Investment Strategy by Jeffrey Saut

Episodic volatility
February 8, 2016

“The year ahead will be one of ‘episodic volatility’ – rather than wildly veering highs and lows – an environment that will create opportunities for astute investors.”

. . . Simon Ho, Triple 3 Partners

As many of you know, I was in New York City last week seeing institutional accounts and speaking at the IMCA conference (Investment Management Consultants Association). During the panel discussion between myself, Mary Ann Bartels (Merrill Lynch), and John Mackay (Morgan Stanley), I first heard the phrase “episodic volatility,” as used by Mary Ann. It was a catchy quip and is defined by Simon Ho as, “The past month is a portent of what is to come on the markets this year – bouts of volatility. It will not be calamitous as it was in 2008. It hasn’t been like that and it won’t be like that. Instead we will see small market movements of a few percent frequently, rather than any large GFC – like [big] one day falls (GFC = Global Financial Crisis).” When I Googled said phrase, the quote from Simon Ho popped up, so I don’t know if Mary Ann coined it, or someone else, but whoever did certainly captures what has been happening year-to-date! As my pal Doug Kass says, “The market has no memory from day to day,” as can be seen in the chart of the D-J Industrial Average (INDU/16204.97) so far this year. In studying the attendant chart the validity of Dougie’s statement becomes imminently apparent. Despite Mr. Market’s sociopathic attitude, the action year-to-date has leaned mainly to the downside as we surmised the first week of January and described it as a “selling stampede.” However, over the course of the stampede there have been a number of “thin reeds” we have tried to weave into an “investment basket” to determine when the stampede will subside. So let’s review.

After our fall off of the horse “rip your face off” Santa rally “call,” we got back on “the horse” and on January 6, 2016, when the major averages fell below their respective December closing lows, we surmised the S&P 500 (SPX/1880.05) was involved in a “selling stampede,” which typically lasts 17 – 25 sessions. During the current skein, the news backdrop has been brutal. To wit:

1) The Royal Bank of Scotland says to “sell everything,” which even if right is irresponsible.
2) JP Morgan is somewhat more responsible in saying “sell rallies.”
3) China devalues its currency as the economy slows.
4) North Korea sets off a hydrogen bomb.
5) Saudi Aribia executes 47 Shia enraging Iran.
6) Yemen launches numerous scud missiles at Saudi oil fields.
7) Oil crashes to $26 per barrel (oilmaggedden) and the list goes on.

More recently there have been numerous “thin reeds” suggestive of a bottoming process:

1) The highest odd lot short sales since March 2009 (small investors are bearish).
2) The most Google searches for the term “bear market” since March 2009.
3) There were no IPOs (initial public offerings) in the month of January.
4) The majority of stocks are down 20% or more from their 52-week highs.
5) Bearish sentiment is about as bleak as we have ever seen.
6) According to SentimenTrader, “Active investment managers are not only under-exposed to stocks, they're confident about it. This week, the average manager was only 22% exposed to stocks (see chart 2).”
7) According to the esteemed Dorsey Wright organization, “Looking back over the last 20 years, we can easily identify four previous time frames in which the BPNYSE has fallen in to the green zone (read: bullish), below the 30% level (chart 3).

So where does all of this leave us? Well barring a “black swan” event, we should be nearing, or already at, the end of the “selling stampede.” Last week I was thinking the stampede ended on Thursday (1-28-16) at session 21. Last week, however, that view was called into question as the major indices still have not been able to string together three or more consecutive positive sessions, which is what is required to break the back of a stampede. It is also important not to commit capital until that sequence occurs. Regrettably, many have tried to catch the “falling knife” over the past five weeks only to have their fingers cut off. As for not doing “something stupid,” which is the phrase one of our financial advisors said to me last week; ladies and gentlemen, sometimes doing “something stupid” is the preferred strategy when you are trying to manage the risk in a portfolio. Take Tableau Software (DATA/$41.33) last week. It may have felt “stupid” selling it when it fell below its September 2015 lows of about $76 a week ago, but it doesn’t look “stupid” now with the shares changing hands at $41. Indeed, as Benjamin Graham wrote, “The essence of portfolio management is the management of RISKS, not the management of RETURNS.”

So what do we do here? Well for those of you that managed the risk and have some cash, I think we are close enough to a low to begin buying some select mutual funds. In my recent travels I met with a number of portfolio managers, but two of them really stood out for me. First was my friend Steve Vannelli who manages the GaveKal Knowledge Leaders Fund (GAVAX/$13.11), which I own and have written about numerous times. Second is Dan Roarty, portfolio manager (PM) of the AB Global Thematic Growth Fund (ATEYX/$79.47), which I am considering buying. I have met with Dan a few times and have become comfortable with his investment style. He took over the management of the fund a few years ago after an abysmal record by the previous PM. His fund is thematically centric, which obviously is a huge focus of mine. Themes discussed included: 1) Technological Innovation, 2) Demographic Change, 3) Sustainable Development, and 4) Emerging Market Evolution. Of particular interest, Dan showed me a chart and explained that in this turbulent market, participants are “paying up” for safety making allegedly “safe stocks” extraordinarily expensive. Plainly, I agree.

The call for this week: Last week a couple of new boogiemen arrived on the scene when Deutsche Bank shares (DB/$16.89) fell below their 2008 lows, fostering fears of a banking implosion; and Venezuela, as the Financial Times wrote, “It Could Be Too Late to Avoid Catastrophe in Venezuela.” Whatever the reason, something still feels “out of balance in the universe,” a phrase we have been repeating for many weeks. That said, we have now had one 90% Downside Day (2-2-16) and two 90% Upside Days (January 26 and 29 when 90% of total volume traded came in on the upside) reinforcing our belief that the selling stampede ended at session 21 on 1-28-16 with a “print low” for the SPX at about 1872. That intraday low has been tested twice since then. First on February 3rd and again last Friday. So far the 1872 level has contained the declines. If that level “falls,” however, it would suggest a full downside retest of the January lows between 1810 and 1820. Also if that happens, it would extend the “selling stampede,” making today session 28. As often stated, “A few stampedes have lasted 25 – 30 sessions, but it is very rare to see one go for more than 30 days.” And this morning the stampede continues, despite the Broncos’ win, as crude oil slides (-2.5%), North Korea launches ICBMs, China’s FX reserves fall to 2012 levels, Russian firepower helps Syrian forces edge toward Turkey boarder, and the U.K. considers leaving the EU; What a Wonderful World ( And that’s the way it is at session 28 in what is turning into a very long “selling stampede!” It is also why sometimes you do need to do something stupid to manage the risk and to NEVER try and catch a falling knife. We need three or more consecutive positive sessions before the “all clear” bell is sounded . . .

Rich man, poor man
February 1, 2016

Given the unmerciful “selling stampede” ushered in with the new year, I thought it would be appropriate to republish one of my strategy reports from a few years ago, because its advice is timeless. Indeed, after 45 years in this business, I have seen a number of cycles and developed a long-term perspective, much like Richard Russell wrote about in “Rich Man, Poor Man.” I like this story:

“In the investment world, wealthy investors have one major advantage over the little guy, the stock market amateur and the neophyte speculator. The advantage wealthy investors possess is they DON’T NEED THE MARKETS. I can’t begin to tell you what a huge difference that makes, both in one’s mental attitude and in the actual handling of one’s account. The wealthy investor doesn’t need the market, because he already has all the income he needs. He has money coming in via bonds, T-bills, money market funds, real estate, and stocks. In other words, the wealthy investor never feels pressured to ‘make money’ in the market.

The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry is on the ‘giveaway table,’ he buys them. In other words, the wealthy investor puts his money where the values are. And if there are no outstanding values, the wealthy investor waits. He can afford to wait. He has money coming in daily, weekly, monthly. In other words, he doesn’t need the market. He knows what he is looking for, and he doesn’t mind waiting weeks, months or years (they call it patience).

What about the little guy? This fellow always feels pressured to ‘make money,’ to ‘force the market to do something for him.’ When this fellow isn’t buying stocks at 3% yields, he’s off to Vegas or Atlantic City trying to win at craps or he’s spending ten bucks a week on lottery tickets or he’s ‘investing’ in some crackpot real estate scheme with an outfit that his bowling buddy told him about. And because the little guy is forcing the market to do something for him, he’s a consistent and constant loser. The little guy doesn’t understand values, so he always overpays. He loves to gamble, so he always has the odds against him. He doesn’t understand compounding and he doesn’t understand money. He’s the typical American, and he’s perpetually in debt.

The little guy is in hock, and he’s always sweating, sweating to make payments on his house, his refrigerator, his car or his lawnmower. He’s impatient, and he constantly feels pressured. He tells himself he has to make money fast. And he dreams of ‘big bucks’. In the end, the little guy wastes his money on the market, he loses his money on gambling, and he dribbles it away on senseless schemes. In brief, this ‘money-nerd’ spends his life running up the down-escalator. Now here’s the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than his income, if he had taken that extra income and compounded it in safe, income-producing securities – in due time he’d have money coming in daily, weekly, and monthly – just like the rich guy. Then in due time, he’d start acting and thinking like the rich guy. In short, the little guy would become a financial winner instead of a loser.”

I lost my friend Richard Russell late last year in a reoccurring nightmare where I continue to lose my mentors as they either pass away or retire. After more than 50 years of writing “Dow Theory Letters,” Richard Russell said the most popular piece he’s ever published is his “Rich Man, Poor Man” essay. In this day and age of constant advertisements, infomercials, junk mail, harassing cold calls haranguing all about how to make a killing in the stock market, real estate, commodities, etc. etc., etc., it’s refreshing to read some advice from an honest old pro that makes sense. Moreover, most stock-centric magazines you see tell you what mutual fund you should buy, how to invest to retire, how you can make it big in whatever. I would bet that those writers, advisors, and testimonial seers who concoct those pieces make more money selling their “pitch” than following their own advice. Putting that pitch on paper or through the TV, radio, or phone is a lot easier than actually putting up their own money. I know many stock brokers, advisors, writers, etc. who never invest themselves. Yet they make their money telling others how to do it. A case in point is a story in a widely read financial magazine. It chronicles a now successful promoter who, earlier, tried the get-rich-quick schemes, which didn’t work for him. So that led him to “why not trade commodities and get rich,” which again did not work for him, and then, later, “why not write a book about how to trade commodities and get rich.” To make a long story short, he made mucho moola selling the book and NOT investing his own money!

STOP HERE NOW and go back and read RICH MAN, POOR MAN again!

In the world we live in, few look at risk. Most only look at reward. The few who do look at risk (the educated, the street savvy, etc.) make their money at the expense of the great unwashed majority who swallow the noise nonsense about getting rich quick. Investing is a get rich slowly process. You have to put your money at risk in the face of uncertainty. Emotions run rampant before the uncertainty of floating, fluctuating, often violent and volatile markets. Constantly discounting prices are fickle and full of surprises. Disorder is usually the norm. Importantly, remember when you do invest and put your money at risk, you are using “after-tax” dollars. The federal, state, and local governments, along with sales tax, are confiscating more and more. While the POOR MAN pays fewer taxes, the RICH MAN pays much more when you take into account the top bracket rate including the surtax, the Medicare payroll tax, the work-sheet phasing out of deductions, and exemptions, etc. Therefore, when you consider straying away from a compounding type of investment, make sure you understand risk and that you get value and a margin-of-safety price concession. Maybe John Burr Williams, a pioneer in the concepts of modern portfolio theory, said it best, “The value of any stock, bond or business is determined by the cash inflows and outflows, discounted at an appropriate interest rate, which can be expected to occur during the remaining life of the asset.” Oh, and by the way, if you doubt the magic of compounding, consider this little ditty from Andrew Tobias:

“There was the king who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels, or enough, if each kernel is a quarter-inch long (which may not be; I’ve never seen wheat in its pre-English-muffin form), to stretch to the sun and back 391,320 times.”

That was nothing more than one kernel compounding at a 100 percent square for 64 squares. Accordingly, remember the old adage, “He who understands interest – earns it, he who does not understand interest – pays it.”

The call for this week: So far this year, the “rich man” has not needed the stock market. That may have changed last week. Last Thursday, I said, “I think the equity markets are bottoming at session 21 in the typical 17-25 day ‘selling stampede’ sequence.” In Friday’s missive, I wrote, “I think the ‘selling stampede’ pretty much ended at session 21 with yesterday’s (last Thursday) whippy action between plus and minus, which is typically how bottoms are made.” About a week ago, I noted that, if we do bottom in the 17-25 session timeframe, the S&P 500’s (SPX/1940.24) first upside target zone would be 1940-1950. Well here we are, which makes this week critical. If we can get through 1940-1950, the odds that we have made a sustainable bottom increase notably. If we don’t, it would mean another downside retest. I will say that there is a FULL change of “internal energy” available for a pretty decent move from here. Stay tuned . . .

Saved by the bell
January 25, 2016

“Saved by the Bell” except in this case we are not referring to the late-1980s TV sitcom that focused on a group of high school teens and their principal, but last Wednesday’s closing bell on the floor of the New York Stock Exchange (NYSE). The day began well enough with the preopening S&P futures only off about 9 points when I slid into my trading turret around 5:30 a.m. From there, however, things got pretty ugly as the D-J Industrial Average (INDU/16093.51) went into a minicrash that would see the senior index shed some 567 points and in the process break below its August 25, 2015 closing low of 15666.44. Of course my phone, and email box, lit up with the ubiquitous question, “Hey Jeff, you chose to ignore the Dow Theory ‘sell signal’ of last August unless both the Industrials and the D-J Transports (TRAN/6778.54) broke below those lows. Well the Transports broke their August low last December and today the Industrials are doing the same. Do we raise more cash here?” The question was so prolific that I ended up cutting and pasting this response, “Intraday ‘price prints’ do not count in Dow Theory. It’s only the closing price that counts. Yet, if the Dow closes below 15666.44 I will have to go through my portfolio and look at the weakest stocks that have broken below major support levels and at least sell half of the position.” Fortunately, in Wednesday afternoon’s trading we got a stock market lift, leaving the Industrials at 15766.74, so I didn’t have to execute on that strategy. The next day, however, I got pounded again.

Thursday’s questions were driven by an article from The The title read, “A ‘Dow Theory Sell Signal Suggests the ‘Year of the Bear’ Will Continue,” and was actually written by a very bright strategist I know, as he wrote:

This economically sensitive Dow Industrials closed at 15,766.74, below the prior closing low of 15,871.35 set on Aug. 24, considered Black Monday in China. [The] Dow Transports already closed below its Aug. 24 close of 7,595.08 back on Dec. 11 with a close of 7,524.64. This set up [is] a potential "Dow Theory Sell Signal" when the Dow Industrials followed (see the article here: (Suttmeier).

While he has the right closing prices for August 24, 2015, he has the wrong date for the closing lows of both indices. As often stated in these missives, the low closing prices for both the Industrials and the Trannies occurred on August 25, 2015, not on the 24th. To be sure on August 25th the Industrials closed at 15666.44 and the Transports at 7466.97. Hence, while the Trannies fell below their August low on December 18, 2015, the Industrials have yet to close below their respective August low.

On that same day I was also pounded with emails wanting to know where I saw that Goldman Sachs was telling clients to “buy” crude oil and did I think oil had bottomed? Hereto, I cut and pasted this response, “I have wrongly attempted to ‘call’ the bottom on oil three times last year and been wrong every time, so I am deferring to my energy analysts that say their model is more bullish than at any time in the past four years. They are looking for higher oil prices in the back half of this year.” As for Goldman’s bullish oil call, you can see that here (Oxford World Financial Digest); and, so far Goldman has been right as the March crude oil futures contract has rallied some 23% from last Wednesday’s intraday low into Friday’s intraday high. Of course such a rally in crude has produced rallies in the energy stocks (the average energy stock is up 22% from last Wednesday’s lows). Of particular interest to us is the recent rally in the mid/downstream master limited partnerships (MLPs). For the past few weeks we have suggested that investors have been able to buy an investment grade portfolio of such MLPs with an aggregate yield of over 7%, some of which is tax deferred because it is classified as return of capital. As always, names and fundamentals should be vetted before purchase.

So what happened late last week that gave us the first back-to-back “two step” (Thursday/Friday) in months that added some 327 points to the Dow? As I stated a couple of times on TV last week, I think the “fuel” was the surprisingly large $60 billion liquidity injection by the People’s Bank of China (PBOC) and the “match” was Draghi’s latest iteration of “whatever it takes.” Other metrics setting the stage for a rally were: 1) last Wednesday saw the highest odd-lot short selling by individuals ever (contrary indicator); 2) Google Trends showed searches for the term “bear market” at its highest level since March 2009; 3) stocks above their 50-day moving averages was below 10% (oversold); 4) the NYSE McClellan Oscillator was about as oversold as it ever gets; 5) more than 40% of the stocks traded on the NYSE traded to new 52-week lows on Wednesday (historic); 6) investors pulled $25.6 billion from U.S. stock mutual funds over the past three weeks, and the list goes on. As well, last Wednesday was session 15 in the envisioned “selling stampede” that tends to last 17 – 25 sessions before exhausting itself, which was close enough for government work. Still, so far we have only experienced a two-session “throwback rally.” As stated, such stampedes are only interrupted by one- to three-session pauses/rally attempts, making today extremely important, yet it certainly feels like this rally could last for a while with the SPX’s first target 1940 – 1950.

The call for this week: My friend Arthur Cashin has said, “When the fear of losing money overcomes the fear of looking stupid . . . that’s a bottom!” Last week that is exactly how many folks felt on the Street of Dreams. We’ll see if that mood prevails this week, allowing stocks to trade higher. A step in that direction would be for the major averages to rally for more than just three sessions. As for last weekend’s snow storm, which is being trumpeted as the worst storm for NYC ever, I drudged up the first paragraph from my report titled “The Great White Hurricane.” To wit:

“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 400 people would die before the storm was over. The resulting transportation crisis led to the construction of New York’s subway system.

P.S. – By far the best prose I read last week was written by Howard Marks of Oaktree Capital (Oaktree):

Especially during downdrafts, many investors impute intelligence to the market and look to it to tell them what’s going on and what to do about it. This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. . . . You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. It would be wrong to interpret the recent worldwide drop as meaning the market “knows” tough times lay ahead. . . . It’s important to understand for this purpose that there really isn’t such a thing as “the market.” There’s just a bunch of people who participate in a market. The market isn’t more than the sum of the participants, and it doesn’t “know” any more than their collective knowledge.

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