Running Out of Time
December 2, 2013
Well, so far the Federal Reserve is winning out over my timing models that continue to suggest caution should be the preferred strategy in the short-term; and last week that strategy was wrong footed as the D-J Industrial Average (INDU/16086.41) notched another new all-time high. Still, over the years I have learned to trust my indicators even if at times they have proven overly cautious. Indeed, better to lose face and save skin! Nevertheless, in my travels last week I continued to talk to various portfolio managers (PMs), and this week I am in New York City seeing more PMs and visiting with the media. Late last week I reconnected with David Ellison, portfolio manager of the Hennessey financial funds. In a recent missive David had this to say:
Conclusions from recent company visits:
- Credit conditions are continuing to improve.
- Loans going on the books the last 3-5 years are the best quality in 25-30 years.
- Loan demand is slowly picking up – starting to see competition.
- Cost cutting/efficiencies are a growing management focus. – 2-3 years to work through.
- Improving fee income another growing focus of management – loan demand will help this effort.
- Balance sheets are liquid with much improved liability structures – I see some of the best balance sheets of my 30-year career.
- M&A activity expected to increase as regulatory process clears up – everyone is looking.
- Dividends and buybacks are expected to increase.
- Valuations (P/E and PR/BK) are around the average historical ranges.
In general, companies will benefit from higher lending activity as liquidity (yielding 0.25% at the Fed) is deployed into loans at current rates in the 4% range. Companies will benefit as cost cutting and fee income enhancements work through the income statement. Companies will benefit as credit continues to improve and the cost associated with bad assets abates. I believe a rise in rates and/or increase in loan demand will benefit EPS growth more than the market believes. I believe the market is underestimating the benefit of cost cutting and fee enhancement. I believe M&A activity will be more than expected as recent deals have been accretive and stocks of both buyer and seller have risen. If you believe the economy is getting better, and this will show up in loan demand and modestly higher rates, then I think financials are an attractive investment. Financials are “economic growth stocks.”
And then there was this from another portfolio manager friend, namely Shad Rowe, founder of Dallas-based Greenbrier Partners, who had this to say in his recent letter to investors:
The questions I am most often asked, and the questions I ask myself are: “Is the bull market over?” “Is it too late to own stocks?” “Is it time to get defensive?” My answer to each question is a cautious “No.” A useful stock market adage is, “A bull market climbs a wall of worry.” Goodness knows our elected officials in Washington have given us plenty to worry about. As a result, distracted investors may be ignoring developments both in Washington, and in our economy, that may enable a more sustained bull market than most people can contemplate. We have been over these developments in previous letters so we will skip covering old ground. Meanwhile, our major themes appear to be intact and our companies’ businesses are performing as hoped. Our top 16 positions represent approximately 89% of our equity and are listed below in descending order of value. Included are our rationales for continuing to own these stocks.
Of those 16 stocks, six of them are followed by our fundamental analysts with favorable ratings. They are listed below with Shad’s reason for owning them:
Facebook (FB/$47.01/Outperform). Facebook is the backbone of the social media experience for more than one billion connected users around the world and provides the means for marketers to reach these potential customers with more efficiency and precision than has ever been possible.
Apple (AAPL/$556.07/Strong Buy). Apple represents the most desired digital ecosystem in the world and it trades at a discount in comparison to its peers, the market, and its intrinsic value on virtually every metric.
Google (GOOG/$1059.59/Outperform). Through organizing and providing access to the world’s information, GOOG has become the most powerful force in advertising and is navigating the transition to mobile and video beautifully.
eBay (EBAY/$50.52/Outperform). eBay has quietly put together a powerful combination of digital assets that position the company to thrive in the $10 trillion global commerce and payments markets.
Bank of America (BAC/$15.82/Outperform). Bank of America represents a proxy on an improving domestic economy and a company that still has vast room for operational improvement.
Qualcomm (QCOM/$73.58/Outperform). Qualcomm’s patented technology and innovative products are vital to the growing, global mobile device industry and management has a proven track record.
As for last week’s stock market action, despite signs of increased risk of another pullback the equity markets notched new highs with the NASDAQ Composite actually closing above 4000 for the first time since 9/7/00. The D-J Industrials have now made it eight weeks in a row on the upside, although Friday’s late sell-off was somewhat disappointing. The upside skein has left five of the 10 macro sectors pretty overbought with the remaining five being Consumer Staples, Energy, Materials, Telecom Services, and Utilities, which are not overbought. Interestingly, eight of the 10 S&P macro sectors closed lower for the week, a sign there is at least some kind of distribution going under the guise of higher major market indices. Moreover, the S&P 500 (SPX/1805.81) is trading at its highest price-to-earnings ratio in a year. In addition to my timing models continuing to counsel for caution, there are signs that the stock market is becoming more selective. For example, the percentage of stocks above their respective 30-day moving averages continue to trace out lower highs and lower lows, as can be seen in the chart on page 3 from the good folks at the Lowry’s organization. Further, one of my indicators is flashing a warning sign not seen since the tops in 2007 and 2000. Yet I have to admit, time is running out for the bears because I have learned the hard way it is tough to put stocks away to the downside in the ebullient month of December.
The call for this week: While time may be running out for the bears (this week should tell), time is not running out to start making your tax-loss bounce list. Remember, some stocks that have not performed this year will be sold for tax losses to offset gains taken in other positions during 2013. To that point, there was a story in the weekend Wall Street Journal titled “Coal Plants Shut By Marcellus Glut.” The gist of the story is that coal-fired utility plants are shutting down because natural gas is so cheap in certain areas of the country, and electric prices are so weak, that nobody can make a profit. The story reminded me of when “they” were closing copper mines like the Anaconda Copper Mine in Lyon, Nevada back in 1978, and all the copper stocks were screaming buys. Over the next few weeks I will be looking at the beaten up coal stocks, as well as other tax-loss bounce candidates.
“Sir Isaac Newton”
November 25, 2013
“I can calculate the movement of the stars, but not the madness of men.”
... Sir Isaac Newton, after losing a fortune in the South Sea bubble
In 1711 the Earl of Oxford formed the South Sea Company, which was approved as a joint-stock company via an act by the British government. The company was designed to improve the British government’s finances. The earl granted the merchants associated with the company the sole rights to trade in the South Seas (the east coast of Latin America). From the start the new company was expected to achieve huge profits given the believed inexhaustible gold and silver mines of the region. It was anticipated the company would ship British goods to the South Seas where they would be paid for in gold and silver. Rumors swirled that Spain was going to give free access to its ports in Chile and Peru for a share of the South Seas stock and share prices soared. Sir Isaac Newton was an early investor in the stock, investing a decent amount of money into the shares. He exited those shares a number of months later with a good profit, leaving him a happy investor. Subsequently, the shares soared into bubble proportions, and as Newton saw his friends getting rich, greed overtook fear and Newton took most of his cash and re-bought the shares. Not long after that, the share price peaked, and then crashed, leaving Sir Isaac Newton broke (see chart).
I revisit the South Seas bubble, which is chronicled in Charles MacKay’s epic book, Extraordinary Popular Delusions and the Madness of Crowds, not because I think the equity markets are in a bubble (I don’t), but as an example that even one of the most brilliant men in history was overcome by greed at exactly the wrong time. As my father used to say, “In the long-term it is all about earnings, but in the short/intermediate-term the stock market is fear, hope and greed only loosely connected to the business cycle.” He also taught me that cash is an asset class, unlike many in our business who don’t believe it. As the brilliant investor Seth Klarman espouses (as paraphrased by me), “To assume the investment opportunity sets that are available to you today are as good (or better) than those that will present themselves next week, next month, next quarter is naive and you need to have cash to take advantage of those new investment opportunity sets.” For those of you that don’t know who Seth Klarman is, he is an American billionaire who founded Baupost Group, a Boston-based private investment partnership. He is also one of the best money managers on the planet and has the track record to prove it. He authored a legendary book that sits on my desk titled Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. Recently Seth spoke at James Grant’s investment conference. Here are some of his comments, as paraphrased by me. To wit:
Of the $30 billion we have under management, $14 billion resides in cash because we don’t see a lot of compelling investment opportunities currently. The ones we find, we pull the trigger on and purchase. We worry about things from a “top down” standpoint, but pick our investments on a “bottoms up” (fundamental) basis. We think inflation is likely and view gold at these levels as the best hedge against a worst case environment. However, we only have a couple of percent of assets positioned in gold. We own some commercial real estate in Japan and a few equities, as well as some investments in Russia.
In viewing Seth’s purchases I found it interesting that Baupost recently took a significant position in one of Raymond James’ Strong Buy rated stocks, namely Micron (MU/$20.19/Strong Buy). Along this individual stock investment line, in last week’s Morning Tack I mentioned if we get some kind of pullback in the weeks ahead, investors should consider purchasing stocks with strong “power ratings.” I have received numerous emails for such a list. So this morning I give you a number of those stocks, which not only have strong “power ratings” and Outperform ratings from our fundamental analysts, but also screen positively on my proprietary trading system. The list includes: Amerisource Bergen (ABC/$70.02), CVS (CVS/$66.68), Delta (DAL/$28.60), Federal Express (FDX/$137.07), McKesson (MCK/$163.61), Lincoln National (LNC/$50.48), Bard (BCR/$139.85), and Old Republic (ORI/$17.36). Like stated last Monday, put these stocks on your “watch list” for potential purchase.
This week, we enter the holiday-shortened week of Thanksgiving and I will be in New Orleans and then the Washington D.C./Richmond, Virginia areas. The history of the week is generally positive having averaged a gain of 0.65% since the mid-1940s about 62% of the time. It will therefore be interesting to see if the historic precedent takes control, or if my timing models prove correct and a moderate pullback commences. One thing for sure is that Wall Street attendance will be limited as the “pros” desert the Street of Dreams for the holiday. Also of interest will be how the equity markets react to the first substantive Iranian nuclear deal in a long time. Indeed, for the second time in three months, our President has pulled a rabbit out of his hat. First it was the Syrian solution, thank you, Vladimir Putin. Last weekend it was the deal struck between Iran and six of the world’s nations. The deal places qualitative/quantitative restrictions on Iranian nuclear enrichment for the next six months. Following that, a longer-term agreement is to be negotiated. Strategically, one would think said deal might take some of the geopolitical risk premium out of world oil prices. Tactically, however, the world’s Iranian oil embargo remains in place. According to the White House, “In the next six months, Iran’s crude oil sales cannot increase.” Consequently, Iran’s oil exports will remain capped (cut by ~1.5 MMbpd since 2012), which is neutral for near-term oil market fundamentals, according to our fundament analysts. Yet this morning, crude prices are noticeably lower.
The call for this week: The divergences of the past few weeks continued last week. For example, the number of new 52-week highs on the NYSE has diminished over the past three weeks. Additionally, the Advance/Decline Lines for most of the small-cap complexes have not made new highs. NYSE stocks above their respective 50-day moving averages continue to decline, many of my overbought/oversold indicators are currently overbought, the S&P 500 is at the top end of its Bollinger Band (read: caution), bullish sentiment is at a decade high (read: caution), interest rates are rising, housing is stalling because mortgage rates have risen and affordability is diminishing, real final sales are sluggish, the global economy is under pressure, yet the Federal Reserve still has the peddle on the metal. And that, ladies and gentlemen, has been able to trump any of the natural forces suggesting a pullback. While I recommended recommitting some of the cash raised last June when the Syrian Solution arrested the anticipated decline at 6% versus my expectation of a 10% decline in August/September, I still have too much cash at a 25% recommendation given what the markets have done. Hopefully, we can still get some kind of pullback into early December setting up the fabled “Santa Rally.” As stated, the first support zone exists between the upper pivot point of 1784 and the previous reaction highs of 1775. Falling below that brings into view the 1750 – 1760 level, which if violated would suggest a 5% - 7% correction. This morning, however, world markets are celebrating the Iran deal with the preopening futures better by about 5 points. Yet, as the world likes the deal, two of our staunchest allies, the Israelis and Saudis, are fuming. Hereto, it will be interesting to see what happens to oil prices if the Saudis decide to make their displeasure felt.
“Who is Right on the Stock Market?”
November 18, 2013
If you’ve been wondering whether it’s possible to regularly beat the stock market averages – a natural question with the market at an all-time high – you didn’t get any guidance from the Nobel Prize committee this year: Two of the winning economists disagree on that perennial issue. In one corner is Robert Shiller, the Yale economist who argues that markets (and by implication, share prices) are often irrational and therefore beatable. He famously predicted the bubble in technology stocks in the late 1990s. In the other corner is Eugene Fama, the father of the view that markets are efficient and that they are always processing all available information. Mr. Fama’s followers believe that investors who try to beat the averages will inevitably fail. I get Mr. Fama’s theory, but the evidence points decidedly in the opposite direction. I have met many investors who have consistently outperformed the market. Take, for example, the world’s most famous – and most successful, if judged by personal net worth – investor, Warren Buffett. Mr. Buffett began an investment partnership in 1956 and, over the next 12 years, achieved a 29.5% compounded return, mainly by buying carefully selected stocks and then almost always holding them for a long period. In comparison, the Dow Jones Industrial Average rose by 7.4% per year during that same period.
... Steven Rattner, The Wall Street Journal (11/15/13)
Efficient, or inefficient, that is the key question. I would argue that at major inflection points the stock market is ANYTHING but efficient. That’s because, as my dear, departed father used to say, “The stock market is fear, hope, and greed only loosely connected to the business cycle!” Plainly, I agree and would note that when on March 2, 2009 I stated the stock market was going to bottom that week, I was greeted with cat-calls of disbelief. The same was true with the Dow Theory “sell signal” calls of September 1999 and November 2007. Currently my belief is that we are into a new secular bull market, which is drawing similar cat-calls from the negative nabobs of the investment community. What they continue to not understand is that the equity markets do not care about the absolutes of “good” and “bad.” All they care about is if things are getting “better” or “worse;” and things are definitely getting better. That said, my timing models have suggested caution on a short-term basis from mid-November into early December. Last week that strategy looked foolish, but I have repeatedly looked foolish over the past 43 years at various inflection points. And while nobody can consistently time the stock market, the astute observer can absolutely determine if they should be playing “hard,” or not be playing so “hard.” To be sure it is better to lose face and save skin in the investment business; or as Charles Dow wrote, “The successful investor needs to be able to ignore two out of every three money-making opportunities.”
Last week I chose to ignore the S&P 500’s move to new all-time highs because my instruments (the short-term timing models) suggested that caution is currently warranted. Just like flying an airplane in blacked-out conditions, one needs to trust the instruments, or run the risk of a major accident. In this business a “major accident” involves a substantial loss on investment capital. Beneath the ebullient dance of the Dow, however, there is a battle between good and bad. The bad is that mortgage interest rates are again rising (see chart on page 3), calling into question how impactful it will be on housing. The good is that gasoline prices are falling to their lowest level since February of 2011, which is tantamount to a huge tax cut for the American consumer. Interestingly, one month later, the five best performing macro sectors following a 10% decline in gasoline prices have historically been Consumer Discretionary, Transportation, Industrials, Financials, and Energy. Three months following such a decline in fuel prices it has been Consumer Discretionary, Financials, Technology, Energy, and Industrials. As far as some of the best performing stocks in the Russell 1000 from Raymond James’ research universe that perform the best after a 10% decline in gasoline prices, consider: Tempur Sealy International (TPX/$46.54/Strong Buy); Valero Energy (VLO/$43.00/Strong Buy); Lennar (LEN/$34.17/Outperform); Trinity Industries (TRN/$56.65/Outperform); Fleetcor Technologies (FLT/$118.20/Outperform); and Micron Technology (MU/$19.46/Strong Buy). Meanwhile, 58.6% of all reporting companies are beating their earnings estimates and 53.2% are beating their respective revenue estimates. This continues to suggest the S&P 500’s (SPX/1798.18) ~$107 earnings estimate for this year remains intact, likely implying next year’s ~$121 estimate is also achievable. If the SPX continues to trade at its current P/E ratio of 16.4x in 2014, the SPX’s target price become 1984 (16.4 x $121 = 1984) next year. That’s a long way above current prices!
So late last week I returned from Scottsdale, and last night from Key West, where I was seeing various accounts. In Arizona I was speaking at numerous events for our financial advisors and seeing institutional accounts. When I met with the portfolio managers (PM) for the state of Arizona, one particularly bright PM that embraced my theme of the election of smarter policymakers and therefore smarter policies over the next three to five years opined, “We are just one grand bargain from America regaining the world’s lead for the next 100 years;” and, I agree! Somewhat surprisingly, the faux pas of the Obamacare rollout may just lead to such a grand bargain! Verily, the so called “fumble” is a huge game changer in many ways. Lawyers I know, which are constitutional lawyers, do not think the President has the authority to pull the switcheroo he is currently trying to engineer. I actually feel like I am living in “Bizarro World,” where everything is “wired” backwards. How the government can tell us what kind of healthcare plan to buy is, well at best, weird. Also weird is the stock market’s recent action given the weight of the evidence suggesting cautious in the near-term.
The call for this week: The Advance/Decline Lines are not confirming the Dow’s new all-time high. Likewise, there is a lack of New Highs on the NYSE. Moreover, my timing models continue to suggest caution in the near term. Yet despite all the negative nabob’s comments, the weight of the evidence still points to higher prices and a healthy secular bull market in the years ahead. In the short-term, however, the stock market’s internal energy is totally used up. Last week’s decline in crude oil prices (-0.80%) sparked a rally in the Transports of 2.76% for the largest gain in any of the major indices. Meanwhile, the decline in gasoline prices drove a 2.54% advance in the Consumer Discretionary sector, a sector repeatedly favored in these reports. As for the question I posed at the beginning of this missive – is the stock market efficient or not – in yesterday’s New York Times another voice was heard from. This time it was Peter Hansen, a professor at the University of Chicago. He had this this to say, “A common theme in our work is that we’ve all characterized the puzzling implications that emerge from financial market data. But we take different approaches.” To which I say, “If markets were efficient J.P. Morgan (JPM/$54.87/Strong Buy) would have never traded at $15!”
Additional information is available on request. This document may not be reprinted without permission.
Raymond James & Associates may make a market in stocks mentioned in this report and may have managed/co-managed a public/follow-on offering of these shares or otherwise provided investment banking services to companies mentioned in this report in the past three years.
RJ&A or its officers, employees, or affiliates may 1) currently own shares, options, rights or warrants and/or 2) execute transactions in the securities mentioned in this report that may or may not be consistent with this reports conclusions.
The opinions offered by Mr. Saut should be considered a part of your overall decision-making process. For more information about this report to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy please contact your Raymond James Financial Advisor.
All expressions of opinion reflect the judgment of the Equity Research Department of Raymond James & Associates at this time and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets or developments mentioned. Other Raymond James departments may have information that is not available to the Equity Research Department about companies mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this presentations conclusions. We may perform investment banking or other services for, or solicit investment banking business from, any company mentioned. Investments mentioned are subject to availability and market conditions. All yields represent past performance and may not be indicative of future results. Raymond James & Associates, Raymond James Financial Services and Raymond James Ltd. are wholly-owned subsidiaries of Raymond James Financial.
International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.
Investors should consider the investment objectives, risks, and charges and expenses of mutual funds carefully before investing. The prospectus contains this and other information about mutual funds. The prospectus is available from your financial advisor and should be read carefully before investing.