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Investment Strategy by Jeffrey Saut

Buy C-R-A-P

January 9, 2017

We live in a modern world of acronyms and buzzwords, and the financial industry is certainly no exception. In fact, it may be one of the worst culprits, what with FANG, ZIRP, TINA, BREXIT, QUITALY, BRIC, etc. all entering the lexicon over the last few years. Yet, creating some catchy collection of consonants remains one of the most surefire ways to attract attention in this business since it, admittedly, makes for a great headline and gives strategists like us something fun to write about (“fun” being a relative measure). Well, now the new eye-catching acronym to watch, according to Tom Lee of Fundstrat is C-R-A-P – Computers, Resources, American Banks, and Phone Carriers – which are all levered to the investment recovery, inflation, and deregulation expected over the next year. Before I comment further on those recommendations, though, I want to point out that I like to follow Tom Lee’s thoughts because, like us, he lets the data do most of his thinking, and, like us, he was one of the few pundits last year who actually saw potential for the U.S. stock market. He backed that up, too, with one of the highest S&P 500 targets among strategists for 2016 (2325), but now, according to Bloomberg, he has the lowest price target for 2017 among the fifteen strategists they track (2275), further proof that he doesn’t just parrot consensus numbers.

Reading between the lines of his comments, Lee does not see substantial upside for the stock market as a whole in 2017, at least not without a pullback first, but he does believe potential exists among individual areas of the market. This line of thinking is consistent with our view that passive indexing may be more frustrating in this type of investing environment because you will be dragged down by the underperforming sectors and the increased volatility may make it more difficult to hold onto positions long enough to achieve the eventual performance. We generally agree, too, that the C-R-A-P stocks should do well in the political and economic landscape that many expect is on the horizon. If inflation does pick up, driven by fiscal stimulus and more robust economic growth, Fundstrat argues that the contemporaneous increase in wages will not hit technology company margins as hard given their reliance on more high-skilled workers, and we, too, continue to advise an overweight of Tech to benefit from the Computers sub-sector. The big acronym of 2015 and 2016, the so-called FANG stocks, may already be coming back into favor, as well, with Facebook Inc. (FB/$123.41/Outperform), Amazon.com Inc. (AMZN/$795.99/Outperform), Netflix Inc. (NFLX/$131.07/Outperform), and Alphabet Inc. (GOOG/$806.15/Outperform) all breaking out to new reaction highs last week.

We also continue to like the Energy sector for the Resources play, as our fundamental analyst team in Houston still sees upside for the price of oil over the next couple of years and the companies should be run a bit more efficiently after all the cost-cutting that has been implemented. Their current favorites in the space are Oasis Petroleum Inc. (OAS/$15.58/Strong Buy), Unit Corporation (UNT/$30.25/Strong Buy), Kinder Morgan Inc. (KMI/$21.81/Strong Buy), and Tesoro Logistics L.P. (TLLP/$53.80/Strong Buy).

There are no shortage of American banks to choose from, either, but Bank of the Ozarks Inc. (OZRK/$52.36/Strong Buy) and Signature Bank (SBNY/$150.50/Strong Buy) are the two preferred by our analysts at the moment. I have actually received some questions lately asking if the run in banks is coming to an end, and not just in the short-term but for good. We think that’s ludicrous considering Financials have largely underperformed the broad market going all the way back to the early 2000s and it’s going to require more than a two-month run to begin to correct that divergence (Chart 1). In the near term, yes, many of the banks have likely come too far, too fast, but pullbacks should still be for buying, in our opinion as the yield curve is largely expected to steepen further.

Finally, the Phone Carrier part of C-R-A-P is a little trickier, as Donald Trump has already come out in opposition of at least one of the proposed mergers to further consolidate the industry and put more control in the hands of the major players. However, if we do experience a run of broad deregulation across the general business landscape, the big phone carriers could see some benefits in the form of pricing power (per Forbes), in addition to improving demand as the overall economy gets better. Verizon Communications Inc. (VZ/$53.26/Outperform), AT&T Inc. (T/$41.32/Outperform), and T-Mobile US Inc. (TMUS/$56.77/Outperform) are all rated “buys” by our fundamental analysts.

Fundstrat concluded their C-R-A-P report by throwing in some caveats, including the risk that “sloppy White House organization creates confusion on U.S. policy, particularly as tweets become policy." They estimate the new administration could bring with it at least a 5% dip in the first half of the year, something that should come as little surprise given the great run we have enjoyed and should not be a significant concern. Coming into 2017, the biggest risk, in our opinion, was that no one seemed to be talking about any risks, and I think it’s pretty telling that Tom Lee is the most pessimistic strategist in the Bloomberg survey and even his year-end target is almost exactly where we are now – so not exactly bearish.

However, risks do exist (and these are just the obvious ones):

  • Perfection from Trump and the Republicans is largely priced in over the near term;
  • There is bound to be a disappointment at some point – either not enough stimulus or deregulation vis-à-vis market expectations or it doesn’t come quickly enough;
  • A few reports I have seen indicate that some businesses may be delaying further investments or other strategic actions until the new administration’s policies become clearer; if they are forced to wait indefinitely it could start to hurt the overall economy;
  • The same goes for many investors, who likely held off on selling positions last year with the expectation that lower taxes would be coming. The question now becomes do we see a round of delayed selling as soon as we get a better idea about the tax implications;
  • Considering investors everywhere are refreshing Twitter every few minutes to see what Donald Trump will say next, the market is always one tweet away from being scared off certain companies or industries.

So, it is not unreasonable to think we may start to see some weakness in the coming sessions as inauguration day approaches. As Jeff Saut wrote in our Morning Tack from last Thursday:

Our models continue to telegraph a move higher into late month, although approaching mid-month, we are trimming some of our enthusiasm. That view rests on the fact that we have played the rally pretty aggressively. However, from a tactical standpoint, we are taking a more cautious stance as mid-January approaches consistent with our model’s cautionary call for late January.

I have heard from a lot of smart people that the days around the inauguration could end up representing a short-term trading top, as profits from the election rally are locked in and we start to get a real idea of how President Trump will differ from Candidate or President-elect Trump. And if enough traders start to believe an impending top is coming, they may accelerate their selling. To be clear, we don’t anticipate any major correction to occur and we still believe stocks will largely go up in 2017, but a pullback in the 5-10% range would not be the worst thing in the short term and would likely give you a good chance to buy those stocks previously mentioned.

The call for this week: As SentimenTrader pointed out on Friday:

Despite a new all-time high in the S&P 500, there were more declining securities than advancing ones on the NYSE. The amount of volume flowing into those securities was the 5th-worst ever on a day the S&P hit an all-time high. And the percentage of issues reaching a 52-week high wasn't far behind, also lagging badly. The last time breadth was this bad at an all-time high in the S&P was the bull market peak on March 24, 2000.

Moreover, the equal-weight S&P 500 did not join its more common, cap-weighted cousin by making a new all-time high (Chart 2), and small cap stocks, which led for most of this recent rally, have finally started to slacken. So, market breadth does seem to be slumping a bit, which is often a preamble to weakness in the major averages, and we could start to see traders position themselves for short-term trading top coinciding with the inauguration. Therefore, if you are looking to take profits and reduce equity exposure, this coming week may be a good opportunity to do so. The anticipated weakness in the coming sessions should not significantly impact more long-term investors, and may finally give those who missed out on the election rally a chance to buy in, but it is cause to remain vigilant. The “big test” for the S&P 500 I have mentioned recently remains its place as resistance (Chart 3), and, unless we can rise above that level (roughly 2280-2285), there may be limited upside in the near term.


Market mantras

January 3, 2016

“It’s what you learn after you know it all that counts.”

. . . Earl Weaver

Now is the time of year when strategists, economists, gurus, etc. all join in on the annual nonsense of predicting “What’s going to happen in the markets for 2017?” For many, this ritual is an ego trip, yet as Benjamin Graham inferred, forecasting where the markets will be a year from now is nothing more than rank speculation. Or, as we have noted, “You might as well flip a lucky penny.” Manifestly, while forecasting is fun, it should in no way be construed to be investment advice. That is why we try hard to avoid the annual guessing game and attempt to focus on what the markets are “saying,” what sectors look favorable, and what stocks we want to own in the new year. This year we have made an exception to that strategy, because our new friends at Alex Brown want a price target for the S&P 500 (SPX/2238.83) in 2017. In past missives, we have explained why our price target for 2017 is 2450. However, typically when “pressed” for a prediction, we tend to look at where the SPX is currently trading and state, “The average yearly return for the S&P 500 since 1926 has been ~10.4%, so we think it will be up 10.4% in the new year. Surprisingly, a 10.4% gain in 2017, from where the SPX currently resides, is very close to 2450 (2238 + 232=2470).

That said, lost in the “noise” of the annual soothsaying contest are some simple tenets of investing, with one of the best examples published in The Financial Analysts Journal in 1995. It was penned by Arthur Ziekel (at the time head of Merrill Lynch Asset Management) as a letter to his daughter on investing. To wit:

“Personal portfolio management is not a competitive sport. It is, instead, an important individualized effort to achieve some predetermined financial goal balancing one’s risk-tolerance level with the desire to enhance capital wealth. Good investment management practices are complex and time consuming, requiring discipline, patience, and consistency of application. Too many investors fail to follow some simple, time-tested tenets that improve the odds of achieving success and, at the same time, reduce the anxiety naturally associated with an uncertain undertaking.

I hope the following advice will help:

A fool and his money are soon parted.

Investment capital becomes a perishable commodity if not handled properly.

Be serious. Pay attention to your financial affairs. Take an active, intensive interest. If you don’t, why should anyone else?

There is no free lunch.

Risk and return are interrelated. Set reasonable objectives using history as a guide. All returns relate to inflation. Better to be safe than sorry. Never up, never in.

Most investors underestimate the stress of a high-risk portfolio on the way down.

Don’t put all your eggs in one basket.

Diversify. Asset allocation determines the rate of return. Stocks beat bonds over time.

Never overreach for yield.

Remember, leverage works both ways. More money has been lost searching for yield than at the point of a gun (Ray DeVoe).

Spend interest, never principal.

If at all possible, take out less than comes in. Then, a portfolio grows in value and lasts forever. The other way around, it can be diminished quite rapidly.

You cannot eat relative performance.

Measure results on a total return, portfolio basis against your own objectives, not someone else’s.

Don’t be afraid to take a loss.

Mistakes are part of the game. The cost price of a security is a matter of historical significance, of interest only to the IRS.

Averaging down, which is different from dollar cost averaging, means the first decision was a mistake. It is a technique used to avoid admitting a mistake or to recover a loss against the odds. When in doubt, get out. The first loss is not the best but is also usually the smallest.

Watch out for fads.

Hula hoops and bowling alleys (among others) didn’t last. There are no permanent shortages (or oversupply). Every trend creates its own countervailing force. Expect the unexpected.

Act.

Make decisions. No amount of information can remove all uncertainty. Have confidence in your moves. Better to be approximately right than precisely wrong.

Take the long view.

Don’t panic under short-term transitory developments. Stick to your plan. Prevent emotion from overtaking reason. Market timing generally doesn’t work. Recognize the rhythm of events.

Remember the value of common sense.

No system works all of the time. History is a guide, not a template.

This is all you really need to know.

Love, Dad”

The call for this week: Unless the equity markets rally sharply today and tomorrow, we did not get a Santa Claus rally (SCR). Recall, the SCR is the seasonal tendency for equities to rally during the last five sessions of the year through the first two trading sessions of the new year. Many pundits take the lack of a SCR as an ominous warning for stocks; we do not. Admittedly, we did not get an SCR in 2015, and we got a “trapdoor” decline into the SPX’s February 11, 2016 “low” of ~1810. That decline also rendered a negative reading from the January Indicator (so goes the first week of the new year, so goes the month and so goes the year); and, the first week, of 2016 was down as was the month of January. As well, the January Barometer (if the December closing low is violated any time in the first quarter of the new year, watch out) registered a negative signal when the December 2015 closing low was “taken out” on January 4, 2016. Despite that cacophony of negative signals, our models flipped positive on February 5, 2016 “calling” for a market bottom the next week. From that week’s low (1810) the SPX gained ~23.7% into last Friday’s closing bell . . . not bad! So, our intermediate-term model called the recent rally, from before the election, no matter who won. We have to admit that the Trump win accelerated the envisioned rally. Subsequently, our short-term model called for a trading top the week of 12-11-16 and was “looking” for a bottom into late last week with a +/-5 session variance. Since mid-December, the SPX has pulled back about 1.5%, and that “stall” has permitted the stock market’s “internal energy” to rebuild to almost a full charge. This suggests our intermediate-term model’s “call,” prior to the election for the equity markets to trade higher into late January/early February, is still enforce. If that pattern proves correct, the models then look for some kind of downside attempts beginning in late January, which do not get very far. Our long-term model has not varied since March of 2009 in that we are in a secular bull market that has years left to run. And that’s the way it is on session 36 of the “buying stampede.”


“If Santa Fails to Call the Bears Will Roam on Broad and Wall”

December 27, 2016

As we enter 2017, we expect the current economic rebound to continue suggesting GDP growth will likely move toward the 3% level by the end of the year based on less monetary stimulus, more fiscal stimulus, a reduction in the corporate tax rate, and deregulation.  Our S&P 500 price target for the year is 2450, but we believe the S&P 500 may actually exceed that level as earnings growth ramps.  We think the post “Trump Trades” will continue to have “legs.”  Our team favors small capitalization names over large caps and value over growth.  We also urge investors to overweight Financials and underweight bonds, bond proxies, Consumer Staples, and Utilities.  In our opinion interest rates have bottomed, deflationary trades are wrong-footed, inflation is rising, “real assets” names should be bought, the U.S. dollar probably trades a little higher, the labor market continues to tighten, wages rise, and business investment improves.

To be sure, yearend letters are always hard to write because there is a tendency to discuss the year gone by, or worse to predict what is in store for the new year.  Quite frankly, how many pundits predicted Brexit, or a Donald Trump victory?  Certainly it wasn’t Andrew Adams or I.  Yet, we think by far the biggest message as we prepare to enter 2017 is that the equity markets are transitioning from an interest rate driven bull market to an earnings driven bull market.  This is being reflected in the analysts’ earnings revisions, which have taken a decidedly upward turn (Chart 1).  Currently, the S&P 500’s bottom up, operating earnings estimate for 2017 is around $131.  That leaves the S&P 500 trading at a P/E ratio of ~17x forward earnings.  However, Thomson Reuters notes that for every 1% decline in the corporate tax rate it “hypothetically” generates an additional $1.31 in earnings for the S&P 500.  If President-elect Trump can get his envisioned 15% corporate tax rate that would imply another ~$26 in earnings for the S&P 500 (20 x $1.31 = $26.20).  Accordingly, if you hold the P/E constant at 17x, and add another $26 to the $131 estimate, it yields an earnings estimate of $157 leaving a forward price target for the S&P 500 of ~2670 ($157 x 17 = 2669).  Yet, getting corporate tax rates down to 15% could prove to be difficult.  Still, a 25% tax rate would produce an earnings estimate for 2017 of ~$144.  Again holding the P/E ratio constant at 17x gives us a price target for the S&P 500 of roughly 2450 in the new year.  In either event, we believe stocks are going to trade substantially higher over the next few years.  Will there be pullbacks?  You bet there will, but in our view pullbacks are for buying.  Going into the presidential election our models suggested the equity markets were set up for a decent rally no matter who won the election, although we have to admit the Trump win clearly accelerated the envisioned rally.  Bingo, because the S&P 500 futures have rallied over 200 points from their November 8 overnight lows.  From those lows our models forecasted the S&P 500 would grind higher into late-January/early-February; and, they remain in that rally mode.  In the very short term those same models called for a trading peak the week of December 11, 2016, followed by a pause and/or an attempt at a minor pullback into this week.  So far that has been a pretty good “call.”

Speaking to the fixed income markets, a pickup in GDP growth combined with reflationary pressures and potentially a more hawkish Federal Reserve suggest a higher interest rate environment is sustainable.  These metrics also are supportive of a stronger U.S. dollar, which will likely cause the euro to trade to par in 2017.  While this represents headwinds for commodities, over the past few months we have been recommending the return to “stuff stocks” given the fact the price of real assets, assets relative to financial assets, is at historic lows (Chart 2).  Looking at the charts of the U.S. dollar, commodities, bonds, stocks, etc. show that volatility is here to stay.  We believe political risk could amplify this “episodic volatility,” especially as deepening populism potentially gains traction around the world.

Looking at valuations, using trailing 12 month figures leaves the equity markets trading at historically lofty valuations.  However, as my friends at Bespoke Investment Group point out:

Already, there has been increasing chatter in the last several days that the rally since the November election is based on hype and sentiment and nothing concrete.  We will be the first to admit that we have no idea how the next four, or possibly longer, years will ultimately turnout, but one thing we would stress is that if you are in the business of investing and haven’t realized that the market is forward looking, you are in the wrong business.

It is our belief the equity markets are looking forward to a huge rebound in earnings.  As another friend writes (Rich Bernstein of Richard Bernstein Advisors):

One of the things that has scared people away from equities is high P/Es (Price to Earnings Ratio).  People have said, “When P/Es are high, your returns have to be low.”  That's not always true.  Where it's not true is in what's called an “earnings-driven” market.  There have been many earnings-driven markets through time, but it's funny how people think the only way the market can go up is by interest rates falling and multiples expanding.  That's not true.  That's an interest-rate-driven market, but there're also earnings-driven bull markets.  The early 2000’s bull market was an earnings-driven market.  One of the reasons people got trapped at the end was that they forget they'd started with a very high P/E and ended with a low P/E.  When you had the low P/E, people said, “Look how cheap equities are.”  And they missed the fact that it was an earnings-driven market, and you sell an earnings-driven market when the P/E is low, much like a deep cyclical stock.  You buy a deep cyclical stock when the P/E is high, and you sell it when the P/E is low.  That's what we think is going on for the whole economy.  That's been our story, that, yes, the multiple is high, but we think we're entering an earnings-driven market.  So the bull market will be accompanied by shrinking P/Es.

The call for this week: For almost two years the S&P 500 (SPX/2263.79) was locked in a trading range (Chart 3) as many pundits proclaimed a “top” was being formed, a crash was coming, etc.  We, however were steadfast in the belief all that was happening was an upside consolidation building the base for another leg to the upside in this secular bull market.  In August of this year the SPX broke out of that trading range and subsequently gained over 100 points, Q.E.D.!  Plainly, the equity markets are seeing that something “good” is coming.  Again as Bespoke notes, “If you are in the business of investing and haven’t realized that the market is forward looking, you are in the wrong business.”  And maybe, just maybe, the market is realizing that for the most part deal maker businessmen, who know how to get things done, will be running the government for the next four years (just a thought).  This week participants will be watching for the fabled Santa Rally, which occurs between Christmas and New Year’s.  To wit, according to the Stock Trader’s Almanac:

Since 1969 the Santa Claus rally has yielded positive returns in 34 of the past 45 holiday seasons — the last five trading days of the year and the first two trading days after New Year’s. The average cumulative return over these days is 1.4%, and returns are positive in each of the seven days of the rally, on average.

Following that folks will be watching the January Indicator, while we will be watching the January Barometer.  More on those two indicators in days to come . . . 

Jeff saut commentary
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Jeff saut commentary
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Jeff saut commentary
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