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Investment Strategy by Jeffrey Saut

A new queen bee?!

February 21, 2017

By the time a queen bee is five she is old and no longer reproduces, leaving her army of honeybees torn between loyalty and survival. Since the hive cannot survive without a productive queen, the beekeeper reaches into the hive with a long-gloved hand and squashes the enfeebled queen. With the entire hive as a witness, all know the queen is dead. Absent the scent of their leader, the honeybees panic. But, the beekeeper is prepared, having ordered a new queen from a bee breeder. Arriving in a two-inch-long wooden box with a screen at the top and bottom, the queen is accompanied by a court of six to eight escort bees who care for her every whim, cleaning her, feeding her, removing her waste. At one end of the box a tiny piece of hard candy blocks access to the queen. When the box is inserted into the hive, the first instinct of the worker bees, who immediately know she has the wrong scent, is to kill the new queen. The workers struggle to reach her, but are blocked by the candy. Soon they become diverted by the sweet [candy], and over the two or three days it takes to eat through it they succumb to the enticement. Their fealty is won. All hail the new queen.

“Three Blind Mice” by Ken Auletta (American writer, journalist and media critic)

Something similar to this “new queen bee” story is happening now. The “old queen” has been the Federal Reserve and monetary policy. The “new queen” appears to be the White House and fiscal policy. The White House seems nervous that monetary policy, the Fed, and up until recently the continuing policy of lowering interest rates, has not produced the typical strong economic rebound following a “soft patch.” So, the “new queen” looks to be fiscal policy and the White House. As repeatedly stated, “The White House is ‘driving’ the equity markets and not the Fed, which is a huge change from the past two decades.” Now Wall Street loved the old queen. The Street loved lower interest rates, figuring that stimulation would revive the banks, business, and the economy in general. Yet many investors are leery about the new queen. The Street worries that tax cuts could be a catalyst for bigger budget deficits and higher inflation. Moreover, the media, the Democrats, and even many Republicans appear to be taking every opportunity to undermine our new President. However, the White House figures that Wall Street will eventually succumb to the sweet lure of tax cuts, reduced regulation, repatriation of foreign corporate profits, a fix for Obamacare, etc. But, beekeepers sometimes get stung! The head beekeeper in Washington D.C., the President, knows that the economy remains in a fragile state. He knows the worker bees are worried about their jobs, their hive, and their honey. He knows they will sting Republicans in the next election if he does not get the economy moving again, but we think he will.

Wall Street is also worried about getting stung. The Street has bid the S&P 500 (SPX/2351.16) up ~30% from last year’s February lows, and up nearly 10% from the Presidential election lows, with many indices doing better than that. So what’s driving the Trump rally? Well, as the always insightful Craig White, portfolio manager of the Canada-based HugganWhite Wealth Management organization, writes:

  1. Stimulus measures proposed by the new administration including tax reform, increased infrastructure spending, a reduction in regulation and the potential repatriation of off-shore dollars.
  2. A strong fourth quarter earnings season, highlighted by more than 65% of reporting companies beating expectations.
  3. Multiples that are fairly valued based on forward earnings expectations.
  4. An economic backdrop that continues to show resilience with employment, manufacturing, wage growth etc. all trending positive (chart 1 on page 3).
  5. Business optimism that has picked up materially over the past year (NFIB Small Business Optimism Index – chart 2).
  6. Fund flows benefiting equities for the first time since mid-2104.
  7. An improvement in overall sentiment compared to early 2016 (chart 3).

We agree with point 1, except we do not think infrastructure spending will occur quickly. The majority of infrastructure spending happens at the state and local level, so it is hard to envision how the government can wave a magic wand and immediately foster such spending. Recall that when the American Recovery and Reinvestment Act (ARRA) was passed it took a long time before the first dollars “showed up.” Point 2 we clearly agree with since we remain of the view the “profits trough” occurred in the 2Q16 and the equity markets are/have transitioned from an interest rate driven to an earnings driven, secular bull market. Indeed, as of last Friday, of the S&P 500 companies that had reported 4Q16 earnings, aggregate earnings improved by 7.5% with 69% of those companies reporting better than expected numbers. Three, if you believe S&P’s 2017 earnings estimate for the S&P 500, and that for every one point drop in the corporate tax rate hypothetically adds $1.31 to those earnings, stocks are not all that expensive. Four, there is little doubt the economy is getting better. Five, hereto there is little doubt small business optimism has soared. Six, investors poured nearly $18 billion into equity mutual funds and exchange-traded funds in the week of February 15. And seven, sentiment is profoundly ebullient, which is actually a cause for some near-term concern.

The call for this week: Vince Lombardi once opined, “I never lost a game. I was only behind when time ran out!” And that appears to be the operative quote for me and my short/intermediate models over the past few weeks since the SPX has overrun my models’ maximum upside trading target of 2330, as well as “Trumping” the models’ downside window of vulnerability slated for late January/early February. Indeed, since the election the SPX has not experienced a 1.5% drawdown on a closing basis from a closing high. In fact, the SPX has gone 89 sessions without even a 1% decline. To be sure, the equity markets have thumbed their collective noses at: a negative astrological sign where on February 10/11 we got a Snow Moon; a Lunar Eclipse, and a Comet (Snow Moon); negative Treasury tax receipts for the first time since the financial crisis; a raging battle between the White House and the intelligence community and the media; rising inflation; a more hawkish Fed; an overbought condition; hints of protectionism; a downside “island gap” in the SPX chart; and a historically low Volatility Index (VIX). To this VIX point, the longest dated VIX futures contract (October 2017) traded below 17 recently. This is a fairly rare event and tends to be associated with “trading tops.” Furthermore, this type of recent panic buying is strongly correlated with the kind of buying you see toward the end of a trend and not the beginning of a new upside trend. Still, in this business price is reality and the reality is we have gotten wrong-footed over the past few weeks. Fortunately, most of the stocks featured in these reports have continued to do well. One that has lagged, and remains positively rated by our fundamental analysts, is Premier, Inc. (PINC/$31.35/Outperform), a healthcare improvement company. Additionally, we talked to a wicked smart, healthcare-centric portfolio manager last week who suggested we take a closer look at Mylan N.V. (MYL/$42.05/ Strong Buy), which screens well on our models and carries a favorable rating from our fundamental analyst. For more information please see our analysts’ reports. This morning the S&P 500 preopening futures are higher again by about 5.50 points on no real overnight news.

The great white hurricane

February 13, 2017

“Unseasonably mild and clearing,” was the weather forecast going into the Ides of March back in the year of 1888. And it was true, as temperatures hovered in the 40s and 50s along the East Coast. However, torrential rains began falling, and on March 12th the rain changed to heavy snow, temperatures plunged and sustained winds of more than 50 miles per hour blew. The “Great White Hurricane” had begun! In the next 36 hours some 50 inches of snow would blanket New York City and the winds would whip that snow into 40- to 50-foot snowdrifts. Telegraph and telephone lines were snapped, fire stations were immobilized, New Yorkers could not get out of their homes, 200 ships were blown aground, and before the storm was over 400 people would die. The resulting transportation crisis led to the construction of New York's subway system.

We revisit the Great Blizzard of 1888 this morning because of the weather that has crippled the Northeast corridor beginning last Thursday. Actually, I guess it was on Wednesday the storm hit because my friend and VE Capital portfolio manager Eric Kaufman’s plane was canceled early Thursday morning on his way to Orlando to speak at the Money Show and then spend some time with us here in Saint Petersburg. I didn’t see the final tally, but NYC was expecting a foot of snow and Boston was slated to get even more. Fortunately, communities are more capable of dealing with such storms today than they were more than a century ago.

I remember the big snow storm that “stopped” NYC in February 1978 when Central Park saw an accumulation of some 18 inches and the trading on the NYSE was impacted. This time trading was not nearly as impacted as the S&P 500 (SPX/2316.10) traded decent volume and rose from Wednesday’s closing price of roughly 2289 to Friday’s close of ~2316, trading to a new upside break-out high (Chart 1). Plainly this flies in the face of what our short/intermediate-term models were suggesting since they “looked” for a downside window of vulnerability in late January, or early February. The catalyst du jour for the nearly +1.2% two day two-step once again appeared to be vibes emanating from the D.C. beltway and the White House. To wit, DJT told airline executives, “Lowering the overall tax burden on American business is big league . . . that's coming along very well. We're way ahead of schedule, I believe. And we're going to announce something I would say over the next two or three weeks that will be phenomenal in terms of tax.” That announcement reversed worries that President Trump’s tax agenda was going to get lost in the “Washington Shuffle.” To reiterate, as Andrew and I have stated repeatedly, “DJT’s bark is worse than his bite.” We have written about this many times in that his background is in real estate. For example, say you put your house on the market for $1,000,000 and someone offers you $800,000. Your response would likely be, “Okay, how about $950,000” – the counter offer might be $850,000 – as the two of you negotiate toward the “middle.” That, dear readers, is DJT business model. Just think back to President Trump’s terse rhetoric regarding Japan a few months ago. Now the Trumps, and Japan’s Abes, are best friends enjoying life at the Florida White House. Indeed, DJT’s “bark is worse than his bite!”

So what does all of this mean? Well, earnings continue to come in on the brighter side (as we expected) with 65% of reporting companies beating consensus estimates. Meanwhile, revenues are besting estimates by 57% reinforcing our belief the equity markets are transitioning from an interest rate, to an earnings driven, secular bull market. According to Thomson, “Fourth quarter earnings are expected to increase 8.4% from Q4 2015. Excluding the Energy sector, the earnings growth estimate improves to +8.6%.” As for sectors beating both earnings and revenue estimates, they are fairly consistent with those sectors emphasized in these reports. To that point our friends at the Bespoke organization write:

Technology and Financials — the two largest sectors of the market — have the strongest earnings beat rates, and they’re the only two sectors with stronger readings than the overall beat rate of 65%. Consumer Discretionary and Materials are the two cyclical sectors with the weakest earnings beat rates. In terms of revenues, Technology has the highest beat rate, while Consumer Staples and Utilities have the lowest.

That is consistent with our strategy over the past six months in that we have liked Technology and the Financials and have believed the “low volatility/defensive sectors” were overvalued (see Chart 2).

If you do not want to adopt our more cautionary near-term trading stance, we would point you to the “triple plays” (companies that beat earnings/revenue estimates, raised guidance, screen well on our models, and are favorably rated by our fundamental analysts) that have been featured in recent missives. Also for your consideration should be the Financial sector, which looks to have broken out to the upside (Chart 3).

While our models have not been correct recently, we have not given up on them since they have been generally correct for a long time. In point of fact, our short-term model is suggesting a trading top is currently occurring. Meanwhile, last week’s market move happened as Andrew and I received numerous emails from financial advisors telling us the equity markets are involved in a “melt up.” Ladies and gentlemen, that has historically been a worrisome sign. If our models prove to be wrong, we will adjust. However, we continue to adhere to those models and the market mantra, “The first objective of investing is to do no harm!”

The call for this week: There were a lot of positive things that came together last week in addition to the president’s “phenomenal in terms of tax [policy]” statement. The Fed’s Bullard said interest rates can remain low through 2017, oil prices rebounded on stronger consumer and labor numbers, and China praised our president for wanting a “constructive relationship.” This week’s attentions will probably focus on the comments from a plethora of Fed speakers including two trips to Capitol Hill by Janet Yellen. Those comments could cause some market consternations, as could some of these observations about last week’s action: the FANGs did not leap, Friday saw the first hour of trading to the upside and the last hour to the downside from the session’s highs, Syria’s Assad told news sources that some refugees are definitely terrorists, Pat Buchanan told the president that he needs to break judicial power calling for Congress to start using Article III, Section 2 (, and then there was this from the always insightful Jason Goepfert (SentimenTrader):

The rally's meek underpinnings. Stocks have rallied strongly over the past three months, but there have been few breadth thrusts. The S&P 500 has enjoyed a 65-day, 10% gain to new highs, but there have been only two days during that stretch that would qualify as a thrust. That's the weakest such rally since 1999.

Our models continue to suggest that it is unlikely this is going to be the beginning of a whole new up leg for the S&P 500. In fact, our models telegraph that the maximum upside from here for the SPX is 2330. That said, they also suggest no big downside collapse either.

PS: From The King Report, “In the current environment, it is dangerous to forecast beyond a few hours because a DJT tweet or pronouncement can occur at any moment. However, barring the appearance of new dynamics in the interim, the grand unveiling of DJT’s tax plan should generate some type of stock market peak.

Nothing feels stable

February 6, 2017

“You have enemies? Good. That means you've stood up for something, sometime in your life.”

. . . Winston Churchill

I recalled the aforementioned quote while reading a rather interesting article by the always erudite Peggy Noonan. The article was titled “In Trump’s Washington, Nothing Feels Stable.” Ms. Noonan goes on to write:

We are living through big history and no one here knows where it’s going or how this period ends. Everyone, left, right and center, feels the earth is unsteady under their feet. Too much is happening. Democratic senators boycott confirmation hearings, Iran tests ballistic missiles, President Trump has testy phone calls with prime ministers and it’s quickly leaked to the press, the president tells Senate Majority Leader Mitch McConnell to “go nuclear” — meaning use the so-called nuclear option to get the new Supreme Court nominee through. . . . Everyone’s political views are now emotions and everyone now wears their emotions on their faces. People are speaking more loudly and quickly than usual. At parties, dinners and gatherings the decibel level hits the ceiling right away and stays there. No one can hear anything. It somehow seemed right that a 25-pound bobcat escaped from the National Zoo; a Washington Post columnist speculated it fled to Canada.

I used some of Ms. Noonan’s first paragraph in said article, because “Everyone, left, right and center,” does indeed “feel the earth is unsteady under their feet.” I have lived through 12 presidents in my life, and I have never seen anything like what is currently happening. I am sure somewhere in U.S. history there has been other protests against presidents, but I can’t recall anything like what we are seeing now. The acrimony is palpable and suggests the president is in trouble. That statement brings back memories of a market axiom from my departed friend Richard Russell (Dow Theory Letters) who used to write – when the president is in trouble, the stock market is in trouble – something participants might want to consider. Verily, there is the potential that the stock market may begin to realize that the unprecedented acrimony could impair President Trump’s agenda. Obviously, it took a step in that direction over the weekend when a federal judge ordered the halt of the president’s travel suspension executive order. It will be interesting to see the stock market’s reaction to that news this week.

Last week, however, the equity markets were on their “heels” until Friday’s better-than-expected employment report saved the day. The Friday Fling, of roughly 187 Dow points, left the senior index virtually flat for the week. But that “fling” was driven almost entirely by the financial sector. For example, the rally in Goldman Sachs’ shares accounted for 72 of the Dow Wow points and, when combined with three other financial stocks, accounted for 124 of the Dow’s ~187 point gain. Of course, that sits well with Andrew Adams and me, since financials, energy and technology are three of the macro sectors we have suggested overweighting in portfolios. Speaking to technology, it is worth noting that, so far in this earnings season, 81% of the reporting companies in the tech sector have beaten the consensus earnings estimates, and 69% have bettered the consensus revenue estimates by (chart 1). As for the energy sector, 58% of reporting companies came in above earnings’ estimates and 68% beat the revenue estimates. Meanwhile, the financial sector saw an earnings and revenue beat rate of 66% and 55%, respectively. Overall, with some 1,000 companies reporting, 65% have beaten earnings estimates and 56% have better revenues estimates (chart 2). All of this “foots” with our sense that the secular bull market is transitioning from one that is interest rate driven to one that is earnings driven.

Continuing with this earnings season theme, there were more triple plays last week. That would be companies that beat earnings and revenue estimates and raised forward guidance. In addition to those companies for your consideration offered in last Monday’s missive that are triple plays, favorably rated by our fundamental analysts, and screen positively on our models (NFLX/$140.25/Outperform, NOW/$89.47/Strong Buy, BABA/$100.39/Strong Buy), last week, these companies also met those same metrics: MarineMax (HZO/$20.70/Strong Buy), American Financial (AFG/$90.81/Outperform), and Cavium Networks (CAVM/$66.95/Strong Buy).

Plainly, last Friday’s employment report breathed new life into the recently-sagging equity markets. Indeed, nonfarm Payrolls rose by 227,000, well above the median forecast of +175,000, with some anticipation of an upside surprise (chart 3). To that report, our economist, Scott Brown Ph.D., writes:

A good report, but this is January data (payrolls fell by 2.95 million before seasonal adjustment). (Adjusted) payrolls exceeded expectations, although largely offset by downward revisions to the previous data. The increase in labor force participation is a good sign, but still little changed over the last year. Average hourly earnings rose mildly, but these figures are choppy (the trend is gradually higher). Nothing here to suggest that the Fed needs to slam on the brakes, but consistent with a gradual pace of policy normalization (that is higher short-term interest rates). Market reaction is likely to be a bit mixed. The economic calendar will be thin until March 15, when we get CPI, retail, sales, industrial production, and more importantly, Yellen’s monetary policy testimony.

In addition to the strong employment report, we would note that the overall economic numbers are getting better. As the Bespoke organization writes:

Earlier this week we got the monthly ISM Manufacturing reading, and it posted a very strong number of 56. As shown in the chart below [chart 4], this is a sharp move higher from levels seen a year ago. Unfortunately, the Prices Paid inflation reading in this month’s ISM Manufacturing report spiked up to 69 as well, which was the highest reading seen since 2011. Surely the Fed took notice.

Clearly the reflation trades should continue to have upside “legs.” Bolstering the “reflation trade” is the recent weakness in the U.S. Dollar Index (chart 5), which could put a bid under the sectors with more international revenue exposure (chart 6).

The call for this week: Bullish sentiment across all venues is extreme (read: bearishly). Selling Pressure rose last week as Buying Power declined. According to the astute Lowry’s service, there has not been a 90% Upside Day since November 7, 2016. The stock market is overbought on a short-term basis. Our method of measuring the stock market’s “internal energy” is down to levels rarely seen (out of gas), and our short/intermediate models continue to counsel for caution. That said, Friday’s Fling may extend the rally attempt, but we do not think the S&P 500 gets very far above the 2300 mark. And remember, February historically tends to be a tough month for the equity markets (chart 7).

P.S.: Helene Meisler @hmeisler: Holy cow. ETF put/call ratio was 44% [Extreme optimism/panic buying]

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