Investment Strategy by Jeffrey Saut
‘Tis the Season?
November 16, 2009
‘Tis the season . . . except in this case we haven’t quite yet entered the Christmas season. However, we have entered the best six months of the year for the equity markets. Clearly, history demonstrates that the November through April periods have on average shown superior stock market performance to that of the May through October half of the year. As our South African friend Dr. Prieur du Plessis notes, “(since 1950) the ‘good’ six-month period of the year shows an average return of 7.9%, while the ‘bad’ six-month period only shows a return of 2.5%.” This performance can be seen in the first chart on page 3.
In addition to the aforementioned seasonality, there are some equally compelling shorter-term metrics. To wit, over the past 12 years the DJIA has always shown a profit between November 11th and December 5th. Additionally, since 1976 the DJIA has posted a positive return between October 26th and January 1st every year except 2007. As for those that suggest the markets have rallied too far too fast, we offer these comments from the always insightful folks at “The Chart of the Day.”
“To provide some perspective to the current Dow rally that began back in March, all major market rallies of the last 109 years are plotted on today's chart. Each dot represents a major stock market rally as measured by the Dow. As today's chart illustrates, the Dow has begun a major rally 27 times over the past 109 years which equates to an average of one rally every four years. Also, most major rallies (73%) resulted in a gain of between 30% and 150% and lasted between 200 and 800 trading days (9.5 months to 3.2 years) -- highlighted in today's chart with a light blue shaded box. As it stands right now, the current Dow rally would be classified as both short in duration and below average in magnitude.”
To us the real question is not whether this is a counter-trend rally in an ongoing bear market, but rather is this the beginning of a new secular bull market, or a bull market within the confines of the trading range we have been in for the last nine years? In past missives we have often reminded participants that since 1900 there have been only three secular bull markets. They were from 1921 – 1929, 1949 – 1966, and 1982 – 2000. Following each one of those secular bull market peaks the DJIA has been “range-bound” for a period of years. Using the 1966 bull market peak as an example, the Dow was mired in a trading range for 16 years before embarking on the next secular bull market. Of course, those of us that lived through the 1966 – 1982 debacle know that there were a series of bull and bear markets within the confines of that trading range. In fact, there were at least ten 20%+ rallies and/or declines in that ongoing range-bound market. Accordingly, investors had to have a more proactive strategy for their portfolios, much like we have had to use for the past number of years.
While NOBODY can answer our proposed question, what we can attempt to do is position portfolios in a manner that deals with the current environment as we see it. To that point, since last April we have been using the stock market’s chart pattern from 2003 as a template for this rally. Recall that the S&P 500 bottomed in March 2003 and rallied sharply into to June. From there it flopped/chopped around for a few months, but never gave back much ground, and then it took off on the second leg of the rally, rising into the first quarter of 2004. The first “leg” of the 2003 rally was driven by liquidity, much like 2009’s first leg (March – June). The second leg of the 2003 rally was driven by improving fundamentals and earnings, just like 2009’s “July through now” rally.
To be sure, we have turned cautious a couple of times since the March “lows,” but we have never turned bearish. Most recently, we wrongfully turned cautious at the beginning of October, worried that the July – September upside vacuum created by the melt-up might get “filled” to the downside once quarter’s end window dressing was over. Obviously, that was wrong-footed because all the markets have done is work off their pretty overbought condition at the end of September into a very oversold condition a few weeks ago. We chronicled that oversold condition in our report of November 2, 2009, but regrettably didn’t act on it. Accordingly, we corrected that cautious “call” last week by adding some “long” index positions to the trading account. While we would have felt better adding those positions if the markets had pulled back, or if the S&P 500 (SPX/1093.48) had rallied above its potential double-top of 1100, in this business you have to take what the markets give you. Whatever the resolution in the short term, we continue to believe the major market indices will trade higher into the first quarter of 2010.
Plainly, we agree with the astute GaveKal organization in that the normal economic cycle is for corporate profits to increase, which drives an inventory rebuild and subsequently capital expenditure cycle, and then comes employment expansion that revives consumption. Currently, corporate profits are surging at their largest ramp rate since mid-1975. According to ISI, “profits have increased sequentially for the past three quarters at an estimated +34.8% annual rate – a record for a recessionary environment.” As of yet, however, the inventory rebuild has been muted. But with inventories plumbing record lows, we think the inventory cycle is about to begin. If correct, the aforementioned sequence should play. Importantly, consumption comes at the back-end of the cycle, not the front-end. Consequently, those arguing we cannot have a normal recovery until unemployment declines are like skiers skiing downhill looking at the tails of their skis.
We think the normal economic cycle will play once again. If so, economic reports, fundamentals, and earnings should continue to improve, putting even more pressure on underinvested participants (according to the latest surveys, hedge funds are only ~52% net long). And, that pressure should buoy stocks into the first part of 2010. It is the back half of 2010 that begins to worry us due to harder earnings comparisons, loss of the “sugar high” stimulus funds, higher taxes, an election year, increased government regulation, etc. In fact, it is the probability of further government regulation of corporate America that worries us the most, and we are not alone. As our energy analysts wrote last week:
“ENSCO International (ESV/$45.94/Market Perform) to pick up shop and head to U.K. After watching rivals Transocean (RIG/$87.31/Strong Buy) and Noble Corp (NE/$43.28/Strong Buy) move to Switzerland, ENSCO has announced its intentions to re-domesticate from Delaware to the U.K.”
ENSCO joins a growing list of companies, like Tyco (TYC/$36.50), that are moving offshore driven by worries of increased regulation and taxes. I am old enough to remember the exodus of U.K. companies, and talented people, to America in the 1960 – 1970s for similar reasons. Another example of governmental incursion came full circle last week when Pfizer announced the closing of six Research and Development facilities. One such site is located in New London, Connecticut. It was four years ago when the government used eminent domain to seize homeowners’ homes. The government (state/local) then spent $78 million to bulldoze those properties to build condos, and offices, to enhance Pfizer’s nearby research facility. The “spin” was that the project would create jobs and bring in more taxes. Now that land stands vacant, without any of those promised benefits. With Pfizer’s closing of its New London facility that land will likely remain fallow. As The Wall Street Journal writes, “Economic development that relies on the strong arm of government will never be the kind to create sustainable growth.”
The call for this week: In bull markets, be they secular or not, it is rare to get anything more than a 7% - 10% correction; while we have been looking for such a correction for more than a month, time is running out. The trick then becomes to commit some capital to areas that have good risk/reward metrics. By our pencil, the sectors displaying the best relative strength are Energy, Consumer Non-Cyclicals, Basic Materials, and REITs (real estate investment trusts). Our REIT analysts just returned from the NAREIT national conference and reiterated their Outperform rating on 3.5%-yielding Apartment Investment and Management Company (AIV/$13.48). Another way to get at the REIT theme would be via the ETF iShares REIT (IYR/$43.19). On the energy theme, our analyst upgraded American Superconductor (AMSC/$31.00/Strong Buy) this morning. As for Consumer Non-Cyclicals, the ETF that makes sense to us is the Consumer Staples SPDR (XLP/$26.72), as does Wal-Mart (WMT/$53.20). And, we still like our previous recommendations of Pfizer (PFE/$17.59) and Altria (MO/$19.26), which are both followed by our research correspondents.
I Should Have!?
November 9, 2009
“... 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 that 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 into 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 eleven. ‘I should have pulled the string when there were twelve inside,’ he thought, ‘but maybe if I wait, he will walk back in.’ While he was waiting for his twelfth turkey to return, two more turkeys walked out. ‘I should have been satisfied with the eleven,’ 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 ...”
... Why You Win or Lose, by Fred C. Kelly
“I should have bought at Dow 8000 when the DJIA broke above the downtrend line that was formed by drawing a descending line from the May 2008 high to the September 2008 high. Now we are probing another descending trend line that can be seen by drawing a similar line connecting the October 2007 high with the highs of December 2007, May 2008 and October 2009.” So exclaimed one disgruntled portfolio manager last Friday since the senior index again continued to not surrender much ground last week. Indeed, despite all the “calls” for a correction (including ours) the Dow remains resilient. And, those “correction calls” are now legend with certain pundits trumpeting that the “bear market rally is over” and we are now going to re-test, and break, the March lows. Other mavens continue to opine that the 1937 – 1938 Dow déjà vu is the preferred pattern, which also suggests that new lows lay ahead.
To be sure, references to the 1930s abound with folks like financial historian Niall Ferguson appearing on Charlie Rose waxing that the United States will suffer the same fate as Britain following World War II. To wit, the U.K. was broke, deeply in debt, the British Pound was destined to lose its status as the world’s reserve currency, and Britain itself was in secular decline. Shortly after Mr. Ferguson’s appearance was Singapore’s first Prime Minister Mr. Lee Kuan Yew. He too opined that the U.S. was potentially at the end of an era unless the nation summons the mental fortitude, and toughness, to reverse its current course. Clearly, nostalgia is reigning on the “Street of Dreams,” causing one savvy seer to recall Vera Lynn’s 1930s song, “We’ll Meet Again.” The lyrics are:
“We'll meet again. Don't know where, don't know when. But I know we'll meet again. Some sunny day. Keep smiling through. Just like you always do. 'Till the blue skies drive the dark clouds far away.”
Plainly, this song suggests the end of something, and in fact was played at the end of the movie “On the Beach.” Said movie centers on a post World War III environment whereby the entire northern hemisphere is polluted by nuclear fallout. The only part of the earth that is still habitable is the far south of the global, namely Australia. Yet as the radiation spreads, even the Australians begin dying. The final scenes show the deserted streets of Melbourne as the song “We’ll Meet Again” plays. Indeed, the end of an era.
We, however, don’t buy the idea that our nation is at the end of an era. While the U.S. is certainly in a “hard spot,” our sense is that economist Joseph Schumpeter’s notion of “creative destruction” will play once again. One can actually see it at work as labor and capital are moving from dying industries to growing industries like electric cars, biotechnology, green companies, infrastructure, etc. We have been on the infrastructure theme for years, with particular emphasis on electricity and water. Interestingly, much of the stimulus money earmarked for infrastructure is going to go for replacing our country’s aged water pipes. Obviously, that’s good news for pipe manufacturers and we have tilted portfolios accordingly.
As for the equity markets, while we have wrongly been looking for a correction since the beginning of the fourth quarter, the S&P 500 (SPX/1069.30) still hovers around the same level it was when we turned cautious. To us that’s pretty bullish, for as stated in last week’s letter:
“While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish.”
Indeed, despite the “bad mouthing,” all stocks have done over the past month is consolidate their July – September rally by moving sideways. Moreover, that sideways consolidation has seen the equity markets work off their overbought condition into one of being pretty oversold. Ladies and gentlemen, to an underinvested portfolio manager the current environment is a nightmare, especially if you believe as we do that we are going to see an upside celebration into year-end. Manifestly, we have argued that with credit spreads below their pre-Lehman bankruptcy levels there should be no reason why the equity markets can’t “fill up” the downside vacuum created in the charts by said bankruptcy. As can be seen in the following chart, that gives the S&P 500 an upside target of 1200 – 1250. If correct, it implies that the cash rich, underinvested portfolio managers (PMs) will once again be forced to chase stocks higher. Our guess is the PMs will chase the “winners” since the March lows rather than buying the laggards. That suggests investments in emerging and frontier markets, technology, financials, base/precious metals, etc. should trade higher if the aforementioned scenario plays.
Along this “chase ‘em” theme, we have screened the Raymond James universe of stocks that have rallied more than 100% since the March lows, which were rated Strong Buys in March, and are still rated Strong Buy. If we get “melt up” stage 2, such a list should make a decent idea list. The names for your consideration are: RF Micro (RFMD/$4.02); Bank America (BAC/$15.05); Hughes Communication (HUGH/$24.60); Continental Resources (CLR/$37.17); AFLAC (AFL/$42.19); Whiting Petroleum (WLL/$61.30); ADC Telecommunications (ADCT/$6.52); NII Holdings (NIHD/$27.82); Micron Technology (MU/$7.08); JDS Uniphase (JDSU/$6.46); Motorola (MOT/$8.89); Encore Acquisition Co. (EAC/$44.74); Service Corporation (SCI/$7.55); BPZ Resources (BPZ/$6.84); and KVH Industries (KVHI/$10.99).
The call for this week: Time is running out for the bears if our year-end celebration is going to play. If the major averages break out above their recent reaction highs the party could commence. As for us, we are on the road again this week, so these will likely be the last strategy comments for the week.
Dow Theory Sell Signal?
November 2, 2009
We arrived in San Francisco around noon last Monday. After a quick lunch with friends in Atherton, followed by another short visit with more friends in Los Altos, Cheryl and I pulled up to the hotel De Anza in San Jose (a wonderfully refurbished 1920s hotel with a great Italian restaurant named La Pastaia). After checking in I warped into the Internet only to find my email “box” slammed with questions about Dow Theory. Those questions were kindled by some alleged pundit who appeared on CNBC and declared that a Dow Theory “sell signal” had been rendered. While it is true that there are numerous practitioners of Dow Theory, over the years I have learned that many of them do not interpret the theory the way I was taught.
Charles Dow began publishing The Wall Street Journal in 1889. Considered a very astute stock market observer, Dow wrote a number of editorials wherein the concept of Dow Theory originated. Those theories were expanded on by S.A. Nelson, in collaboration with Charles Dow, in a series of WSJ editorials titled, “The ABCs of Stock Speculation.” At the end of those quips resided a footnote that read “Dow Theory.” Shortly after Dow’s death, William P. Hamilton became editor of the WSJ and wrote hundreds of similar editorials, leading to his epic book “The Stock Market Barometer.” It was Hamilton who first wrote about the “confirmation principal” between The D-J Industrials (DJIA) and The D-J Transports (DJTA), which to me is the bedrock of Dow Theory. Following Hamilton’s death in 1930 his student, Robert Rhea, began publishing a market letter titled “Dow Theory Comment.” Rhea “called” the bottom of the stock market in July of 1932, as well as the subsequent downturn of 1937. Rhea died in 1939, leaving Dow Theory fallow until the 1940s when the great Dow Theorist George Schaefer resurrected it. To me, these folks were the “expanders” of Charles Dow’s original stock market observations. And to my knowledge the only market maven of today that really understands, and adheres to, the brilliant work of those Dow Theorist icons is Richard Russell of “Dow Theory Letters” fame.
While I could certainly respond as to why there was NO “sell signal” last Monday, Dick Russell explained the situation in his always excellent letter dated October 26, 2009 (the brackets are my inserts). To wit:
“The secret of the direction of the great primary trend of the market lies in the secondary reaction and what happens AFTER a secondary reaction. A secondary reaction usually takes three weeks to three months in duration while correcting one-third to two-thirds of the previous move. Since the March low, we have yet to experience a true secondary reaction. And I'm wondering whether we could be on the edge of a secondary reaction now. Following a secondary (reaction), if BOTH Averages (Industrials and Transports) rise to new highs, the primary trend is taken to be bullish. Following the lows of a secondary reaction, there will be a rally. If (that) rally fails to take both Averages to new highs, and the Averages then turn down and break to new (reaction) lows, the primary trend is taken to be as bearish. Secondary reactions often start with one of the Averages sinking while the other Average continues to the upside.”
Well said Dick Russell. We, therefore, told our callers, “How can you have a sell-signal when we have not even experienced a downside secondary reaction since the March lows?” Indeed, you need a downside reaction, which “sets” the reaction lows, followed by a rally. If that rally fails to make a new reaction high, and subsequently breaks below the aforementioned reaction lows, then (and only then) will we have a Dow Theory “sell signal,” at least as I understand Dow Theory.
For the record, the recent closing price reaction “highs” are 10092.19 for the DJIA and 4045.11 for the DJTA. Measuring from those highs suggests a one-third “give back” would leave the DJIA at ~8910 and the DJTA at ~3412. That would be consistent with our comments in which we stated that we thought any correction would probably be contained between the 50-day moving average (DMA) and the 200-DMA. In the Dow’s case the 50-DMA is currently at ~9718 and the 200-DMA at ~8593, while the Transport’s 50-DMA resides near 3613 and the 200-DMA around 3269. Of course the markets can do anything, but I would be surprised if the Averages correct by more than one-third. Nevertheless, we have been pretty cautious since the latter part of September, fearing that the vacuum created by the July to September melt-up might get “filled” to the downside once quarter-end window dressing is over. Initially that strategy looked good, and then it looked bad; but all said, the Averages are only marginally below where they were when we turned cautious. Yet, we are still cautious.
In the way of a follow up to last week’s comments about, “farmland being the only asset class left behind by the rally in everything;” most of the publically traded Ukrainian agricultural companies we gave to our liaison desk for your consideration turned out to be available only to institutional investors. As for the companies mentioned in the Barron’s article that boost agricultural productivity, the readily available ones to U.S. investors are: Agrium (AGU/$46.95), Archer Daniels (ADM/$30.12), Bunge (BG/$57.06), Monsanto (MON/$67.18), and Mosaic (MOS/$46.73). Sticking with the agricultural theme, this week’s Barron’s had another ag-related story titled “Hogs Climb Out of the Mud.” The article speaks of the two-year nightmare hog producers have experienced as prices plunged while feed prices rose. The article concludes that the bottom is now “in” for hog prices. We wrote about this same scenario late last summer, noting that many hog farmers were slaughtering their breeding-stock because they couldn’t afford to feed them. Our conclusion was that when the cycle turned, and demand picked up, hog prices might rise faster than most expect since it takes roughly 18 months to rebuild one’s breeding stock. Our vehicle of choice to play this theme was the iPath DJ-UBS Livestock Exchange Traded Note (COW/$28.20), which is ~68% live cattle and ~32% lean hogs. However, like our stock trading strategy over the past four weeks, COW is not much higher now than it was when we first mentioned it. Still, we like the hog/cattle theme.
Coincidentally, in Friday’s WSJ there was yet another article about agriculture titled, “Late Harvest Sows Problems for Farmers.” Said article speaks to this year’s late harvest due to wet weather. As written, “On Monday, the U.S. Department of Agriculture said just 20% of the corn crop had been harvested in the major corn producing states, compared with 58% on average by this point in 2004 through 2008.” Moreover, the grain crop is just too wet, and therefore subject to mold, especially in the warm delta region. Wet conditions also suggest a late start for next spring’s planting, as well as the potential of compacting dirt in fields that could hurt future crop yields. Meanwhile, global grain inventories are at record lows. Hereto, we wrote about this situation months ago and recommended a number of vehicles playing to this theme like: PowerShares DB Agriculture Fund (DBA/$25.57), GreenHaven Continuous Commodity Fund (GCC/$25.10) and iPath UBS Grain ETN (JJG/$38.00). As always, the terms and details of such funds should be vetted thoroughly before purchase.
The call for this week: When the going gets tough the tough go on the road. That’s what we did last week and that’s what we are doing again this week, so once again these will likely be the last strategy comments of the week. Nevertheless, last week’s “wilt” left everything we follow lower except for the U.S. Dollar Index. And while the DJIA (9712.73) averted a loss in October, none of the other indices we monitor did. Indeed, the S&P 500 (SPX/1036.19) slid 3.9%, bringing its two-week retreat to 5.6%. While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish. Ergo, until Dow Theory “tells us” otherwise, we think the primary trend remains UP, and we continue to trade, and invest, accordingly.
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