Investment Strategy by Jeffrey Saut

The Climb

March 20, 2017

“The Climb”

“There's always gonna be another mountain
I'm always gonna wanna make it move
Always gonna be an uphill battle
Sometimes I'm gonna have to lose” (Climb)

. . . Miley Cyrus

I spent last week climbing the mountains of Idaho and Utah, seeing accounts and doing presentations for our financial advisors and their clients. In my absence, the stock market did some climbing of its own as the S&P 500 (SPX/2378.25) came within five points of its all-time closing high (on an intraday basis), causing one old Wall Street wag to comment, “Can you spell double top?!” The challenge of the all-time highs came on last Wednesday’s “celebratory climb” following Ms. Yellen’s rate ratchet of 25 basis points, which occurred amid a string of softening economic statistics (sidebar: The Taylor Rule suggests the Fed is behind the curve by over 260 basis points). Despite last “Wednesday’s Win”, the SPX had no upside follow-through on Thursday, or even in Friday’s “quadruple witch twitch,” leaving it trapped in its 2350-2400 trading range that has existed since mid-February. Interestingly, given said rate rise, the 10-year T’note’s yield actually fell from Wednesday’s pre-FOMC announcement of over 2.6% into Friday’s close of ~2.5%. Almost on cue, the U.S. Dollar Index (DXY) declined from Tuesday’s intraday high of 101.79 to close the week at 100.31. Over that same timeframe, crude oil prices rose from $47.09 to $48.78, and gold rallied from $1196.80/ounce to $1229.80. On a very short-term basis, using NO fundamental analysis and just looking at the price charts, the 10-year T’note’s yield appears to have peaked (Chart 1 on page 3), crude oil looks to have bottomed (Chart 2 on page 3), gold has the appearance of a bottom (Chart 3 on page 4), and the S&P 500 looks toppy (Chart 4 on page 4).

Speaking to our models, and the stock market’s “internal energy,” our long-term proprietary model flipped positive in October 2008 and has NEVER turned negative since then. In recent history, our intermediate model turned positive the week before the presidential election but flipped negative at the end of January and remains in cautionary mode. Likewise, the short-term model turned positive the week prior to the election and turned negative the last week of January; however, it flipped positive around the beginning of March. Obviously, our short and intermediate models are in conflict, which is why Andrew and I have often said that this is a confusing time in the equity markets. In the past, when our models have been conflicted, we have exercised patience, a strategy we are currently embracing. Certainly the large commercial hedgers are somewhat confused, because, with the stock market trading towards new all-time highs, they are “short” (betting on the downside) holding the second largest short position in the equity index futures in history. Meanwhile, there are some pretty weird breadth readings. According to the sagacious Jason Goepfert (SentimenTrader), “Advancing securities on the NYSE accounted for only 43% of all volume, while more than 60% of the issues actually rose. Since 1965, there was only one other day with a divergence like this. With lesser divergences (less than 45% Up Volume but more than 55% Up Issues), stocks struggled over the shorter term, with the S&P rising over the next seven days nine out of 24 times, averaging -0.7%.” The eagle-eyed Jason goes on to note, “One of the major reasons we were expecting volatility to rise in January (which likely meant stocks would also fall) was the fact that options traders were betting on an outsize moved, but it was being masked by what everyone was seeing in the VIX. We've looked at the ratio of the SKEW to VIX indexes for years as a way to get a little more information as to how traders are pricing in volatility expectations. In January, traders were pricing in a relatively high probability of a "black swan", or large, sudden move, in the next 30 days. That was a complete failure. Now it's even more extreme.” (Chart 5 on page 5)

Of course, this concurs with our “internal energy” model, which while not having a full charge of energy, has almost a full charge. This, too, implies a big move is capable of happening in the short run. If that energy is released on the downside, it is a long way down to even a shallow 0.382 retracement of the rally off of the pre-election lows with a target downside target of 2278 for the SPX. The ideal set-up for a pullback would be an early week rally attempt that either fails to exceed 2400 or marginally exceeds 2400, followed by steady stock market price erosion. Plainly, it is not required for the equity market to pull back, but our models suggest it should be difficult for the SPX to make meaningful upside progress from its current position. We guess it could grind away in a churning fashion, allowing the SPX to re-energize, but in our view, that is a low probability “bet.”

As for the sectors, excluding Real Estate, because it was not a sector back in 1990, weightings have changed dramatically since 1990, and even since 1999, as can be seen in Chart 6 on page 5. Of note is that four cyclical sectors currently have weaker breadth readings than the broad S&P 500: Energy, Materials, Industrials, and Consumer Discretionary (a tip of the hat to Bespoke Investment Group). That mix is likely due to the softening economic statistics and has caused some pundits to cry “a recession is coming.” We, however, believe the underlying economy is much stronger than the government’s figures suggest. To examine that “stronger economy” viewpoint, we are having a conference call with our pal Joe Brusuelas, who is the Chief Economist at RSM US LLP (formerly McGladrey LLP).

Sticking with the economy, and parsing President Trump’s proposed budget, shows the winners and losers. The winners: Defense with an increase of $52.3 billion (+10%), Veterans Affairs an increase of $4.4 billion (+5.9%), and Homeland Security with an increase of $2.8 billion (+6.8%). The losers: Health and Human Services (-17.8%), State (-28.7%); Education (-13.5%), Housing and Urban Development (-13.2%), Agriculture (-20.7%); Labor (-20.7%), Transportation (-12.7%), Energy (-5.6%), Commerce (-15.7%), Interior (-11.7%), Justice (-3.8%), Treasury (-4.1%), and the EPA (-31%). Moreover, President Trump’s proposed budget would eliminate: Community Development Block Grants, the Weatherization Assistance Program, the Low Income Home Energy Assistance Program, the National Endowment for the Arts, and the Corporation for Public Broadcasting. And don’t look now, but the House Budget Committee voted 19 to 17 to advance the Republican healthcare bill. Amid the cacophony of last week’s “political noise”, almost unnoticed was this Department of Commerce request: The Department of Commerce is seeking information on the impact of federal permitting requirements on the construction and expansion of domestic manufacturing facilities and on regulations that adversely impact domestic manufacturers.

Ladies and gents, this is HUGE, because fewer regulations will unleash the entrepreneurial spirts of America’s free enterprise system.

The call for this week: The SPX has experienced two “inside days”, meaning Thursday’s intraday high/low was “inside” Wednesday’s intraday high/low, and Friday’s action was “inside” Thursday’s range. According to Investopedia, “An ‘Inside Day’ is a candlestick formation [in the charts] that occurs when the entire daily price range for a given security falls within the price range of the previous day. Inside day often refers to all versions of the harami [chart] pattern and can be very useful for spotting changes in the direction of a trend.” We would also note there is a small upside gap in the SPX chart that occurred in last “Wednesday’s Win” between 2368.55 and 2368.94. Recall that gaps tend to get filled. Interestingly, the SPX’s 20-day moving average has proved to offer buying opportunities and it is now at 2371.64, so watch those two levels. This week’s trading action is key . . .

Being wrong and still making money

March 13, 2017

The brilliant Peter Bernstein (author, historian, and economist) once wrote:

After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winningest forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive! Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.

I was a mere “pup” in this business when my father would tell me, “Son, if you think the market is going up be bullish. If you think it’s going down be bearish, but for gosh sakes make a call. And when you make a ‘call’ you are going to be wrong at times. The trick, however, is to be wrong quickly for a de minimis loss of capital.” Wow, that sounds a lot like Peter Bernstein’s “Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect.”

I came across Bernstein’s cogent comments while culling through reams of material, and reexamining my models and investment method, to see if I would have done anything differently given my too cautious stance over the past four weeks. The answer is “not really” because for the past few weeks there have been some pretty noticeable divergences. As Robertson Thomson & Associates’ eagle-eyed portfolio manager Mick St. Amour notes, “Small caps, transportation stocks, and financials have been good indicators of risk appetite for equities, as well as leadership groups, but now they are lagging” (see charts on pages 2 and 3). So from Andrew’s and my perch, if we have lost anything it has only been “opportunity costs” and not real money. Indeed, better “to lose face and save skin!” I also came across another piece I have written about in the past that divides investors into three categories: Assassins, Hunters, and Rabbits. The article was written by Lee Freeman-Shor and titled “Being Wrong and Still Making Money.” The author asks, “The investment ideas of some of the greatest investors on the planet today are wrong most of the time, and yet they still make a lot of money. How can this be? How can the world's best investors get it wrong and still make millions?" The author continues by noting:

My findings suggest the odds are that an investor's great ideas will lose money. As such, before you invest a cent into an investment idea, it is imperative to have a plan of action as to what you will do if you find yourself in a losing position. When losing, the successful investors I worked with planned to become either Assassins or Hunters. Assassins sold losing investments that fell by a certain percentage or that declined by any amount and showed no signs of recovery after a certain period of time. Hunters invested a lesser amount at the outset and with a plan of buying significantly more shares if the price fell. Hunters were also unafraid to sell if it became clear that they had made a mistake. The bad investors didn't have a plan and consequently turned into Rabbits. When losing money, Rabbits neither bought more shares nor sold their holdings. Once forming an initial perception, Rabbits were achingly slow to change their opinion of a stock. Which tribe will you become a member of?

I don’t know about y’all, but I tend to be a “Hunter.” Case in point; a little over a week ago, when the D-J Industrial Average “popped its top” and leaped some 300 points, that Dow Delight looked a lot like an upside blow-off to me. Therefore, I studied one of my accounts only to find roughly 15 stock positions that really had not performed all that well in the ~13% rally by the S&P 500 (SPX/2372.60) since the presidential election. Subsequently, I sold those positions and said so in these letters. Some took that action to mean that I am out of the market, which is patently untrue. All I did was raise a little cash in one particular account with the strategy of putting that cash back to work in either the pullback my models have been looking for, or in some fresh ideas from last week’s Raymond James 38th Annual Institutional Investors Conference.

While there were many names at our institutional conference, the ones I saw that I wanted to buy and are also rated positively by our fundamental analysts are: Hilton (HLT/$56.48/Outperform); Flexion Therapeutics (FLXN/$20.73/Strong Buy); Nvidia (NVDA/$99.12/Strong Buy); Iridium (IRDM/$8.45/Strong Buy) and its preferred, which I own; and, Texas Capital Bancshares (TCBI/$86.45/Strong Buy). I offer these names for your consideration for future purchases in any pullback in the major market averages. Please see our fundamental research on these names for more insight.

The call for this week: I am in Sun Valley Idaho speaking at an event, and then in Boise, from there I am in Salt Lake City speaking at another conference. My sagacious friend, Mick St. Amour concludes his comments by writing, “Putting it all together, the main and bigger move for equities remains higher given an economy that in general continues to improve and a Fed that remains net accommodative. But in the short term there are some divergences when we look at credit markets, breadth, and perhaps evidence of early rotation out of more cyclical groups into more defensive groups which suggests risk appetite may be waning a bit. The longer this divergence lasts as equities move higher the bigger the correction within the context of our current cyclical and secular bull market. Proceed cautiously for now.”

Not afraid

March 6, 2017

Around the turn of the century a bandit rode in from Mexico, robbed a small Texas bank, and fled back across the border. A Texas Ranger picked up his trail and nabbed him in a Mexican village. The bandit spoke no English and the ranger no Spanish, so another villager was asked to interpret.

“Ask him his name,” said the ranger.

“He says his name is Jose,” said the interpreter.

“Ask him if he admits robbing the bank.”

“Yes, he admits it.”

“Ask him where he hid the money.”

“He won’t tell me.”

Leveling his pistol at Jose’s head the ranger said, “Now ask him again where he hid the money.”

Jose quickly blurted out in Spanish, “The money is hidden in the well in the village square.”

“What did he say?” demanded the ranger.

The interpreter replied, “Jose says he’s not afraid to die!”

The translation and interpretation of the news can play a crucial role on Wall Street. This is especially true when it comes to public perception. Importantly, the financial media plays a dominant role when it comes to shaping the investing public’s perception; and, for the most part their modus operandi is clear. For instance, everyone has heard the classic – is the glass half full or half empty? Well, much of the time when it comes to media translation and interpretation of the news it’s often “half empty” because bad news sells more newspapers and gets more radio/TV time, while good news doesn’t. It’s reminiscent of the famous newspaper mantra, “If it bleeds it leads!” So let’s reflect back on the “glass is half empty” news about the President since the election. Indeed, according to CBS News, “Majority of Americans think the press has been too critical of President Trump,” according to a new poll. In fact, only 3% of NBC and CBS reports depicted President Trump positively. Moreover, a lot of the negative press has had to have been leaked by the Deep State and the intelligence community. However, that could be coming to an end since last week one of my contacts on “The Hill” hinted that the FBI has the names of the “leakers.”

Over the weekend there was another allegation by the President in that he tweeted the previous administration had “tapped” his phones at Trump Tower. I too have heard that rumor over the past few weeks, but I am challenged to believe it. As for the “Russian Connection,” last week House Intel Committee Chair Devin Nunes (R-CA) said, “We have not seen any evidence” of contacts between the Trump campaign and Russia. Whether true or not the stock market does not seem to care as the D-J Industrial Average (INDU/21005.71) gained another nearly 184 points. Similarly, the S&P 500 (SPX/2383.12) was lifted by 0.67%. Those results caused many pundits to trumpet that as we approach the eighth birthday of the bull market on March 9, 2017, we are moving in on the second longest bull market in history. Of course readers of these reports know that is patently untrue because said pundits are using the wrong measuring stick. They tend to cut the 1982 to 2000 secular bull market off in 1987 and the 1949 to 1966 secular bull market off in 1956. Yet as anyone can see (chart 1 on page 3) those end-points did NOT end the secular bull market. Then there is the Shiller Cyclically-Adjusted PE (CAPE) that the “bears” always point to. Last week it crossed above 30x for only the third time. The first time was in 1929 and led to a crash and the Depression. The second time was in 1997, however, and the market ran another 80%+. In past missives I have stated why I believe the CAPE is a flawed indicator, but suffice it to say the CAPE would have kept you out of the market for the past seven years. I don’t have much use for an indicator that would have kept me out of a rally by the SPX from 1000 to 2400!

While the bears focused on the CAPE, the real event of last week was President Trump’s address. As CBS News noted, “It was a very different speech for President Trump. He repeatedly reached across the aisle to the Democrats.” CNN’s Van Jones even went one better when he said, “He became President of the United States in that moment, period!” Obviously the stock market liked the address as the senior index tacked on some 300 points. In fact, stocks actually ignored the hawkish Federal Reserve comments and the heightened probability of a rate hike in March. That further reinforces our observation that DJT is driving the equity markets and not the Fed, which is a distinct change from the past 10 years.

Other “sound bites” from last week include: 1) China’s factory activity expanded faster than expected; 2) China’s Congress is kicking off. Remember, China’s Congress elects the Central Committee, who elects the Politburo that elects the all-important Standing Committee; 3) Chinese wages are now higher than Brazil, Argentina, and Mexico; 4) Real Personal Income in the U.S. declined by the most since 2009 (-0.3% m/m); 5) Our president called for a “merit-based” immigration system; 6) the EU escalated the “visa wars” with Americans set to lose visa-free travel to Europe; 7) IRS, FDIC, and Commerce Department agents are involved in the Caterpillar investigation; 8) Construction Spending declined 1.0% in January; 9) 1Q17 GDP estimates were cut; 10) Macron is on course to beat Le Pen in the French presidential election; 11) U.S. pending home sales in January tumbled 2.8% to a 12-month low; 12) Wendy’s to install ordering kiosks in 1,000 stores this year in a brewing minimum wage disaster; 13) Russian diplomats keep dying unexpectedly. I guess I will stop at a “baker’s dozen.”

The call for this week: Andrew and I are at the 38th Annual Raymond James Institutional Investors Conference in Orlando, where there will be some 1,000 portfolio managers and approximately 300 presenting companies. We will be seeing companies’ CEOs, CFOs, COOs, etc. Interestingly, such corporate insiders sold $7.8 billion of their companies’ stock in February, which was the most in roughly six years. What do they know that we don’t know? Maybe they know that the Daily Sentiment Survey of Futures Traders shows a 92% Bulls reading. In the three times the reading has been that high since 2011 it has led to declines of 7% (2/11), 8% (5/13), and 3% (11/13). Also of note is that late last week the number of stocks making new 52-week highs on the NYSE collapsed by some 80%. Then there are the bullish sentiment figures that are at danger levels (chart 2 on page 3). All of this continues to leave us in a cautionary stance despite the fact that stance has been wrong for three weeks. An important point to watch, however, is the upside gap in the charts created by last Wednesday’s “Moon Shot.” Usually such gaps are filled within three sessions, which would be today. That single-point number to watch is 2363.64 on the SPX. That “gap” was not filled on Friday. This morning the SPX preopening futures are off 7 points at 5:00 a.m. as North Korea launches four missiles, one of which is capable of reaching the U.S., and DJT’s escalating war on the Deep State, the intelligence community, and now BHO. We think the equity markets are at an inflection point. The next few sessions should tell if this is the case.

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