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Investment Strategy

Investment Strategy by Jeffrey Saut

Wait until you get a pitch right where you want it!
April 25, 2016

One of the most successful investors in history received the only A+ from Professor Benjamin Graham (of Graham and Dodd “Security Analysis” fame) at Columbia: the chairman and chief executive officer at Berkshire Hathaway, Inc., which traded as low as $38 per share in the early 1970s and now trades around $219,000 per share. If you haven’t guessed who by now, it’s Warren Buffett. How does he do it? Well, the following are excerpts from financial media interviews back in the late 1980s:

“The most important quality for an investor is temperament, not intellect. You don’t need tons of IQ in this business. You don’t have to be able to play three dimensional chess or duplicate bridge. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd. You know you’re right, not because of the position of others, but because your facts and your reasoning are right. . . . Most investors do not really think of themselves as owning a piece of the business. The real test of whether you are investing from a value standpoint or not is whether you care if the stock market opens tomorrow. If you’ve made a good investment, it shouldn’t bother you if they close down the stock market for five years. You own a piece of business at the right price and that’s what’s working for you. . . . In 30 years of investing I have never bought a technology company. I don’t have to make money in every game. There all kinds of things I don’t know about—like cocoa beans. But, so what! I don’t have to know about everything. The securities business is the perfect business. Every day you literally have thousands of the major American corporations offered you at a price, and a price that changes daily, and nothing is forced upon you. There are no called strikes in the business. The pitcher just stands there and throws balls at you and you can let as many go by as you want without a penalty. In real baseball, if the ball is between the knees and the shoulders, you either swing or you get a strike called on you. If you get three strikes, you’re called out. In the securities business, you stand there and they throw U.S. Steel at $28 and General Motors at $80, and you don’t have to swing at any of them. They may be wonderful pitches, but if you don’t know enough, you don’t have to swing. And you can stand there and watch thousands of pitches, and finally you get one right there where you want it, something that you understand and is priced right – and then you swing . . .”

On many occasions I have said, “The rarest thing on Wall Street is patience!” That quote is akin to Buffett’s quote, “If you don’t know enough, you don’t have to swing.” For most of last year, we didn’t “swing.” Then, in late August, our model told us to “swing” and we did. That was the week of the August 24, 2015 “lows” around 1800 on the S&P 500 (SPX/2091.58). The next time we “swung” was on December 11, 2015 when our model called for a “rip your face off” rally. About a week and a half later, we had to admit that was a bad “call.” In this business, when you are wrong, you admit it quickly for a de minimis loss of capital. So we came into 2016 with a defensive stance. But on Friday, February 5, CNBC’s Becky Quick asked me what the model was “saying” now. I responded, “It is saying we bottom next week” and we are tilting accounts according. It was during that week (February 11 to be exact) the SPX retested its August 2015 “lows” and the rest, as they say, is history. So where does this leave us now?

Well, the consensus “call” is that we are either making a “top” followed by a big decline or we are at the top of the trading range that has been intact since October 2014 (~1800 - ~2130) and now the SPX is headed back down. That view is reflected in this excerpt from our friends at the Boston-based Fidelity organization: “While this rally may continue to play out, the stock market may not break out of its year-long trading range until earnings growth stabilizes and the policy divergence between the Fed and other central banks ends.”

We are not of that view. Our work suggests the SPX will break out to the upside of the over-one-year trading range. As stated in prior missives, “To me, this feels very much like 2013 where the markets ground down every short seller into the May timeframe before a near-term top arrived. If that pattern plays here, it would fit nicely with my internal energy indicator, whose energy would be totally used up by mid-May. It still feels like new highs to me.”

And maybe, just maybe, the S&P Total Return Index is pointing the way higher as it traded to new all-time highs while the D-J industrials notched new reaction highs (INDU/18003.75). Now, if the D-J Transports (TRAN/8085.98) can better its November 2015 closing high of 8301.80, we will have a Dow Theory “buy signal.” If not, it will be an upside non-confirmation and likely lead to a pullback in stocks. If the Trannies are going to make a new reaction high, it will have to come quickly, because as stated, by mid-May, the equity market’s internal energy should be totally used up.

As for earnings season, while it is still a small sample of the S&P 500 companies that have reported 1Q16 earnings, 78.3% have beaten their lowered estimates (as of last Thursday). That is the best showing since 3Q09 and much better than the past few quarters. There have been some high-profile company “misses,” but the operative word (at least so far) for this earnings season is “beat.” Perhaps the better-than-expected earnings season is telegraphing stronger GDP numbers in the months ahead, although last week’s economic reports were on the softer side. This week, we get a slew of economic reports (Durable Goods, GDP, Core PCE, etc.) as well as the FOMC meeting. As I have repeatedly stated, IMO, if the Fed doesn’t raise rates this week, I doubt if they raise rates until after the election. However, the bond markets seem to think something’s afoot as the Roll-Adjusted Ultra Long Bond Future has broken down in the charts suggesting higher interest rates (chart 1). And, that could be what caused the Bloomberg US Dollar Index to try and reverse it downtrend (chart 2). Or maybe the interest rate complex is anticipating stronger GDP growth in China where energy and electricity consumption is strengthening and things like the Shanghai Steel Rebar Futures are surging (chart 3). It is also worth noting that, last week, Schlumberger said the crude oil surplus would be gone by year’s end and Caterpillar sees its business bottoming globally.

The call for this week: Well, today is actually session 50 (I miscounted when I said last Friday was session 48, because I failed to account for one of the holidays) in the second-longest “buying Stampede” I have ever seen. As SentimenTrader’s cerebral Jason Goepfert writes, “The S&P 500 has gone 10 weeks since trading below a prior week's low. This is the longest such streak since 2011 and among the most impressive since 1928.” That skein has left most of the macro sectors overbought. We are also within a week of the month of May where the market’s internal energy wanes. We have been steadfastly bullish since our model telegraphed the SPX would bottom the week of February 8; however, while we do expect an upside breakout by the SPX to new all-time highs, we are not real excited about adding to the many stocks featured in these reports since those February lows. In fact, according to one particularly brainy colleague, “Everything is expensive except emerging markets.” This morning, futures are flat as participants await the Fed meeting.

Shad Rowe
April 18, 2016

For years, when I was living in Virginia, I attended the annual Shad Planking. As described by Wikipedia (paraphrased):

The Shad Planking is an annual political event in Virginia, which takes place every April near Wakefield, Virginia. It is sponsored by a chapter of the Ruritans, a community service organization. Ostensibly the event is to celebrate the running of shad where the oily, bony fish are smoked for the occasion, nailed to wood planks, and then stuck in the ground around an open flame wood fire. The event began after WW II, and was long a function of the state's Conservative Democrats, whose political machine dominated Virginia politics for about 80 years (from the late 19th century until the 1960s). However both Virginia, and the Shad Planking, had evolved into a more bipartisan environment by the 1980s. In modern times, would-be candidates, reporters, campaign workers, and locals gather to eat shad, drink beer, smoke tobacco, and kick off the state's electoral season with lighthearted speeches by the politicians in attendance.

This morning, however, I am not referring to Virginia’s “Shad Planking,” but rather my friend Frederick “Shad” Rowe, captain of the Dallas-based money management firm Greenbrier Partners. Back in the 1970s/1980s I used to read Shad’s sage comments in Forbes Magazine, but regrettably he is no longer a contributor. He now writes an insightful letter to investors in his partnership every month, which I very much look forward to. This month’s letter was no exception. To wit:

Investing has always been a game of alternatives. What do we do with our money? Cash is not a reasonable answer because it is depreciating all the time. Bonds are not the answer either – with a 1.8% yield, a 10-year U.S. government bond trades at roughly the equivalent of a stock selling at more than 80x after-tax earnings. In comparison, the S&P 500 trades at approximately 18x expected earnings with a current dividend yield of 2.2%. It is worth noting that the bond’s interest payments are fixed, while S&P 500 earnings and dividends are likely to increase over time. The nature of real estate has changed – a new world is unfolding with people shopping online and working from home – and you still have limited liquidity. Sometimes the obvious answer is also the correct answer. The stock market is the obvious answer. It has generated superior returns over time. But the volatility scares most investors. Ultimately we believe that a broad spectrum of investors will reach the same conclusion that we reached long ago. After seven years of generally rising stock prices, we still have not seen the broad, enthusiastic participation that generally indicates market tops. For investors of most stripes, the stock market remains the only viable game in town – a game which many natural participants may have forgotten, but we trust will remember soon enough. And while stocks may not be cheap relative to where they trade at stock market bottoms, they remain very cheap relative to the other outlets for our hard-earned cash.

Obviously I agree with Shad and if S&P’s earnings estimates are close to the mark the S&P 500 (SPX/2080.73) is in fact trading at 17.6x this year’s estimate of ~$118. Yet if next year’s estimate of ~$136 is correct, the SPX is trading at 15.3x earnings. So as Shad eloquently points out, “while stocks may not be cheap relative to where they trade at stock market bottoms, they remain very cheap relative to the other outlets for our hard-earned cash.” Speaking to “cheap” stocks, last week the Financial sector soared with a weekly gain of 3.95%, and why not, for it is truly the cheapest sector out there. Indeed, the Financials trade at an earnings yield of 9.89% (earnings/price), possess an enterprise value to earnings before interest and taxes (EBIT) of 10.28, with an aggregate P/E multiple of 10.11x (see chart 1 on page 3). While most folks want to talk about the major banks, some of the names mentioned to me by various portfolio managers in NYC recently were more obscure. EverBank Financial (EVER/$15.19/Outperform) was one, as it provides a diverse range of financial products and services directly to clients nationwide through multiple business channels. A quick trip to EverBank’s website shows some of their unusual products, like CDs denominated in foreign currencies. The shares trade near book value, at roughly 10x our fundamental analyst’s earnings estimate for 2016, and with a 1.6% dividend yield. Other financial names mentioned, and with favorable ratings from our fundamental analysts, include: Pacific Premier Bancorp (PPBI/$20.85/Strong Buy); Q2 Holdings (QTWO/
$23.74/Outperform); BOFI Holdings (BOFI/$17.25/Strong Buy), which has sold off recently on a negative story from a salacious source; and Carolina Financial (CARO/$18.23/Outperform).

So the Financial sector “painted the tape” higher last week, potentially resolving the question I have heard from the negative nabobs for over a month, that being, “The overall stock market can’t rally without the financials rallying.” To be sure the consensus “call” has been for either a big decline for stocks, or the ubiquitous “call” for a continuation of a trading range. Ladies and gentlemen, I can make a cogent argument that the SPX has been trapped in a trading range since April 2014 between 1800 and 2130 (see chart 2). That’s over two years, which is about as long as a consolidation period lasts within a secular bull market. And yes Virginia, I still believe we are in a secular bull market that has years left to run!

Our model “called” the low of February 11, 2016 and at the time we featured numerous stocks for your consideration in these reports. Since then, the SPX has gained ~15%, which has left the SPX testing its downtrend line in the charts that began last May (chart 3 on page 4). Of interest is that the economically sensitive D-J Transportation Average (TRAN/7978.23) has rallied a large ~20% from its January 20, 2016 low and may be pointing the way higher for the overall stock market. The Trannies’ rally is impressive given crude oil’s ~55% rally from its mid-February low. That “crude climb” has lifted the S&P 500 Energy Index ~22% (chart 4) with many of our energy stocks rallying significantly more than that. Ladies and gentlemen, such actions are not typical of what precedes a recession. Meanwhile, the cumulative Advance/Decline has broken out to new highs (chart 5 on page 5). As for the economic data, most of it has been on the softer side recently, implying interest rates should remain low. The exception to the economic malaise was last week’s Empire Manufacturing Report, which showed its third straight month of improvement (chart 6). China also showed renewed economic strength with iron ore and crude oil imports at all-time highs (chart 7 on page 6). Meanwhile, the dearth of bullish sentiment suggests a bottom for stocks is at hand (chart 8) and our proprietary measurement of the equity market’s internal energy has rebuilt to nearly a full charge, suggesting an upside breakout to new highs is likely in the cards. As for the alleged horrible earnings season, while it is a small sample, of the 49 companies in the S&P 500 that have reported 34 (69%) have exceeded estimates, eight have matched estimates, and seven have missed. Obviously, we will have a better sample by this Friday.

The call for this week: Today participants in the Boston Marathon will race for the finish line. Hopefully, the S&P 500 will race for its respective all-time high “finish line” of 2130.82 as well. The setup is certainly right given the aforementioned metrics and the historical precedent that stocks tend to do pretty well with the SPX gaining ground over 70% of the time the week, and month, following “tax day.” And as SentimenTrader’s perspicacious Jason Goepfert writes:

Stocks enjoyed a rare kind of breakout this week. As volatility compressed over the past month, the S&P 500's Bollinger Bands started squeezing together, and this week the index broke out above its upper Band. That was the first time in nearly 400 days it was able to do so, the 2nd-longest streak in its history. Generally, stocks did well after triggering a breakout like this after having gone a long time without one. The small-cap Russell 2000 is nearly above its 200-day average. The last of the four major stock indexes to climb above its long-term average, when the Russell ended a streak of at least six months below its average, it tended to continue to rally going forward. A new high in the Advance/Decline Line tends to lead to gains. In response to some questions regarding Thursday's Report on the A/D Line, when it moves to a multi-year high, the S&P 500's maximum loss at its worst point over the next year has averaged -3.9%.

Indeed, as we have been saying, “Buy the dips!” And this morning you are going to get another opportunity to buy the dips as there was no oil production cut at the Doha meeting, leaving oil down 4%, the preopening S&P futures off 6 points, and an earthquake in Japan has investors shaken, not stirred.

Never on a Friday
April 11, 2016

“Never on a Friday” is one of the mantras that has served me well over the years. Long time readers of these letters know its meaning. To wit, when the equity markets are involved in a pullback attempt they rarely bottom on a Friday. Nope, they tend to give participants time over the weekend to brood about their losses, tell their wives they can no longer buy the new Mercedes Benz (which makes for a pretty tense weekend), and consequently return to The Street of Dreams on Monday/Tuesday in “sell mode.” That sequence typically leads to the phrase “Turning Tuesday” implying the market bottoms either late in Monday’s trading session, or early the next day. In last Friday’s Morning Tack I reiterated said mantra and looked fairly foolish as the Dow Dance took the senior index over 150 points higher early in the day. Nevertheless, in this business you have to have certain disciplines to manage the risk and “never on a Friday” is one of my disciplines. Subsequently, as I winged my way back to Saint Petersburg, after a week of seeing accounts, speaking at a conference, and doing various media “hits” in New York City, as I traveled south, so did the equity markets. By Friday’s closing bell the Industrials (and the S&P 500) had lost 1.21% for the week, the Transports slid 1.92%, but the real loser was the S&P SmallCap 600 (-2.28%). As for the sectors, energy and healthcare were the only positive macro sectors for the week with energy better by 2.20% (driven by an 8.13% pop in crude oil prices). To be sure, crude oil has broken out to the upside of the downtrend line that has “capped it” for the past 12 months (Chart 1) and the energy sector is attempting to do the same (Chart 2). Meanwhile, the healthcare sector lifted 0.89% on the week, while the financials dropped a rather large 2.90%. To see what sectors worked in 1Q16, and what is working so far in 2Q16, please see Chart 3.

So this week in earnest begins the 1Q16 earnings report season, with expectations for earnings to decline anywhere from off 7% to off 9% y/y. Those negative estimates have been rising over the past number of weeks. Many pundits suggest that unless earnings, and forward guidance, are better than expectations, the equity markets will travel back down to the Netherworld of 1800 basis the S&P 500 (SPX/2047.60), but we are not one of them. As the good folks at Bespoke Investment Group note (as paraphrased):

Given that we track this kind of information on a regular basis, we looked to see how the S&P 500 performed during earnings seasons (six-week period beginning the Friday before Alcoa report) since the start of 2009. . . . Of the 28 reporting periods, the direction of the market during earnings season was the same as the net guidance spread only ten times (36%). Furthermore, in the last twelve quarters (three years) the guidance spread has been negative eleven times, and the S&P 500 has been down during the corresponding reporting period just once. As we have discussed in prior reports on the subject, when it comes to earnings season, what really matters is expectations heading in. When expectations in the form of analyst revisions are negative leading up to the start of earnings season, equities typically rally during earnings season, while positive sentiment leading up to earnings season sets a high bar to surpass.

So in between speaking engagements and media events, I had the opportunity to meet with a number of portfolio managers last week. I always enjoy talking with Federated Investors’ Phil Orlando and some of the team in Boston and Pittsburgh. Two of the trends they have been discussing are the recent weakness in the U.S. dollar and the recent strength in crude oil. I told them that I have thought the dollar has been making a “top” for over a year as measured by the Dollar Index (Chart 4). My track record on oil, however, is not so good - having wrongly attempted to make a bottoming “call” on crude oil three times over the past year has not played! I did say that the head of our energy team has a pretty darn good record of doing so, having made the negative “call” on prices and then a few months ago making the bottoming “call.”

Next I met with JP Morgan’s Jeffrey Geller and Scott Davis and gleaned from these PMs that: 1) There is more earnings operating leverage in Europe than the U.S. 2) There is finally stability in emerging markets’ currencies and commodity prices. 3) There are just enough risks out there to balance the good that is emerging. 4) Portfolios should overweight: banks, brokers, insurance, auto, transportation, and semiconductors.

Then there was my friend Mary Lisanti, portfolio manager of the Lebenthal Lisanti Small Cap Growth Fund (ASCGX/$15.98). She told me, “When you talk to small-cap companies all you hear is that business is pretty good and that after this quarter’s earnings report you should have 6 to 7 quarters of easy comparisons.” She further opined the worlds’ central banks have converged in their views that interest rates are going to stay relatively low; and that even at $35 a barrel, the Permian Basin is profitable. At $40 she thinks there will be two or three more basins that will become profitable. Mary’s focus is small capitalization growth companies that do things better, faster, and cheaper, which is why I own her fund. We discussed many of the stocks in her portfolio, but I don’t have the space to mention them.

While I saw more PMs, as stated I don’t have enough space to talk about everything discussed. I will say my meetings with the real estate folks at Cohen & Steers were particularly timely since real estate is becoming the 11th GICS sector (instead of 10 macro S&P sectors there will be 11 beginning in September 2016). According to Cohen & Steers, that new sector has the potential of driving $100 billion into REITs from 40 Act mutual funds just to get them up to a portfolio weighting of neutral. They believe the small and mid-capitalizations funds are more underweighted than the large cap funds. Some of the team I met with help manage the Cohen & Steers Realty Shares Fund (CSRSX/$72.56).

The call for this week: So the insightful McClellan Report writes, “Bearish for short and intermediate trading styles, bullish long term. The DJIA fell back down through a previously broken downtrend line, not a good sign for the bulls.” Guy Ortmann, at Scarsdale’s Securities writes, “In conclusion, our near term outlook remains neutral while the intermediate term has turned ‘neutral’ as valuation issues are beginning to temper that outlook along with recent insider selling activity. Forward 12 month earnings estimates for the SPX from IBES (Institutional Brokers Estimate System) of $122.64 leave a 6.01% forward earnings yield on a 16.8 forward multiple.” And our friend, Mick St. Amour, at the astute The Collier Group writes:

While the S&P 500 has gotten ahead of itself since the mid-February lows, I suspect whatever pullback we get will be more consolidating and working off overbought conditions versus the start of another major move downward. Improving stock market breadth, a more dovish Fed, and the prospect that the worst of the earnings declines could very well be behind us tell me that the bear market scenario that we worried about at the beginning of the year is off the table for now. Investor positioning shows a reluctance to hop on board this rally, which also tells me there is still enough fuel in the tank for the S&P 500 to grind higher in the weeks and months ahead once we work off the overbought conditions. I think for the time being equity market weakness will be confined to the 1950-2000 region for the S&P 500 and this is where I would selectively add back to equities for underinvested accounts.

Plainly, we agree. While the number of stocks in the S&P 500 that remain above their 50-DMAs continues to be near-term overbought at 83.1%, the NYSE McClellan Oscillator has become somewhat oversold. Further, there has been a rather rare “breadth thrust” signal registered suggesting that near-term weakness in stocks should be bought with appropriate stop-loss orders to manage the risk. This morning the preopening S&P 500 futures are better by 9 points on no real overnight news. Chinese March CPI rose 2.3% vs. expectations for 2.5%, giving the PBOC the ability to stimulate; while Japanese Machine Orders beat estimates (-9.2% vs. -12.5%) helping to steady the yen.

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