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Roger Redux?!
February 8, 2010
“Who framed Roger Rabbit?!”... except in this case we are referring to Roger Blough. Return with us now to those thrilling days of yesteryear. The year was 1962, John Kennedy was President, and Roger Blough, the then CEO of U.S. Steel, had signed an agreement with President Kennedy not to raise prices. However, just four days later he raised steel prices right in President Kennedy’s “face.” The outraged President went after Mr. Blough and when Roger Blough tried to argue his point, Jack Kennedy stated, “My father told me that all steel men are #@Q&%!” The battle lines were thus drawn; government contacts were switched from U.S. Steel in favor of steel companies that didn’t raise prices, and with that governmental incursion into corporate America, the D-J Industrial Average (DJIA) shed 26% in just six weeks. Fast forward to today. The major banks have paid outsized bonuses right in the “face” of President Obama; and, it appears he has gone after them. Accordingly, the stock market has gone into the dumper, as can be seen in the attendant chart (for the record, I am neither a Republican nor Democrat; so stated before I get another onslaught of hate mail). Whether the 1962 analogy continues to “fit” remains to be seen, but it is a very interesting comparison that participants should ponder since we continue to believe the markets are in “selling stampede” mode.
Recall that “selling stampedes” tend to last 17 – 25 sessions, with only one- to three-session counter-trend rallies, before they exhaust themselves on the downside. It just seems to be the rhythm of the “thing” in that it appears to take that long before everybody gets bearish enough to jettison their stocks and make a decent tradable low. While it’s true some stampedes have lasted 25 – 30 sessions, it is rare to have one extend for more than 30 sessions. Therefore, we “put blinders on” to last Friday’s late-day upside reversal, consistent with our mantra of “never on a Friday.” That mantra was learned from numerous Friday “head fakes” implying that markets rarely bottom on a Friday once they are into a downtrend. Rather, participants tend to go home over the weekend, brood about their losses, and show up the following week in “sell mode.” So, while the markets may attempt to build on Friday’s late reversal, we have little confidence that any rally will last more than one to three sessions since today is only session 14 from the trading top of January 19th. That said, the equity markets are pretty oversold; and, our proprietary indicators do indeed suggest that a rally attempt is due.
Last Friday’s reversal was likely driven by the fact that the various averages have corrected approximately 10% since history shows that in the first year of a “bull move” it is rare to see much more than a 10% correction. Consequently, the psychology of an underinvested portfolio manager goes like this: “The typical bull market lasts three to five years, so any correction is for buying.” While we certainly hope that is the way it plays, we remain suspect this is the first leg of a new secular bull market. Rather, we think it is just another “bull move” within the context of the range-bound stock market we have been mired in for the last 10 years. Another driver of Friday’s reversal could have been the “break” below 10,000 on the DJIA, which is also a psychological support level that should be respected. Then too, the White House’s statement that the Healthcare Bill is probably “dead” may have triggered a positive response from the equity markets. Nevertheless, we doubt the political maneuvering is over on healthcare. However, the loss of political momentum inside the Beltway is amazing and potentially worrisome for the markets.
Be that as it may, many of the exchange-traded funds (ETFs) we monitor tested, and held, their respective 200-day moving averages (DMAs) last week, which could be yet another reason for a rally attempt. For example, look at the financials, as represented by the Financial Select Sector SPDR ETF (XLF/$13.94) that tested (and held) its 200-DMA, giving hope to investors in this complex. Another ETF we monitor, in an attempt to glean an edge, is the Market Vectors-RVE Hard Asset Producers (HAP/$30.78). Hereto, after plunging from its mid-January price peak, it tested (and held) its 200-DMA last week. Interestingly, many of the “hard asset” names, particularly some of the precious metals stocks, showed upside reversals on Friday. However, while we continue to like “stuff stocks” for the long-term (energy, timber, cement, water, precious/base metals, agriculture, etc.), we have been, and remain, cautious on them coming into the new year, fearful the dollar carry-trade was unwinding and that a whiff of deflation might be in the air. Ergo, on January 19th we wrote:
“Then there is ‘Dr. Copper,’ the metal with a Ph.D. in economics, which recently recorded a 12-month rolling rate of return in excess of 150%. Historically such a ‘copper cropper’ has marked a ‘trading top’ in copper and telegraphed caution for the equity markets.”
More recently, in our verbal strategy comments, we have referenced the gold to silver ratio (the gold price divided by the silver price; currently ~71 to 1) by noting when that ratio has “spiked” like it has recently, it too has suggested caution. All said, we remain cautious until there are convincing signs that a bottom is in place for both stocks and commodities. We do believe, however, once this correction runs its course, the major averages will trade to new reaction highs. Inasmuch, we continue to monitor stocks for the investment account. In past missives we have mentioned a number of potential purchase candidates, most of which have actually declined over the past few weeks. That does not mean we have given up on them! Indeed, most of them remain on our “watch list.” And, last week we added a few more when North American Energy Partners (NOA/$8.62/Strong Buy) reported a very strong earnings number. Subsequently, our Canadian analyst (Ben Cherniavsky) raised his estimates, as well as his price target, on the company’s shares. NOA is a leading provider of earth-moving equipment, infrastructure, and construction services mainly in the Alberta Tar Sands area. As we understand the story, NOA has the largest fleet of Caterpillar equipment in Canada and is therefore the “swing provider” to the now improving Alberta Sands projects. For further information see Ben’s recent report.
Another stock we added to our “watch list” is Cenovus Energy (CVE/$23.70/Outperform), which is also followed by Canadian research team with an Outperform rating. CVE was created when EnCana (ECA/$30.45/Outperform) split itself into two companies. Our analyst Justin Bouchard notes that CVE holds some of the best “in situ” leases in the Alberta Tar Sands with roughly 40 billion barrels in place. With solid capital efficiencies, and a technological leader, CVE expects to add incremental oil sands production at a capital efficiency of approximately $20,000 per flowing barrel, the lowest in the industry. At an attractive valuation, and with self-funding growth, we find CVE interesting. Hereto, for further information see Justin’s reports.
The third name we added to our list was Walter Energy (WLT/$67.54/Outperform), which is followed by Jim Rollyson and our Houston-based energy team. As one of the leading exporters of metallurgical coal, as well as a producer of steam coal, coal bed methane gas, metallurgical coke, and other related products, Walter should do well as demand from the emerging/frontier markets continues to ramp.
The call for this week: Economist, historian, and savvy seer Eliot Janeway stated decades ago, “When the White House is in trouble, the markets are in trouble!” Plainly, we agree and would add that the January Barometer has registered a cautionary signal, as has Lucien Hooper’s December Low indicator. That said, Friday’s turnaround, accompanied by pretty oversold readings, should lead to some sort of one- to three-session rally attempt. To that point, the NASDAQ 100 (NDX/1746.12) was “up” last week (+0.29%), as was Info Tech (+0.72%), Materials (+0.83%), and Natural Gas (+6.7%); so they may lead the “bounce.” Luckily, we have investments in all of these complexes. However, at session 14, in the envisioned 17- to 25-session “selling stampede, we remain cautious.
Selling Stampede?
February 1, 2010
“The World MSCI has now fallen for six consecutive days and shed -5.6% in the process. Over the same period, 1-month T-bill yields have fallen into negative territory and the US$ index has broken back above its 200-day moving average (an upside breakout not seen since August 2008). This combination of events has undeniably re-hashed a lot of bad memories for some clients. As an old friend put it: ‘The last time I saw the MSCI fall for six days with no rally, UST yields in negative territory and the US$ shoot up simultaneously was in August 2008 . . . and I didn't like the rest of the movie!’ Just like in the summer of 2008, the fear of a debt crisis is at the centre of the current shakedown. Back then, it was of course Lehman. And today, it is obviously Greece.”
...GaveKal (1/28/10)
It should be noted, however, that in the summer of 2008 the leverage in the financial system was far greater than it is today; and, the derivative “spider web” that had been knitted into balance sheets was legend. As the brainy GaveKal folks observe, “Almost every financial market participant is now operating with far less leverage and there are risk managers looming behind every equity and bond trader.” Accordingly, we think the odds of another post-Lehman type of meltdown are de minimis. Further, we believe the decline that began on January 20th is merely the normal correction everybody has been looking for since July. Buttressing that view is the fact the advance/decline line is firm (read: the breadth is still good), the number of new annual lows on the NYSE is not expanding, the yield curve remains steep, none of our proprietary intermediate indicators have rendered a “sell signal,” and the list goes on. All of this suggests the cyclical bull-market is still intact and stock prices should find support at, or above, the 200-day moving average (DMA), which is currently at approximately 1013 basis the S&P 500 (SPX/1073.87). Moreover, readers of these missives should not have been surprised by the recent stock slide.
Indeed, we have repeatedly written about how the first few weeks of the new year are littered with examples of “head fakes,” both on the upside and the downside. As well, history shows early January is also littered with “trading tops.” Therefore, we counseled for caution upon entering 2010 and we have the hate mail to prove it. Additionally, the 2003/2004 template we have been using since May of 2009 also hinted that a stock market decline should be expected. Recall, the SPX bottomed in March 2003 and rallied. The first leg of that rally peaked in late-May/early-June. From there, stocks flopped/chopped around, but never really gave back much ground. Then stage 2 of the rally began, which carried stocks higher into January 2004. The first leg of that 2003/2004 rally was driven by liquidity, while the second leg was spurred by improving earnings and fundamentals. If that sounds familiar, it should, because that is pretty much the sequence we have seen since the March 2009 “lows.” If that pattern continues to play, it calls for roughly a 10% correction and then a resumption of the rally.
To be sure, we have (and continue) to opine that with credit spreads back to pre-Lehman bankruptcy levels, and improving fundamentals, there is no reason the SPX should not “fill” the downside vacuum created in the charts by said bankruptcy. As often stated, that gives the SPX an upside target of 1200 – 1250. Hence, while we hedged some long stock positions for a correction, and recommended cash in trading accounts, we continue to favor the strategy of holding fundamentally sound, long-term investment positions and adding to such positions when signs of a bottom develop. The question then becomes, “What type of stocks should be accumulated?” If global growth remains strong, deep cyclics, transports, materials, energy, etc. are likely the stocks of choice. If, however, the central banks begin providing less liquidity, or the U.S. dollar continues to strengthen (the Dollar Index broke above its 200-DMA last week), or China continues its monetary tightening cycle, then overweighting technology, healthcare, consumer staples, and select emerging/frontier markets is the preferred strategy. Since we are currently in “cautionary mode,” we are opting for the latter sectors.
Speaking to the strong economy point, Friday’s headline GDP figure of +5.7% was met with a Dow Delight that rallied the senior index 120 points within the first hour of trading. From there, however, stocks slid into the close, leaving the DJIA down 53 points for the session, and off some 6% since the decline began. The reason for Friday’s fade was likely in the details of the GDP report. As our economist, Dr. Scott Brown, wrote early Friday morning:
“Real GDP rose at a 5.7% annual rate in the advance estimate for 4Q09 (median forecast: +4.7%), boosted largely by inventories. A slower pace of inventory reduction added 3.39 percentage points to the headline GDP figure. Real Final Sales (GDP less inventories) rose 2.2%, better than expected (median forecast: 1.6%). Domestic Final Sales (GDP less inventories and net exports), the best measure of underlying domestic demand, rose at a 1.7% annual rate (about as expected). The bottom line is that it was a stronger than expected headline figure, but underlying domestic demand was relatively lackluster, consistent with a gradual economic recovery. Equity futures are higher, but the enthusiasm may not last as market participants sift through the details.”
Clearly, Scott’s – “Enthusiasm may not last as market participants sift through the details” – was an excellent observation! Yet while economic figures come and go, the real question for us remains, “Is this a rally within the ongoing trading range we have been mired in for the last 10 years, or are we in a new secular bull market?” Plainly, we would like to believe it is a new secular bull market. However, if we are going to err, we will err on the side of conservatism, leaving us with, “Only a rally within the context of a range-bound stock market.” Of course if we are wrong, accounts will still stand to benefit handsomely. If we are right, we should continue to accrue the type of portfolio returns, based on our range-bound strategy, that have afforded accounts respectable risk-adjusted results.
In last week’s letter we suggested the stock market’s recent decline has given us the ability to see which RJ&A research universe stocks have resisted the overall price decline the best (read: good relative strength). That list can be retrieved from you financial advisor. This morning, we offer you another name from one of our research correspondents, which is favorably rated. To wit, biotech leader Celgene (CELG/$56.78). Celgene is in year three of its rollout and has the fastest launch of a hematology product ever, which should exceed $2 billion this year. For the first time ever, three trials have been halted in less than a year due to hitting their “end points” and this should lead to higher sales. A real key for the story is March 4th, which is the company’s first R&D day in years, where it will review the 20 phase three trials. This is the fastest growing EPS story in the S&P 500. The company’s patent projection is solid. Its internal goal is for 25-30% earnings growth. Celgene appears unique since it owns its drugs, it has no debt, $3 billion in cash, gross margins exceed 90%, and it has hidden assets. For example, Celgene’s production plant in Switzerland was opened last year and the Swiss gave the company a ZERO percent tax rate for a decade. So to a major drug company, this could represent something else that would have it look at Celgene, which we think is the last of the true growth major biotechs as its patent protection on Revlimid goes until 2026. If Celgene gets another drug, and it has those shots on goal, it could become bigger than Amgen (AMGN/$58.48) in market capitalization.
The call for this week: Potentially, today is session 9 of a selling-stampede, which has often been chronicled in these reports. Recall that such stampedes tend to last 17 to 25 sessions, with only one- to three-session counter-trend rallies, before they exhaust themselves on the downside. The January “stock sprawl” has left all of the averages we follow down year-to-date, as well as below their respective December “lows,” thus evoking Lucien Hooper’s warning, “If the December low is violated any time in the first quarter of the new year, watch out!” Accordingly, we remain cautious.
“You’ve Got Mail”
January 25, 2010
It’s been said that if you tell 100 people something bad is going to happen 50 of them will hate you immediately, and if you are right, the other 50 will hate you as well. Over the years I have found that axiom devastatingly true and last week was no exception. Indeed, shortly after releasing my strategy report last Tuesday I received a number of emails. This one was typical:
“Mr. Saut: In my life I do not believe I have encountered a larger burst of hot air than regularly shows up in your weekly so called commentary. More importantly, every time you have gotten bearish since your admittedly good ‘call’ of the market’s bottom last March, the stock market has rallied. The beginning of 2010 is just the latest example. Why don’t you get another job?!”
Over the years I have learned that such emails tend to coincide with “inflection points;” and maybe last week’s malicious mail will again prove that point. For the record, however, while it’s true I have gotten cautious a number of times since the March “lows,” I have never turned bearish. Indeed, getting cautious at the beginning of May 2009 was a pretty good “call,” especially since during the first week of July we wrote that the cautionary period was over and it felt like stage two of the rally was about to begin. Getting cautious at the end of September (3Q09), worried that the vacuum created by the July to September “melt up” might get “filled” to the downside with the start of the new quarter, was a “bad call” that we had to quickly correct. Similarly, turning cautious coming into 2010 looked wrong-footed, at least until last week.
Nevertheless, we clung to our new year’s cautionary stance since history shows that the first few weeks of the year are littered with examples of head fakes, both to the upside as well as the downside. In past letters we mentioned the biggest upside head fake chronicled in our notes was 1973 when the DJIA rallied to a new all-time high of 1051.70 during the first three weeks of the year, only to peak and begin a slide that would leave the senior index at 851.90 by August. To be sure, leaning against “conventional wisdom” is a lonely stance that often evokes “hate mail,” but as Yale University’s investment guru David Swensen writes:
“Contrarian investing poses extraordinary challenges under the best of circumstances. ...Unfortunately, overcoming the tendency to follow the crowd, while necessary, proves insufficient to guarantee investment success. . . . While courage to take a different path enhances the chances for success, investors face likely failure unless a thoughtful set of investment principals undergirds their courage.”
Then there is this from legendary investor Seth Klarman:
“Risk control to us is a careful aligning of interests, a proper balance in our investing between greed and fear, experienced and collaborative senior management and investment teams that have worked together for quite some time, a consistent and disciplined investment approach where every opportunity is individually and meticulously evaluated on its fundamentals, a strict sell discipline,a willingness to hold cash when opportunity is scarce, a complete avoidance of recourse leverage, and a healthy level of fear."
Speaking to this “willingness to hold cash” point, readers of our work know that we too are unafraid to hold cash. Indeed, we consider cash an asset class because to assume that the investment, or trading, opportunity “sets” that present themselves today are as good (or better) than any that will present themselves next week, next month, next quarter, etc. is naïve. And to take advantage of those future opportunity “sets,” you need to have some cash. Accordingly, in last week’s strategy report we wrote:
“The solar eclipse came and went in ‘Neverland’ between 11:06 a.m. and 2:00 p.m. last Friday with an attendant stock slide that should have stopped participants out of our remaining index recommendations. And, despite all the ‘Tinkerbell clapping,’ the S&P 500 is virtually no higher now than it was after the rally of January 4th.”
Consequently, trading accounts should have been back in cash early last week, thus avoiding the late week wilt. Still, our phones rang off the hook Thursday afternoon with the ubiquitous question, “After this two-day drubbing is it time to buy stocks?” In response to those queries, we had this to say in Friday’s verbal strategy comments:
“Never on a Friday – is a mantra that has served us well over the years, implying that markets in a downtrend rarely bottom on a Friday. Verily, participants usually brood about their losses over the weekend and show up Monday morning in ‘sell mode.’ And, I don’t know if it’s a Grecian default, a Chinese rate rape (read: monetary tightening cycle), a dollar delight that is causing an unwinding of the U.S. dollar carry-trade, a geopolitical gotcha’, etc.; something is lurking out there that trumped what should have been a decent rally attempt on Scott Brown’s victory. I mean Senator-elect Brown even won 61% of the Kennedy stronghold Hyannis Port for gosh sakes! So the fact that we didn’t even get the hint of a rally from the ‘Massachusetts Massive’ is worrisome. Now I am certainly not predicting it, but I remember July 1998 when the DJIA peaked around 9338 and began to slide. That Dow slide turned into a mini-crash and NOBODY knew why. And then b-a-n-g, out of the blue came Long Term Capital Management that almost ended financial life as we knew it. Accordingly, we remain cautious.”
One good thing about market declines is that they give us a chance to see which stocks hold up better than others. Those stocks go on our “watch list” for potential future purchase, or for additional purchase if we already own them. Some of the names, all of which are rated Strong Buy by the respective fundamental analyst team, that held up include: NCI, Inc. (NCIT/$30.04); O’Charley’s (CHUX/$7.41); Radiant Systems (RADS/$11.29); Select Comfort (SCSS/$6.80); Cogent (COGT/$10.97); Phase Forward (PFWD/$15.65); Stanley (SXE/$27.74); Dine Equity (DIN/$24.33); Wintrust Financial (WTFC/$34.77); CVS (CVS/$33.24); and Nuance (NUAN/$16.12).
One stock that did not hold up was A-Power (APWR/$12.31/Outperform), which declined 25% for the holiday-shortened week. As our fundamental analyst wrote last Thursday:
“A-Power announced a 5.8 million share private placement, with proceeds totaling $83 million. The deal was priced at $14.37 per share, a ~15% discount relative to yesterday's close. Additionally, the company issued warrants adding up to nearly 2.9 million shares. ...Collectively, the placement represents approximately 22% dilution based on the current shares outstanding (15% of this being immediate, and the rest upon warrant exercise), and accordingly, we are reducing our EPS estimates for 2010 and 2011. ...We are also reducing our target price from $20.00 to $17.00, based on ~13x our new 2011 EPS estimate, which we view as conservative given our three-year earnings CAGR assumption of at least 25%. With the conversion of its notes (issued last June) on December 31, leaving essentially no debt, we believed A-Power had gotten all its ducks lined up in a row when it comes to its balance sheet. As such, this private placement struck us as a major surprise, especially considering the hefty size of the deal. ...Notwithstanding (the) disappointing news, we remain positive on A-Power's leverage to the robust long-term growth potential of the Chinese wind market, the world's largest.”
The call for this week: They don’t call ‘em surprises because you expect them; and, clearly A-Power’s announcement was a complete surprise. It does, however, demonstrate why we never recommend buying an entire position all at once, but rather tranching “in” using three or four purchases. Speaking to the equity markets, for the first time since the March 2009 “lows” the S&P 500 (SPX/1091.76) has experienced three consecutive 1% downside days. The result has left the SPX below its 50-day moving average (1114). It has also left all of the macro sectors pretty oversold and therefore probably set for a rally attempt. That view is buttressed by the fact that the SPX is below its lower Bollinger Band for the first time since November 2008, as can be seen in the nearby chart. However, just like a heart attack patient doesn’t get right up off of the gurney and run the 100-yard dash, we think the equity markets will need time to convalesce after an initial recoil rally. As the Lowry’s service writes, “Attempting to gauge how long a correction might persist, and what losses it might entail, is generally an exercise in futility.” Plainly, we agree and merely hope we will be able to identify when the next rally “leg” begins within this ongoing cyclical bull market.
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