groups which suggests risk appetite may be waning a bit. The longer this divergence lasts as equities move higher the bigger the correction within the context of our current cyclical and secular bull market. Proceed cautiously for now.”

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