Investment Strategy by Jeffrey Saut

“Precisely Watson?”
January 30, 2012

Sherlock Holmes: “And, then there was the event of the dog barking in the night.”

Dr. Watson: “But Holmes, there was no dog barking in the night!”

Sherlock Homes: “Precisely Watson!”

According to Wikipedia (as paraphrased by me):

It is precisely on this distinction that Holmes bases his insight. When the inspector asks, “Is there any point to which you would wish to draw my attention? Holmes responds, “To the curious incident of the dog in the night.” But, protests the inspector, “The dog did nothing in the night.” To which Holmes delivers the punch line, “That was the curious incident.”

For Holmes, the absence of barking is the turning point of the case: the dog must have known the intruder. Otherwise, he would have made a fuss. For us, the absence of barking is something that is all too easy to forget. We don’t even dismiss things that aren’t there; we don’t remark on them to begin with. But often, they are just as telling and just as important – and would make just as much difference to our decisions – as their present counterparts. How asking what isn’t there can help us make better decisions.

And, last week there was indeed a “dog barking in the night” as Chesapeake (CHK/$22.05/Market Perform) announced it was shutting down numerous natural gas wells due to low gas prices, a signpost coincident with many “bottoms.” On that announcement natural gas futures went from $2.23 per MMcf to $2.75 into last Friday’s closing price. That’s a 23% upside reversal and likely sets the low water mark for natural gas. While our Houston-based research team doesn’t believe it, and they have been more right than me, I think the “lows” for natural gas are “in.” Certainly, major corporations think there is a future for natural gas given the buyout activity over the past few years in the natural gas space. Names for your consideration that are favorably rated by our fundamental analysts include: Anadarko Petroleum (APC/$79.32/Strong Buy); EnCana (ECA/$19.60/Outperform); Williams Companies (WMB/$28.55/Outperform); and Devon Energy (DVN/$65.01/Outperform).

Speaking to Devon, I have mentioned this company before, sparked by my friends at the “must have” Bespoke Investment Group. To wit, January 17th’s missive stated:

“In business school they teach you that investing is all about earnings, and while I think fear, hope, and greed play a role in the investing equation, over the long term earnings indeed play the dominant role. Realizing this, the good folks at Bespoke have assembled a list of companies that have consistently reported the strongest earnings since March 2009 that report between now and February 24th. Names favorably rated by our fundamental analysts making said list include: Citrix Systems (CTXS/$65.14/Outperform); Devon Energy (DVN/$65.01/Outperform); and Tempur-Pedic (TPX/$70.09/Strong Buy).”

Most recently, our exploration and production analyst Andrew Coleman had this to say about Devon:

“On January 5th, we upgraded Devon to a Strong Buy from Outperform. Earlier this week, Devon announced a $2.2 billion joint venture with the Sinopec International Petroleum Exploration & Production Corporation (SIPC). The deal gives SIPC a 33% working interest in Devon's 1.2 million acres across five New Venture plays (e.g. Niobrara, Ohio Utica, and Tuscaloosa Marine shales as well as the Mississippi Lime and the Michigan basin). We value the transaction at $5,500 per acre overall. As a result of the deal, we are raising our production growth expectations for 2012 from 7.5% to 10% (vs. peers at 16%).”

Interestingly, the reciprocal to my natural gas “dog barking in the night” theme is Apple (AAPL/$447.28), which had a “blow out” earnings quarter last week. Indeed, Apple reported 1Q12 sales of $46.33 billion and profits of $13.1 billion. That was the second highest quarterly profit for any company ever! Such metrics lifted the company’s cash hoard to $97.6 billion, making its cash position larger than the market capitalization of 448 of the companies in the S&P 500. Apple sold 37 million iPhones in the quarter for a y/y growth rate of 128%; and, has now sold a total of 315 million iPhones, iPads, and iPod Touch devices. On the earnings release Apple’s shares leapt from $420.41 (last Tuesday’s close) to Wednesday’s opening price of $454.44, making Apple the world’s most valuable company ($417 billion) by exceeding Exxon’s (XOM/$85.83/Market Perform) market capitalization of $413 billion. Clearly, an astounding quarterly report that caused one old Wall Street wag to exclaim, “When the news can’t get any better I sell.”

Turning to the stock market, in last week’s report I wrote:

“The recent rally has not been accompanied by a noticeable increase in Buying Demand as measured by Lowry’s Buying Power Index. Rather the rally has occurred more from a reduction in Selling, which is reflected in Lowry’s Selling Pressure Index. Then too, the percentage of stocks above their respective 10-day moving averages (DMAs) has failed to confirm the upside and the New High list is not expanding. In fact, 40% of my short-term indicators are now bearish and none are bullish. Meanwhile, the NYSE McClellan Oscillator is overbought, the stock market does not have much internal energy left for a big rally, the S&P 500 is three standard deviations above its 20-DMA, the Volatility Index is telegraphing too much complacency, and we have negative seasonality for the next few weeks. Nevertheless, I continue think it is a mistake to get too bearish because I believe any pullback in the various indices will be contained.”

The conclusion to last Monday’s missive was to look for a short-term trading peak followed by either a pause or a correction that could pull the S&P 500 (SPX/1316.33) down to the 1280 – 1290 level. And, the week turned out to be just a “pause” saved by a rally attempt on the more dovish than expected FOMC statement. While the pause didn’t really correct the overbought nature of the NYSE McClellan Oscillator (see the chart on page 3), it has somewhat rebuilt the stock market’s internal energy. It should be noted the D-J Industrial Average (INDU/12660.46) edged above its July 2011 closing high on an intraday basis last Thursday, as well as that the new rally highs in the INDU and SPX have been confirmed by new rally highs in the Cumulative Net Points and Cumulative Volume Indices. Meanwhile, the NYSE Advance/Decline Line continues to move to new all-time highs. Interestingly, given the year-to-date strength, there have been no 90% Upside Days, a reflection of the aforementioned reduced volatility. Also of interest is that unlike prior quarters fundamental analysts are not raising their earnings estimates as earnings season is underway. This could be because the current earnings “beat rate” is not nearly as robust as past quarters.

To be sure, I have repeatedly commented that earnings comparisons were going to get more difficult because the trailing four quarter’s earnings reports have been so strong; and, that’s precisely what is happening. For example, with 180 of the S&P 500 companies reporting, there has been 1.81 upside earnings surprises for each disappointment versus a more normal ratio of 3:1. Accordingly, it makes sense to screen for companies producing “Triple Plays” – that would be companies beating earnings and revenue estimates and also raising forward earnings guidance. Three names from our research universe that qualify as Triple Plays and are favorably rated by our fundamental analysts for your consideration, include: Arctic Cat (ACAT/$30.65/Strong Buy); Caterpillar (CAT/$111.28/Outperform); and Xilinx (XLNX/$35.99/Outperform).

The call for this week: Well, I am traveling the balance of this week to see institutional accounts, speak at an Investment Banking Conference, and present at a handful of retail seminars. Consequently, there will be no verbal strategy comments for the rest of the week. Therefore, I will leave you with these thoughts. The January Barometer has sounded the “all clear” signal with a monthly gain for the INDU of 3.36% and a 4.67% rise in the SPX. History suggests double-digit returns for the rest of the year with positive returns occurring more than 80% of the time. Two sectors have been the main drivers of this January Jump, namely Consumer Discretionary and Technology. Unsurprisingly, the Consumer Discretionary, Technology, Industrial, and the Materials sectors are all beating earnings estimates at the highest “beat rate,” while Consumer Staples, Energy, Financials, and Healthcare are not. While I remain somewhat timid on a short-term trading basis, I continue to believe the year of the Water Dragon will bestow the five Chinese blessings of harmony, virtue, riches, fulfillment, and longevity. That adds even more weight to my growing belief that 2012 will be about breakthroughs, not disasters.

P.S. – As an aside, maybe participants should consider that Warren Buffett is not paying too little a percent of income tax, but rather his secretary is paying too high a percent!

Company Citations
Company Name	Ticker	Exchange	Currency	Closing Price	RJ Rating	RJ Entity
Anadarko Petroleum Corp.	APC	NYSE	$	79.32	1	RJ & Associates
Apple Inc.	AAPL	NASDAQ	$	447.28	NC
Arctic Cat, Inc.	ACAT	NASDAQ	$	30.65	1	RJ & Associates
Caterpillar Inc.	CAT	NYSE	US$	111.28	2	RJ LTD.
Chesapeake Energy Corp.	CHK	NYSE	$	22.05	3	RJ & Associates
Citrix Systems Inc.	CTXS	NASDAQ	$	65.14	2	RJ & Associates
Devon Energy Corporation	DVN	NYSE	$	65.01	2	RJ & Associates
EnCana Corporation	ECA	TSX	C$	19.58	2	RJ LTD.
Exxon Mobil Corp.	XOM	NYSE	$	85.83	3	RJ & Associates
Tempur-Pedic International Inc.	TPX	NYSE	$	70.09	1	RJ & Associates
The Williams Companies, Inc.	WMB	NYSE	$	28.55	2	RJ & Associates
Xilinx, Inc.	XLNX	NASDAQ	$	35.99	2	RJ & Associates

Notes: Prices are as of the most recent close on the indicated exchange and may not be in US$. See Disclosure section for rating definitions. Stocks that do not trade on a U.S. national exchange may not be approved for sale in all U.S. states. NC=not covered.

---

Everybody’s Unhappy!?
January 23, 2012

“Money managers are unhappy because 70% of them are lagging the S&P 500. Economists are unhappy because they do not know what to believe: this month’s forecast of a strong economy or last month’s forecast of a weak economy. Technicians are unhappy because the market refuses to correct and gets more and more extended. Foreigners are unhappy because due to their underinvested status in the U.S. they have missed a big double play: a big currency move plus a big stock market move. The public is unhappy because they just plain missed out on the party after being scared into cash. It almost seems ungrateful for so many to be unhappy about a market that has done so well. Unhappy people would prefer the market to correct to allow them to buy and feel happy, which is just the reason for a further rise? Frustrating the majority is the market’s primary goal.”

... Bob Farrell, Merrill Lynch; September 1989

The bears are unhappy since the Santa rally, which began last Thanksgiving, has given the short-sellers no comfortable place to cover their shorts. Last week the bears suffered even more angst as most of the indices I follow tagged new reaction highs. The upside skein from the December 19th “low” has left the senior index better by ~8.1%, and up an eye-popping 13.3% since Thanksgiving. Counting the trading days from that mid-December “low” shows the rally has now encompassed 21 sessions with no more than a 1 – 3 session pause and/or correction. That makes this a fairly long of tooth “buying stampede.” Recall, buying-stampedes typically last 17 – 25 sessions, with only 1-3 session pauses/corrections along the way, before they exhaust themselves on the upside. It just seems to be the rhythm of the “thing” in that it takes that long to get participants bullish enough to throw in the towel and “buy ‘em” right before the markets peak and have a downside correction. Moreover, during the current stampede just about everything has been “run,” including all the sectors punctuated by the Banks +11.6% performance YTD. Accordingly, the only thing missing for a short-term “top” is a final burst to the upside driven by short-covering. My sense is this will occur into tomorrow night’s State of the Union address, which should be followed by a post address letdown for the stock market.

To be sure, the recent rally has not been accompanied by a noticeable increase in Buying Demand as measured by Lowry’s Buying Power Index. Rather the rally has occurred more from a reduction in Selling, which is reflected in Lowry’s Selling Pressure Index. Then too, the percentage of stocks above their respective 10-day moving averages (DMAs) has failed to confirm the upside and the New High list is not expanding. In fact, 40% of my short-term indicators are now bearish and none are bullish. Meanwhile, the NYSE McClellan Oscillator is overbought, the stock market does not have much internal energy left for a big rally, the S&P 500 (SPX/1315.38) is three standard deviations above its 20-DMA, the Volatility Index (VIX/18.28) is telegraphing too much complacency, and we have negative seasonality for the next few weeks. Nevertheless, I continue to think it is a mistake to get too bearish because I believe any pullback in the various indices will be contained.

My bullishness was reinforced last week during a conversation with Frederick “Shad” Rowe, the sagacious general partner of Dallas-based Greenbrier Partners. Summing the conversation, we decided the world is becoming richer faster than debt is expanding. This is not an unimportant point since everyone seems to be focusing on the “debt bomb,” which likely means it is the wrong question. Clearly, some folks are living above their means, some below, but many are living within their means, which can be seen in the Household Debt Service Ratio chart that is plumbing generational lows. Manifestly, the world is getting more prosperous and is producing more for less driven by technology. Truly, it is “one world” and we should start thinking of the U.S. as a state within that “one world.” This view is plainly stated in Federal Express’ annual report. To wit:

“We’ve reached a tipping point in how the world works. The largest economy in the world is no longer the economy of any one country – it’s the economy of global trade of goods and services. Value: $18.3 trillion in 2010. At FedEx, our job is to facilitate these transactions, the heart of commerce, by providing access – moving goods across the global supply chain.”

Or, how about this from Google’s annual report:

“Google is a global technology leader focused on improving the ways people connect with information. We aspire to build products that improve the lives of billions of people globally. Our Mission is to organize the world’s information and make it universally accessible and useful.”

One world indeed and there are actually a lot of good things happening. While the world is still a violent place, it is becoming less so as the wars we have been fighting come to an end. Additionally, the U.S. finally appears to be heading down the road of energy self-sufficiency, which should increase employment, and the U.S. dollar is currently the least unattractive currency in the world. Furthermore, as scribed in previous reports, there is a huge hidden layer of the U.S. economy that is becoming the engine of growth and wealth creation; and, this hidden layer is misrepresented in corporate financial reports. Surprisingly, the equity markets appear to value this hidden layer at approximately zero suggesting huge opportunity for investors to profit. The hidden layer referenced is Organizational Capital and Knowledge Capital, both of which reside under the macro moniker – Intangible Capital – so often mentioned in these missives. As the astute GaveKal organization writes:

“When we account for intangibles the picture of the U.S. economy changes. It is revealed that we are saving more and investing more than we thought. This means our economy is much more dynamic than we thought. This result is relevant in view of the perception of a low rate of saving in the U.S. economy, particularly because existing measures exclude much of the investment in knowledge capital that is a defining feature of the modern U.S. economy. ... Validating intangibles is the key to eliminating the guesswork in valuing a company correctly. Indeed, this ‘new view’ of intangibles suggests they are the missing link between financial accounting and financial valuation.”

These observations, taken in concert amid the backdrop of a world that is profoundly underinvested in U.S. equities, continues to leave me walking on the “sunny side” of Wall Street even though in the very short term I am looking for a trading peak. During the envisioned decline investors should consider companies playing to the Intangible Capital theme. While participants should study all investment situations for themselves, some names for your consideration from our research universe playing to the Intangible Capital theme, and favorably rated by our fundamental analysts, include: Micron (MU/$7.76/Strong Buy), Analog Devices (ADI/$39.78/Strong Buy), Maxim Integrated Products (MXIM/27.83/Outperform), Texas Instruments (TXN/$33.64/Outperform), Xilinx (XLNX/$35.77/Outperform), Nuance (NUAN/$29.08/Strong Buy), Google (GOOG/$585.99/Outperform), Delta Air (DAL/$9.41/Outperform), and Urban Outfitters (URBN/$25.40/Outperform). Of course there is a way to purchase all of these companies that are accumulators of Intangible Capital (and more) via the GaveKal Platform Company Fund (GAVIX/$11.18).

The call for this week: Last Thanksgiving I suggested the Santa rally was beginning. I stuck with that “call” into the new year. On January 3, 2012 I stated that session felt like an “emotional peak” and that January 10, 2012 felt like the “price peak.” Subsequently I wrote, “The only question in my mind is if the markets are going to have a pullback into the 1230 – 1240 support zone, or go sideways to correct their overbought condition and allow the internal energy to be rebuilt.” So far, it has been a sideways consolidation until last week’s upside breakout causing one old Wall Street wag to exclaim, “Breakout or fake-out?!” On a short-term basis I think it is a fake-out believing a trading top is due this week ...

---

“The Turtle?”
January 17, 2012

“We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the century is over; that the rapid improvement in the standard of life is now going to slow down; that a decline in prosperity is more likely than an improvement in the decade which lies ahead.”

... John Maynard Keynes, 1930

I recently reread the aforementioned quip from John Maynard Keynes (as paraphrased by me). While it sounds like it was written in the past year, it was actually penned in 1930 and titled Economic Possibilities for our Grandchildren. I revisit Keynes’ prose this morning because I did a video conference with a large U.K.-based institutional account last week where I repeatedly stressed that while I guess the U.S. could talk itself into a recession, as I read the tea leaves the economy looks to be in a self-sustaining economic recovery. Subsequently, our London institutional sales manager sent the following message to that account:

“There may be no value in drawing comparisons with past market patterns, but I find it irresistible. In 1994 I was a U.S. portfolio manager and the debate of the day was whether the U.S. economy would succumb to recession. If my memory is correct, the term ‘double-dip’ was coined at this time as the U.S. was still suffering the hangover from the Savings & Loan crisis that had exacerbated the 1991 recession. Despite this background of doom and gloom the S&P 500 advanced by 34% in 1995.

Lest you think there was much less to worry about back then, here are some of the headlines:

Nov 1994 - Norwegian voters decide not to join the European Union.

Dec 1994 - Boris Yeltsin orders troops into Chechnya.

Dec 1994 - Mexican Tequila Crisis – ‘unleashing the Tequila effect on global financial markets.’ The U.S. agrees to a bail-out.

Jan 1995 - Kobe Earthquake in Japan.

Feb 1995 - Barings collapses due to speculative trading by Nick Leeson.

Apr 1995 - Oklahoma City bombing kills 168 people.

Jun 1995 - Iraq disarmament crisis.

... you get the picture - plenty to worry about - plus ca change.

So a prudent man may have been tempted to hold back from investing in early 1995, but that would have been foolish. The market rose in 7 of the first 8 weeks of the year. By the end of February the S&P 500 was up 6%, and then rose nearly 3% in March, another 3% in April and over 3% in May. By the time most of the Cassandras were re-evaluating their position the S&P 500 had advanced ~20%.

That’s my point: don’t stand back and deny the move; participate. I was the prudent man.”

Fast forward to today, there are certainly plenty of reasons to be bearish. Amidst all of this, I have been sticking my neck out since the day after Thanksgiving, believing the Santa rally was beginning and the economic data was improving. Despite that backdrop the S&P 500 (SPX/1289.09) went absolutely nowhere last year, although it did rally nearly 12% from Thanksgiving into the first trading day of this year. Indeed, in 2011 the SPX was down 0.003% for the second flattest year in history (1947 was the flattest at 0.000%). Speaking to that, the must have Bespoke Investment Group writes:

“Looking at the prior years where the S&P 500 saw small changes, there was only one year where the index saw a move of less than +10% the following year, and the S&P 500 was positive seven out of nine times. Although the S&P 500 went nowhere in terms of price [in 2011], earnings were impressive. While the fourth quarter numbers have yet to come in, based on estimates the S&P 500 is on pace for EPS growth of 16% [last] year. This would put earnings at a record level of $97.10, eclipsing the prior record of $87.70 from 2006.”

Think about that, while earnings have grown by about 16% the SPX’s valuation has plunged by about 17% on a forward P/E basis (from a P/E multiple of roughly 16x at the start of 2011 to a forward P/E multiple of 13.3x today). So as our London sales manager implies, investors were so mesmerized by the headline du jour (Euroquake, tsunamis, nuclear disasters, etc.) they were frozen into inaction.

While I have been somewhat inactive since January 3rd’s Dow Wow, I have continued to suggest all we would see is a modest pullback and/or a sideways consolidation. As stated, the stock market’s “emotional peak” felt like it occurred the first trading day of the new year when the DJIA (INDU/12422.06) “gapped” 262 points higher, only to close up 179 points. The nominal price peak, at least for me, happened on 1/10/12 with an intraday high of 12514.69. Since then the senior index has been consolidating. In that consolidation the short-term overbought condition is being worked off and the market’s internal energy is being rebuilt.

Meanwhile, 4Q11 earnings season began last week punctuated by Friday’s solid report from JP Morgan (JPM/$35.92/Strong Buy). This is not an unimportant earnings report since approximately 26% of this year’s SPX earnings estimate ($106.81e) comes from the Financials. Clearly, the banks are anticipating decent earning this year given their year-to-date sector outperformance of +9.08%, which has left all of the Financial indices I track either near, at, or above their respective 200-day moving average. In business school they teach you that investing is all about earnings, and while I think fear, hope, and greed play a role in the investing equation, over the long term earnings indeed play the dominant role. Realizing this, the good folks at Bespoke have assembled a list of companies that have consistently reported the strongest earnings since March 2009 that report between now and February 24th. Names favorably rated by our fundamental analysts making said list include: Citrix Systems (CTXS/$64.85/Outperform); Devon Energy (DVN/$63.10/Outperform); and Tempur-Pedic (TPX/$58.94/Strong Buy).

The call for today: The turtle makes no progress until it sticks its neck out; I have been sticking my neck out since Thanksgiving, believing the Santa rally was beginning. I stuck with that strategy until the first day of trading this year, which felt like a short-term emotional trading peak. A short-term price peak occurred on 1/10/12 at 1296.46 basis the SPX, as chronicled in these missives. The only question in my mind was whether we were going to get a pullback into the 1230 – 1240 support zone, or if we would experience a sideways correction as the overbought condition was worked off and the market’s internal energy was rebuilt. So far it’s been a sideways correction, leaving the NYSE McClellan Oscillator not overbought, but not oversold either. In fact, it is hovering around the neutral line. Meanwhile, the stock market’s internal energy is almost fully recharged. And this morning we are greeted with better than expected Chinese GDP growth (+8.9% vs. +8.7%E), a worldwide interest rate easing cycle, the largest jump in German investor confidence ever, a decent Spanish bond auction, and hints of another round of quantitative easing. The result has the pre-opening S&P 500 futures up double digits, precious metals sharply higher, crude oil back above $100/bbl., and a lower U.S. dollar. Accordingly, while I would have liked to see more of a pullback to a minimum of 1250 – 1260, I’ll say it again – I think it is a mistake to become too bearish ...

---

Additional information is available on request. This document may not be reprinted without permission.

Raymond James & Associates may make a market in stocks mentioned in this report and may have managed/co-managed a public/follow-on offering of these shares or otherwise provided investment banking services to companies mentioned in this report in the past three years.

RJ&A or its officers, employees, or affiliates may 1) currently own shares, options, rights or warrants and/or 2) execute transactions in the securities mentioned in this report that may or may not be consistent with this report’s conclusions.

The opinions offered by Mr. Saut should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your Raymond James Financial Advisor.

All expressions of opinion reflect the judgment of the Equity Research Department of Raymond James & Associates at this time and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets or developments mentioned. Other Raymond James departments may have information that is not available to the Equity Research Department about companies mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this presentation’s conclusions. We may perform investment banking or other services for, or solicit investment banking business from, any company mentioned. Investments mentioned are subject to availability and market conditions. All yields represent past performance and may not be indicative of future results. Raymond James & Associates, Raymond James Financial Services and Raymond James Ltd. are wholly-owned subsidiaries of Raymond James Financial.

International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.

Investors should consider the investment objectives, risks, and charges and expenses of mutual funds carefully before investing. The prospectus contains this and other information about mutual funds. The prospectus is available from your financial advisor and should be read carefully before investing.

© Raymond James Financial, Inc. All rights reserved.