Investment Strategy by Jeffrey Saut

"Activity Versus Inactivity"
April 20, 2015

Penalty kicks are a critical time of decision making for both the goal keeper and the penalty taker.  Given that, for most professional games, the average number of goals scored is around 2.5, a penalty kick can have a major influence on the outcome of a match.  Penalty kicks may reach speeds near 125 mph and are usually over within a quarter of a second.  Thus, the goal keeper must make a decision on how to stop the shot before the ball is struck. Statistics show that goal keepers will most often jump to the left or right, hoping to guess correctly and place him (or her) self in a position to block the kick.  Is this action by the keeper the best strategy?  Research headed by Michael Bar-Eli at the Ben-Gurion University of the Negev in Israel makes some interesting conclusions about how goal keepers should defend penalty kicks.

Goal keeping behavior explains part of the goal scoring successes.  In attempting to stop the penalty kick, goal keepers jump to the right or left 94% of the time.  In doing this, they guess correctly only about 40% of the time (i.e. jump left, shot placed left).  However, even when they guess correctly, they only stop 25-30% of the shots.  The most intriguing part of the Dr. Bar-Eli’s analyses is that when goal keepers remain in the center of the goal and the shot is placed in the center, they make the save 60% of the time.  Given that about 30% of penalty kicks are placed in the center third of the goal, remaining stationary in the center of the goal increases the keepers’ chances of stopping the shot from about 13% to more than 33%.

. . . The Science of Soccer Online

Human nature is a funny thing, as demonstrated by Ben-Gurion University’s study, because there is the human trait to be active.  This is why soccer goalkeepers try to anticipate which way the penalty kicker is going to kick the ball and “dive” left or right to block it before the ball is actually kicked.  In reality, the chances of blocking the kick increase by more than 100% if the goalkeeper remains “inactive” and stands in the middle of the goal!  The same can be true for investors.

Plainly there are times for investors/traders to be active.  But there are also times for them to be inactive, despite the trait of human nature to be “active;” and, for the past few months inactivity has been the best overall strategy.  For example, last November the S&P 500 (SPX/2081.18) was changing hands around 2076.  It now resides at 2081 for a change of some 5 points, or a gain of 0.00096%.  More recently, since early February the SPX has been locked in a trading range between 2040 and 2120.  While clearly there have been some stock “wins” over the past two months, most of the traders trying to trade the markets have not made much money, and in many cases lost money.  The action has been consistent with our year-end “call” to raise some cash because our indicators/models suggested the first few months of 2015 were going to be rocky and more volatile.  Now obviously last Friday’s Fade (-23 S&P points) had a lot to do with bringing the SPX back down from “tax day’s” ~2112 print-high, and an attempt to break above 2120 level, back into the position for a potential test of 2040 area.  Also among the obvious were the various pundits’ reasons for the Spoo’s Swoon.

To be sure, the outage of Bloomberg terminals around the world overnight caused angst as the pros were “flying blind” without the benefit of quotes on investments/trades.  When anything like that happens, the human trait to be active and sell takes over.  China’s ill-timed change in margin requirements for OTC stocks certainly unnerved participants as margin financing was banned.  Then there were renewed worries regarding Greece as rumors swirled that Greece would exit the EU in the next two weeks.  Other excuses included: last Friday’s option expiration; earnings; negative Bund yields in Germany; the potentially blocked Time Warner deal; rising energy prices; the “never on a Friday crowd” (meaning in a free fall stocks rarely bottom on a Friday); and the list goes on.  Whatever the reason, the SPX closed back below its 50-day moving average (DMA) of 2084.98, implying its 100-DMA at 2064.59 might have a magnetic attraction early this week.  We remain focused on the aforementioned trading range of 2040 to 2120, preferring to remain “inactive” until one those levels is breached.  That said, from our perspective, some very interesting chart events occurred last week.

Indeed, the SPX, after failing to break out of the topside of the wedge formation, has now retreated to the bottom of that chart formation (Chart 1, see page 3).  If it violates the bottom of the wedge’s uptrend line, it means there should be at least a downside test of the 2040 support level.  While the Russell 2000 (RUT/1251.85) has not worked its way into a similar “wedge pattern,” it has declined to its rising trendline (Chart 2), which if not held would imply lower prices.  Then there is the D-J Transportation Average (TRAN/8647.50), whose upside non-confirmation with the D-J Industrial’s (INDU/17826.30) new all-time high on March 2, 2015 at 18288.63 with a new all-time high of its own (Chart 3), has been a concern of ours for more than a month.  Also worth noting is that the Trannies are again in jeopardy of breaking below a spread quadruple bottom.  Speaking of quadruple bottoms, the S&P Energy Sector has held its respective quadruple bottom, and has broken out above its downtrend line (Chart 4), consistent with our “call” of months ago that crude oil has bottomed.

Speaking to the sector performance year-to-date, Healthcare, Consumer Discretionary, Materials, and Energy have outperformed the SPX, which “foots” with our preferred portfolio strategy (Chart 5).  Given such performance finds the Energy sector overbought, and the Technology and Telecommunications sectors oversold, on a near-term basis.  Meanwhile, as noted two weeks ago, earnings revisions have turned up after months of declines (Chart 6).  Also worth consideration is that so far 63.7% of the companies reporting 1Q15 earnings have beaten their estimates (Chart 7).  We continue to think, for many of the reasons mentioned in these reports, that come May the economic statistics will reaccelerate, leaving GDP growth at a more normalized 3% growth rate.  Near-term, however, the equity markets do not believe this, still leaving them vulnerable to a downside “trap door.”  If so, the “trap door” should be viewed within the construct of a secular bull market that has eight to nine years left on the upside.

The call for this week: My colleague Andrew Adams and I are in Las Vegas to deliver a keynote address at Raymond James Financial Services’ National Conference.  If past is prelude, something impactful will happen in the equity markets in our absence.  In fact, six years ago last month I stepped up on stage in Las Vegas in front of more than 2,000 financial advisors and said, as I held up a $100 bill:

“Who wants this $100 bill?”  All the hands went up.  I crumbled it up and said, “Who still wants this $100 bill?”  All the hands went up.  I then threw the bill onto the floor and ground it with my heel into the stage.  I held the crumpled and soiled bill and said again, “Who now wants this $100 bill?” Again all the hands went up.  Holding that same $100 bill in the air I spoke the words, “Just like y’all that have been crumbled, and soiled by the 2008 – 2009 Financial Fiasco, you too have NOT lost your value, just like this $100 bill has not lost it value!”  With that, I threw the $100 bill into the audience and said, “Your worries are over.  The stock market has bottomed!”  I will reiterate that stance this year at our national conference, even though the near-term remains sketchy on a trading basis, which is why we continue to exercise the rarest commodity on Wall Street, patience!

Managing risk
April 13, 2015

Most people acknowledge that losses will happen regardless of the type of business venture. A light bulb manufacturer knows that two out of three hundred bulbs will break. A fruit dealer knows that two out of one hundred apples will rot. Losses per se don’t bother them; unexpected losses and losing on balance does. Acknowledging that losses are part of business is one thing; taking and accepting those losses in the markets is something else entirely. In the markets, people tend to have difficulty actively taking losses. This is because all losses are treated as failure; in every other area of our lives, the word loss has negative connotations. People tend to regard the words loss, wrong, bad, and failure as the same, and win, right, good and success as the same. For instance, we lose points for wrong answers on tests in school. Likewise, when we lose money in the market we think we must have been wrong.

... What I Learned Losing a Million Dollars, by Jim Paul and Brendan Moynihan

While some of this letter is a reprint from an era gone by, its wisdom stands the test of time because everyone knows how to win and few know how to lose. Yet the secret to making money in the markets is knowing how to lose, or how to control your losses. Listen to the pros:

“I’m always thinking about losing money as opposed to making money. Don’t focus on making money; focus on protecting what you have.” – Paul Tudor Jones

“The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and costs them dearly.” – William O’Neil

“One investor’s two rules of investing:

1) Never lose money.
2) Never forget rule No. 1.” – Warren Buffett

All of those pros have different market philosophies. They have contradictory strategies for making money. Some are traders; some are value players; some are growth-stock advocates; others are emerging-growth seekers; etc., etc., etc. But the message is clear – “Learning how not to lose money is more important than learning how to make money!” Now consider another quote from the brilliant Peter Bernstein (author of “Against the Gods”):

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 winning 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 than 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. 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 disappeared from the scene.

I don’t know how much of a “colorful character” I am, but I am a survivor because I learned to manage the risk of being “wrong” during the 1973 to 1975 bear market. Manifestly, managing losses has been a lesson that has served me well over the years. It has been particularly helpful during the 2000 – 2013 range-bound stock market. To be sure, since the Dow Theory “sell signal” of September 1999 I have tried to manage the risk in keeping with the mantra, “Don’t let ANYTHING go more than 15% - 20% against you.” In conjunction with that mantra I have also employed asset allocation, as well as a strategy of rebalancing investment positions in an attempt to manage the risk.

Portfolio rebalancing, when done correctly, is an art form. Simply stated, port­folio rebalancing is the strategic redistribution of asset classes within a portfolio to keep said portfolio’s objectives in-line with its original objective. As John Valentine of Valentine Capital notes:

To provide a simplified allegory, think of investment planning for the future as an automobile, conveying an investor to his or her financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture, and the assets invested are the fuel. The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation, run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momen­tum. ... Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank. ... Rebalanc­ing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously. ... The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercus­sions associated with a compromised allocation: being overexposed to the downside and underexposed to the upside. Don’t let this happen to you!

At the end of last year I strongly recommended rebalancing portfolios with the cry, “If you have stocks in your portfolio that have not rallied in this straight-up rally since June of 2012 there is probably something wrong with the company. Since the indicators/models that have served us so well over the years are ‘saying’ the first few months of 2015 are going to be rocky and more volatile, you should sell those non-rallying stocks and raise some cash to take advantage of forthcoming opportunities in the new year.” So far that has been a pretty good call.

The call for this week: In the near-term the S&P 500 (SPX/2102.06) has worked itself into what a technical analyst would term a wedge chart formation (see chart on page 3). It has also been trapped between 2120 and 2040 since early February of this year. Accordingly, I told Jacqueline Doherty of Barron’s (see today’s issue) last Friday, “While no one can consistently time the stock market, if you listen to the market’s message you can certainly decide if you should be playing hard, or not playing so hard. Eventually the SPX will resolve its range-bound condition and hopefully we will be able to recognize it when that happens.” This morning the preopening S&P 500 futures are relatively flat (-3) amid the headlines “China’s exports shrink by 15% y/y in shock fall,” Greece may have blown best hope for a debt deal,” and “The U.S. loses sparkle as Europe shows signs of hope.” Headlines like these have oil up (+1%) and the U.S. Dollar index better by 0.6%.

Brobdingnagian top?
April 6, 2015

According to Wikipedia, “Brobdingnag is a fictional land in Jonathan Swift's satirical novel about Gulliver's Travels whose land is occupied by giants. Lemuel Gulliver visits the land after the ship he is travelling on is blown off course and he is separated from a party exploring the unknown land.” I thought of Brobdingnag as I stared at a chart of the D-J Transportation Average ($TRAN/8605.31) last week, which looks like it is making what a technical analyst would term a giant broadening top, or in my terms a “Brobdingnagian Top?” The chart pattern begins in November with a false upside breakout (to ~9310) that is followed by a decline into mid-December (to ~8581). Those high and low points set the stage for the parallel channel the Trannies have been locked in for going on six months. Interestingly, the chart formation also shows a spread quadruple bottom (four low points). Therefore, if 8580 is decisively broken to the downside, it is going to look pretty ugly in the charts (see chart 1). While it would not be a Dow Theory “sell signal,” it certainly would raise a red flag, at least on a short-term basis. Another “uncle point,” I wrote about last Thursday is the 2060 level for the S&P 500 (SPX/2066.96). Hereto, a close below that level would not look good to me. Meanwhile, the MACD indicator (Moving Average Convergence/Divergence is a trading indicator that is supposed to reveal changes in the strength, direction, momentum, and duration of a stock/index/commodity/etc.) is currently flashing the same type of warning signals it did in 1Q00 and 4Q07, not that I expect similar downside results. Then there is what Jason Goepfert, of SentimenTrader fame, wrote about last week. To wit, “Buying power available to investors is near an all-time low. The NYSE Available Cash figure has dropped to one of its lowest levels, and the last two times it was near this level, stocks struggled in the months ahead (see chart 2).” Meanwhile, again as Jason notes, “According to the American Association of Individual Investors, mom-and-pop investors have their highest exposure to stocks since 2007, and nearly their lowest cushion of cash since 2000 (see chart 3).” Whether any of this will be impactful in what is the best upside statistical month of the year (April) remains to be seen, but it has pushed me back into cautionary mode.

Whatever happens in the short run, I have never wavered in my long-term belief that we are in a secular bull market that has years left in it. This point was strongly reinforced as I read my friend Frederick “Shad” Rowe’s quarterly letter to his investors. I spoke with him last Thursday. Shad is captain of Greenbrier Partners, a private partnership that invests in publicly traded securities and has produced excellent returns since 1985. These are Shad’s words that resonated with me:

Many investors constantly worry about the state of the world or whether the United States is undervalued or overvalued relative to French stocks or whatever case they are making. They are failing to see that we are in the midst of a long-term cycle of wealth creation by American companies. ... Rapid technological change is doing more for people and doing it faster, better, cheaper, etc. ... and that trend is only going to accelerate. Interestingly, according to a recent Bank of America survey, investor sentiment toward American stocks is at the lowest point it has been since 2008. Some investors are skeptical of American stocks because they are more fully priced than some companies in Europe or some companies in Asia. But there are reasons for it. First among them is our increasing energy independence. There is also our ability to take what some people call ‘Moneyball,’ borrowed from Michael Lewis’ book about applying rigorous data analysis to baseball, and apply it to every aspect of American life: do it better, faster, cheaper, and do it in a way that is scalable and salable across the world. They are looking backwards not forwards and what I see are the same opportunities I saw three years ago only bigger.

Some of the stocks that Shad holds in his fund, which are rated Outperform by Raymond James’ fundamental analysts, include (with some of Shad’s comments attached):

Facebook (FB/$81.56) “Facebook Messenger now has 600 million monthly active users (up from 500 million in November), Messenger is becoming a platform for other apps (this is the route to monetization), Facebook user data can now be used to target non-Facebook mobile advertising via LiveRail, and that virtual reality seems as promising and far-off as ever.”

Apple (AAPL/$125.32) “Apple has the most desired digital ecosystem in the world and trades at a discount in comparison to the market and its intrinsic value on virtually every metric. Tim Cook’s performance at this year’s annual meeting could hardly have been better. He has escaped the shadow of Steve Jobs and is clearly in charge.”

Google (GOOG/$535.53) “Through organizing and providing access to the world’s information, GOOG has become the most powerful force in advertising and is navigating the world’s transition to mobile and video beautifully.”

eBay (EBAY/$56.91) “The value of eBay’s digital assets remains unrecognized by the investing public. We expect this to change over the next few months, as the PayPal spinoff approaches.”

Pulte (PHM/$22.70) “The current housing cycle appears to be different. A far more sustainable recovery in homebuilding is slowly gaining traction and is dominated by the biggest, most efficient builders.”

Bank of America (BAC/$15.54) “Bank of America represents a proxy on an improving domestic economy and the stock is cheap at 0.7x book value (1.1x tangible book value).”

We will be watching these stocks closely on pullbacks as potential “buy candidates.”

The call for this week: On Friday the U.S. March employment report did not make for pleasant reading with non-farm payrolls increasing by a mere 126,000 versus the consensus guess of 244,000. It was the worst report since December 2013. Adding insult to injury, there was a net revision of -69,000 jobs to the January and February numbers. Our economist, Scott Brown, Ph.D., had this to say, “Disappointing at face value – a smaller than expected increase in payrolls in March and a downward revision to the two previous months. Bonds have rallied, the dollar has weakened, the Fed funds futures have pushed out (implying a slower trajectory for short-term rates), and equities are poised to open sharply lower on Monday. The financial markets rarely look beyond the headline numbers, but this report wasn’t as bad as it seems. We could merely be seeing a statistical moderation (strong 4Q numbers followed by ‘softer’ 1Q figures).” This morning, however, Mr. Market is manic again leaving the preopening S&P futures off about 15 points at 6:00 a.m. on the jobs’ report. This is very likely going to break the TRAN below its spread quadruple bottom and the SPX below the 2060 level. If they close below those levels, it will not look good in the charts and will bring into view 1980 – 2000 for the SPX. On a more positive note, Saudi Arabia raised crude oil prices to Asia over the weekend on strengthening demand.

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