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Investment Strategy by Jeffrey Saut

September 26, 2016

Schadenfreude: is pleasure derived from the misfortune of others.

What a week! We first met with Steve Eisman, and then did a conference call with Rich Bernstein followed by a video with SEI’s portfolio manager Steve Treftz. Subsequently, it was off to visit some more of our new best friends at the Alex. Brown offices in Atlanta and North Carolina . . . I’m exhausted.

For those that haven’t seen the movie “The Big Short,” Steve Eisman became famous for the fortune he made shorting subprime mortgages prior to the financial fiasco of 2007-2009. He was profiled in Michael Lewis’s book, “The Big Short,” and was portrayed by Steve Carrell in the movie (The Big Short). He joined Neuberger Berman in 2014 as a portfolio manager for the Eisman Group, managing a hedge fund in which participants can invest. In the meeting Steve chronicled the sequence of events leading up to the 2008 debacle. He said you need three things for such an event: 1) too much leverage; 2) a big asset class that blows up; and 3) large institutions holding most of the asset class that blows up. At the onset of the financial crisis he said many of the large institutions were leveraged over 30 to 1 allowing the executives of said organizations to make tens of millions of dollars a year in compensation as corporate profits soared. According to Steve those executives confused leverage for genius! Beginning in 2002 mortgage underwriting standards got easier and easier until in early 2007 the standard was “if you can breathe we have a mortgage for you.” Suddenly, in late 2007 the refinance binge came to a halt and the rest, as they say, is history. Steve concluded that Europe is currently sick, the U.S. is likely destined for slow growth because there is not a big enough mortgage refi pipeline to boost the economy, and that Italy is in big trouble. Steve said to be a short selling you need to embrace “Schadenfreude.”

On that sour note, we proceeded to dial up our bullish friend Rich Bernstein (ex-Merrill Lynch star strategist and now eponymous captain of Richard Bernstein Advisors) to begin a conference call to some 500 Raymond James financial advisors (replay: 855.859.2056 / ID: 62645632). Rich said he continues to think this current secular bull market is the biggest/longest of his career, obviously we agree. He said that while statistically this is the second longest bull market on record, it has NO gray hair and there is no excitement which is generally seen at the end of bull markets. He further opined it is amazing investors continue to pile into a VERY expensive bond market on the belief interest rates will stay low forever. That’s interesting because the U.S. money supply is growing faster than average and inflation is doing the same. The implication is interest rates should slowly increase over the longer term. In such an environment cyclical stocks should be favored. He particularly likes the consumer discretionary space, but not consumer staples, which (like me) he believes to be very expensive. Rich thinks the profit cycle for companies has bottomed and the markets are transitioning from an interest rate-driven to an earnings-driven secular bull market. On Brexit, he notes that while the crowd was horrified by that vote predicting the end of the EU, Rich deduced that something always benefits from any event - in Brexit’s case it was the U.K. multinationals, due to the weaker British pound - and he tilted portfolios accordingly. He is becoming more constructive on emerging markets. Rich concluded with the question, “Does anyone know how much the S&P 500 (SPX/2164.69) is up over the trailing 12 months?” Asked and answered, he said it is up 14.6% to the surprise of just about everyone. There are a number of Eaton Vance funds that are managed by Rich for your invest consideration.

From there, we strolled over to our studio to film a video with SEI’s Portfolio Manager Steve Treftz. Steve manages the SEI Multi-Asset Fund (SIOAX/$10.57), and is also in the bullish camp with very similar views to those of Rich and me. He too believes in managing risk. The fund has access to institutional money managers that may not be directly available to advisors and retail investors. Steve uses a multi-manager approach in constructing the Multi-Asset Income Fund to build a comprehensive income strategy believing managers have different expertise in which they can combine and allocate capital to various managers/styles as environments shift. Steve believes proof of concept is important and that his approach enables him to provide a high level of income with an attractive risk/return profile relative to peers. (There is no guarantee this will occur.) The video should be available early this week.

The latter part of the week was spent on the road seeing the good folks at Alex. Brown. For the past month we have been visiting some of the Alex. Brown offices since they have become associated with Raymond James. A few weeks ago Harry Katica, Nick Lacy, and I journeyed to the Alex. Brown offices in D.C., Baltimore, Philadelphia, NYC, Greenwich, and Boston to tell the Raymond James story. Last week we visited the Atlanta and Winston-Salem offices. I am fortunate to have known Alex. Brown in its heyday before Bankers Trust acquired them followed by Deutsche Bank’s purchase of Bankers Trust. I got to see Alex. Brown at its best when I moved to Baltimore to run capital markets, and be director of research, for a Baltimore-based brokerage firm. The “House of Brown’s” bullpen back then was awesome. Nobody had an office because everyone wanted to sit in the bullpen behind the magnificent roll top desks. The firm had topnotch research and investment banking departments and the financial advisors were of the highest quality. While the research and investment banking departments are gone, the advisors we have met with continue to be of the highest caliber. We look forward to working with them.

In our absence the Fed did what we expected, NOTHING. The equity markets responded with a spring-loaded rally that finally breached the S&P 500’s intraday high of 2163.30 made on September 12, 2016 that had contained the upside until last week. The rally, however, did not leap above our 2187 pivot point, which would have given us a buy signal. I do find it interesting that the SPX pulled right back to that 2163 “attractor” level in last Friday’s Fade. Nevertheless, the Fed induced two day “two step” left the McClellan Oscillator very overbought in the short term and my internal energy indicator totally out of energy, so Friday’s pullback should have come as no surprise. The question currently is, “What now?”

Well, my various indicators are somewhat confused. One scenario is that the current pattern is reminiscent of the June-July 2015 timeframe. As Steve Shobin writes, “At that time, the market had an abrupt fall, a quick bounce back to the top, followed by a gut checking decline into mid-August” (August 24’s selling climax and we were bullish). The alternate scenario would be for the SPX to breakout above 2187 and continue to grind higher all the way into 1Q17. That, by the way, would really confuse most participants. In either event the long-term secular bull market remains in force and we will wait for the market to “tell” us what’s next in the short run.

The call for this week: So our models nailed the mid/late-September market vulnerability timeframe and as expected the Fed did nothing. Somewhat surprisingly, stocks leaped on the Fed’s Foible as the Fed cut potential economic growth prospects to the lowest on record. Meanwhile, swooning tax receipts confirm the recently softening economic reports leaving the Citi Economic Surprise Index back to neutral after tagging a three-year high six weeks ago. Meanwhile, the New York Fed released the Empire State Manufacturing Survey, which somehow rose from -4.21 to -1.99 despite the fact that all of its components deteriorated. And after the Dallas Fed told banks to NOT write down the value of their E&P loans, the SEC is now investigating Exxon for not writing down the value of its reserves as things are getting curiouser and curiouser, which is why we continue to exercise patience. As Benjamin Franklin opined, “He that can have patience can have what he will!” Of course, all of this takes a backseat to tonight’s 9:00 p.m. “Clash of the Titians.”

September 19, 2016

A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door, which he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back to the box, which would scare away any turkeys lurking on the outside.

One day he had a dozen turkeys in his box. Then one walked out, leaving 11. “I should have pulled the string when there were 12 inside,” he thought, “but maybe if I wait, he will walk back in.” While he was waiting for his 12th turkey to return, two more turkeys walked out. “I should have been satisfied with the 11,” he thought. “If just one of them walks back, I will pull the string.” While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return . . .

“I should have” sold at 2190! Many a trader and investor went home last Friday night uttering those words. The S&P 500’s (SPX/2139.16) 2190 level has really been frustrating since early August. To be sure, the SPX has tried numerous times to vault above that level for the past seven weeks with eyes for 2200. “Surely,” participants thought, “Following the strong upside breakout above the 2120 – 2130 zone, which had contained the SPX since March of last year, the next logical price target should be the round number of 2200!” “Such round numbers are typically money in the bank,” was the cry, but a funny thing happened en route to 2200.

In past missives we have chronicled various indictors and events that concurred with our timing model’s message that mid-/late-September was the first point of downside vulnerability for the equity markets. Most recently it has been interest rate worries that slugged stocks, as participants pondered a rate increase at this week’s FOMC meeting. For our part, Andrew and I have been quite adamant for five months that rates are not going to be raised until after the presidential election. Nevertheless, the world is expecting interest rates to eventually increase as yield curves everywhere appear to be steepening (chart 1). Typically, when that happens it suggests either a stronger economy, or a pickup in inflation, and maybe both. In last Friday’s verbal comments we noted that Thursday’s action, where bond prices declined (higher rates) and the U.S. dollar rose, it implied Mr. Bond wants interest rates to rise. Moreover, a steepening yield curve is a decided positive for the financial complex, which is why most of the financial-centric indices have broken out to the upside in the charts.

Speaking to higher interest rates, while a quarter point increase in the Fed Funds rate would likely cause a stutter-step in the equity markets, the impact on the overall economy should be de minimis. In fact, it just might cause a flurry of refi’s on the assumption the low water mark for the mortgage market is “in.” Interestingly, it was the surge in mortgage refinancing years ago that caused the consumer to buy more “stuff” and helped drive a pickup in the economy. Importantly consider this, an argument can be made that the Federal Reserve is not really “tightening” until they raise interest rates above the embedded rate of inflation. Until that happens it can be said the cost of money is still relatively “cheap” and abundant. In the current case that would mean Fed Funds would have to rise above ~2% before it should be considered a “tightening.”

Turning to the equity markets, I found this gleaning from my friend, and savvy investor Joe Monaco, Ph.D., pretty interesting:

I keep hearing, from almost every source, that the entire market’s returns are being driven by four stocks, Netflix, Amazon, Apple and Google. However, did you know that over the past 24-months both the Dow Jones Industrial Average and the S&P 500 have had almost the exact same return with almost the exact same volatility? And yet, Netflix, Amazon, and Google are nowhere to be seen among the Dow’s 30 stocks. As proof of my analysis, please look at the comparative chart of the Dow Jones Industrial Average along with the S&P 500 (I actually used the DIA and SPY ETFs for charting purposes), courtesy of Stockcharts.com (chart 2). I think this reasoning is just portfolio managers justifying why they have so very much underperformed.

We have touched on this underperformance point before by noting, “If the active portfolio manager (PM) doesn’t outperform the bogey index, but outperforms the ETF that is supposed to track said index, is that a win for active management?” Indeed, except for the S&P 500, whose ETF tracking error is small, the tracking error for most of the other ETFs is large. The problem is that you can’t buy the index! Further, there are implementation costs for any strategy and “cash drag” for the active managers since they all hold a position of the portfolio in cash, which is earning nothing. Consequently, if you view active performance through this ETF comparison lens, you find more than 50% of active PMs outperform their respective ETF. What we found is that when stocks are undervalued, and the index is going straight up, you want to own “cheap beta.” However, when the markets are neutrally valued, or overvalued, you want active management. The reason is the active manager can say, “I don’t want to play in that particular game.” But what are individual investors currently doing? They are doing the exact wrong thing. They are selling active managers’ funds and buying passive funds.

Speaking to active management, I have always found Thomas Lee’s market insights to be net worth-changing; first, as J.P. Morgan’s Chief Investment Strategist, and now at his own firm (Fundstrat.com), where he currently makes a compelling case for buying the recent pullback. He writes, “Has our conviction changed about markets staging gains into yearend (YE)? No. Since 1940, to gauge what stocks do between 9/15 and YE is simply look at YTD performance. When stocks are up 5% or better, they rally into YE 87% of the time (90% when between 5% and 20%). In other words, we believe this 3% pullback NEEDS TO BE BOUGHT aggressively.”

The byline to his report reads, “Why we are buyers of this pullback and see 6%-8% gains into yearend: History says 90% likelihood of YE rally – 12 stock ideas.” Of course readers of these reports know that we too have stated the current pullback is unlikely to be anything more than a 3% - 6% drawdown setting the stage for a year-end rally. As a sidebar, MarketWatch’s Barbara Kollmeyer writes, “The crowd wants this stock market correction too badly for it to happen,” which inferentially bolsters our shallow correct “call,” but I digress. Parsing Thomas’ 12 stock ideas, which are also favorably rated by our fundamental analysts and screen positively on our proprietary algorithm, for your consideration include: Cisco (CSCO/$30.84/Outperform), Praxair (PX/$117.68/Strong Buy), Texas Instruments (TXN/$69.36/Outperform), Microsoft (MSFT/$57.25/Strong Buy), Xilinx (XLNX/$53.36/Strong Buy), Kinder Morgan (KMI/$21.47/Outperform), Union Pacific (UNP/$92.38/Strong Buy), and Apple (AAPL/$114.92/Outperform). To paraphrase Thomas, sell the outperformers over the past few years and buy the underperformers.

The call for this week: To discuss the current state of various markets, my friend Rich Bernstein (ex-investment strategist at Merrill Lynch and now eponymous captain of Richard Bernstein Advisors) and I will conduct a joint conference call tomorrow (Tuesday 9-20-16) at 4:00 p.m. The dial in number is (866) 393-4306 with the password Eaton Vance. Tactically speaking, this week the Fed and the BOJ (Japan) will provide their latest views on monetary policy. We think both will be a non-event. And then there was this from BlackRock’s Rob Kapito, “Stocks globally could continue to rise as interest rates remain low as investors who have stockpiled some $70 trillion in cash seek higher returns from the market. People are tired of earning zero," Kapito said at the Barclays Global Financial Services Conference in New York, “There's more cash in the system than ever before.” And don’t look now but tech has broken out to the upside in the charts (chart 3). Be optimistic my friends . . .

Time or timing?!
September 12, 2016

“Hey Jeff,” an emailer wrote on Friday as we arrived in Quebec City from Cape Cod to have dinner with some family and Insitutional friends, “I thought you said it would not be until mid/late-September before a point of vulnerability would arrive! Today is merely September 9, what gives?” I responded, “As often expressed in our missives/comments, the short/ intermediate-timing models ALWAYS have a 3-5 session margin of error. That implies anywhere within 3-5 sessions of that mid/late-September ‘call’ is close enough for government work.” Subsequently, Friday’s Dow Dive (-395 points) was attributed to a myriad of things that have been rehashed so many times by the media, and false pundits that never saw it coming, there is no need to repeat them here. Suffice it to say, anyone reading these reports should have treaded cautiously going into September. Still, if past is prelude, I would not look for anything more than the ~3% to a little over 5% pullback as we have suggested countless times for numerous stated reasons. So, the title of today’s report is “Time or Timing.” For over 40 years, one of my market mantras has been, “Nobody can consistently ‘time’ the markets, but if one listens to the message of the market, you can certainly decide if you want to be playing hard or not playing so hard (that’s timing). Time, however, is a totally different animal.

“Time” is the Archimedes’ lever of investing. Archimedes is often quoted as saying, “Give me a place to stand and a lever long enough, and I shall move the earth.” In investing, that lever is time. The length of time investments will be held, the period of time over which investment results will be measured and judged, is the single most powerful factor in any investment program. If time is short, the highest return investments – the ones an investor naturally most wants to own – will be undesirable, and the wise investor will avoid them. But if the time period for investing is abundantly long, the wise investor can commit without great anxiety to investments that appear in the short run to be very risky.

Given enough time, investments that might otherwise seem unattractive often become highly desirable. Time transforms investments from least attractive to most attractive – and vice versa – because, while the average expected rate of return is not at all affected by time, the range or distribution of actual returns around the expected average is very greatly affected by time. The longer the time period over which investments are held, the closer the actual returns in a portfolio will come to the expected average. The following table shows the compounding effect on $1.00 invested at different compound rates compounded over different periods of time. It’s well worth careful study – particularly to see how powerful time is. That’s why time is the “Archimedes’ lever” of investment management.

Compound Interest over Time

Compound Rate of Return Investment Period
5 Years 10 Years 20 Years
20% $2.49 $6.19 $38.34
18 2.29 5.23 27.39
16 2.10 4.41 19.46
14 1.93 3.71 13.74
12 1.76 3.11 9.65
10 1.61 2.59 6.73
8 1.47 2.16 4.66
6 1.34 1.79 2.65
4 1.22 1.48 2.19

Source: Investment Policy, How to Win the Loser’s Game; Charles D. Ellis

When asked what he considered man’s greatest discovery, Albert Einstein replied without hesitation: “Compound interest!” But compound interest is ignored in most bull markets. For instance, the late-1990s, the bulls said compounding dividends doesn’t matter. Nobody wants to pay double taxes on ‘em, and that old bear growl about the markets being vulnerable when the yield on the S&P 500 drops below 3% hadn’t been valid for years (the same can be said from the 2009 lows). So who cares if the current yield is only roughly 2.0%? Well, we happen to think dividends are very important. Indeed, historically, a major percentage of the return on stocks has come from dividends.

How much? Of the ~10.4% compounded annual return generated by stocks in the S&P 500 since 1926, nearly “half” has come from dividends, according to Ibbotson Associates. Their studies show that, over the long term, stock prices have risen at an annual pace of less than 7% with most of the rest of the returns coming from compounding reinvested dividends. Now the more popular index with the public, and the financial media, is the Dow Jones Industrial Average (INDU/18085.45), which also shows a yield of roughly 2.0%. Year-to-date from December 31, 2015 close, up until last Friday’s Flop, the Dow has gained some 6%. Historically, the INDU has also averaged a little over 10% total return annually. Most of the time, however, the INDU showed a 4% to 5% dividend yield, with price appreciation making up the 5% or so of the difference of that 10% annual total return. Accordingly, if you only have a current 2.0% yield, that means you have to get an 8.0% annual price appreciation.

Now, if the Dow 30 have already scored a ~6% return for the year, combined with a dividend yield of ~2%, that implies we should expect a mere 2.0% appreciation into year’s end. We actually think the gains will be greater than that as this bull market transitions from an interest rate-driven to an earnings-driven bull market. But, “This time it’s different” say many pundits. Capital gains will more than make up for the compounded annual returns from dividends. Well, when dividends and the magic of compounding are ignored, those pundits have to be counting exclusively on a capital gain and the assumption that they can predict tomorrow. Now predicting tomorrow is virtually impossible unless you are ______. Well you can fill in the blank after you read the following story from Connie Bruck’s book, Masters of the Game: Steve Ross and the Creation of Time Warner, about the now deceased Steve Ross, the former head of Time Warner:

In February 1962, just a month before Kinney Services (the predecessor to Warner Bros.) went public, its Riverside funeral chapel division had contracted to purchase a location on Broadway, which it intended to convert to a new funeral chapel. Shortly afterwards, it was announced that Lincoln Center was to be constructed just across the street from the projected Riverside chapel. As Ross would later tell the story, he instantly realized that this would be an opportunity to make money. Before long, he received a call from Governor Nelson Rockefeller, who asked if he was thinking of building a funeral chapel across from Lincoln Center. When Ross assented, Rockefeller asked if Ross had received approval from the zoning commission. Ross said he had. Rockefeller then said, “Have you checked that?” Ross said, “Yes.” And then Rockefeller said, “No, I mean have you checked that tomorrow?!”

That story kind of reminds me of the FBI’s “data dump” the Friday before the Labor Day weekend, “Have you checked that tomorrow?” We actually have and think a mid/late-September swoon in the equity markets is for buying. The next few weeks will tell, so stayed tuned.

The call for this week: Our timing models, and internal energy models, are not always right. When that happens, we admit it quickly for a de minimis loss of capital. However, our models are right a whole lot more than they are wrong. So our hope, although not really embraced because of our models, that the recent intraday low around 2158 (basis the S&P 500) would contain the decline, proved to be wrong. Subsequently, when that level gave way, a trapdoor opened, leaving the S&P 500 (SPX/2127.81) trading slightly above its 2100-2120 support level with a single-point “attractor” target price of 2108. Failing that, 2092 is the next “attractor.” Friday’s Fade caused the SPX to break below its 50-day moving average (DMA), but the Russell 2000 and the NASDAQ Composite did not follow (possible a downside non-confirmation). For what it’s worth, by our work, the two most oversold sectors are Consumer Discretionary and Consumer Staples on a short-term basis. Interestingly, both the SPDR S&P 500 (SPY/213.28) and the iShares Barclays 20 Year Treasury Bond ETF (TLT/135.52) were off more than 1% last Friday (SPY -1.90% and the TLT -1.63%). Historically, when that coincident combination has happened, the SPY is up 0.10% a week later and up 1.30% a month later 57% of the time according to our friends at Bespoke. Back on the Brexit Bombshell, with the Industrials off some 600 points that Friday morning, we advised doing nothing because what typically happens is that investors brood about their losses over the weekend. Then they show up on Monday in “sell mode,” which leads to “Turning Tuesday.” Said strategy worked like a charm on the Brexit vote, and we actually came out with a “buy list” that “Monday Melt” (6-27-16). We are not as sure the same chart pattern will play this time, but we are hopeful it will! I will concede the McClellan Oscillator is very oversold, so if early this week we get a downside whoosh to anywhere between the 2092-2108 “attractor” zone, we should get a recoil rebound. But, right now, we are not sure it will be sustainable. North Korea’s bomb, Hillary’s health, and Trump’s election odds just recalibrated the stock market’s odds, leaving the preopening S&P futures off 14 points as I look out over the Saint Lawrence Seaway at 5:00 a.m. and prepare to meet with portfolio managers.

P.S.: It was fifteen years ago on Monday (9-10-01) when I used Obi-Wan Kenobi’s quote from Star Wars, which read, “I felt a great disturbance in the Force, as if millions of voices suddenly cried out in terror, and were suddenly silenced. I fear something terrible has happened.” The quote was used because, since August of 2001, the stock market should have been going up and it wasn’t! I miss the 16 friends I lost the next day.

I do not think the same sequence is going to play here . . .

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