THE SHAH GROUPIndependent Establishment

Investment Strategy by Jeffrey Saut

May 26, 2015

“The clichés of daily life are those of routine, discouragement, tiredness; of the rat race; of a cold, the IRS. People are always complaining that there should be more good news, when there isn’t. Americans are often described as basically optimistic, when in reality it is that they are perpetually hopeful. Guys even root for dreadful teams for years – keep buying season tickets in hope that eventually they’ll own seats for the Super Bowl or World Series. And better than being a sport fan – because you can actually participate – and even better than gambling – because it is socially acceptable – playing the stock market becomes a way out of an otherwise mundane and stressful environment. It has glamour, plus the chance of improving one’s lot without being an overt bet. There’s an environment to it, along with the illusion that a successful investment is almost within reach, if one only knew how to tap it. The market seems to represent hope itself. And yet, among professionals, even those who function on the stock exchange floor, a frequently heard stock market expression is ‘No one ever said it was going to be easy’.

“When even the good news of a rising market is stressful – might not last longer than yesterday; it’s rising, but we don’t own the right stocks; and so on – no wonder we long for some security. Indeed, the market often does look easy . . . in hindsight. Tops are made as everyone rushes to buy what has been profitable already. At that point, to the astonishment of those who’ve missed it, the cliché becomes: ‘The easy money has been made.’ But while it is happening no one realizes it; investors are caught up in the classic ‘wall of worry’ instead. It never can be easy because the rule of the market is that you have to act before you know enough. Because it is a process, there is no one moment, or single point, at which one can make an obvious ‘sure’ decision.”

... The Nature of Risk, Justin Mamis

My father first introduced me to Justin Mamis’ work by giving me a few of the books he had written like When to Sell: Inside Strategies for Stock-Market Profits, How to Buy: An Insider’s Guide to Making Money in the Stock Market, and my favorite, The Nature of Risk. Justin penned his last stock market letter at the age of 85 and his work is missed to this day. He was a stock market historian, author, strategist, and a technician’s technical analyst. I quoted him this morning because the stock market this year has been anything but “easy.” Indeed, “It never can be easy because the rule of the market is that you have to act before you know enough. Because it is a process, there is no one moment, or single point, at which one can make an obvious ‘sure’ decision.” I began this year thinking it was not going to be an easy year because my models/indicators suggested the first few months of the year were going to be rocky with a lot more volatility. Last week was no exception.

Since Mr. Mamis was a technician’s technical analyst, I will highlight some of the technical standouts of last week, at least from my perspective. First was the technical breakdown in the D-J Transportation Average (TRAN/8482.31), which fell below its 8520 – 8580 support level (see chart on page 3). That zone had contained declines seven times since last December. The persistent weakness in the Trannies has been chronicled in these missives ever since their Dow Theory upside non-confirmations began last December. That was the first time the D-J Industrial Average (INDU/18232.02) made new all-time highs, but was unconfirmed with a similar high by the Transports. Quite frankly, that upside non-confirmation didn’t mean much and I am hopeful that last week’s downside non-confirmation (the Industrials did not confirm the breakdown in the Transports) will not be all that impactful either.

Second, as we surmised, crude oil tried to pull back last week. I had commented this might be the case since oil was extended in price on a near-term basis; and, given the potential for a nuclear deal with Iran, if that deal arrives, it implies Iran’s crude oil should come back on line (read: lower prices). If the trading call for a pullback is correct, it should arrest itself in the $52 - $55 level. While oil’s price overextension was anticipated, last week’s upside reversal in the U.S. Dollar Index (DX-Y/96.88) was not (see chart on page 3). The week’s 3.4% rally in the buck left it within striking distance of its 50-day moving average (DMA) at 97. I continue to think the dollar has topped on an intermediate basis and that last week’s rally was just a countertrend move. Therefore, it will be interesting to see how the greenback acts around the 97 level. The fourth item of note was the new 2015 low in the Volatility Index (VIX/12.13), which on an intraday basis traded down to 11.82 (see chart on page 4). Given that roughly 50% of this year’s trading sessions have experienced triple digit moves by the Dow, it seems somewhat counter-intuitive the Volatility Index could be plumbing new yearly lows, but there you have it. Obviously, that action does not foot with my models/indicators that predicted an increase in VOL for 2015. Hereto, it will be interesting to see how the VIX acts going forward. I do recall we saw similar action last year, causing many pundits to call for an increase in volatility. But, just because VOL is low does necessarily mean it has to pick up, which is what happened last year (no volatility increase).

Last week the S&P 500 (SPX/2126.06) tagged another new all-time high as the upside breakout from the often discussed wedge formation in the charts continued, although you could draw an ascending wedge that has not broken out to the upside as of yet. Surprisingly, the American Association of Individual Investors (AAII) sentiment survey showed investors’ bullish sentiment at a two-year low and has now dropped for five contiguous weeks. Normally, such readings have had a bullish resolution, but the lack of upside oomph on this upside breakout is a head scratcher.

In conclusion, I harken back to Justin Mamis’ quote, which ends this way, “It [the stock market] never can be easy because the rule of the market is that you have to act before you know enough. Because it is a process, there is no one moment, or single point, at which one can make an obvious ‘sure’ decision.” That evokes another quote from the legendary Leon Levy: “I think a trader has to have the ability – or an investor I should say – has to have the ability to adjust to being wrong. In other words, you can’t be too stubborn. You must have a certain degree of flexibility as to what’s going on.”

The call for this week: Over the decades I have learned to “adjust to being wrong.” Accordingly, while I continue to favor the upside, if the SPX closes decisively below 2115, it will be a red flag for trading accounts on a short-term basis. Investors, however, could see the SPX pull back to 2090 – 2100 and still have no damage to the overall secular uptrend. Moreover, both Advance/Decline Lines I follow made new highs last week, the NYSE McClellan Oscillator is no longer overbought, New Highs continue to outpace New Lows, and many of the indices I follow traded to new all-time highs last week. The lack of upside follow-through is problematic, but it is more about a lack of Demand (read: buyers) than an increase in Supply (sellers). I am hopeful the balancing act between Supply and Demand will be resolved to the upside this week. Yet if it is not, I will adjust my near-term strategy. This morning, the dollar is up~1%, crude oil is down ~0.7%, and the preopening futures are off ~9 points and look to be testing my 2115 level on negative news out of Greece and Spain.

Crescendo or consolidation?
May 18, 2015

The S&P 500 (SPX/2122.73) has basically been locked in a trading range between 2040 and 2100 since early February of this year. Some technical analysts term the subsequent chart pattern a wedge and others call it a rising wedge. While pundits can debate the difference between the two, the important point is which way said chart pattern will be resolved with either an upside breakout, or a downside breakout. I have been somewhat sanguine on that question until the past few weeks. My reasoning is that recently there has been a ton of bad news on most fronts and yet the major indices have refused to go down very much. That caused one old Wall Street wag to scribe, “When the markets ignore bad news, that’s good news!” Consequently, I have been adamant that I am expecting a decent move to the upside despite the old market “saw” sell in May and go away. The Bureau of Economic Analysis’ (BEA) flash estimate of 1Q15 GDP was weak with a mere 0.2% rise, yet the equity markets really did not collapse on that report. The reasons offered up for the weakness were a strong U.S. dollar, the weak oil sector, the West Coast port strike, and the brutal winter weather. While 2Q15 could also prove squishy, we believe growth will pick up in 3Q and 4Q of this year.

Last week there was more bad news with retail sales (ex autos and gas stations) up just 0.2%, May NY manufacturing less than expected, U.S. Industrial production fell 0.3% month-over-month in April, University of Michigan Consumer confidence was down 7.3 points, and 30-year mortgage rates hopped to their highest level in nine weeks as interest rates continued the surge that began in mid-April. Despite this onslaught of negative news, the SPX notched new all-time highs. While the D-J Industrial Average (INDU/18272.56) has not done that, it is very close to its all-time high of 18288.63 (3/2/15). However, the D-J Transports (TRAN/8680.78) remain troublesome, having failed to confirm the Dow’s new all-time high since March. I have written about that upside non-confirmation ad nauseum, but would note the Trannies have also tried seven times to break below their support level, between 8520 and 8550, and as of yet have been unable to do so.

Meanwhile, my internal energy indicator has the highest charge of energy I have seen in years, and as repeatedly stated, “I think it is going to be released on the upside. If I am wrong, I will have to readjust.” “But Jeff,” one all in cash investor said to me in Philadelphia last week, “Stock valuations are extremely high, so how can the S&P vault above your ‘upside breakout’ level of 2100 – 2126 and push higher into your 2150, and maybe as high as 2250, zone?” My response was that while a few indicators are richly priced, most of the ones I use are not. I believe my thinking was best summed up by Clearbridge Advisor’s Paul Ehrlichman, who said, “The world is invested for ‘Stagflation,’ what if we get growth? The world is also invested for the ‘black swan,’ what if instead we get growth?” Obviously, he thinks we are going to get growth and I agree.

Speaking to valuations, the only valuation metrics I look at that suggest stocks are expensive are the Cyclically Adjusted Price Earnings (CAPE) and market capitalization to GDP. I rule out the CAPE for a number of reasons. I think changes in the accounting rules in the 1990s, which make companies take large write-offs when assets they hold go down in price, but do not allow them to boost earnings when the price of those same assets rise, is an issue since CAPE uses a backward looking analyses of earnings. The CAPE also requires a consistent measure of inflation, when in fact the government frequently makes changes to the index that measures inflation. Finally, the CAPE assumes a normal business cycle. In past missives I have argued that due to the severity of the 2007 – 2009 financial fiasco the mid-cycle recovery is going to be much longer than your father’s typical business cycle.

As for Warren Buffett’s favorite stock market valuation tool, the market capitalization to GDP ratio, hereto I think it is different this time. Coincidentally, my friend and terrific portfolio manager David Kotok (Cumberland Advisors) recently wrote:

The longer-term trend level of S&P 500 value to US GDP is about 95%. The current level of the S&P 500 is about 105% of GDP. So at first view it would appear that the US stock market is richly priced, but not by very much. But history suggests that analysis may not be really complete. The range of about 35 points from peak to trough in the ratio of stocks to GDP has held roughly constant for the last century. The 1929 high was an extreme overshoot. The World War II-era, 1942 low was an extreme undershoot; it occurred after Pearl Harbor and before the Doolittle bombing raid on Tokyo. So at today’s 105% we are not much above the range. But something else has happened since the 1982 low. The foreign-sourced profit share of American corporations has risen from 10% to 30%. Thus an additional 20% of profits now being earned by American corporations originates from their activity abroad. However, US GDP does not include the foreign GDP that is the source of that additional 20% profit share. In other words, our domestic GDP generates only 70% of profits; thus using GDP alone to value the stock market is ignoring the growing foreign GDP that has become very significant.

What can we infer? Maybe the current level of stock prices is forecasting that the profit share from foreign sources is going to decline abruptly, while the domestic share is not going to grow. That is possible, but we do not see any forces at work to make it happen. Maybe the taxation of American corporations is about to go up significantly so that after-tax profits will decline. That is possible, but we do not see it as likely. The other side of the argument is that the profit share from abroad will continue to grow, as it has for the last 30 years, and that US corporations will continue to gain global market share. Or, at least, we may infer that they will hold their own. They may gain by acquisitions, as we just saw with Monsanto. Or they may gain by market penetration, as we just saw with Apple in China. How they gain is not the important issue from the perspective of the stock/GDP ratio. As long as they gain, this measure of stock market value remains a critical macro indicator. If we are close to being right, the adjusted trend for the stock/GDP ratio would actually be below the current level rather than above it. Adjusted for the profit share change, the stock market is cheap, not richly priced. And if the foreign-sourced earnings trend continues upward, the S&P 500 Index could easily reach 3000 by the end of this decade, at a time when US GDP will be about $20 trillion.

The call for this week: Monday is shaping up as a non-event with the trading action. Indeed, the preopening S&P futures are directionless. By mid-week, however, the stock market’s internal energy should be ready to be released on the upside; and that energy is as high as I have seen it in years. This suggests that the upside fireworks should begin in the Tuesday through Thursday timeframe with a very near-term price objective of 2145 – 2165. Of interest is the NASDAQ Financial Index has broken out to the upside. In my discussions last week with one savvy value-centric portfolio manager in Philadelphia, he said the Financials were likely the only value sector currently. For ideas in that space, please see our fundamental analysts’ recommendations.

The happening
May 11, 2015

“The Happening” . . . except in this case I am not referring to the 1967 movie, whose title song was sung by the Supremes, but last Thursday’s “Friends of Fermentation” (FOF) gathering at Bobby Van’s across from the NYSE. We actually parachuted into the city the afternoon before, just in time to have dinner with two portfolio managers (PMs) at one of my favorite Italian restaurants, Da Noi at 49th Street and 3rd Avenue. Following that were after dinner drinks at what is arguably the best Greek food in the city, Avra. Thursday morning was spent on the floor of the NYSE doing CNBC and then lunch at Circo with two investing veterans.  After visiting with a number of other accounts, and a great discussion with Goldman Sachs’ John Tousley (and I apologize to all the portfolio managers I missed because this was such a short stay), “It Happened”; FOF began Thursday at 4:30 p.m. In attendance were the usual suspects, captained by none other than UBS’s Arthur Cashin. I was very sorry my friends Bob Pisani and Kelley Evans from CNBC could not make it, as well as my friend Rich Bernstein, but a few of my favorite associates from Raymond James did. Sonja White, a terrific portfolio manager in her own right, stole the show, as can be seen in the attendant picture with Arthur. At about 6:30 p.m. the party broke up and we traveled to a fabulous French restaurant named Picholine for a wonderful meal with the best MLP portfolio manager I know, Eric Kaufman, and his brilliant portfolio managing partner Victoria Crisologo, of the venerable money management firm VE Capital. Obviously I gleaned a number of interesting investment ideas during my New York stint, which I will be sharing in these missives.

Friday morning was a blur after the night before festivities, but I did have breakfast with a hedge fund and then spent two hours with the good folks at Blackrock. The first meeting was with Jeff Rosenberg, Chief Investment Strategist for Fixed Income, and we chatted about the Blackrock Strategic Income Opportunity Fund (BSIIX/$10.17), which is a true bond fund. Jeff opined, “Europe may be reflecting a fundamental turn in the economic outlook. To the extent it does, it underlines our view that rising European interest rates reduces the ‘low global yield’ argument, leaving the back-end of the U.S. yield curve vulnerable. As such, we continue to favor the belly of the yield curve exposures in the U.S. interest rate complex, with flatteners on the front end and steepeners in the long end.” For non-bond folks, that means he is anticipating higher long-term rates and flat short-term rates. A couple other interesting data points surfaced in our discussion. While I have argued the depth of the Financial Fiasco in 2008 – 2009, and the subsequent muted economic recovery, should extend the length of the mid-cycle recovery, Blackrock’s Rosenberg thinks we are in the late-cycle stage of the credit cycle. He also told me the credit cycle typically lasts seven years and in the high yield complex, over that seven-year cycle, there is a 30% default rate. Of course we talked about interest rates, the U.S. dollar, energy, international markets, Robo investors, inflation, et all.

Following that meeting, Blackrock’s Michael Fredericks, Head of Asset Allocation for the BlackRock Portfolio Strategies Group and lead PM for the Multi Asset Income Fund (BAICX/$11.23), arrived with some of his team. Their strategy is risk adverse, noting they have less risk than most of their competitors with similarly structured mutual funds. Their portfolio is roughly 30% comprised of dividend-paying stocks and 70% in shorter duration fixed income. I like the fact they sell out-of-the-money “call options” against many of their stock positions to help produce a current yield of more than 5%. One of Blackrock’s economists was in this meeting and said the Industrial sector’s business bottomed in 1Q15 and should come back to life in 3Q and 4Q of this year (I agree). He also stated consumer spending should snap back in that same timeframe after the 1Q15, and maybe 2Q, lag. We did touch on what they think is the best valued class of securities currently, namely preferred securities. They did share that an eye-popping $141 billion in stock “buybacks” took place in April, up a stunning 100% year-over-year. I discussed that topic with Craig Drill, at the firm that bears his name, late-day Friday (I wish I could have gone to the opera with Craig, his wife, and Mr. and Mrs. Paul Volcker that night, but I already had a dinner commitment with Mr. X, a guru who wants to remain unmentioned). Nevertheless, Craig said, “You need to deduct ‘option buying’ from that ‘buy back’ equation and the results are not nearly as overpowering,” which is a pretty insightful observation. Blackrock also said to expect a “material economic acceleration” in Europe, believing domestic consumption has returned, but that the “export shoe” has yet to drop despite the mini-crash in the euro currency. 

So in Thursday’s CNBC interview I told the wicked smart Sara Eisen I thought Friday’s employment report would be stronger than most expect and – bingo – it was, with a concurrent explosion in equity prices. Unfortunately, the “explosion” stopped (once again) at the topside of the wedge formation in the chart of the S&P 500 (SPX/2116.10) that has been in existence since February around the 2120 level. I have written repeatedly that I think the SPX is going to make an upside breakout above the 2120 to 2126 level, leaving the biggest surprise for most investors/traders a resulting upside spurt to more than 2200, which has caused many pundits to think I am totally NUTS! Indeed, in this business I have been told for more than 40 years, “If you give ‘em a price, do not give ‘em a timeframe; and, if you give ‘em a timeframe, don’t give ‘em a price.” Alas, I have done both, or as my dearly departed father use to tell me, “Jeff, please take a stand. Too many Wall Street wags write/talk in such a way that no matter what happens they can say they were right. Please take a stand, and if you are wrong, say you are wrong and readjust, but for God’s sake . . . take a stand.” I miss my dad!

So Sara asked me twice, “What do you think about Janet Yellen’s statement that stocks are overvalued?” My response (twice) was, “Janet Yellen is an economist, not a strategist.” You can see the details in the aforementioned video from CNBC. As for this reporting season, unfortunately the percentage of companies beating earnings estimates has fallen to 60.3% this quarter with revenue “beats” declining to 49.7% for the S&P 1500. The readings are much better for the smaller sample of S&P 500 companies, but I prefer to use the broader 1500-stock sample. Does the earnings dirge deter me from my bullish tilt? Absolutely not! I would also note that earnings estimate revisions have hooked up over the past month (see chart on next page).

The call for this week: I should mention that both of the discussed Blackrock funds have a Highly Recommended rating from our Mutual Fund Research Department, which has certainly taken a stand on these two funds. “Taking a stand,” what a novel concept in this business where few actually make a “call.” My colleague Andrew Adams and I took a stand during the bottoming process in crude oil between January and March of this year, often stating, “Crude oil is/has bottomed,” while many seers were calling for $20 to $30 per barrel oil. Near-term crude oil is overextended and should attempt to pullback, especially if there is a deal with Iran. Andrew and I also “took a stand,” and did a special strategy call on October 15, 2014 commenting, “If you didn’t raise cash on a trading basis when we suggested last June/July, you DO NOT sell stocks here. This is how bottoms are made.” We are taking a stand again, believing an upside breakout is coming. If we are wrong, we will adjust, but at least we are taking a stand and making a “call!” Can you hear me now?!

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