Investment Strategy by Jeffrey Saut
DeVoe’s unprovable but highly probable theories
August 31, 2015
For the College Humor Magazine I submitted a collection of many ‘laws’ and other items , including my College Course Descriptions: 1) If it’s green, wiggles or slithers, it’s biology; 2) If it stinks, it’s probably chemistry, although don’t rule out economics; 3) If it doesn’t work, it’s most likely physics, although don’t rule out economics; 4) if it’s incomprehensible, it’s most likely mathematics, but that’s part of economics also; 5) if it stinks, doesn’t work, is incomprehensible, and doesn’t make sense, it’s either economics or philosophy.
. . . Ray DeVoe
I don’t claim to be an economist, although I do have a degree in economics. Fortunately, I have forgotten most of the economics I learned at university. Also fortunate is that I work with one of the best economists on Wall Street in the form of Scott Brown, Ph.D., but I digress. For the past few months I have been suggesting the economy was doing better, which has brought about cat calls from many of the negative nabobs. My sense has been that GDP was growing by at least 3%. Bolstering that belief, on one of my CNBC appearances I actually heard Tim Geithner say, “I think the U.S. economy is stronger than the official figures suggest.” Last week that proved to be the case as the Gross Domestic Product (GDP) figures came in much stronger than anticipated, prompting Scott Brown to write, “Real GDP rose at a 3.7% annual rate in the 2nd estimate for 2Q15 (vs. +2.3% in the advance estimate).”
Now I have always found the terms “real” versus “nominal” to be interesting. The main difference between nominal and real values is that real values are adjusted for inflation, while nominal values are not. As a result, nominal GDP will often appear higher than real GDP. Last week’s “real” GDP number brings back memories of a Jim Grant conference where Van Hoisington (Hoisington Investment Management) was a guest speaker. He began (as paraphrased):
Real GDP does not exist. I mean, literally, it does not exist. It’s a figment of the imagination of scorekeepers at the Department of Commerce who apply various adjustments to nominal GDP. Nominal GDP is what’s in your billfold. You go to a grocery store, you give them a dollar. That’s nominal GDP. That’s the sales that are entered as nominal growth. Nominal interest rates are what you pay. You have never met a real interest rate; I have never met one. You have never met a real GDP; I have never met one.
“Nominal versus Real,” what a novel concept; so, let’s see what happens if we apply it to the stock market. Measuring the D-J Industrials Average (INDU/16643.01) from its then all-time high of 11722.98 in the spring of 2000 shows that index is higher by 42%. However, in “real” terms the Industrials are virtually unchanged. Of course, hereto, you have never met a “Real Dow.” I have never met a “Real Dow.” While these charts from Advisor Perspectives are a few months old, you’ll get the idea. We live in a nominal world, not a “real” (inflation-adjusted) world. So, what happened in nominal terms last week?
Actually, the saga began in early July when my timing models said the equity markets were going into a period of contraction that should last into August 13 – 18th +/- 3 sessions. Since Friday August 21st fell within that +/- 3-session margin of error, August 21st’s 531-point drop should have come as no surprise. Normally, or should I say nominally, that Friday should have been “it” on the downside. But, as I stated on CNBC that morning, “Never on a Friday,” meaning once the stock market gets into one of these “selling skeins” it rarely bottoms on a Friday, giving participants over the weekend to brood about their losses and show up Monday/Tuesday in “sell mode” . . . aka, “Turning Tuesday.” And, that is pretty much the way it played, which is why I stated on CNBC the following Monday (8/24/15) today is “it,” the bottom/capitulation. Tuesday morning that “call” was looking good, but the early/mid-session strength gave way to late-session weakness as a number of trading platforms like the BATS Exchange were “off line,” causing liquidity to evaporate. That freaked traders out and they hit what bids were out there, leaving the senior index off 205 points at the closing bell. Still, our conviction was high and we bought some stocks. Obviously that conviction was rewarded on Wednesday (+619 points) and Thursday (+369 points). The 1300-point Dow Wow, from Monday’s intraday low to Thursday’s intraday high, took the Industrials back up to resistance levels, which is why we said, “We would not look for much more upside strength.”
Importantly, last Monday did qualify as a 90% Downside Day, as well as the most oversold the S&P 500 (SPX/1988.87) has been since the 1987 crash. At such inflection points what you typically see is a two- to seven-session recoil rebound. I think that started on Tuesday, leaving us four sessions into said rebound. If correct, it would imply some kind of downside retest beginning sometime this week. Yet by far, at least for me, the biggest event of last week was Monday’s Dow Theory “sell signal.” As repeatedly stated last week, we are temporarily ignoring that signal, but it does make me nervous. The next few weeks should tell us if ignoring such a signal is right or wrong. If wrong, we will change our views. In the meantime, on the premise that we are in a successful downside retest environment, we continue to urge you to get your shopping list together. Last Monday we gave a list of our fundamental analysts’ best ideas for sustainable high single-digit (or higher) free cash flow yields companies. Last week another list was compiled with our fundamental analysts’ strongest conviction ideas. While the list consisted of 12 names, only three of them screened well on our algorithm system. Those were: Ctrip.com (CTRP/$69.50/Strong Buy); Jarden (JAH/$52.34/Strong Buy); and Yadkin Financial (YDKN/$20.39/Strong Buy).
I also bought some mutual funds last week. I have met with Columbia Threadneedle’s portfolio manager David King a number of times and have become comfortable with his investment style. The two funds I bought were Columbia Flexible Capital Income Fund (CFIAX/$11.51) and Columbia Convertible Securities Fund (PACIX/$18.07). CFIAX takes a different tack from most other equity income funds in that it is able to invest across ALL asset classes without sector or security constraints. PACIX is just what its name states, a convertible securities fund. Those of you that have followed my work over the years know that I really like converts. In fact, one idea I shared with David was Iridium Communications’ 6.75% convertible preferred (IRDMB/$279.50), which is currently yielding 6% and whose common shares (IRDM/$7.18) have a Strong Buy rating from our fundamental analyst. Last week I also met with arguably the best straight preferred portfolio manager (PM) in the country. Don Crumrine is the PM for a number of preferred stock mutual funds and closed end funds. I bought one of his funds as well last week, the Flaherty & Crumrine Dynamic Preferred and Income fund (DFP/$22.42). As a sidebar, Don managed a preferred portfolio for Charlie Munger and Warren Buffett. For more information on such funds, please contact our mutual fund research, and our closed-end funds, research departments.
The call for this week: A few weeks ago I said I was not concerned with China’s wrongly named “devaluation” and its potential to start a currency war. Over the weekend China stated there is no basis for the renminbi’s continued depreciation. Speaking to China’s impact on the U.S., Gluskin Sheff’s David Rosenberg notes that China’s economy has only a 16% correlation to the U.S. economy and is therefore insignificant. Bank of America Merrill Lynch writes that $19 billion of mutual fund redemptions occurred last Tuesday, the second largest since 2007, which smacks of capitulation. Of course, capitulation was also registered by two consecutive 90% Downside Days (August 21st and 24th), which were followed by last Thursday’s 90% Upside Day. Such capitulation is typically followed by a two- to seven-session “throwback rally” and then a downside retest. If that pattern plays, it should tell us over the next few weeks if ignoring last Monday’s Dow Theory “sell signal” is the correct strategy. And this morning our late week “call” to not expect much more upside above the 1970 – 2000 level on the SPX appears to be playing with the S&P preopening futures off some 16 points. Stay tuned . . .
Days of yesteryear
August 24, 2015
“Return with us now to those thrilling days of yesteryear. From out of the past come the thundering hoof-beats of the great horse Silver. A fiery horse with the speed of light, a cloud of dust and a hearty ‘Hi-Yo Silver’ the Lone Ranger rides again” . . . except in this case we are not referring to the iconic radio/TV show, The Long Ranger as played by Clayton Moore, but last October. I awoke early on October 15, 2014, looking for more news on what had caused the 18 session bone-crushing decline. Indeed, after tagging the new all-time intraday high of 2019.26 on September 19, 2014, the S&P 500 (SPX/1970.89) began to slide. That slide started docilely enough with the SPX off a mere ~2.5% on its October 8th close. But, in the last five days of the rout, the SPX plunged another ~148 points to an intraday low of 1820.66 on October 15th for an intraday top to intraday low correction of some 9.84%. There were talks of Dow Theory “sell signals,” Hindenburg Omens, stock market crashes, Iran, Iraq, etc. and fear was rampant. It was on that day (October 15, 2014) Andrew Adams and I did a special strategy call at 4:15 in the afternoon. The message that day was:
Folks, if you didn’t raise some cash like we suggested last summer, you DO NOT raise cash here. This is how bottoms are made. The internals of the equity markets have been weakening since July with many of the indices’ components off more than 20%, while a few of the larger capitalization stocks have been able to keep the overall indexes only marginally lower. Verily, the troops have declined while the generals have held up, but now the generals are retreating. This is how declines end, unless the markets are going to crash. Historically, at market bottoms, the stocks that have tended to hold up finally succumb to the downside creating a panic plunge that is for buying. All investment books tell you the time to buy stocks is when they are out of favor. Regrettably, those same books don’t tell you how to summon the courage to buy stocks when things look so bleak. The quid pro quo is that it is nearly impossible to get investors to sell when stocks are zooming higher and times are ebullient. Amazingly, this is the only product I know of that when they put the product on sale, nobody wants to buy it!
To be sure, “return with us now to those thrilling days of yesteryear” because what is currently happening on Wall Street is almost an exact replay of last October. To wit, the internals of the equity markets have been deteriorating for months. Andrew and I have repeatedly written about this. As previously stated (paraphrased from the astute Day Hagan money management firm whose risk-adjusted mutual fund I own):
The U.S. equity markets continue to evidence deterioration beneath the surface. For example, based on the largest 4000 publicly traded companies on U.S. exchanges, more than 45% of those companies, or 1,804 of them, are 20% or more below their 3-year highs. Furthermore, 24.09% of those 4000 companies are 40% or more below their respective 3-year highs (we use 3-year highs to eliminate misleading short-term spikes that could skew results).
Accordingly, we have been writing that what has been happening is the “troops” have been retreating while the “generals” have been hanging in there, creating the illusion things were okay. Last week, especially the last three sessions, those generals began retreating, which spilled over into the “pornographic plunge” I spoke of on CNBC last Friday. Quizzed about what that means, I quoted the response from Supreme Court Justice Potter Stewart about pornography, “You will know it when you see it!” And, that is exactly what we got on Friday, a “pornographic plunge.” Said plunge left the SPX at the lower end of the 1970 – 2000 support level we have described as what we would ideally like to see that index travel into for a potential bottom. It is also worth noting our timing models had targeted August 13 – 18th, with a +/- 3 sessions margin of error, as where to look for a stock market low. Those are the same models that suggested in early July the equity markets were going into a period of “contraction.” That said, in last Friday’s Morning Tack, titled “Capitulation,” I wrote:
And yes, I think we are bottoming. It might happen today. The only caveat I would offer is one of my mantras, “Never on a Friday,” meaning when markets get into one of these selling squalls they rarely bottom on a Friday, giving investors the weekend to brood about their losses. Subsequently, they show up the next week in “sell mode,” which often leads to “Turning Tuesday.”
Also of note is that once the markets get into one of these selling-stampedes, they tend to last 17 – 25 sessions (last October’s was 18 sessions), with only 1 – 3 sessions pauses/rally attempts, before they exhaust themselves on the downside. It is just the rhythm of the thing in that it seems to take that long to get everyone bearish enough to throw in the towel and capitulate. Today (last Friday) would be session 24, which might also be exacerbated by the option expiration.
Of course, last week’s pounding, like last October’s decline, was accompanied with worries about China, GDP, ISIS, war in Korea, interest rates, the Fed, recessions, etc. The result has pressured the SPX down ~7.7% from its May 20th intraday high, while the D-J Industrial Average (INDU/16459.75) has shed ~10.3% from its mid-May highs. So, the Industrials are into correction territory, but the SPX is not. Now the SPX has not experienced a 10% correction in 46 months for the third longest stretch ever. Remember, a less than 5% drop is considered a “pause,” a 5% - 10% slide is termed a “dip,” a 10%+ decline is a “correction,” and a 20%+ plummet is a “bear market.” In Friday’s morning missive I wrote about many of the finger-to-wallet indicators/ratios I monitor that have been stretched to extreme oversold levels (Link to the Full Research Document). On Friday after the close, Bespoke wrote this, “While it was already a weak day on Friday, equities finished at their lows of the day and the week. With that drop the index closed out the week trading 4.4 standard deviations below its 50-DMA, which is the most oversold reading since 10/19/87, which was the day of the crash (see chart 1).” In addition to those points, last week Bespoke wrote (as paraphrased): The last 2 times the VIX was up 10%+ 3 days in a row, the SPX was higher 1 week and 1 month later. In the month following 10/13/14, it jumped almost 9%.
Not to be outdone, the sagacious Jason Goepfert (SentimenTrader) notes:
Now I highlight the VIX term structure above because the VIX curve has now become inverted or gone into a state of backwardation, something we only see when markets have entered the panic phase of a correction. Now in plain English all backwardation means is that traders expect heightened volatility in the short term but expect volatility to subside the further out in the future we go. Normally it is the other way around where the markets place a higher premium on volatility the further out in future you go, much like the interest rate curve. Note in the chart how conditions today with the VIX resemble what we saw back in early August of 2011 as we approached a short term low (see chart 2).
So late last week the call went out to our fundamental analysts, “In the midst of the current market dislocation, we are looking for names that have the highest sustainable free cash yields, upper single digit or higher if possible.” Here is the resultant list so far, in no particular order: CACI (CACI/$80.46/Outperform), Cisco (CSCO/$26.47/Outperform), Booz Allen Hamilton (BAH/$26.88/Outperform), CVS (CVS/$102.21/Outperform), Enterprise Products (EPD/$27.33/Strong Buy), Polycom (PLCM/$10.43/Outperform), Republic Services (RSG/$42.00/Strong Buy), and Manhattan Associates (MANH/$59.91/ Outperform).
The call for this week: Last week we told you to get your “buy lists” ready. This week, unless we are into a “crash” (we don’t believe it), we should see some kind of tradeable low. Reinforcing that view is a friend of mine from an era gone by. It was in the early 1970s when John Gaynoe and I worked at the venerable brokerage firm of EF Hutton, which is where I began writing investment strategy in December of 1974. John went on to become a senior portfolio manager at Capital Guardian LLC Wealth Management. Late last week he penned a letter to clients, with whose points I absolutely agree. I am only including the Q&A portion of John’s letter below. This morning, however, the preopening S&P 500 futures are off some 45 points at 5:00 a.m. as China loses 9% overnight and the U.S. dollar swoons. Turning Tuesday, anyone?!
Q&A Below Courtesy of John Gaynoe, Capital Guardian LLC Wealth Management
Q) How significant was the 21 August decline?
A) Not nearly as significant as it may appear. The “Obama Bull” began on the open 10 March 2009 with a rally of 5.65%. This Bull Market has had twenty two moves of 3% or more: ten up moves and yesterday the twelfth move down.
Q) Yesterday the market dropped -3.39%. How does that compare to the average DJIN price change in this bull Market?
A) The average daily price change on the DJIN in the Obama Bull has been .94%.
Q) Can you put that in context?
A) Yes; the 21 August decline was about 3.6 times the average price change in the DJIN for this Bull Market. The average daily price change has been 125.3 points since March 2009.
Q) The average daily price change on the DJIN has been 125.3 points! Are you sure?
A) Yes I’m sure; I was very surprised at this number as well.
Q) You often write about what normal looks like. What do these observations mean for the future?
A) Our Valuation model projects a year 2020 target on the DJIN of approximately 29,079. If this target is reached and the volatility remains constant at about .94% average daily price change, the average daily price change on the DJIN over the next five years will be about 214 points.
Q) Your 2020 target on the DJIN is over 29,000. What does this assume?
A) The 30 stocks in the DJIN have been valued at 16.5 times earnings over the past years and are expected to earn $6.07 in 2016. The five year growth rate estimate is 9.45% per year. This gives us $8.71 a share in DJIN earnings by 2020. The average DJIN stock closed at $81.31 on 21 August. The 2020 earnings target is $143.73 per share. The ratio of the average stock price to the DJIN currently is 202.32; $143.73 times 202.32 is 29,079. This is not guess work here.
Q) Is the DJIN over valued as many “experts” contend?
A) Not at all; the DJIN is currently valued at 13.4 times 2016 earnings whereas the trailing five year average is 16.5 times earnings. Since yearend 2006 the DJIN has been valued at 15.3 times earnings.
Q) Based then on the technical evidence, what just happened?
A) The market almost certainly experienced a text-book Selling Climax on 21 August 2015. It is likely this was also a Terminal Shakeout. But this must be proven or disproven by the market action over the next several days.
Q) Is the market decline over?
A) Extremely likely but nothing is certain. But the key issue is this: if this was a Selling Climax coupled with a Terminal Shakeout, a yearend target of 20,000 is realistic. We will know in a few days.
The one percent
August 17, 2015
Let me be blunt. If anyone of you out there believes that anyone in our business is going to be right all of the time, I have some news for you. Better yet, I have a few yards of swampland in the Everglades I would like to sell you. Writing your feelings, doing radio, getting on TV and just putting yourself out there is not easy . . . especially when it has to do with the markets, which are psychotic most of the time. I don’t need to defend Mr. Landry. Mr. Landry does just fine on his own. But coming from me – someone who is my own biggest critic as well as a critic of Wall Street – you best realize that Mr. Landry is in the top 1% of people on Wall Street. He is clear, he is concise, and he is right more than he is wrong. AND more importantly, when he is wrong he doesn’t just sit there and fight the tape. He adjusts unlike [many] of the bonehead strategists on Wall Street; stop reading and listening to him at your own risk.
Ladies and gentlemen, that prose came from Gary Kaltbaum back in the troubling times of early 2003, a man I consider to be one of the best and brightest on the Street of Dreams. He penned those words when someone attacked Mr. Landry (another excellent pundit) for being wrong on some short-term wiggle in a financial asset. I recalled Gary’s article titled “Why This Man Is One Of Wall Street’s Top One Percent” as I was attacked last week about my March “call” that crude oil had bottomed. The reason for the attack was because the August crude oil futures contract nudged below last March’s intraday low of $42.03 per barrel by tagging $41.35 on an intraday basis last Friday. Despite that “undercut low” (below the March low) I am still of the belief oil is bottoming. If that proves to be wrong, like Mr. Landry, I will not sit there and fight the tape. I will adjust, as I have often had to do over the years. As my father used to say, “Son if you are going to be wrong, be wrong quickly, and for a de minimis loss of capital.” According to one Wall Street icon, namely Leon Levy:
“I think a trader has to have the ability – or an investor I should say – has to have the ability to adjust to be wrong. In other words, you can’t be too stubborn. You must have a certain degree of flexibility as to what’s going on.”
“Being wrong,” what a novel concept, and as the brilliant Peter Bernstein notes:
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 (maybe the real trick is persuading clients of that inexorable truth). 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 since disappeared from the scene.
As stated, I continue to think oil is in a bottoming phase. In fact, the stocks in the energy sector are extremely oversold. Looking at the energy stocks in the D-J Industrial Average (INDU/17477.40) that are oversold, and positively rated by our fundamental analysts, shows only one: Chevron (CVX/$85.91/Outperform). Speaking to stocks that benefit from lower energy prices, it is worth noting the D-J Transportation Average (TRAN/8318.70) looks to have bottomed and has broken out to the upside of its downtrend line that has been intact all year (see chart 1 on page 3). We have written about the Trannies non-confirmation since last December when the Transports failed to make new highs along with the Industrials. Many self-proclaimed Dow Theorists termed that a Dow Theory “sell signal,” but in reality it was only an upside non-confirmation. And for the hundredth time, for me to get a Dow Theory “sell signal” would require the Industrials to close below their October 13, 2014 closing price of 16117.24 with a concurrent close by the Transports below their October 16, 2014 close of 7717.69.
So where does all of this leave us? Well, as with our now in question oil bottoming call, we are still not mincing words after telling accounts in early July the equity markets’ “internal energy” was totally used up and we were likely going into a period of contraction. At the time we stated our timing models were targeting the August 13th through August 18th, 2015 timeframe as where at least a trading bottom, if not a more significant bottom, should occur. We are about to find out if that “call” proves to be correct over the next few weeks. If not, we will adjust.
Meanwhile, all of the indices and macro sectors we monitor closed “up” last week as they turned a deaf ear to the Chinese gotcha, the Hindenburg Omen, the alleged negative cross over by the 50-day moving average below the 200-DMA in the SPX chart, the higher than expected inflation report (PPI) . . . well, you get the idea. Such action caused one of my emailers to ask, “So what does the stock market know that most investors don’t and what are the catalysts that will cause stocks to rally?” Admittedly, last quarter’s earnings season wasn’t so hot, although 60.4% of reporting companies beat estimates and 52.6% bettered revenue estimates. Yet the figure catching our attention was that the spread between the percentage of companies raising versus lowering forward earnings guidance has shown dramatic improvement. We would also note earnings comparisons year-over-year, as we get into 2016, should look pretty good, especially for the energy sector.
Another catalyst could be that the economy is actually getting better. Consumer spending improved in July, ditto the job market, companies are increasing production, the sale of heavy trucks has gone vertical (companies don’t buy heavy trucks unless they plan to ship more product), industrial production is revving up (chart 2), inflation is picking up at the margin, and the list goes on. As I stated on CNBC last week, “I think the economy is currently running at a 3% GDP growth rate.” And, we will find out if that is correct when the 2Q15 revised figures are released later this month.
The call for this week: I am in Boston this week seeing accounts and speaking at events. As for this week’s anticipated action, according to my friend Jason Goepfert and his invaluable research firm of SentimenTrader, “Weakness in stocks, not necessarily reflected in big indexes like the S&P 500, has been weighing on bullishness, at least in many of the sentiment surveys. That has pushed the AIM Model to its 2nd-lowest reading in three years. When occurring in bull markets or near a recent high in the S&P, it has led to consistent positive returns (chart 3).” This morning, however, everything is flat on no real overnight news. Still it is a triple-witch expiration week, which tends to favor the upside. We think the contraction phase has ended and an expansion phase is beginning.
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