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Investment Strategy by Jeffrey Saut

Market bubbles
May 23, 2016

“Market bubbles occur when the price of an asset significantly deviates from its intrinsic value. There have been numerous bubbles predicted in my 20 years as a professional investor. Fortunately, only two, from the perspective of U.S. investors, came to pass. The technology bubble in 2000 and the financial crisis in 2008.”

. . . Scott Kubie, Chief Strategist at CLS Investments

As many of you know, last week I traveled throughout Mississippi and Alabama presenting to our financial advisors and their clients. My message was upbeat, yet many of those investors think the equity markets are in a “bubble.” Why this “bubbleicious” sentiment is so pervasive is a mystery to me, because using S&P’s earnings estimates for this year and next (~$114 and ~$134) leaves the S&P 500 (SPX/2052.32) trading at 18x this year’s estimate and 15.3x next year’s. As written last week, “In 2000, the S&P Total Return Index was trading for more than 30x earnings (excluding negative earnings), and if one includes negative earnings, the P/E ratio was pushing 60x.” As I was attempting to explain such metrics to one of our clients last week, an email from a European account arrived. The prose was from Scott Kubie, sagacious strategist who hangs his hat at the insightful CLS Investments organization, and the first thing I saw was the equation that serves as the title for this report.

The author explains said equation by noting: 1) FCF is free cash flow one year in the future, 2) R is the required rate of return, and 3) G is the future growth rate. Scott Kubie then elaborates:

“Whether you totally grasp the equation or not, the key points are: higher cash flow and growth raise the value of the firm, and a higher required rate of return lowers the value. The last two U.S. market bubbles occurred because investors were fooled by inflated values in one of these numbers. Interestingly, the 2000 and 2008 bubbles occurred in different parts of the equation. In 2000, investors assumed Internet companies would take over every aspect of commerce. Small startups were projected to grow into behemoths down the road. The growth rates assumed far outpaced potential, and a bubble ensued. High price-earnings (P/E) ratios for technology stocks were an expression of high growth expectations. As growth (g) gets closer to the required rate of return (r), valuations can get very high. 2008 resulted from inflated cash flow. In this period, investors assumed the high profits and cash flow generated from housing loans were sustainable. Instead, those numbers were based on errant assumptions about the housing market. Those profits were restated as massive losses in the following years. In this case, the valuations looked legitimate the entire time; it was the profit numbers that were inflated. So, where should we look for the next bubble? Investors and generals are known for fighting the last war. People looking for financial decline due to increasing student loan debt or riskier car loans are looking in the wrong places. Even the optimism in Internet firms or biotech companies pales in comparison to 2000’s tech bubble. Instead, look to the variable in the equation that hasn’t caused a recent bubble. Required rates of return (r) may be too low for some assets.”

I agree with this analysis and would urge investors not to get too bearish despite the difficult stock market environment. To be sure, the past nearly two years has been one of the most challenging markets I have ever seen. As the good folks at Bespoke write, “Markets have basically gone nowhere for the last 24 months. With fixed income yields as low as they are and equity markets basically returning nothing, investors have had a very tough time generating any kind of returns since mid-2014. Sideways action is a lot better than down action, but another leg higher at some point would sure be nice.”

And that’s true; the SPX has been range-bound (~1800-2130) since October 15, 2014. During that timeframe, Andrew Adams and I have made a number of tactical trading “calls,” most of which have produced decent results. Speaking to the “bad calls” we have made, as often stated, “When you are wrong, be wrong quickly and for a de minimis loss of capital.” We had to admit to a “bad call” back in mid-April when the SPX failed to follow its brethren, the S&P Total Return Index, to new all-time highs. That action produced a “polarity flip” in our model, suggesting a move to the downside into the week of May 8 (∓3 sessions) with a downside price target of 1990-2000. So far, the timing model has been generally correct but precisely wrong given the “low print” of last week at 2025.91. Of course, that is inconsistent with our price target, yet in this business, you have to take what the markets give you. However, the past few weeks have produced another oversold condition with the SPX becoming as oversold as it was last February (chart 1). That’s interesting, because the SPX is only off ~2.4% from its mid-April closing high. At the February oversold reading, the SPX was down some 13.3% from its November reaction high.

Given this year’s non-linear (trendless) performance, it is thought provoking to look at the sector performance year-to-date (chart 2). Utilities have been the clear winner with a YTD gain of 10.85% followed by Energy (+9.86%) and Telecom (+9.21%). That sector performance is a head scratcher, because Utilities, Energy, and Telecom have not had the best earnings momentum. Maybe the equity markets are looking forward to and anticipating better earnings. That certainly is what is occurring with forward earnings guidance, which is back in the “green” for the first time since early 2014 (chart 3). This is not an unimportant point, because the performance of companies the beat their earnings estimate, beat revenue estimates, and raised forward earnings guidance has been pretty good. Some such names from Raymond James’ research universe, which have favorable ratings from our fundamental analysts and screen well using my proprietary algorithm, include: C.R. Bard (BCR/$219.74/Outperform), NVIDA (NVDA/$44.33/Strong Buy), Newell Brands (NWL/$47.14/Outperform), UnitedHealth (UNH/$130.94/Strong Buy), and Wal-Mart (WMT/$69.86/Strong Buy).

The call for this week: According to the perspicacious Jason Goepfert (SentimenTrader), “It has now been a year since the S&P 500 was at an all-time high. This is one of the longest streaks without seeing a new high, with one of the smallest losses during the streak. Other times the S&P went this long without a new high led to highly variable returns, but they were better when the maximum loss had been under 20% as it has been so far (chart 4).”

Of course, such action has left AAII Bullish Sentiment plumbing the lows (chart 5). Indeed, all the ingredients are here for a bottom. This morning, the preopening futures are down a frack as the Nikkei shed 1.63% overnight on some ugly trade data. I do find it interesting that the SPX is testing its April lows, but the Advance/Decline Line continues to trade higher. We continue to exercise the rarest commodity on Wall Street, patience…

Penultimate preparedness
May 16, 2016

The day after the market crashed on October 19, people began to worry that the market was GOING to crash. It has already crashed and we’d survived it (in spite of our not having predicted it), and now we were petrified there’d be a replay. Those who got out of the market to ensure that they wouldn’t be fooled the next time as they had been the last time were fooled again as the market went up.

The great joke is that the next time is never like the last time, and yet we can’t help readying ourselves for it anyway. This all reminds me of the Mayan conception of the universe.

In Mayan mythology the universe was destroyed four times, and every time the Mayans learned a sad lesson and vowed to be better protected—but it was always for the previous menace. First there was a flood, and the survivors remembered it and moved to higher ground into the woods, built dikes and retaining walls, and put their houses in the trees. Their efforts went for naught because the next time around the world was destroyed by fire.

After that, the survivors of the fire came down out of the trees and ran as far away from woods as possible. They built new houses out of stone, particularly along a craggy fissure. Soon enough, the world was destroyed by an earthquake. I don’t remember the fourth bad thing that happened—maybe a recession—but whatever it was, the Mayans were going to miss it. They were too busy building shelters for the next earthquake.

Two thousand years later we’re still looking backward for signs of the upcoming menace, but that’s only if we can decide what the upcoming menace is. Not long ago, people were worried that oil prices would drop to $5 a barrel and we’d have a depression. Two years before that, those same people were worried that oil prices would rise to $100 a barrel and we’d have a depression. Once they were scared that the money supply was growing too fast. Now they’re scared that it’s growing too slow. The last time we prepared for inflation we got a recession, and then at the end of the recession we prepared for more recession and we got inflation.

. . . This ‘penultimate preparedness,’ is our way of making up for the fact that we didn’t see the last thing coming along in the first place . . .

One Up On Wall Street, Peter Lynch, formerly of Fidelity-Magellan Fund

Well, this time around you can take your pick about the “upcoming menace” from: A) Recession; B) Banking Crisis; C) War in the Middle-East; D) Inflation or Deflation; E) Presidential race; F) All of the Above, and more. The consensus pick is obviously “F” All of the above, and more. Indeed, most investors believe in their hearts that we haven’t seen the stock market low, or that we are not even in a bull market. More importantly, they are also guarding their investment pocketbooks because they can’t understand how the stock market can make a real bottom before resolving the various “menaces.” What they fail to appreciate is that the Wall Street financial markets are a discounting barometer. In other words, that is what the Dow Dive from last November’s nearly 18000 “print” to the mid-January 2016 “print low” (~15450), approximately 2500 intraday points, was all about!

The problems have been so widely publicized in the financial media that they have become popular fare in the network TV circles, in the print media with everyday columnists articulating those problems, and even my 85-year old Aunt Doris called to ask if the world is coming to an end? She called asking if the banks are safe, is real estate going to crash, is ISIS going to take over the world, will there be war with North Korea or in the Middle East, etc. I reassured her that her bank was not going broke, that her house value is not going to zero, that ISIS is not taking over the world, that if there is a war it wouldn’t be anything like WW II . . . even with a new offensive option against ISIS.

My point is, if all the popular media venues know all the negatives, and the negatives are the new media feature, then 90%+ of our problems are already baked into stock prices. So, anyone waiting for the resolution of all the negatives before buying is completely ignoring the stock market’s historical role as a discounting barometer, not to mention the confirmation from my Aunt (bless her)! Speaking to this point was none other than Julieta Yung, an economist in the research department at the Fed Bank of Dallas, and Michael Antonelli. To quote them, as written in Pensions & Investments:

“Short-term fluctuations in equity prices come too fast and furious and are caused by such a multitude of inputs that assuming they’ll directly translate into changes in real economic output is an error,” Ms. Yung wrote. Michael Antonelli, a trader at Robert W. Baird & Co., says “Big swings often just reflect human emotions. The two can disconnect in the short-term because of the immediate effect sentiment has on stocks. Then that nervousness wanes, and people capitulate, and that’s when you see the market come back.”

Indeed, “Short-term fluctuations in equity prices come too fast and furious,” and that was certainly the case last week as the D-J Industrial Average (INDU/17535.32) whipsawed its way through the week with Monday – Friday gains/losses like these: -35, +222, -217, +9.38, -185, which drove the day-trading crowd nuts. By week’s end the Doleful Dow had lost more than 200 points, and in the process broke below its May and April reaction lows. That action leaves the Industrials in negative territory for the year once again, and the S&P 500 (SPX/2046.61) darn close to doing the same. While the SPX has not violated its respective May/April reaction lows, it did break below its 10-day moving average (DMA) that we worryingly wrote about in last Friday’s Morning Tack. It also broke below its 50-DMA, which suggests it has “eyes” for its 200-DMA at 2012. Of course that would fit nicely with our model, which telegraphed a decline into last week (∓ 3 sessions), with a target of 1990 – 2000, when the SPX did not follow the S&P 500 Total Return Index to new all-time highs four weeks ago.

Within the “bookends” of the week the retail sector got slammed, leaving the retail indices down some 20% YTD. In the past this has been a modest warning signal for the overall stock market. Yet the real star for the week was the energy complex with crude oil up 3.66%, natural gas better by 5.98%, and gasoline soaring some 6.23%. Surprisingly, most energy stocks did not dance higher with the surge in energy commodities. Indeed, last week was a pretty weird week, but should have come as no great surprise given what our model has been telegraphing.

The call for this week: The stock market’s recent manic depressions have been centered on the word “recession.” I have repeatedly written that I see NO signs of an impending recession. In Barron’s over the weekend, my friend Sam Stovall (S&P Capital IQ and son of the legendary keeper of the GM indicator Bob Stovall), wrote:

“Granted the current [economic] expansion is the forth longest since 1900 and lasted more than twice the median duration of the prior 21. Yet we think this worry is premature, and put the likelihood of slipping into a recession during the remainder of President Barack Obama’s second term in office at 15% to 20%.”

Plainly we agree! Worth noting is that in the past three years, paycheck income has increased by a 4.3% annualized rate, far better than the real GDP growth rate. Moreover, every other semi-truck I see has a sign on the back saying “drivers needed” (buy the trucking stocks recommended by our analyst); and, every other fast food restaurant my grandkids want to stop at has a sign reading “Help Wanted.” These are not the kind of things you see in front of a recession. Clearly, Andrew and I attempt to “call” the near-term wiggles in the equity markets. However, we have NEVER wavered in our belief that the secular bull market remains alive and well. Just look at the attendant chart on the next page and observe that every market peak has subsequently been surmounted with higher prices. We have no doubt that will be the case this time. Our model was looking for a meaningful “low” last week, or early this week (∓ 3 sessions), so stay nimble on a trading basis. Longer-term, this is still a secular “bull market.”

John H. Cochrane for President
May 9, 2016

“John H. Cochrane for President” is my “call” after reading his article in last week’s Wall Street Journal (read it here: Slow Growth). Mr. Cochrane is a senior fellow at Stanford University’s Hoover Institution and in my opinion a really smart, and pragmatic, guy. The first paragraph of the article reads:

Sclerotic growth is America’s overriding economic problem. From 1950 to 2000, the U.S. economy grew at an average rate of 3.5% annually. Since 2000, it has grown at half that rate – 1.76%. Even in the years since the bottom of the great recession in 2009, which should have been a time of fast catch-up growth, the economy has only grown at 2%. Last week’s +0.5% GDP report is merely the latest Ground-hog Day repetition of dashed hopes.

The erudite professor goes on to note that while the differences between 3.5% growth and 2% may seem small, the resultant consequences are large. For example, by 2008 Americans were three times better off than they were in 1952. He writes, “Real GDP per person rose from $16,000 [per year] to $49,000.” However, if growth in the 1950 to 2000 timeframe was only 2%, instead of 3.5%, the per capita income metrics for that same timeframe would have been just $23,000, not $49,000.

If incomes could increase to their long-term average growth rate, the U.S. would be able to pay for Social Security, Medicare, defense, environmental concerns, and the U.S. debt. Presciently he writes, “Doubling income per capita would help the less well-off far more than any imaginable transfer [of wealth] scheme.” So why has economic growth slowed? Hereto the professor offers three responses. From camp one comes the idea that we have just run out of ideas. Camp two believes the U.S. is in “secular stagnation.” However, camp three (Cochrane’s camp) thinks the U.S. economy is overrun “by an out-of-control and increasingly politicized regulatory state.” He holds:

It takes years to get the permits to start projects and mountains of paper to hire people, if every step risks a new criminal investigation people don’t invest, hire, or innovate. The U.S. needs simple, common-sense, Adam Smith polices. America is middle-aged and overweight. The first camp says, well, that’s nature, stop complaining. The second camp looks for the latest miracle diet – try the 10-day detox cleanse! The third camp says get back to tried, true and sometimes painful: eat right and exercise.

In the article Mr. Cochrane shows an interesting chart titled “Ease of Doing Business and Per Capita Income.” The chart basically plots various countries’ 2014 income per capita against the World Bank’s “Distance to Frontier” ease of doing business for the year 2014. The higher the score on the chart, the higher the country’s per capita income. While the U.S. scores well there is still plenty of room for improvement. As the article states:

If America could improve on the best seen in other countries by 10%, a 110 score would generate $400,000 income per capita, a 650% improvement, or 15% additional growth for 20 years. If you think these numbers are absurd, consider China. Between 2000 and 2014, China averaged 15% growth and a 700% improvement in income per capita. This growth did not follow from some grand stimulus or central plan; Mao tried that in the 1960s, producing famine, not steel. China just turned an awful business climate into a moderately bad one.

Toward the end of the article the good professor concludes, “Parties argue over tax rates, but what’s really needed is deep tax reform, cleaning out the insane complexity and cronyism.” So, I titled this letter, “John H. Cochrane for President.”

Professor Cochrane holds out hope for the U.S. suggesting, “While the current presidential front-runners are not championing economic growth, House Speaker Paul Ryan and other House members are.” Of course that “foots” with my theme of the past three years that “We are going to elect smarter policymakers and therefore will get smarter policies.” My sense is this is one of the things that has helped fuel the secular bull market since March of 2009 (we were bullish at those March 6, 2009 lows). Recently, however, that secular bullish view has been questioned. Indeed, I have received numerous emails about certain pundits predicting a “market crash” for the equity markets. I would remind investors that these negative nabobs are the same folks who have been predicting Armageddon for years. I debated one such “permabear” at The MoneyShow recently and he hung his hat on the fact that he predicted the 2008 – 2009 debacle. I would note, however, I have known him for over twenty years and he has always been bearish, except on gold. I would also remind you that Dow Theory registered a “sell signal” on November 21, 2007, as well as a “buy signal” near the bottom in 2009. So, if we are going into a bear market (I doubt it) Dow Theory should tell us. Additionally, last week’s weakness brought the S&P 500 (SPX/2057.14) back down to its 2040 – 2050 support zone and left the McClellan Oscillator oversold. Moreover, from the February 11, 2016 low to the April 20, 2016 high the SPX gained roughly 16%, yet sentiment hardly improved. Since that high the SPX has given back a mere 2% and the bearish sentiment has gotten even worse; and, actually accelerated to the downside last week (chart 1). Speaking to my “Trump Tumble” note of last Friday, the good folks at Bespoke also noticed the concurrent stock weakness since the Trump victory (chart 2) as things get curiouser and curiouser. And that’s the way it is on session 60 of the current “buying stampede.”

The call for this week: We have targeted this week as an all-important week according to our models. The ideal pattern would have been for an upside blow-off into mid-May to new all-time highs, but two weeks ago we had to admit that was not going to play out. Therefore, our alternative strategy called for a mild sell-off into mid-May that should re-energize the equity markets’ internal energy and sink a meaningful low. The ideal pattern this week for that to happen would be for an early week decline with the maximum downside at the 1990 – 2000 level. This morning, however, it does not look like that is the pattern we are going to get despite China’s weak import/export data, the falling yen, the burgeoning Panama Papers, North Korea’s expanding nuke program, and Greece’s “gotcha” as the preopening S&P 500 futures are better by 6 points at 5:00 a.m.

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