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Investment Strategy by Jeffrey Saut

It’s someone else’s money
October 17, 2016

The analogy between the stock market and poker has always been irresistible. Interestingly, the stock market increasingly resembles a low-stakes recreational game among friends and less the sort of ‘there goes the ranch’ game favored by cutthroat professionals. Recreational poker is frustrating but ultimately profitable to the serious player. Recreational players come to play. They play every hand. They make long-odds bets. They are hard to read because fear of losing money is not a factor in the game. They can’t be bluffed. The serious player is a different animal, playing the odds, maximizing winnings on pat hands, and figuring that in the long run his superior abilities will prevail.

The stock market is dominated by institutional equity fund managers who are paid to own stocks. The decision to own stocks already has been made by an asset allocation committee or by the individuals who bought the mutual fund. Like the recreational poker player, equity fund managers are there to play. It is not their money and they are far less worried about losing money than underperforming the market. Put it this way: Individuals in the ‘business of investing’ want to out-perform their peers. It’s a different kind of game. If the market is down 20% and the equity professional is down 15%, he or she is ecstatic. If the market is up 20% and the equity professional is up 15%, he or she is despondent. The growing dichotomy of purpose between the owners of the money and the people managing the money is little understood.

When individuals played a bigger role in the stock market, those great allies of the serious independent – fear and greed – came more frequently into play. Every couple of years there would be compelling bargains or shorting opportunities. The market favored by institutions – the S&P 500 – is expensive by historical standards. But the institutions aren’t selling – as individuals might have done – because they have to be invested, and where else can they put all that money?

. . . Frederick “Shad” Rowe, Greenbrier Partners

The aforementioned prose was scribed by my friend Frederick “Shad” Rowe, of Greenbrier Partners fame, decades ago and it is just as relevant today as it was back then. I dredged it up this morning because I am in Dallas this week to attend Shad’s “Great Investors’ Best Ideas Symposium” (GIBI) tomorrow. Tonight I will be attending the speakers’ dinner convened at Shad’s home where Michael Price, David Einhorn, T. Boone Pickens, and Mario Gabelli (to name but a few) and I will dine to discuss the “state of the state.”

Obviously, one of the main topics of discussion will be about the recent stock and bond market consternations since mid-September. Of course my models suggested such consternations would be the case since late August, however I did not think the environment would be this frustrating. So, we got the first “consternation” on September 13 when the D-J Industrials (INDU/18138.38) fell 258 points, while the S&P 500 (SPX/2132.98) surrendered 32 points and, in the process, tested its 2100 – 2120 support level. That downside test proved successful, leading to a rally that carried the SPX back to its 2180 – 2200 overhead resistance zone. While many pundits believed that rally meant the correction was over, Andrew and I were less sanguine since our models failed to confirm that THE low was “in.” Sure enough, the SPX came back down and broke below the September lows in mid-October and again select pundits said the correction was over. Hereto, our models were not so sure. So far, all we have seen is the July upside breakout from the nearly two-year range-bound stock market and a subsequent downside retest of the support level of 2100 – 2120 (see chart 1). Last week we experienced more frustration with the Industrials up about 88 points on Monday, off 200 points Tuesday, better by 15 points on Wednesday, down 45 points comes Thursday, and up some 40 points on Friday, although we would note the Industrials were up over 100 points early in Friday’s session. That caused one savvy seer to lament, “Up mornings and down afternoons is not particularly good market action!”

For the week, the Industrials fell 0.56%, the SPX declined 0.96%, and the NASDAQ Comp surrendered 1.48%. On a sector basis, the worst sector was Healthcare (-3.27%) with Utilities (+1.33%) and Consumer Staples (+0.66%) the only sectors posting gains. The weekly wilt left the SPX and NASDAQ Comp at critical support levels. As often stated, 2100 – 2120 is the key support zone for the SPX with downside “pivot points” at 2108 and 2092. If these levels are violated on a closing basis, we will have to rethink our near-term strategy. But until then, as repeatedly stated last week, “What has happened this week is NOT a definitive break to the downside.”

Two of the major events that occurred last week happened in the bond market, where the 10-year T’note yield broke out to the upside (read: higher rates – chart 2) and the collapse of the British pound (chart 3). The weaker British pound is actually quite bullish for British multinational companies and I am tilting portfolios accordingly. I am using select actively managed mutual funds to accomplish this. As often stated, I think individual investors are doing the exact wrong thing by selling actively managed funds, while buying passive funds. When stocks are undervalued, and the indices are going straight up, investors need to own “cheap beta” (passive funds). However, when stocks are neutrally valued, or by some measurements over-valued, you want actively managed funds. The reason is that an active manager can say, “I don’t want to play in that particular game because valuations do not make sense.” Case in point, for months Andrew and I have made the argument that the defensive stocks, or low volatility names (chicken longs) are extraordinarily expensive. And guess what, that space has “rolled over” in the charts and has broken down. We suggest pruning those names from portfolios.

The call for this week: I should be gleaning some good investment ideas from tomorrow’s GIBI event. Additionally, I will be speaking at Thursday’s “Money Show” here in Dallas where the preponderance of speakers will be bearish, except on gold. To those “bear boos” we offer this from the astute Lowry’s Research organization:

Since the sideways trading range in the S&P 500 began in mid-July, our Buying Power Index has weakened by 41 points. During the same period, our Selling Pressure Index has increased by a relatively minor 17 points – far short of the intense selling needed to turn the Advance-Decline Lines sharply lower, in order to warn of an impending major market decline (chart 4). Therefore, a short term correction may be needed to revitalize investor Demand. However, over the past 90 years, with few exceptions, major bear markets have been preceded by a contraction in the Advance-Decline Line lasting for a period of at least four to six months before the S&P 500 Index reaches its final bull market high. Thus, while portfolio holdings should be given extra scrutiny, it still appears to be too early to abandon all equities.

Plainly we agree, yet our models suggest the period of consternation should continue into the last week of October. Until then, we are not doing very much. This morning at 4:00 a.m., the preopening S&P futures are off 6 points as the U.S. threatens Russia with cyber-attacks. I would note that if said attacks on Russia were real it would not have been announced and it would be the NSA, not the CIA, carrying them out. Still, this is really serious stuff.

Darvas discipline
October 10, 2016

I knew that I had to adopt a cold, unemotional attitude towards stocks; that I must not fall in love with them when they rose and I must not get angry when they fell; that there are no such animals as good or bad stocks. There are only rising and falling stocks – and I should hold the rising ones and sell those that fall. I knew that to do this I had to achieve something much more difficult than anything before. I had to bring my emotions – fear, hope and greed – under complete control. I had no doubt that this would require a great amount of self-discipline, but I felt like a man who knew a room could be lit up and was fumbling for the switches. . . . I started to see that stocks have characters just like people. This is not so illogical, because they faithfully reflect the character of the people who buy and sell them.

Like human beings, stocks behave differently. Some of them are calm, slow, and conservative. Others are jumpy, nervous, and tense. Some of them I found easy to predict. They were consistent in their moves, logical in their behavior. They were like dependable friends. And some of them I could not handle. Each time I brought them they did me injury. There was something almost human in their behavior. They did not seem to want me. They reminded me of a man to whom you try to be friendly but who thinks you have insulted him and so he slaps you. I began to take the view that if these stocks slapped me twice I would refuse to touch them anymore. I would just shake off the blow and go away to buy something I could handle better. . . . I tried to detect those stocks that resisted the decline. I reasoned that if they could swim against the stream, they were the ones that would advance most rapidly when the current changed.

After a while, when the first initial break in the market wore off, my opportunity came. Certain stocks began to resist the downward trend. They still fell, but while the majority dropped easily, following the mood of general market, these stocks gave ground grudgingly. I could almost feel their reluctance. On closer examination, I found the majority of these were companies whose earnings trends pointed sharply upward. The conclusion was obvious: capital was flowing into these stocks, even in a bad market. This capital was following earning improvements as a dog follows a scent. This discovery opened my eyes to a completely new perspective.

I saw that it is true that stocks are the slaves of earnings power. Consequently, I decided that while there may be many reasons behind any stock movement, I would look for one [thing]: improving earnings power, or anticipation of it. To do that, I would marry my technical approach to the fundamental one. I would select stocks on their technical action in the market, but I would only buy them when I could give improving earnings power as my fundamental reason for doing so.

. . . Nicolas Dravas, How I Made $2,000,000 in the Stock Market

Read that last paragraph, and then read it again, because the wisdom of those words is profound! It is particularly significant since we believe the equity markets are transitioning from an interest rate-driven bull market to an earnings-driven bull market. Indeed, we think the “profits recession” troughed in 2Q16 and that easy earnings comparisons will be seen in 3Q and 4Q of this year. Now many strategists and analysts downplay such an earnings improvement as being driven by “easy earnings comparisons,” but as our friend Rich Bernstein writes: “However, every profits cycle, by definition, begins with a series of easy comparisons. It is impossible to begin a cycle with difficult comparisons.”

Meanwhile, select pundits continue to predict a calamitous end to this secular bull market. Hereto, Rich Bernstein of Richard Bernstein Advisors (RBA) writes:

Some market observers have cautioned that overvaluation always leads to poor returns because multiples contract. There is indeed history to support such concerns. However, the key word is “always.” As we have shown, there have been many periods in stock market history during which earnings growth improves, interest rates increase, PE multiples contract, and a bull market continues. They are called earnings-driven bull markets. It is always headline-grabbing to predict a calamitous end to a bull market, and a broad range of sentiment data strongly suggests investors are quite scared. At RBA, however, we continue to swim against that fearful tide, and our portfolios are positioned for a cyclical rebound in earnings and an earnings-driven bull market.

Sticking with the “earnings” theme, 3Q16 earnings season begins this week when Alcoa reports. Of interest, at least to Andrew and I, is that more fundamental analysts are raising their earnings estimates on the Technology sector than lowering them (see chart 1 on page 3). Obviously, that is music to our ears, because we have recommended a large portfolio overweighting in Technology. Meanwhile, net earnings revisions for the S&P 500 continue to be negative but to a lesser degree (chart 2). Interestingly, earnings revisions by sector are favoring Technology, Utilities, and Financials (chart 3 on page 4), while the percentage of raised guidance by sector is also worth consideration (chart 4). Nevertheless, recall that, going into 2Q16 earnings season, we opined earnings were going to “come in” better than the lowered-bar expectations. Bingo! . . . Last quarter, 64% of reporting companies beat their earnings estimates and 57% beat their revenue estimates. We expect the same kind of results (or better) for 3Q16.

Within the bookends of last week there were some significant events: 1) the yield on the 10-year T’note surged from 1.59% to 1.72%; 2) higher rates caused the U.S. Dollar Index to rise as the British Pound collapsed versus the greenback last Friday; 3) rising rates left the defensive stocks (we have termed them “chicken longs”) under pressure, because most of them pay high dividends and most of them are very expensive, as we have suggested for months; 4) another “defensive play” fell last week as gold traded lower and tagged its 200-day moving average; 5) crude oil had a very good week for a multiplicity of reasons; 6) the ISMs had their biggest monthly rise ever (read: no recession); 7) the employment report was not as bad as the media said; 8) the Labor Force Participation Rate looks to have bottomed (chart 5 on page 5); 9) Bullish stock sentiment has been below 40 for 49 weeks (historic); 10) seasonal factors favor the “bulls” as we move into mid-October, which is the second best month of the year for the past 20 years (chart 6); and the list goes on.

Speaking to the recently stronger dollar, while longer term we think the U.S. Dollar Index has traced out a giant top in the charts, near term the dollar could trade higher given the higher environment of short-term higher interest rates. Historically, periods of dollar strength tend to see stocks with the majority of their revenues coming from the U.S. to outperform. Therefore, for your potential “buy lists,” we have screened stocks from the Russell 1000 that have large domestic revenues, are favorably rated by our fundamental analysts, have attractive long-term chart patterns, and have positive metrics on our proprietary algorithms: Sun Trust (STI/$45.69/Outperform), Incyte (INCY/$97.83/Outperform), Laboratory Corp of America (LH/$138.87/Outperform), Union Pacific (UNP/$98.07/Strong Buy), Booz Allen (BAH/$30.19/Outperform), and Vantiv (VNTV/$56.48/Outperform).

The call for this week: Despite the bravado, the reality is seen in the chart of the S&P 500 (SPX/2153.74), which in early July, broke out to the upside of nearly a two-year trading range with bullish implications (chart 7 on page 6). More recently, we have targeted the triangle chart formation the SPX has worked itself into since early September (chart 8 on page 6). The SPX is now at the apex of that triangle and should be resolved with either a break to the upside or the downside. A break up would obviously have positive ramifications, while a break down would suggest further consolidation. As stated, there is a decent chance our models’ prediction of downside vulnerability in the mid/late September timeframe may be over, but it will take a close above 2187 by the SPX to turn our models positive. If that happens, it would suggest the equity markets will grind higher into 1Q17, which would surprise the greatest number of participants. However, until our models “flip” positive, we continue to exercise patience.

October 3, 2016

One of the rarest traits on Wall Street is patience, yet patience is one of the biggest secrets of successful investing. As noted in R.W. McNell’s book Beating The Stock Market:

If there is ever a time when speculators should exercise patience, it is in waiting for a proper opportunity to buy stocks. The desire to make money is at the foundation of all commercial and financial transactions, but the mere desire to make money should never be the mainspring of speculative action. Knowledge or belief based on intelligent analysis that a speculative opportunity presents itself is the only safe basis for making purchases of stocks. It is in forgetting that principal that so many speculators err. They do not ask when they are preparing to buy stocks, ‘Is the stock cheap, and is it selling below its real value?’ but ‘Is that stock going up?’ The only sound reason for buying stock is that it can be had cheap. Granted that, and also that it represents ownership in one of our great essential American industries, a speculative profit is practically assured, if one have patience, regardless of whether the price goes lower before it goes higher. But when anyone buys a stock merely because he thinks or someone tells him it is going up, regardless of its real value, he is following a speculative plan which is absolutely certain to lead on to ruin. He may make a profit once, twice, or half a dozen times by that method, but sometime he is absolutely certain to be badly hurt.

It has been said if you don’t like the weather . . . wait a minute. Recently, the same can be said about the stock market. I mean really, here are the daily point gains and losses for the D-J Industrials over the past two weeks: +200, -196, +111, +133, -167, -131, +99, +164, +10, -363. Evidently Mr. Market has had a case of schizophrenia since mid-September. And that, ladies and gentlemen, is why we have elected to have patience until our models render a clear-cut direction for the equity markets in the short run. For the longer term, we have not wavered in the belief the secular bull market remains alive and well. However, we have also tried to “call” some of the shorter-term vagaries of the equity markets in an attempt to help clients adjust their portfolios. For example, coming into September I recommended trimming some stocks from portfolios to raise a little cash for future investment opportunities. At the time we said history shows that all we should get in terms of a pullback is 3% to 6%; and what we got was 3.4%, at least so far. So the question du jour would currently be, “Is the pullback over?”

As repeatedly stated in these missives, while we hope the pullback is over, our models are currently unclear. Over the past 46 years we have learned that when that happens it is best to have patience and do nothing until the models “speak.” Therefore, until the S&P 500 (SPX/2168.27) closes above its 2187 “pivot point,” our models remain in a defensive posture. That does not mean I have not been adjusting portfolios. On Friday I sold two energy stocks that have rallied sharply since the February lows, and over the past few weeks I have actually bought some select stocks and mutual funds to rebalance my portfolio. My purchases, however, have NOT been in the defensive sectors that have been so popular year-to-date. As my friend Jason Goepfert (SentimenTrader) writes:

Defensive sectors have been the best performers so far this year. Through September, the most defensive sectors have been the most consistently good performers, while the most economically-sensitive sectors have lagged. If we create a score that ranks the performance of the sectors through the 3rd quarter, we see that 2016 ranks among the most extreme. When that's happened in the past, 4th quarter returns were okay, but much below returns when the most aggressive sectors had led through September.

In past reports we have commented on our friends at J.P. Morgan asset management’s work showing the “defensive sector” is massively over valued and should be way underweighted. In our recent conference call with Rich Bernstein he agrees and favors the Consumer Cyclical sector over the Consumer Staples sector. BTW, we favor a number of the Eaton Vance ETFs he actively manages. To that “active management” point, we think investors are doing the exact wrong thing in switching from active managers to passive managers at this stage of the market cycle. When stocks are cheap, and the indices are going straight up, you want to own cheap beta. Yet when stocks are neutral valued (like now) you need to have actively managed portfolios for reasons often stated in these reports.

In addition to Rich’s managed ETFs, and the video I did with SEI’s Steve Treftz, who manages the SEI Multi-Asset Income Fund (SIOAX/$10.56), if I had to buy another stock right here it would be Williams Company (WMB/$30.73/Outperform). Our fundamental analysts like WMB and I would note it is the last “Barbie Doll” on the shelf. Given Canada’s Enbridge recently announced acquisition of Spectra Energy, WMB is indeed the last “Barbie Doll” on the shelf. Williams Company has a terrific pipeline system, a great chemical business, and an MLP that any acquiring company could “drop down assets” into . . . well, you get the idea.

The call for today, according to thechartstore.com:

Mark ‘em up Friday for month/quarter’s end made for a slightly up week (S&P 500 +0.17%). Friday was another one of those rumor filled days centered this time on Deutsche Bank. The week was also filled with Yellen testimony and a never ending parade of Fed presidents spewing the party line. The Fed added talk of buying stocks to the discussion. Oh, for the good old days when price discovery was at play in the markets, not central banks.

The call for this week: So on Friday the Agence France Presse carried a story that the DOJ was close to settling with Deutsche Bank not for the original $14 billion penalty, but for $5.4 billion. Combine that with rumors Germany will not let the bank go under (we have said for months that Angela Merkel would never let a bank with Germany in its name go bankrupt), and the D-J Industrials rallied 165 points helped by the bank and energy stocks. Meanwhile, earnings season is starting and we continue to think earnings will be solid, believing the “profits recession” ended in 2Q of this year. And don’t look now, but Wall Street strategists have been lowering their year-end price targets for the S&P 500 to where it currently changes hands. To that, FundStrat’s Thomas Lee writes, “That’s great news! When market prognosticators predict little or no gain, the S&P 500 has traded higher 12 months later 95% of the time, with an average gain of 11%.” Currently, the SPX has pinched itself into a tight triangle consolidation chart pattern (see chart on page 3). A breakout of that pattern to the upside would suggest an upside test of our 2187 “pivot point.” If the SPX can close above 2187 it will turn our short-term timing models positive, and the forecasted mid/late-September pullback should be over, as the secular bull market continues.

P.S. I will be on the West Coast all this week seeing accounts and speaking at events. I am writing this on Sunday night, and recording the verbal comments without the benefit of the preopening futures prices, because I am not getting up at 3:00 a.m. on Monday morning to do this live . . .

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