THE SHAH GROUPIndependent Establishment

Investment Strategy by Jeffrey Saut

Trains and Boats and Planes?
July 28, 2014

“Trains and boats and planes took you away, but every time I see them I pray. And if my prayers can cross the sea, the trains and boats and planes will bring you back, back home to me.”

... Dionne Warwick (1966)

Those of you who know me know that I have had a love affair with boats ever since I was a kid. In my youth it was speedboats on various lakes in Michigan. In my teens, and into my forties, it was sailboats combined with an occasional trawler. In later life, however, it has been strictly powerboats. Currently, we are on a smaller boat, namely a 33’ Wellcraft. Speaking of boats, the newer generation is having an “affair” with Malibu Boats (MBUU/$19.84/Strong Buy), for a multiplicity of reasons, but that’s a discussion for another time. I have also always loved trains ever since my parents took me from Michigan to my grandparent’s home in Kansas during the 1950s. More recently, I have embraced trains for different reasons. Kansas City Southern (KSU/$114.25/Outperform) is one of those names. Our fundamental analyst has excellent reports on this company, but a few years ago it occurred to me that Mexico had a decent chance of becoming the “New China” for the United States. Clearly the election of smarter policymakers in Mexico is leading to smarter policies typified by the change in Mexico’s energy policies. Well, KSU is an interesting way to get at the “New China” theme since it has rail beds that allow freight to be shipped from Mexico into the heartland of the U.S.

Another name featured more than a year ago in these reports has been Strong Buy-rated Genesse & Wyoming (GWR/$102.28). Hereto, our fundamental analyst has numerous reports on the case for GWR, but my interest was sparked by a gentleman I met on a cross country plane ride in the summer of 2013. The man in question owned a “short line” railroad. A short-line railroad is basically defined as a railroad that operates over a relatively short distance. In my airplane companion’s case it was a ~370 mile railroad in the Dakotas, but I digress. The “thin reed” of information he gave me was about insurance for his company. As it turns out, after the train tragedy in Lac-Megantic Quebec, where a derailment caused an explosion that killed 47 people, insurance coverage requirements were increased dramatically. According to my seatmate, coverage for his company needed to be raised by some 400% with a concurrent increase in premiums. Armed with that information, some back of the envelope research showed there are about 530 short-line railroads in the U.S., most of which are owned by “mom and pops,” and marginally profitable. The inference is that with such a dramatic increase in insurance costs many of said short-lines will have to be sold. Enter Genesse & Wyoming, which owns more than 100 short-line railroads, and which will likely be the consolidator for many of the “mom and pops.” As the safest, and most efficient, operator Genesse & Wyoming is the likely consolidator of choice. Moreover, given recent events, government regulators are having much more to say about who can acquire short-line railroads. Hereto, Genesse & Wyoming is the logical choice. This brings me to planes.

Airplanes have been in the headlines recently. Unfortunately, it has been for tragic reasons. Indeed, last Friday’s USA Today Weekend edition’s headline read, “1 week, 462 lost in crashes,” with the byline, “Four months after Malaysia Airlines Flight 370 disappeared, three other air disasters have occurred. Commercial jet crashes are rare, but it’s not unprecedented that they occur over a short time period.” Such headlines have caused some weakness in the airline complex, as can be seen in the chart on page 3 of the NYSE ARCA Airline Index (XAL/$86.61). From a technical analysis perspective, if the XAL doesn’t hold the bottom-end of the parallel channel seen in the chart, and then breaks below its 50-day moving average (@84.90), the airline group could be in for a pause/pullback after a pretty spectacular rally over the past year and a half. Speaking to that, our airline analysts, Jim Parker and Savanthi Syth, write:

After a year and a half of strong stock performance and four years after the recovery in earnings, the question on investors' minds is if the earnings and margin expansion story is over for the airline sector. In the last few weeks there have been indications of weakness in the Transatlantic market as a result of oversupply. Moreover, following over four years of mostly healthy unit revenue growth in the face of large capacity additions, the Latin American market is starting to show some signs of softening. This, combined with expected moderation in unit revenue growth in 3Q14 due to very tough comps, caused U.S. airline stocks to sell off sharply (last) Thursday. However, we believe the outlook remains positive and that the 2-4% unit revenue growth outlook in 3Q14 is favorable, especially given benign fuel cost trends. Thus, we reiterate our Outperform ratings on AAL, ALK, ALGT, DAL, SAVE, and UAL.

Our analysts went on to discuss three airline themes: 1) returning cash to shareholders; 2) moderating unit revenue growth on tougher comparisons; and 3) capacity discipline holding. For more detailed information, please see our analysts’ report.

Last week, however, most of the equity markets were not dancing to Dionne Warwick’s “Trains and Boats and Planes” (actually it was written by Burt Bacharach) because the “trains and boats and planes” didn’t bring the markets back to me. Well, that is not entirely true, for the anticipated upside breakout in the Chinese ETFs written about in last week’s Morning Tack occurred driven by the best Chinese manufacturing activity in 18 months (see chart on page 3). Yet, the economic news in our country was mixed, leaving most of the major indices I monitor flat to down for the week, save the NASDAQ complex. As for sectors, the Energy (+0.82%), IT (+0.73%), Healthcare (+0.71%), and Materials (+0.35%) sectors were the only macro sectors better for the week. The Energy sector makes sense to me since analysts have been raising earnings estimates at the fastest rate (+19.1%) of all the sectors. The Materials sector does not make sense because analysts are lowering estimates at the fastest rate for the Materials, Telecom, Consumer Staples, and Financial sectors. As for companies reporting 2Q14 results, of the companies that have reported so far, 64.3% have beaten earnings estimates, while 62.3% have better revenue estimates. Within those reporting companies, names from our research universe that have beaten earnings and revenue estimates, and raised forward earnings guidance, and are positively rated by our fundamental analysts include: Amerisource Bergen (ABC/$76.79/Outperform), Manhattan Associates (MANH/$31.45/Outperform), RF Micro (RFMD/$10.89/Strong Buy), Skyworks (SWKS/$51.44/Strong Buy), SBA Communications (SBAC/$103.22/Strong Buy), and United Health (UNH/$84.68/Strong Buy). If we fail to get the pullback I am looking for, this could be a good list in which to redeploy the cash I suggested raising using stocks that have not performed in the 40%+ rally since June 2012.

The call for this week: At the end of this week we get the GDP report, a Fed decision, and non-farm payrolls. All of those are potentially market moving. To that “market moving” point, it is worth noting since the S&P 500 (SPX/1978.34) moved into the 1950 – 1975 zone, targeted by the April 15, 2014 upside reversal at 1816, the SPX has virtually gone nowhere. Meanwhile, the small/mid-cap complex has suffered a decent decline. That negative “price divergence” comes on top of the negative “breadth divergence” previously discussed in these reports. Whether that leads to a full-blown pullback remains to be seen, but it is a reason for near-term caution. This morning the headlines read, “Gaza Fighting Abates as Diplomatic Tensions Flare,” European Markets Subdued, Russian Shares Tumble on New Sanctions,” “Iran Casts Shadow in Asia,” “Argentina Default Looms as Time Runs Out for Debt Deal,” etc. Still, the pre-opening futures are flat. That may be because our ineffectual policy responses to situations around the world are sending the message to Wall Street that “no policy response” implies there will be no direct impact on the economy, and thus the equity markets, as things get curiouser and curiouser.


How High is High? (To Whom?)
July 21, 2014

I have a number of friends who succeeded as investors in the late 1960s, and they are succeeding now. The key to their success more than 20 years ago was that they managed to get out with most of their capital when the market turned down. Most investors were not so astute.

The name of the game most investors play is momentum and relative strength: Buy the strongest stocks and sell them after they have topped. Occasionally I will ask one of my friends, “How can a rational person pay 60 times earnings and 10 times book value for a growth company with dubious long-term prospects?” The reply: “How high is high? If a stock can sell at 60 times earnings, it can sell at 80 times or 100 times. I don't prejudge anything. I don't look at so called values, I look at price action. If they are going up, I buy them. And if they turn down, I sell them.”

It sounds simple and it is. The only difficulty is that the game has caught on and is being played by an unwieldy number of individuals and institutions. An individual with a few thousand shares in each crazily valued position can get out, but an institution with hundreds of thousands of shares in each position will not be so fortunate. As fast as stock markets go up, they always go down faster. And despite the many trading innovations that have recently been developed, it nevertheless remains difficult to push the proverbial elephant through a keyhole when everyone wants to sell and there aren’t any buyers.

… Frederick E. “Shad” Rowe, Forbes magazine (September 2, 1991)

I recalled those words from my friend Shad Rowe, who is the eagled-eyed captain of the Dallas-based money management firm Greenbrier Partners, as I listened to Janet Yellen's testimony last week. Ms. Yellen was opining that the action in social media and biotech stocks is reminiscent of what Shad was warning about in Forbes magazine 23 years ago. I think his comments, from an era gone by, are just as valid today as they were 23 years ago. In fact, they remind me of a story I heard years ago when I first came into the Wall Street world in 1971.

The story was about a customer who called his broker with a hot stock tip. The customer proceeded to buy several thousand shares of the low-priced “stock tip” and saw it move up. The broker explained that the market was thin and that orders in this stock were hard to execute. Still the customer persisted, ordering his broker to buy more and more stock, even as the price rose. Pleased that the stock was acting so well, the customer went long with the last of his money, completing all of his buy orders; though with some difficulty because his bidding pushed the stock price even higher. Several days later the stock drifted down on light volume, below the customer's last large purchase and threatened to break below his average cost. In a panic, the customer called up and commanded his broker to, “Sell!” “To whom?” the broker asked. “Your buying has been the main factor in pushing the stock higher. There are not enough bids to get you out without breaking the stock substantially below your very first purchase!” So, maybe the better title for our above quote is not “How High is High?” but “To Whom?”

I have followed Shad's lead since he was a contributor to Forbes in the 1970s and 1980s. He has led his firm to outsized performance over the years. His aforementioned 1991 comments resonated with me because a few weeks ago I turned more cautious on a near-term basis following the anticipated rally from the April 15th upside reversal session into the envisioned target zone of 1950 - 1975. Indeed, since June of 2012 we have had a 40%+ rally without so much as a 10% decline. As repeatedly stated, the history of such sequences is that sometime this year we should see a 10% - 12% pullback within the context of a secular bull market that has years left to run. Further, if a stock has failed to rally in the 40%+ rally we have seen since June of 2012, there is likely something wrong. Accordingly, I have suggested raising some cash over the last three weeks. If that “call” proves wrong, we can always redeploy that cash in more favorable situations. This strategy, even if wrong-footed, is in keeping with one of my long-term mantras, “Better to lose face and save skin!” Manifestly, the over-riding theme in investing is captured in this quote from Benjamin Graham's legendary book The Intelligent Investor, “The essence of portfolio management is the management of RISKS, not the management of RETURNS. All good portfolio management begins with this premise.” This is the primary tenant of “Shad’s” investment philosophy, and obviously I agree.

Reinforcing my recent “pullback call” has been the weakness in the Russell 2000 (RUT/1151.61) that looks conspicuously like it has put in a double-top and broken below its 50-day moving average (DMA) at 1152.82, as well as its 200-DMA (@1140.83) on an intraday basis (see chart on next page). However, despite the media's trumpeting of those events, the history of such occurrences is pretty spotty. Year-to-date the S&P 500 (SPX/1978.22) is better by about 7%, but the Russell 2000 is down 0.72%. Such underperformance has caused some pundits to question the health of the overall stock market. However, looking at the history of when the RUT underperforms the SPX shows that more often than not following such a period of underperformance has found the SPX going higher. To be certain, the RUT is trading at about 26x its next 12 months' earnings estimates, while the SPX is trading at 16.6x, so I think all that is happening is a valuation correction in the RUT. In fact, if one looks at all the indices except the large cap ones, it shows that we have indeed fallen into a correction over the past few weeks. Of course that “foots” with the historical trends in that we are now into the 64/65 month timing points since the March 2009 low, which historically has proven to be a trouble spot to the various stock market indices.

Also counseling for near-term caution are the negative breadth divergences that have occurred this month. The first was in early July and the second happened last week. When the D-J Industrial (INDU/17100.18) makes a new high and the NYSE Advance/Decline Line doesn’t, that's a negative breadth divergence (see chart on page 3). If such a condition is corrected quickly, then the all-clear is signaled. If not, it is a red flag. It has been roughly three weeks since the first divergence and now we have experienced a second divergence. We also have a negative price divergence with the large capitalization indexes acting perky while the small capitalization indices aren’t. When taken in concert with the other warning cracks, I continue to think if I am going to err here, I am going to err on the side of caution.

The call for this week: I have long maintained that the initial support level for the SPX resides between 1940 and 1950. On July 10, 2014 the SPX's intraday low was 1952.86. Last week's intraday low was 1955.59. Accordingly, if those lows are violated, concurrent with a break below the 1940 - 1950 zone, the odds increase for a pullback greater than the mere 6% “hiccups”we have seen since November 2012. Meanwhile, despite all of the negative nabobs of the past few years telling us earnings were NOT going to be up to expectations, last week’s kick-off of earnings season shows 64.2% of earnings reports, and 57.0% of revenue reports, have beaten expectations!

P.S. — This week I am in Nashville at Raymond James' National Conference.


Fireside Chats
July 14, 2014

The “Fireside Chats” were a series of thirty evening radio addresses given by President Franklin D. Roosevelt between 1933 and 1944. Although the World War I Committee on Public Information had seen presidential policy propagated to the public en masse, "fireside chats" were the first media development that facilitated intimate and direct communication between the president and the citizens of the United States. Roosevelt's cheery voice, and demeanor, played him into the favor of citizens and he soon became one of the most popular presidents ever; often affectionately compared to Abraham Lincoln. On radio, he was able to quell rumors and explain his reasons for social change slowly and comprehensibly. Radio was especially convenient for Roosevelt because it enabled him to hide his polio symptoms from the public eye.

... Wikipedia

While I was in the Pacific Northwest and Canada most of last week, I did have the privilege of listening to J.P. Morgan’s (JPM/$55.80/Strong Buy) Chief Market Strategist last Monday. Dr. David Kelly has long been known for his keen insights on the equity markets, with JPM’s senior portfolio managers like George Gatz and Tom Luddy steering their mutual funds, on said strategic views, to outsized gains for many years. Dr. Kelly began last week’s “Fireside Chat” by noting, “There are basically six themes.” First, the U.S. economy is set up for a rebound. Second, the direction of interest rates is likely higher. Third, you should be cautiously over-weighted equities. Fourth, valuations, while pretty close to historic medians, are still cheap when compared to fixed income yields given the S&P 500’s (SPX/1967.57) earning’s yield of more than 6% based on forward earning’s estimates. Fifth, international markets are doing better on a cyclical and secular basis, and offer a lot less “cyclical drag” going forward. And sixth, as the U.S. economy moves toward full employment, the Federal Reserve is out of “running room.”

Before beginning his discussion, Dr. Kelly said the most important slides in the attendant slide deck were slides 7, 8, 17, 24, 27, 31, 33, 43, 52, and 58. Speaking to his first point David stated that while the economic rebound is below historical trend, the recent -2.9% negative GDP report does not “foot” with most of the other economic reports. Speaking to point 2 (grey line page 27), though core inflation is low, and low inflation equates to low interest rates, the Fed is currently too conservative because “real” inflation is higher than the Fed thinks. Accordingly, nominal interest rates should move higher going forward. The reason they are not currently rising is because the Fed is still buying bonds and the supply is about one-third of what it was a few months ago (read: more demand than supply). That creates an artificial demand that is going to disappear this fall when the Fed’s tapering maneuvers cease.

To point three, Dr. Kelly suggests being mildly overweight U.S. equities (page 8) because while valuations are pretty close to historic norms, earnings yields when compared to bond yields are tilted largely in favor of stocks, thus rendering an overweight to equities. On page 11 of the guide the charts show value stocks versus growth stocks. In a rising inflationary environment “growth stocks” tend to do better than “value stocks.” However, Dr. Kelly noted that U.S. growth stocks are not as “cheap” as they have been over the past few years so investors should consider international growth stocks. Speaking to that international point, on page 43 of the guide he stated that China is doing better with PMIs up for three months in a row and that Taiwan is also improving. Moreover, Europe is doing better (page 48) as the sovereign debt crisis mitigates (page 49). He emphasized that emerging markets had improving demographics, earnings, and valuations metrics (page 52 and 53). In the U.S. he suggested profits are setting up to surge as we move into a full employment situation where unemployment should drop to 5.4%. Again he emphasized that the Fed is out of running room!

Turning to commodities (page 63), the good doctor suggested increasing portfolio weightings to “stuff” (my term of 15 years) while noting the real estate investment trust complex (REITs) does well in the economic environment he envisions in the years ahead; and, that cap rates are still very high at 6.6% (page 58). He concluded that fixed income should be in VERY short-duration bonds and that as he looks around the world he sees more economic growth on a secular basis than a cyclical basis, suggesting a large underweight to bonds. Above all, he thinks investors need to be diversified, and since “cash” has negative investment returns, investors should be invested in something else. And with that last line I find it very interesting where “The 1%” are parking their money.

Indeed, in a recent study on “The 1%” by Cap Gemini and RBC Wealth Management the survey showed that wealthy global investors are keeping an eye-popping 28% of their wealth in cash or cash equivalents. That’s more than their holdings in real estate (20%) or equities (26%); other surveys have shown the same results. Legg Mason conducted a similar survey and found that clients were holding 26.5% of their wealth in cash, while at Wells Fargo it was a stunning 40%. So I will repeat Dr. Kelly’s line again, “since ‘cash’ has negative investment returns, investors should be invested in something else.”

Last week, however, parking cash on the sidelines proved to be a good idea as the SPX lost nearly 1%, the NYSE Composite surrendered 1.52%, and the Russell 2000 was roughed up for ~4%. Despite the five-session slide from its all-time intraday high of 1985.59, the SPX still managed to stay above its 20-day moving average (DMA), as referenced in last week’s letters. Recall, that since late April the 20-DMA has been able to contain declines. In fact, in January when the SPX broke below its 20-DMA it led to a 6% decline. Again in early April when the 20-DMA was violated, the result was a 3% pullback. So when last Tuesday we tested that moving average, it was a logical place to stage a rally attempt. Also worth mentioning was that the NYSE McClellan Oscillator had become about as oversold as it ever gets (see chart on page 3). But while the McClellan Oscillator remains oversold, other oversold indicators are not. For example, the percent of Operating-Companies-Only above their 10-DMAs has failed to travel under 25% when a 10% reading typically signifies an oversold condition. The same can be said about companies below their 30-DMAs at 45% when a reading of 25% or lower tends to signify an oversold reading. Accordingly, this market is “under-bought” rather than oversold.

The call for this week: Toward the end of last week I wrote, “I think the equity markets will remain on the defensive into week’s end and then attempt a rally next week. If in that attempt the SPX fails to achieve a new high, then the markets will become more vulnerable to the 10% to 12% decline called for by the historical odds sometime this year.” And this morning, on the better news tone from Israel, the preopening futures are better by 6 points. So we will see if the SPX can indeed achieve a new all-time high.


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