Investment Strategy by Jeffrey Saut
“The Wile E. Coyote Stock Market?”
April 14, 2014
Last Wednesday, when the D-J Industrials were up some 180 points, I could not shake the feeling that this was the “Wile E. Coyote stock market.” The visual is when Wile runs off a cliff, but his feet keep moving, until he looks down and realizes there is nothing underneath him. The resulting fall was similar to what happened late last week to the equity markets. Indeed, I really did not understand, or trust, last Wednesday’s Dow Wow for the reasons mentioned in these missives. As well, my writings all this year have noted that a 40+% rally, like we have experienced since June of 2012 without so much as a 10% decline, has historically been followed by a 5%-7% pullback in the first three months of the new year, with a 10% - 12% decline due sometime during the year. That view was reinforced by the recent rotation out of last year’s high fliers, which historically has preceded further selling in the overall stock market. Also, the “high flier” selling took the NASDAQ Composite (COMPQ/3999.73) below its 100-day moving average (DMA) a week ago for the first time in over a year. That telegraphed continued selling, not only in the “fliers,” but the overall stock market. Additionally, I have written the S&P 500 (SPX/1815.69) has “bonked” three times into the 1835 -1840 support zone and was likely destined to fail in a fourth test of that level. And, almost on scrip, the SPX knifed through that support zone late last week, bringing into view the next support level of 1780 – 1800. Interestingly, the reasons for that breakdown were given by a number of portfolio managers, and by numerous media anchors, I spoke to in New York City last week.
One of the first reasons given was the Ukraine situation. To wit, last week’s comments by NATO’s chief that troops may be moved into Eastern Europe caused Putin to worry the Kiev government would use that show of strength to announce an alliance with the West and potentially petition to join the European Union. If so, it was feared Putin would supersede said troop movement and annex the rest of the Ukraine. In fact, Friday’s Wall Street Journal carried a story titled, “NATO Says Russia Is Ready to Strike.” Next on the downside “hit parade” was the announcement of the Supplementary Loan Ratio (SLR), which raised fears the big banks would not be able to meet the SLR’s mandate, but as our analyst writes:
“U.S. regulators approved a finalized supplementary leverage ratio (SLR) for the nation's eight largest financial institutions. This was not a big surprise, as U.S. banking regulators chose to adopt Basel's treatment for the denominator of the SLR, while sticking to the 5% bank holding company and 6% subsidiary minimum required levels proposed last July. There were some changes in adopting the global standards for the denominator, but we believe all the banks in our coverage universe can easily get there well in advance of the January 1, 2018 deadline. Companies will be required to disclose their estimated SLR under the new rule starting on January 1, 2015. Regulators said including the revised rule, the estimated capital shortfall at the eight banks was $68 billion, which represented less than 10% of the outstanding tangible common equity at the affected institutions as of December 31, 2013. Banks should be able to exceed the proposed minimums without any capital raises.”
However, JP Morgan’s (JPM/$55.30/Strong Buy) shortfall on Friday did not help confidence about the statement, “Banks should be able to exceed the proposed minimums without any capital raises.” Then there was the slowing economic news from China, where exports and imports fell unexpectedly in March. Exports dropped 6.6% on a same month basis, following an eye-popping 18% decline in February on a year-over-year basis. Meanwhile, imports slid 11.3%. Parsing the numbers showed China’s internal and external demand is indeed slowing. Adding to Wall Street concerns about a slowdown was this statement from China’s Premier Li Keqiang, “We will not resort to short-term strong stimulus policies just because of temporary fluctuations.” Obviously Wall Street read that as no short-term help for the world’s second largest economy.
So those were the major boogeymen served up as the causa proxima for last week’s wilt, but for whatever the reason, the SPX finally fell through its 1835 – 1840 support zone. This is not an unimportant event for that level had supported stocks on numerous occasions. That’s why I wrote in last Thursday’s Morning Tack, “However, if the SPX declines a fourth time into its 1835 – 1840 support, it would be worrisome, at least to me. Worrisome because of the old stock market saw, ‘Triple bottoms typically do not hold’!” And notice how much the selling intensity increased when it became apparent the 1835 – 1840 level was going to fail to hold, bringing into view the next support zone of 1780 – 1800. Failing that would imply a test of the January/February “lows” at the 1740 – 1750 level. Whether this is the 10% - 12% correction I have cautioned would be due sometime this year based on historical precedent is unknowable at this point; but if it is, it would target the 1702 (10%) to 1664 (12%) zone. While I believe such a move is unknowable quite yet, the always eagle-eyed Jason Goepfert notes:
“There have only been two other times in the past 20 years that the Nasdaq Composite had dropped more than -8% from its 52-week high, but the VIX "fear gauge" was still below 17.5, a scenario we have now. It shows relative complacency in the face of a sell-off in higher-beta stocks. Those two occurrences were March 28, 2002 and May 15, 2008. The S&P 500 sold off more than -15% over the next three months both times.”
The call for this week: Last week I was in NYC seeing institutional accounts and doing media appearances. It was great to catch up with a number of my friends at CNBC, Bloomberg, Fox, Yahoo Finance, Arise TV, NYT, etc., but I think the highlight of the week was speaking on a panel for the Tiburon CEO Summit at the Ritz Carlton. On the panel was my friend Rich Bernstein, along with Ron Baron, Derek Young, and me. I began my opening remarks by stating, “I have thought a lot about what is the most important thing I can convey to this august group of 270 CEOs from the financial industry. I think it is that we are in a secular bull market, which has years left to run. The problem is many of the folks in this business have never seen a secular bull market. Their shared experience over the past 15 years has been to buy a stock, and when it rallies 30%, to sell it and look to find another stock to do the same thing. They have not experienced buying high-quality, blue chip/dividend-paying stocks, and holding them through a secular bull market like 1982 – 2000. Manifestly, in such a secular ‘bull’ the art of just ‘sitting,’ without a whole lot of activity, is one of the secrets of compounding wealth. To be sure, there will be pullbacks, so raising cash and repositioning portfolios along the way makes sense, but you should not go into a big cash position.” Following our panel, I was in the lobby of the Ritz when Ron Baron, eponymous captain of Baron Capital, asked me if I would like a ride back to mid-town. Since it was raining, that ride lasted an hour and a half during which we discussed a number of stocks. In fact, I have a number of new names to research this week. As for the stock market, in the near term the McClellan Oscillator is very oversold (chart 1), as well the SPX is at the low end of its 1-year trading range (see chart 2). The blue zone represents one standard deviation above/below the SPX’s 50-day moving average. But in January/February of this year, the SPX traded into the deeply oversold green zone, which marked the yearly “lows” in the aforementioned 1740 – 1750 area. Accordingly, it would not surprise me to see a rally attempt. However, with very little internal energy, I don’t think any rally is sustainable in the short term. Moreover, we could be in one of these 17 – 25 session “selling stampedes” with today being day number 7.
“The Russians Are Coming”
April 7, 2014
The Russians Are Coming, The Russians Are Coming is a 1966 American comedy film directed by Norman Jewison and based on Nathaniel Benchley’s book The Off-Islanders. The movie tells the Cold War story of the comedic chaos that happens when a Soviet submarine runs aground closely offshore a small island town near New England and the crew is forced to come ashore. At the time I saw the movie I was summering at my family’s home on Nantucket Island, which really brought home the ambiance of the movie since the landscape looked remarkably similar to places on Nantucket. Last Friday, however, rumors that the “Russians are coming” swirled down the canyons of Wall Street, causing a late Friday Fade that left the S&P 500 (SPX/1865.09) down an eye-popping 24 points. The rumors went something like this. Vladimir Putin is going to invade the rest of the Ukraine over the weekend because of what is getting ready to happen. According to The Wall Street Journal, “NATO foreign ministers this week directed Gen. Breedlove to craft a response plan, which could include moving NATO equipment and troops into Eastern Europe, beefing up exercises, surveillance and patrols, and speeding up NATO's rapid-response force.” Putin’s worry is that when those troops are moved into such a tactical position, Ukraine’s remaining government will use that opportunity to announce a coalition with the west and potentially petition for membership in the European Union. Whether those rumors turn out to be true remains to be seen, but that is what whacked stocks late Friday afternoon and very few pundits even picked up on it. What was interesting to me is that once my 1872 S&P 500 short-term “failsafe” point was violated to the downside, the selling intensified. This is not an insignificant point because, as repeatedly stated last week, “There is a full charge of internal energy built up in my indicators suggesting if a stock market move begins, it has enough energy to turn into a meaningful move.” I had thought said energy would likely be released on the upside with a peek-a-boo “look” above 1900, but last Friday’s action calls that into question unless “John Wayne” again rides to the rescue.
For weeks I have said that something just does not feel right about this market, but every time I made that statement John Wayne has indeed ridden to the rescue to buoy stocks. This occurred at the March 14th low, and again at the March 27th low, both of which stabilized stocks around the SPX’s 30-day moving average (DMA). Interestingly, at last Friday’s close the SPX was resting marginally above the 30-DMA once again, which now resides at 1863.86. Therefore, the first part of this week shapes up as a pretty important timeframe. If the SPX holds above its 30-DMA, then the rally could resume. If it doesn’t, the often mentioned 1835 – 1840 zone support level again comes into play, which has held three times since the beginning of March, and failing that the 1780 – 1800 level becomes the target zone. Longer term, I continue to believe a secular bull market is afoot that has years left to run.
To that point, in Friday’s Morning Tack I wrote the following:
Nevertheless, a lot of folks believe the stock market has come too far, too fast, and the upside is currently limited. To that point, JP Morgan’s strategist, Dr. David Kelly, hosted a conference call yesterday to allay such fears. The call began with him explaining the economic expansion will be five years old this June. However, he thinks we are into a long, but slow, expansion that has years left to run. Moreover, he stated we are not close to any of the excesses that lead to a recession. While he said the upcoming GDP figures will likely be soft, March figures will show the softness is weather induced. He emphasized while stocks are not as cheap as they were in 2009/2010 (see chart 1), they are still not expensive when compared to cash/bonds. If he had to own bonds, which are in a bear market, he would consider emerging market debt. With $1.9 trillion on the sideline, Dr. Kelley opined there is plenty of “dry powder” to move stocks higher. The JP Morgan mutual fund that was mentioned to take advantage of Dr. Kelly’s views was JVASX. There were numerous other positive points he made, but I am out of space and will try to highlight them in next Monday’s longer strategy report.
Well, it’s “next Monday,” and I will attempt to make good on that promise. Dr. Kelly said that he thinks the Fed is “over cooking” the economy by staying too easy for too long. The result should be a pickup in inflation and higher interest rates. He noted we have almost recaptured all the jobs lost in the downturn, implying an increase in capital expenditures (capex) and an increase in wage pressures (read: inflation). Of interest is that monetary policy leads, while the effects of inflation and employment lag. Europe, he noted, has declining headwinds and is therefore attractive. On emerging markets (EM), they remain “cheap” and are set up for outsized growth over the next three to five years. In our Gleanings report this month, as well as the Investment Strategy Quarterly, we outline the case for EM, and suggest a scaled “in” buying approach. To wit, if you have a $100,000 asset allocation for EM we think you should break that into four $25,000 tranches and buy the first tranche today. Then wait two to three months and buy the second tranche and so forth until the $100,000 allocation is complete. Dr. Kelly opined over the long-term the bullish case for EM rests on: 1) the need for capital growth; 2) labor force growth; and, 3) total factor productivity. He made a strong case for EM, and after strongly recommending EM in 2001 when China joined the World Trade Organization (WTO), we stepped off that theme two years ago for various reasons. Now we agree with Dr. Kelly. As a sidebar, one of the mutual funds mentioned as a way to participate in Dr. Kelly’s themes was the JP Morgan Value Advantage Fund (JVASX/$28.09). The charts to support all of Dr. Kelly’s points may be found at their website (https://www.jpmorganfunds.com) using the search engine’s key word “Guide to the Markets.”
As for the stock market, since the beginning of the year I have written that following a 40%+ rally like we have experienced from the June 2012 low, without any meaningful correction (10% or more), the median historical drawdown is between 5% and 7% over the next three months and between 10% and 12% sometime over the next 12 months. But, such a drawdown/pullback should be viewed within the context of a secular bull market. Well, we had a 6.2% pullback between the intraday high of 1/21/14 and the intraday low of 2/5/14. That means sometime in the next eight months we should see a 10% to 12% pullback, if past is prelude. Whether Friday was the start of such a pullback is unknowable at this point. I will note that Friday was what a technical analyst would term an outside bearish reversal day. Recall that such a day occurs when a price chart pattern of a security's high and low prices for the day exceeds those of the previous trading session. The outside reversal pattern is called by candlestick chartists a "bearish engulfing" pattern if the second bar is a down candlestick; and, that’s exactly what we got last Friday (see chart). Also of interest is that the NASDAQ Composite (COMPQ/4127.73), which has bounced repeatedly off of its 100-DMA for nearly a year, fell below that moving average on Friday. Other worries include that for nearly a year “Payroll Friday” has seen the SPX rally no matter what the condition of the market, the rotation out of the high flyers into more value type stocks, the fact that the selling of high flyers typically precedes more selling in the overall stock market, that historically markets decline during the second and third quarters of a mid-term election year, and the list goes on. That said, I continue to believe any decline should be viewed within the construct of a secular bull market.
The call for this week: I am in NYC seeing accounts and doing media, and if past is prelude something BIG will occur in the stock market in my absence. As stated, there is a full charge of energy in my proprietary indicators, so if a move starts, in either direction, it has enough energy to become meaningful. This morning, the Russian Rumors, which swamped stocks on Friday, indeed proved fallacious. Nevertheless, the preopening futures are down about 6 points (at 5:00 a.m.), begging the question, “Are we going to get another immediate upside reversal like we have seen every other time it looked like stocks were geared for the downside?” Still, as can be seen in chart 2, Sotheby’s has tended to “call” bubbles in the past. If that holds, we are NOT currently in a bubble.
March 31, 2014
Spring has sprung, yet many market pundits are worried about the softening economic reports, causing me to remember the book “Being There” by author Jerzy Kosinski. The story revolves around a simple-minded man named Chance “the gardener,” who knows only gardening and what he sees on television. For his whole adult life Chance has not ventured outside the grounds of his employer’s Washington D.C. manor. Eventually, however, the employer dies and Chance is cast out onto the streets, where through an auto mishap he encounters the wife of a D.C. powerbroker. Thinking her car was the reason for the accident, she insists that Chance “the gardener,” who she interprets to be Chauncey Gardiner, come with her to her husband’s estate. Benjamin Rand (the husband) is completely taken with Chauncey’s simple, direct approach, and mistakenly attaches profundities to Chauncey’s ramblings about gardening. Viewing him somewhat as a savant, Rand introduces Chauncey to Washington’s elite, including the President. In one verbal exchange regarding current economic conditions Chauncey remarks, “As long as the roots are not severed there will be growth in the spring.”
Well, here we are. It’s spring again, yet this year instead of the typical cries of “As long as the roots are not severed there will be growth,” many Wall Street pundits are worried. However, I am feeling rather confident that as the weather warms “there will be growth.” Indeed, it appears there is huge pent up demand as the folks above the 40ᴼ N longitude, and given the extent of the wicked winter maybe as low as above the 30ᴼ N Longitude, are going to go on a spending spree as the weather warms. Case in point, recently I spoke to an auto dealer who told me last March his dealership sold a total of 62 cars. This year his run rate, as of a week ago, was for 169 car sales in the month of March. Such metrics are being confirmed by the venerable ISI organization that writes, “ISI’s company surveys are on track to bounce a significant +1.7 over the past five weeks, led by truckers, auto dealers, and homebuilders. This strongly suggests the economy is bouncing back from bad weather, as do unemployment claims (see chart 1). And, if Barron’s is right (the cover story this week is “Bad News For Putin: Cheap natural gas, plentiful new oil finds, and efficient production methods will drive oil prices to $75 a barrel), oil at $75 per barrel will cause gasoline prices to decline, providing a huge tail wind for consumers. Remember, each penny decline in gasoline puts roughly $1 billion of additional purchasing power into the hands of the consumer. Certainly the “commercial traders” think crude oil is going to decline, having built their largest net short position of all-time!
The astute ISI folks go on to note, “Equities are under pressure, but the economic backdrop is remarkably stable” (see chart 2). And, stable seems to be the action du jour for the equity markets given that the S&P 500 (SPX/1857.62) has been trapped in roughly a 50-point trading range since mid-February. It is also pretty amazing, given all the “shucking and jiving” the SPX has done, that it is only up 0.5% year-to-date. But while the major indices have hugged the flat line YTD, many stocks have experienced 20% declines. Last week the biotech complex was particularly punished, leaving most of the biotech indexes off ~20% from their late-February highs. Despite such slides, the macro selling has not been all that intense, with only March 13th registering an 80%+ Down Volume session. Typically it takes a 90% Downside Day, or a series of 90% Downside Days, to end a correction. So, we are likely either not in a correction or into a stealth correction that has further to run on the downside. At this point in time I am leaning toward the later (more on the downside) because of the aforementioned reasons and because something just does not feel right. As The SentimenTrader’s always insightful Jason Goepfert writes:
The “Smart Money Index” that subtracts the S&P 500's performance during the first half-hour of trading and adds the last hour has plummeted by over 20% during the past two weeks. This shows a repeated pattern of buying during the early morning and selling in the afternoon. Since at least 1998, the index has never suffered a decline like this over a two-week period. The only time that volatility neared this kind of level was late 2007 / early 2008. We're not reading that much into it, but generally a rapidly declining SMI when stocks are near a high leads to sub-par returns going forward.
Then there was this from my friends at Bespoke Investment Group: “If you trade intraday, you’ve probably noticed the strange pattern equity markets have been locked in for the past several weeks. Strong opens build momentum, then start giving up gains between noon and 1 p.m. The weakness continues into the afternoon, gearing up again around 3 p.m. before an occasional bounce into the close.”
There it is again, “The strange pattern the equity markets have been locked in for the past several weeks.” The fact of the matter is there are indeed times when the stock market is strange and trendless. I have learned the hard way when that happens you can lose a lot of money trying to force a trade or for that matter an investment. Currently, the equity markets are in one of those strange and trendless periods, which is why Andy Adams so eloquently wrote in last Thursday’s Morning Tack, “I don’t know, and that’s ok.”
That said, by my work there are no signs the secular bull market is coming to an end. One of the few negatives I see on a short/intermediate term basis is that the number of new 52-week highs is shrinking. Also suggesting there may be some more downside to come is the Russell 2000 (RUT/1151.81), which has traveled below its 50-day moving average (DMA) of 1162.67. Historically small capitalization stocks, as represented by the RUT, are the first to display weakness. That weakness is also apparent in the various NASDAQ indices that have likewise violated their 50-DMAs. So far, however, the D-J Industrials (INDU/16323.06), D-J Transports (TRAN/7451.36), Value Line Arithmetic Index (VLA/4413.33), the SPX, etc. have not traveled below their 50-DMAs. For the record those moving averages are 16120.53, 7372.75, 4380.27, and 1834.05, respectively. Eventually the stock market will resolve its current range-bound indifference, but until it does I remain cautious on a trading basis.
The call for this week: The SPX is still locked in a trendless 50-point trading range while some of the “tell” indices have broken below their 50-DMAs, as well as near-term support levels. Important support for the SPX is at its March 14th reaction of 1839.57, which is in the 1835 – 1840 support zone often mentioned in these reports. A break below that level, on a closing basis, would suggest the 1780 – 1800 level should come into play. The quid pro quo is that a close above 1860 would indicate another attempt at the all-time highs. The recent retest of those all-time highs failed and occurred on light volume, raising the probability that a breakout to new all-time highs was pretty low. In fact, a traders’ “sell signal” was triggered last week when the 14-day Stochastic crossed below its moving average. Of interest is that the NASDAQ Financial 100 Index broke below its rising trendline last week. As readers of these missives know, I avoided the Financials, for the most part, from 1999 until 2012. Since 2012 I have over-weighted them, and I continue to like them, because they are cheap! Last week’s breakdown was mainly caused by Citigroup’s (C/$47.25/Strong Buy) swoon on its Fed’s “stress test” failure. Our fundamental banking analyst, Anthony Polini, had this to say about that in his company comment published March 27:
We reiterate our Strong Buy rating on Citigroup (C). Our investment thesis is still intact despite its qualitative CCAR failure. We view any near-term stock price weakness as a buying opportunity. While the good news on capital return is clearly delayed, our investment thesis remains intact. Furthermore, an accelerated disposition of Citi Holdings assets should pave the way for even more capital returns in subsequent years and help to re-establish positive stock price momentum. We still expect the company to return more than $10 billion annually in each of the next three years. The stock was up 7% last week and will probably give that gain back this week, but upside potential remains well above average given EPS power of $7.00 by 2017. We forecast tangible book value per share to hit $59.00 by year-end 2014 and believe the company will likely exceed all of its capital requirements. Regarding Citigroup's shortfall, the Fed cited deficiencies in capital planning practices, including areas the Fed previously identified as requiring attention and not having shown sufficient improvement. These included its ability to project revenue and losses in the stress scenario for parts of the global operations and its internal stress testing developments to address its full range of business activities and exposures. According to the regulators, "taken in isolation, each of the deficiencies would not have been deemed critical enough to warrant an objection, but, when viewed together, they raise sufficient concerns regarding the overall reliability of Citigroup's capital planning process to warrant an objection to the capital plan and require a resubmission." The company is in the process of evaluating the issues identified, and we should have more details on the 1Q14 conference call (Monday, April 14). Given the Fed comments, a conditional approval may have been more appropriate. You can’t help but wonder if the recent problems in Mexico tipped the scale to failure. Three U.S. subsidiaries of foreign bank holding companies (HSBC, Santander, and RBS Citizens) also failed for qualitative reasons, which appeared to be much more grievous.
Recommendation: Our 12-month target price of $62.00 is based on 10.5x 2015E EPS of $5.88 and about 105% of tangible book. This compares to our recent industry averages (for the nation's 40-largest banks) of about 13.3x 2015E EPS and 183% of TBV. We believe the discount to peers is warranted given risk factors related to the global economy and regulatory environment.
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