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Investment Strategy by Jeffrey Saut

Take a breath
June 27, 2016

“If you can keep your head when all about you are losing theirs and blaming it on you.” . . . Rudyard Kipling

Rudyard Kipling was one of the most popular writers in the United Kingdom in the late 19th and early 20th centuries. Accordingly, today’s quote from him seems appropriate given the U.K.’s vote to secede from the European Union (EU) accompanied by the trouncing of the world’s equity markets Friday morning. That market action brought about instant comments from Wall Street’s gurus about the winners and losers from said vote, as well as instant opinions as to what it all means. I find such a “rush to inform” to be disingenuous and advised folks to sit back and take a breath (a deep breath). Indeed, I think it was futile to instantly speculate on the ensuing economic damage. My advice to the media last Friday was to do nothing. Better to take a breath, sit back, and analyze the facts over the weekend. Above all, I stated, do not panic. Maybe it’s because I am old, or the fact that I have seen this type of action before, but this kind of news generally only has a short-term impact on the markets. As Warren Buffet states, “The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”

Obviously, it was “optimism” about a “remain” vote that rallied the equity markets into last Thursday’s closing bell. Subsequently, I also told inquirers that my mantra of some 50 years has been, “never on a Friday,” meaning equity markets rarely bottom on a Friday. They tend to give participants over the weekend to brood about their losses, leaving them in “sell mode” early the next week . . . aka Turning Tuesday.

So it is now Sunday and I have had a few days to read the news and think about the state of the state. Here are some random gleanings, in no particular order:

  1. The U.K. will face a very long period of uncertainty, which is a negative for its economy.
  2. The U.K. is a net exporter of services and a net importer of goods from the EU. Fifty percent of the U.K.’s exports go to the EU, while only 10% of the EU’s exports go to the U.K. (trade barriers?).
  3. In the coming months there will be a significant decline of business with the U.K.
  4. In the U.K., the sectors that should feel the most negative impact are: auto, energy, telecom, electronics, retail, financial services (including insurance), and the metals industries.
  5. It is in the best interest of the EU, and the U.K., to get a new code of trade as soon as possible.
  6. The Brexit vote is indicative of some longer-term trends of anti-politics and anti-politicians.
  7. Bond yields are not going to go up.
  8. Intervention is coming to stabilize the various markets.
  9. Who’s next to leave the EU? The Podemos in Spain get a lift, the far right in France as well, the Five Star crowd in Italy, the Dutch are likely to vote to leave, and the list goes on.
  10. Germany takes a “hit,” with roughly a fifth of German cars sold to the U.K.
  11. The British pound probably trades to parity with the euro.
  12. London real estate (commercial and residential) takes a “hit.”
  13. Expect more monetary easing around the world (BOJ, PBOC, BOE, etc.)
  14. Investors will overweight low beta and defensive stocks going forward.
  15. The Brexit is more negative for Europe than it is for the U.K.
  16. The real risk to the EU breakup is Italy.
  17. Does this end globalization?
  18. Expect the exit process to begin this fall, but it will take years to complete.
  19. Our “no FOMC rate hike until December” seems more likely.
  20. The U.S. dollar should strengthen (the British pound traded to a 31-year low against the U.S. dollar).
  21. The big winners will be the lawyers.
  22. Boris Johnson is likely to replace David Cameron.
  23. It will not be easy to determine if it is to be a “hard” or “soft” economic landing for the U.K.

Importantly, investors should contemplate that the Brexit vote was indeed a referendum and is therefore not binding for the British government. The British parliament can take that vote and say, “Thank you very much, but we are staying in the EU.” They can also say, “We think the referendum is a mistake and we will take another referendum in six months.” In fact, according to the BBC, “A petition calling for a second referendum on [the] U.K.’s membership of the EU has gained more than two million signatures following the vote to leave” (BBC). Surprisingly, there is also a chance the Brexit vote may actually bring the rest of the EU closer together. Hence, I will say it again, “Take a Breath” (Take a Breath) and exhale for clearer thoughts this week!

Structurally, there is Article 50 in the Lisbon Treaty that states the EU will negotiate with the withdrawing country over a two-year period. Prime Minister Cameron could have invoked Article 50 immediately, but he did not. I take that as somewhat of a positive sign that a deal may still be able to be worked out. Obviously the worlds’ markets were caught wrong-footed, but we have seen that action before. In the fall of 1978, when the anti-Shah forces rioted in Iran, the D-J Industrials quickly lost ~14%. Again in the fall of 1979, when there was a massive flight from the U.S. dollar, the Industrials lost a quick ~11.3%. More recently we experienced the “Flash Crash” of May 2010 and “Flash Crash II” in August of last year, yet the world did not come to an end. This is not a “Lehman Moment,” nor is it a Bear Sterns déjà vu, both of which left the global financial system on the brink of collapse.

Speaking to the equity markets, Friday’s Flop finally broke the S&P 500 (SPX/2037.41) below its 2040 – 2050 support zone, bringing into view the May 19, 2016 intraday low of 2025.91 and the 200-day moving average at 2020.80. It also broke the SPX below its 20-month moving average that we wrote about last Monday. Of note, however, is that while not massively oversold, like it was on June 13th, the NYSE McClellan Oscillator has again become oversold. As well, my proprietary algorithm is still green (green is good) and it has not flipped to red like it did right before Christmas in 2015, which caused me to admit defeat on the “Rip your face off rally.” Given this set of metrics, I think the odds of some kind of “low” occurring this week are pretty decent. Hence, investors should make out their “shopping lists.” While many “bulge bracket” research firms rushed to publish lists of companies with high exposure to the U.K., I think a better strategy is to look for U.S. companies that derive 90% or more of their revenues domestically. A few on my “shopping list,” which are favorably rated by our fundamental analysts and screen positive on my algorithm, include: UnitedHealth Group (UNH/$137.29/Strong Buy), Mid-America Apartments (MAA/$101.11/Outperform), Unum Group (UNM/$32.06/Outperform), and Laboratory Corp of America (LH/$129.62/Outperform).

The call for this week: The Brexit vote is not a “Lehman Moment!” As the always clear-headed Jim Paulsen (Wells Capital) states, “It’s not like the U.K. is going to remove itself from the world economy and not trade with anyone. Once the emotion of this event fades, investors may get back to the fundamentals, which at least in the U.S. are looking better.” And the fundamental fact is that American companies generate ~70% of their revenues in the U.S. So again, “Investors should contemplate that the Brexit vote was indeed a referendum and is therefore not binding for the British government. The British parliament can take that vote and say, ‘Thank you very much, but we are staying in the EU.’ They can also say, ‘We think the referendum is a mistake and we will take another referendum in six months.’ In fact, according to the BBC, ‘A petition calling for a second referendum on [the] U.K.’s membership of the EU has gained more than two million signatures following the vote to leave.’ Hence I will say it again, ‘Take a Breath’ and exhale for clearer thoughts this week!”

P.S. – the SPX gapped down over 3% Friday morning. According to the must-have Bespoke organization, “Of the 17 times the S&P futures or SPY gapped down 3%, the best results were from the open to four days later, up 14 times average 6.5% (see chart on the following page).” This morning, as expected, there is a downside follow through (SPX down 16 points). Get ready to buy em’ . . .

Tired of waiting
June 20, 2016

“I’m so tired

Tired of waiting

Tired of waiting for you”

. . . The Kinks, Tired of Waiting For You (The Song)

“The American people are sick and tired of hearing about your damn emails!”

. . . Bernie Sanders on Hillary’s emails at the October 13, 2015 debate

“The American people are sick and tired of hearing about your damn Brexit!”

. . . Jeffrey Saut about this week’s (June 23rd) Brexit vote by the UK to leave the EU

I did a number of media “hits” last week, yet the question was always the same, “What’s going to happen with the Brexit vote?” As often stated in these missives, “When everyone is asking the same question it is usually the wrong question.” Moreover, I am indeed tired of hearing about the damn Brexit. To be sure there appears, at least superficially, to be some correlation (R2) with the stock market’s action, as can be seen in chart 1 on page 3. However, just as the R2 unraveled between crude oil and the direction of the S&P 500, I think the same thing will hold true with the Brexit. Besides, it’s not the snake you see that bites you. In point of fact, the “snake” nobody is seeing is what is going to happen in Germany tomorrow (21st). To wit, The German Constitutional Court is ruling on the European Central Bank’s (ECB) Outright Markets Transaction operations (OMT). The court will decide if OMT violates German law. If so, it would have important ramifications, likely putting German law directly opposed to European law. Spain also goes to the polls next week (26th) with the far-right and the far-left gaining ground at the expense of centrists. It appears, like last December, nobody will be able to put together a majority for a workable government in Spain. So put these on your radar screen along with Brexit.

Back on this side of the pond politics are also in the air, but not as dramatically. As consummate Washington insider Greg Valliere writes:

“The presidential choice is either Hillary Clinton or Donald Trump – and voters everywhere are asking: is there any other option? We were at a conference this week with over 200 savvy investors who favored ‘none of the above.’ Clinton and Trump had virtually no support with this group, and everyone asked us – is there another choice? There are only four options.”

After listing the four longshots Valliere concludes:

“Sorry, there's virtually no chance that there will be any last-minute surprises. It's the very slippery Hillary Clinton versus the cringe-inducing Trump, with a few fringe candidates lurking. When we tell this to clients and friends, many vow to write in themselves or relatives.”

Now, while there is not much R2 between our presidential election and the stock market, I did have one portfolio manager ask, “Do you think the rally off of the February low into the June high had anything to do with Trump’s rising popularity?” After I got done laughing I responded with a resounding, “No.” However, I must admit as Trump’s faux pas increased the S&P 500 (2071.22) fell some 3.3% into last week’s intraday low of 2050.37, which is the upper-end of the S&P’s 2040 – 2050 support zone. Given the manic depressive mood of Mr. Market I thought it best to “Better Call Saul.” Yet in this case it was not the TV series, but “Better Call Shad,” namely Frederick “Shad” Rowe, captain of the brainy Dallas-based Greenbrier Partners. I first encountered Shad in the 1970s when he was managing money and writing a column for Forbes magazine. His writing skills, and his investment acumen, are legendary. Coincidentally, Shad had written a column for Barron’s last week titled, “Pension-Fund Investing for Success” (Article), with the tag line, “Never mind the consultants, buy US stocks for the long term.” Some of the highlights from said article are:

  1. Have you noticed that since the stock market selloff in 2008, these folks (the consultants) have consistently advised clients that they reduce exposure to U.S. stocks? Their advice has been consistently wrong, as the tough-to-beat Standard & Poor’s 500 hit new highs last year.
  2. Pension consultants’ advice has contributed mightily to the insolvency of cities, states, municipalities, and corporations unable to meet their pension obligations because of poor investment returns on their pension funds.
  3. Let’s consider pension funds, looking at each 20-year period – roughly the typical career length of a policeman or fireman – on a rolling basis over the past 50 years. That is, we’ll look at 20 years, starting in 1965, then 20 years starting in 1966, and so on. Returns on investment in the S&P 500 stock index for each period have fluctuated between 8% and 12%. Each period contained some bad years, but there were always more good years and they outweighed the bad results for every 20-year stretch.
  4. While the actuarially assumed rate of return for most public pension systems is approximately 7.5%, the stock market has managed to climb the proverbial wall of worry and offer superior returns, compared to virtually all available alternatives – if you stayed fully invested in the index for the full 20 years.
  5. Here is a prediction. A gigantic market move to the upside is coming, as investment committees assess their costs and reach the conclusion that the stock market is their best and only hope to meet their obligations.

So despite Shad’s sage advice, the bears are convinced we are in a trading range environment at best, or a major stock market top at worse. Most of their arguments rest on valuations and a lack of earnings growth. Looking at valuations, the only metric that looks overvalued to me is Shiller’s Cyclical Adjusted Price Earnings model (CAPE), which at 26.1x earnings is about 10 points over its long-term average. Most of the other valuation tools are either marginally overvalued, or below their long-term average. Indeed, the trailing normalized P/E ratio for the S&P 500 is at 18.0x versus its average of 19.0x, while the price to free cash flow is at 23.0x versus its average of 28.1x. As for earnings, while it’s true earnings have had negative comparisons since late 2014, revisions to earnings growth estimates has been improving for nearly four months. Manifestly, the positive to negative earnings estimate revisions (EER) is now at nearly a two-year high from its long-term average. Hence, the earnings worm seems to have turned.

From a technical standpoint, the SPX has tended to be okay when it has traded above its 20-month moving average (MMA). Over the past 15+ years it has decisively fallen below that MMA, and failed to recapture it quickly, twice, as can be seen in chart 2 on the next page. That happened in early 2000, and again in late 2008, with devastating results. Currently, the 20-month moving average around 2040 for the SPX, which is one of the reasons the 2040 – 2050 support zone is pretty important.

The call for this week: Last week we mentioned a few times that the British Brexit reminds us of previous non-events like the 2014 Scottish vote, the Greece gotcha, the Italian mob job, Y2K, etc. We expect the UK to stay in the EU, which should produce a Brexit Bounce for the world’s equity markets. As for sectors, last week the only major sector that was up was the Utility sector (+0.88%), which rallied out to new all-time highs, but that paled in comparison to the rally in natural gas of more than 7%. Speaking to the other macro sectors, Consumer Discretionary is on support; the Consumer Staples sector is extended; Energy is on support; Financials, Healthcare, Industrials, and Information Technology are all neutrally configured in the short-term; Materials, Telecom, and the Utility sectors are overbought. This morning, however, stocks soar as British Brexit worries ebb with the preopening S&P futures better by 27 points at 6:00 a.m.

Baby don't go
June 13, 2016

The year was 1964 when Reprise Records released the song “Baby Don’t Go.” Written by Sonny Bono, and recorded by Sonny & Cher (Cherilyn “Cher” Sarkisian), the song became a smash hit and set the duo’s career in motion. The repeating lyric in said song is “Baby don’t go, pretty baby please don’t go.” And that’s the song playing in the various streets of the European Union (EU) as the Brits contemplate leaving the coalition on June 23 (Brexit). The latest odds I saw were those of last Friday where Predata showed 46.04% of respondents wanted to stay “in,” while 59.96 wanted “out.” The media is spinning Brexit such that an exit might cause a domino effect with other EU members following the Brits, potentially setting the stage for a complete dissolution of the EU. I think the odds of that happening are remote, but the politics of a U.K. exit could be impactful. And as long as we are skirting the realm of politics, I found this story, written by my friend Arthur Cashin, to be intriguing and pretty funny. As Arthur writes:

After the close Monday, there was the customary meeting of the Friends of Fermentation. It was far from a plenary session with only a handful of members attending. Perhaps it was the marinating ice cubes, or just the small crowd, but something prompted one of the members to weave a rather illogical but intriguing (at least to me) political fantasy. Say you are a Reality TV celebrity and you decide to throw your hat into one of the presidential races of one of the major parties. To you it's a bit of a lark, primarily a vehicle to enhance your celebrity credentials around the country. In the beginning everything goes well. You claim that the powers that be are conspiring against you and trying to rig the election. Much to your amazement, the other candidates fall by the wayside and you become the presumed nominee. In some ways this is a problem; if you run and lose, the loss may diminish your brand. Worse yet, now that you stand alone, reporters are pestering you with very specific questions on world events, and if you are not fully up to date, they begin to portray you as someone who is less than knowledgeable. That will never do. To lose could be damaging enough to your reputation, but to lose and appear not to be on top of things could wound your image, or even destroy it. In my friend's fantasy, the candidate decides that the only way out is to do many outrageous things before the convention, forcing the party leaders to block the candidate and name a substitute. That allows the candidate to claim he or she was robbed and retain their newly enhanced image. It was an entertaining story but then the peanuts ran out. Guess we're stuck with our current logical election.

While termed a political fantasy, this essay certainly would explain some of the antics being unleased by Mr. Trump. And now you understand why every chance I get I meet with my counterparts of the Friends of Fermentation. Last week, however, I met with folks in Chicago. I would like to thank all of the people at BMO, Putnam, First Trust, Nuveen, and Harris for the ideas we shared, yet the highlight of the week was having dinner with my friend Kurt Funderburg, portfolio manager for First American Bank. Kurt and I worked together in a past life when he was my Healthcare analyst. Over dinner, we talked of old times and swapped investment ideas. One of his favorite names is Dollar General (DG/$91.44/Strong Buy), which is followed by Raymond James’ fundamental analysts with a Strong Buy rating. For more on the DG story, please see our analyst’s reports.

Another portfolio manager (PM) I spoke with was CEO, CIO, and PM of Perritt Capital, namely Michael Corbett. I have met with Mike before and have found him to be a good captain of capital. Two of the funds Mike manages are the Perritt MicroCap Opportunities Fund (PRCGX/$31.90) and the Perritt Ultra MicroCap Fund (PREOX/$14.57). For the record, microcaps have underperformed for the past few years. That underperformance is likely because they did so well in 2013 that valuations got stretched. To be sure, at last February’s low, the Russell MicroCap Index was down some 27%+ from its June 2015 high. Nevertheless, while the micro capitalization universe of stocks has been out of favor, I think it’s time has come. Like Wayne Gretzky states, “I skate to where the puck is going to be;” and I believe “the puck,” at least for some of your capital, should be micro caps going forward. Over the years, many investors have asked me, “If you were going to manage money again, how would you do it?” My response has been, “I would concentrate on micro caps where there is no or little research coverage because that is where the misvalued pieces of paper are.

While we are on the subject of portfolio managers, I will remind you that some of Putnam’s “best and brightest” will be on a conference call with Andrew Adams and me to talk about strategies, discuss individual ideas, and stress the importance of incorporating alternative strategies to help reduce portfolio volatility and risk. It should be a highly interactive and productive discussion. The call is designed to be for investment professionals only, but I am sure there will be some competitors listening. The webinar will take place this Wednesday, June 15, at 4:15 p.m. EDT. To attend the webinar, please click on this link, because there is no phone number. The audio will play through your computer. If you are having any technical difficulties connecting, please contact Putnam Investments at 1-800-354-4000.

So what else did we see and/or learn in our travels last week? Well, I heard a lot of interesting investment ideas from the PMs I met with. One PM pointed out that the iShares 20+ Year Treasury Bond ETF (TLT/$134.78) is breaking out to the upside in the charts (read: lower interest rates/see Chart 1). Another complimented Andrew and me on our call for the past 10 months, that the Dollar Index (DXY/$94.66) topped last year (Chart 2), was correct and suggested select sectors that should benefit from a weaker greenback (Chart 3). Still another PM wanted to know more about the current “buying stampede,” which at session 84 is clearly the longest I have ever seen. To that point, the invaluable Bespoke organization recently wrote:

It’s been nearly four months since the S&P 500’s 2016 low on 2/11, and while it may seem like the market has just gone up every day since then, we were somewhat surprised to see that the frequency of up days over the last four months has been far from extreme relative to the rest of the bull market that began in 2009. The chart (Chart 4) shows the percentage of positive days for the S&P 500 over a rolling four-month period going back to March 2009. As of Wednesday’s close, the S&P 500 has been up in 48 of the prior 84 trading days, which works out to an average of 57.1% of all trading days. In order to compare the current reading to prior readings, whenever the line in the lower chart is red, it indicates that the percentage of up days over the prior four months was greater than the current reading, while the blue line indicates a lower reading. As shown in the chart, there is a lot of red. In fact, the S&P 500 has had a higher percentage of up days over a trailing four-month period on 38% of all trading days since the bull market began. In the top chart of the S&P 500, the red lines mean the same thing as the bottom chart. As shown, in the majority of instances, these periods of consistent up days tended to occur in bunches. Heading into this week, there was no denying that the market was overbought in the short term, and while a period of consolidation or modest declines is possible, the consistency of buying over the last four months has been far from extreme, so it’s not as though investors have been blindly buying.

And now, in addition to Friends of Fermentation, you know why I think serious investors should have access to Bespoke.

The call for this week: In last Thursday’s Morning Tack, I wrote, “Certainly this rally is extended, yet we still don’t see evidence of any ‘sell signals’ or much bearish data. In fact, one of the few cautionary ‘flags’ comes from the McClellan Oscillator, which is overbought on a short-term basis.” So while the past two trading sessions have been painful, it has indeed corrected the overbought condition (Chart 5) I spoke of and still leaves the S&P 500 (SPX/2096.07) above its 50 and 200-day moving averages. Also of note is that crude oil broke below its rising trendline last week and that we expect a decent rally attempt after the Brexit vote. This week, investors’ attention will focus on the FOMC meeting, where we have been saying for months there will be NO rate ratchet and likely no rate increase until after the November election. Many of these machinations will be discussed in this Wednesday’s 4:15 p.m. webinar with myself, Andrew Adams, and some of Putnam’s best and brightest (click here to join the webinar). As I write this on Sunday night in Charleston, SC, the S&P futures are off eight points on Brexit fears, China’s slowing fixed investment flows (15-year low), this week’s FOMC meeting, the Bank of Japan meeting, and Friday option expiration. A close by the SPX below 2078.40 would trigger a short-term trader’s “sell signal” on the daily MACD indicator.

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