Investment Strategy by Jeffrey Saut
July 25, 2016
I got an email last week that read, “What do I do now?” I replied, “I don’t know what you mean.” She wrote back, “I didn’t buy the February lows that your model told us to buy and I didn’t buy any of the stocks on your ‘buy list’ the Monday following the Brexit Bashing. So what do I do now?” I told her I continue to think we remain in the same secular bull market that began in March of 2009 and I think it has a lot farther to go. Yes, I know the equity markets get overbought from time to time. Yes, I know there will be pullbacks. Yes, I know certain valuation metrics are historically expensive, but I also know how secular bull markets work. I have written many times about the fact that there are not many of us left. There are not many of us that have seen a secular bull market. I don’t know where the market mantra came from that a 20% rally is a bull market and a 20% decline is a bear market, but I do not believe that’s the case. Well, it might be the case in the shorter term for tactical bull and bear markets, but it’s not the case for secular bull markets!
Secular bull markets tend to last 14 - 15 years and compound at 16% per year (on average). Study the Dow Jones Industrial Average chart (chart 1). Since the 1929 “crash” there has been just two secular bull markets: 1949 to 1966 and 1982 to 2000. Were there pullbacks during those secular “bulls?” You bet there were. The President Kennedy “steel crisis” of 1962 lopped ~26% off of the D-J Industrials in a pretty short time. Then there was the slight accident in October of 1987 that left the Industrials off 22.6% in a single day, but it was not the end of either of those secular bull markets. Again, study the chart. Every time the D-J Industrial Average (INDU/18570.85) has emerged from a multi-year trading range (1933 – 1949, 1966 – 1982, 2000 – 2013) the markets has entered a secular bull market. I don’t think it is any different this time.
So what’s driving this bull market? One of the drivers is that very few believe we are in a secular bull market. This is reflected by the highest cash balances in portfolios since 2001, according to CNBC. This is not the way bull markets end. Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Clearly we are nowhere near “optimism” and likely years away from “euphoria.” How about earnings? I have posited, and continue to do so, that the earnings bar was lowered way too much for the 2Q16 (-5.5% y/y) and that earnings were going to come in better than expectations. Well, with 25% of the S&P 500 companies reporting, 68% have beaten their estimates. Moreover, in the back-half of this year, earnings comparisons should look really good because last year’s 3Q and 4Q earnings were really bad.
Speaking to valuations, S&P’s bottom-up, operating earnings estimate for next year is roughly $134 for the S&P 500 (SPX/2175.03). As often stated, if that estimate is anywhere near the mark, at the Brexit low (1991), the SPX was trading at under 15x next year’s estimate. “But Jeff,” one of our financial advisors asked me last week, “the S&P 500 is up 365 points (+20%) from your model’s ‘bottom call,’ so the SPX is now trading at 16.2x next year’s estimate, which is above its historical average.” That’s true, but as stated repeatedly using the Rule of 20s, which suggests the P/E multiple should be whatever the inflation rate is added to the P/E multiple to equal 20, stocks are still not fully valued. In the current case, that P/E multiple would be 18x because the inflation rate is around 2% (18 + 2 = 20). Using Ben Graham’s valuation formula, however, produces an even higher multiple [V = EPS x (8.5 + 2g); where V is the intrinsic value, EPS is the trailing 12-month EPS, 8.5x is the P/E ratio of a stock with 0% growth and g being the growth rate for the next 7 - 10 years].
For those of you that didn’t take the time to read Richard Bernstein’s excellent article imbedded in last Friday’s Morning Tack, I will give you some sound bites. Rich states:
One of the most frustrating statements we hear is that bull markets are impossible without P/E ratios expanding. History shows that this is simply not true (Bernstein). There have been interest rate-driven bull markets during which interest rates fall and P/E multiples expand, but there have also been earnings-driven bull markets during which interest rates rise and P/E multiples contract. At Richard Bernstein Advisors (RBA), our portfolios are positioned for an earnings-driven bull market. . . . Portfolio construction during an earnings-driven market needs to focus on P/E contraction, ensuring that multiples contract by ‘E’ going up rather than by ‘P’ going down. Cyclicals tend to outperform stable growth during earnings-driven markets because cyclical companies’ incremental earnings growth more than offsets the negative effect of rising rates. Stable growth companies, by definition, are stable and have little or no incremental growth. Stable companies’ P/Es usually contract by ‘P’ going down because ‘E’ is stable. RBA thinks the next year or so will be an earnings-driven bull market.
Plainly we agree and for another interesting read, “ping” Capital Economics’ June 7, 2016 fascinating report titled “Causes and Consequences of a Lower U.S. Equity Risk Premium” (Risk Premium).
Circling back to the question of “What do I do now?” Well if you believe my friend Rich, you can buy one of his funds. If you want to be more cautious, you can buy Royce Value Trust (RVT/$12.38), which I own. It trades at ~15% discount to net asset value (NAV) and possess a decent distribution rate (yield). The fund’s focus is on small and micro capitalization stocks. Speaking to that asset class, a few weeks ago I featured another micro-cap fund managed by Michael Corbett who is the CEO, CIO and portfolio manager at the Chicago-based Perritt Capital. The fund is called The Perritt MicroCap Opportunities Fund (PRCGX/$33.42). As previously stated, I think the small/micro-capitalization universe is going to do well going forward and would tilt portfolios accordingly.
The call for this week: Winston Churchill once said, “If we open a quarrel between the present and the past, we shall be in danger of losing the future.” That seems to be the appropriate quote for the stock market currently. Too many pundits continue to focus on the past – the range-bound market for the past nearly two years – or the present – valuations are too high – despite the message of the market. That message is – we have broken out to the upside of a two-year consolidation – that produces a technical price target for the S&P 500 of over 2300. Meanwhile, the Wilshire 5000 (the broadest index) has tagged a new all-time high, both the NYSE Advance/Decline Line and the Operating Companies Only A/D Line (eliminates interest sensitive funds/ETFs, etc.) have traveled to new highs, new highs over new lows are expanding, earnings and economic data are coming in better than expected (chart 3), and the list goes on. All of that caused one savvy seer to pen an article titled “Did the S&P 500 Just Enter a New Bull Market?” He states, “The S&P 500 is officially up more than 20% from the February lows. This raises another question: Did a new bull market just start?” There’s that 20% mantra again. The line in his report that leaped out at me read like this, “What makes the recent 20% bounce special is that it took place in just over five months (110 trading days to be exact) and that is much rarer.” Indeed folks, manage money for the environment that you are in, not the one you wish you were in . . .
I love . . . NYC!
July 18, 2016
For me, last week began on Sunday night at Michael Jordon’s restaurant in Grand Central Station with some portfolio managers (PMs). The conversation was informative as were the investment ideas exchanged (more on those ideas after I have had time to study them). It was more of the same at breakfast the next day with another PM. Around 11:00 a.m., my colleague (Andrew Adams) arrived to accompany me to Jersey City for a three-hour stint with PMs at the venerable firm of Lord Abbett. The first hour was spent with Justin Maurer and Tom Maher, co-PMs of the Lord Abbett Value Opportunities Fund (LVOAX/$19.15), which invests 65% of the fund’s assets in small/mid-capitalization companies believed to be undervalued with the rest of the money able to “go anywhere.” They like to find ways in the portfolio to play the themes they like. A few of the themes discussed were: 1) a shrinking of airline capacity, 2) that fiscal spending is coming, 3) that government spending is going to be a growth industry in 2017, and 4) backdoor plays in the cyber security space. Hereto we swapped investment ideas that I will be sharing in the days ahead. I really liked these guys; I liked the way they think, the way they use a thematic approach, and the way they invest.
The next hour was with Walter Prahl, who along with Joe Graham, manages the Lord Abbett Calibrated Dividend Growth Fund (LAMAX/$14.90). I would classify this fund as an equity income fund that likely will not unpleasantly surprise investors. The final hour was spent with my friend Tom O’Halloran, whose fund I own (Growth Leaders Fund/LGLAX/$22.41). Tom looks for companies that: 1) have attractive business models, 2) are organic entities (management), 3) are benefitting from healthy industry conditions, and 4) have a competitive advantage. Tom told us the tech revolution began with the integrated circuit in the 1960s (my first transistor radio) and has morphed into a race to overcome time, distance, and space. He offered up Grub Hub (GRUB/$29.80/Outperform) as an example. Subsequently, Tom took Andrew and me via water taxi to the NYC’s Union Club, which I had not been in for some 30 years, and we were joined by another friend, namely Eric Kaufman captain of VE Capital and founding member of Friends of Fermentation (a tip of the hat to another friend of Arthur Cashin). Next was dinner with my long-time friend and brilliant small-cap stock picker, Mary Lisanti, manager of the Leventhal/Lisanti Small Cap Growth Fund (ASCGX/$17.08), which I also own. This year has been tough for that asset class, but I think its (and her) time has come again. BTW, I only invest with PMs I know, not just professionally, but personally, like Mary, Tom O’Halloran, Eric, etc. As always, ideas exchanged in these meetings will be featured later in subsequent missives.
Comes Tuesday, the day arrives with another breakfast with PMs, and yet another meeting with PMs, and then it was off to Goldman Sachs’ (GS) world headquarters. I actually love GS and own the Goldman Sach’s Rising Dividend Fund (GSRAX/$21.14), which is managed by another friend of mine, Troy Shaver. That afternoon, Andrew and I met with Goldman PMs, two of which I had never seen before, and I was really impressed with their investment style. They manage the GS U.S. Equity Dividend and Premium Fund (GSPAX/$12.16). They buy dividend payers, the fund is sector neutral, it has a Beta of ~1, they sell away 20/30% of the upside using various strategies that serve somewhat as a downside hedge, the fund has an average annual distribution of ~6%, it has very little “line item” risk, and they are thoughtful about the tax ramifications of their distributions. We also met with Osman Ali, a PM I have met with a few times before. It was intriguing to hear him talk about “crowd sourcing”, “machine learning”, and “informational advantages.” Goldman Sachs has taken, for lack of a better definition, Artificial Intelligence (AI) to an art form. Their computers read 26 million reports/articles/10-Ks a year looking for key words to gain an informational investment advantage. For example, in April of 2015, their AI gleaned that web traffic had exploded for Home Depot and Lowes right before those companies’ share price leaped.
Wednesday started with a “hit” on Fox Business TV with Maria, who I have known for 25 years, followed by lunch with friends and then an interview with the good folks at the Wall Street Journal and Barron’s. That night, we met with some Wall Street types and had dinner at the fabulous Italian restaurant Scalinatella. The next day, it was an early meeting at Deutsche Bank Asset Management with about a dozen folks in attendance. At noon, it was a presentation for high net worth clients at our RJA Rockefeller Center offices, a stint at Bloomberg (great to see you Pimm Fox), and a “hit” for CNBC from the floor of the NYSE. Of course, each night was also accompanied with a confab at Bobby Van’s NYSE bar for libations with other members of Friends of Fermentation (FoF). Arthur Cashin was in rare form regaling his famous stories to my colleague Andrew. However, the most amazing meeting of the week was with my dear friend Craig Drill (Drill Capital), who typically arranges a lunch for my NYC visits.
At previous lunches icons like David Einhorn (Greenlight Capital), John Hathaway (Tocqueville), Ken Langone, Joe Perella (Perella Weinberg), Mike Price (MFP Investors) – well, you get the idea – were in attendance. Last Friday’s lunch did not disappoint. While I am not going to name the names, I will tell you the ex-director of the CIA was there, the foremost Alzheimer’s doctor in the world was there, folks from Lee Cooperman’s Omega Advisors attended, a Singapore-based PM was there, my friend Eric Kaufman (the best MLP portfolio manager in the biz) sat in, and there was a cast of others present. The CIA guy said that ISIS was “past its high-water mark and that the Muslim community will eventually confront them.” He also suggested, since ISIS is in decline, it makes them more desperate. The gentleman from Omega began, after I spoke, saying, “I didn’t think there was anybody more bullish than me, but I was wrong!” (that would me). He then listed his bear market check list with five key points: 1) accelerating inflation, or problematic inflation (not here); 2) hostile Fed (not here);
3) prospects for a recession (not here); 4) investor exuberance (not here); and 5) expensive valuations (not here given the interest rate environment). His conclusion, “The only way this secular bull ends in the near term is if there is a ‘black Swan’ event” and, I agree. He also spoke about the concept of “molehill to mountains” falsely trumpeted by the media, citing the Greece Gotcha’, the Italian Job, the Crimea Crisis, the Brexit Bashing (we were buyers of stocks on the belief that new all-time highs were in the offing), and the remaining list is legion. The Singapore PM stated the Japanese election assured more monetary stimulus, that Chinese steel companies are trading at two times earnings, and the commodity cycle has bottomed, and hereto a number of long stock ideas were mentioned that I will vet in the days ahead. The Alzheimer doctor was amazing stating that Alzheimer’s is one of the leading causes of death and that it is the greatest unanswered medical need. To make this point, he posited that if five million folks are affected, and it takes $50,000 a month to attempt to treat it, that foots to $250 billion with the government’s total Medicaid spending (excluding admin costs, accounting adjustments, or data for the U.S. territories) of ~500 billion. Given the aging baby boomers, that is a HUGE problem. While he suggested there are new drugs on the way, exercise and the Mediterranean Diet are a step in the right direction for prevention.
The call for this week: Bespoke points out that, “All ten sectors are overbought for the first time since [last] March” (chart 1). Plainly, we agree given our comments last week about the McClellan Oscillator. However, Bespoke also notes (as paraphrased), “In all the previous times when the S&P 500 has made a new all-time high, following at least 52 weeks below the old high water mark, the average return over the next 12 months has been 12.28% (median +12.30%) with an average pullback of 5.48% (median 2.73%).” Hence, folks waiting for the fabled 20% pullback are likely going to be disappointed. That said, it would not surprise me to see a sell off attempt this week that should not get very far. Meanwhile, while everyone is focused on the major indices at new all-time highs, few are watching the much maligned D-J Transportation Average (TRAN/7985.17) that is breaking out of a downtrend line that has been in effect since March of last year (chart 2). If successful, a new Dow Theory “buy signal” should be enforce. And don’t look now, but last week we experienced the third 90% Upside session in just as many weeks.
July 11, 2016
I have been very lucky in my career in terms of the people I have met. Working in New York City in the early 1970s I was fortunate to meet icons like Larry Tisch, Barton Biggs, Marty Zweig, Ace Greenberg, etc. Regrettably, I have lost, and am losing, many of those icons. While working in Washington DC I used to have high tea at the Hay Adams with Jean Kirkpatrick; and at a black tie affair I talked with a gentleman I would have never thought I would like. He was from Massachusetts and was pretty left of center. I talked to him for over an hour and was struck by his witty brilliance. I told him he should run for President and a few years later he did. His name was Paul Tsongas. While I have met all sorts of folks over the years, one person I have not met is Peggy Noonan, the weekly columnist for The Wall Street Journal (WSJ). She is one of the best writers/thinkers I have ever read. She is wicked smart and scribes articles everyone should read. Roughly two weeks ago she penned a WSJ article titled, “A World In Crisis, and No Genius in Sight.” The gist of the piece was about “genius clusters.” Genius clusters have occurred at certain points in history with one of the best being the one that invented America. She writes, “Somehow Franklin, Jefferson, Washington, Adams, Madison, Hamilton, Jay, and Monroe came together in the same place at the same time and invented something new in the history of man.” A little late in the article she opines:
There was a small genius cluster in World War II – FDR, Churchill, de Gaulle. I should note I’m speaking of different kinds of political genius. There was a genius cluster in the 1980s – John Paul II, Reagan, Thatcher, Vaclav Havel, Lech Walesa, Lee Kuan Yew in his last decade of leadership in Singapore. The military genius cluster of World War II – Marshall, Eisenhower, Bradley, Montgomery, Patton, MacArthur, Nimitz, Bull Halsey, Stilwell – almost rivaled that of the Civil War – Grant, Lee, Stonewall, Sherman, Sheridan, and Longstreet. Obviously genius clusters require deep crises, otherwise their gifts are not revealed. Historic figures need historic circumstances. Also members of genius clusters tend to pursue shared goals. We have those conditions now – the crises, and should be shared goals. Everything feels upended, the old order that has governed things for 70 years since World War II [is] being swept away. Borders have disappeared before our eyes. Terrorism, waves of immigration transforming whole nations, Islam at war with itself and parts of it at war with the world. In the West, the epochal end of public faith in institutions, and a dreadful new tension between the leaders and the led. In both background and foreground is a technological revolution that has actually changed how people experience life. It is a world crying out for bigness, wisdom, steady hands and steady eyes. We could use a genius cluster.
Did I forget to mention that Peggy Noonan is brilliant?! But, where is the genius cluster that we so desperately need? It certainly doesn’t exist with the world’s leaders. It probably exists with some of the world’s military leaders; however, the politicians aren’t paying much attention to their advice. Clearly the world’s populations are seeking a genius cluster given things like the Brexit vote and the rise in popularity of Donald Trump. There is likely a genius cluster on the Street of Dreams, yet even here we see false prophets. I heard one of them late Friday afternoon on CNBC who has totally missed the rally off of the February lows and is currently calling this rally nothing more than a “bull trap.” Be that as it may, there is a book written by Ned Davis that resides on my desk titled, “Being Right or Making Money,” which is reminiscent of the quote, “Knowing and not acting can be as damaging as not knowing at all.” I would rather make money than be right!
Plainly, we have been “acting” since the February lows, believing those lows represented a major bottom, setting the stage for a rally to new all-time highs; and, last Friday that vision almost came true. Indeed the S&P 500 (SPX/2129.90) closed the week within one point of its all-time high (2130.82 on May 21, 2015). My thoughts on this were best expressed by the perspicacious Jim Paulson in an interview on CNBC last week (as paraphrased):
Stocks should make new highs soon, closely followed strategist Jim Paulsen said Wednesday. He's the second market watcher this week to tell CNBC's ‘Squawk Box’ to expect a record run. Paulsen, chief investment strategist at Wells Capital Management, sees the S&P 500 going to the 2,200 level, an advance of 4.75 percent from Tuesday's close, which saw the index break 2,100 for the first time since December. The S&P 500 on Tuesday was also less than 1.5 percent from last May's record 2,130.82 close. Ebbing deflation fears, prospects for better earnings later this year and improving world economies are all reasons to believe U.S. stocks should climb, he said.
If that sounds familiar, it should, for I am the other person that has been calling for new all-time highs. So on the better than expected payroll number (+287k vs. the estimate of 180k), the SPX closed at a new 52-week high last Friday, causing my friend Jason Goepfert (SentimenTrader) to write:
“The S&P 500 closed at a new 52-week high. Using weekly closing prices, this is the first new 52-week high in 50 weeks, the 3rd-longest dry spell in 20 years. Going back to 1928, when the S&P sets its first 52-week high in nearly a year, it has led to mixed shorter-term returns but positive medium- to long-term ones.”
Moreover, Friday morning the astute Bespoke organization noted:
With today’s stronger than expected Non-Farm Payrolls report, the S&P 500 is on pace to cross above and close above the 2,100 level for the 25th time in its history (red dots in chart). Since it first crossed above 2,100 back in February 2015, this level has been quite a stubborn one for the market. For example, the S&P 500 has never closed above 2,100 for more than 14 straight trading days, and in each period where the index crossed and closed above that level, the median number of days it was able to stay above 2,100 was just two trading days (average 3.2 trading days, see chart 1).
Meanwhile, investors’ bullish sentiment is low, cash levels in portfolios is high, the 2Q16 earnings bar has been lowered too much (down ~5%), ~65% of the stocks in the S&P 500 have a higher dividend yield than the 10-year T’note, and EVERYONE is defensively positioned. That defensive positioning has spawned a new acronym STUB (staples, telecoms, utilities, and bonds). Remember when the term FANG (Facebook, Amazon, Netflix, and Google) became lionized the FANG move was long of tooth. Most recently, it is bonds that are actually gapping to the upside in the charts (chart 2). Recall, it was Jim Rogers (co-founder with George Soros of the Quantum Fund) who when asked how he makes money replied, “I buy fear and sell greed.” Then he was queried, “How do you determine when there is fear or greed?” He responded, “I wait until prices start gapping in the charts!”
The call for this week: I know it has been very easy to stay bearish this year given the constant bombardment of bad news, but my indicators, and the actual stock market, are telling us the resolution to the various economic/political messes is coming on the upside. Hence, I will leave you with this quote from my pals at GaveKal, “Most investors go about their job trying to identify ‘winners.’ But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.” Or how about this one, “Manage money for the environment that you are in, not the one you wish you were in.” Be bullish, my friends, be bullish . . .
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