“I Should Have?!”
May 21, 2012
“... 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 sold when the S&P 500 broke below its rising trendline on April 9th at 1397” (see chart on page 3). “I really should have sold on May 11th when the S&P 500 (SPX/1295.22) traveled below its April 10th intraday reaction low of 1357.38.” So exclaimed one disgruntled portfolio manager last Friday since the SPX continued to surrender ground. Plainly, the “I should have” crowd surfaced again last week as the SPX knifed through my envisioned support zone of 1320 – 1340, causing one savvy seer to exclaim, “Markets always go further than most pundits believe, both on the upside and the downside.” Yet the recent downside dive from May 1st’s 1415 level into last Friday’s close of 1295.22 has caused many of my indicators to register readings not seen in a long time. For example, the McClellan Oscillator is now at oversold readings not seen since the recent April 10th trading bottom (see chart on page 3). Then there is the CBOE Equity Put/Call Ratio, which is flashing a “buy signal” that has proven profitable at every downside inflection point since 1994; or, as the astute folks at Bespoke write:
“Following today’s 0.44% decline (5/16/12) in the S&P 500, the 10-day Advance/Decline line for the S&P 500 has now dropped down to –1,930. This is an extreme oversold reading based on historical standards. For those unfamiliar with the indicator, the 10-Day A/D line is simply a rolling 10-day total of the daily net number (of similar readings) shows that equities have historically rebounded after hitting such extreme oversold levels. Over the next week, the S&P 500 averages a gain of 1.21% with positive returns two-thirds of the time. Over the next month, the S&P 500 averages a gain of 5.58% with positive returns 83% of the time. Going out three months, the S&P 500 averages a gain of 7.68%, and over the next six months the index averages a gain of 13.35%.”
Adding to the litany of downside inflection-point indicators is the AAII (American Association of Individual Investors) survey that recorded its lowest bullish reading (23.6% bulls) since August 2010. Moreover, my parade of short/intermediate-term indicators shows a composite reading that is at historic levels. To wit, there have only been only four other times when my indicators have combined to show such negative inclinations. More than seventy percent of the time, given such readings, the major market averages have been higher a week later, while 92% of the time they have been higher a month later. Accordingly, unless we are in “crash mode,” and I don’t believe that, it is time to ready your “buy list” and begin judiciously recommitting some of that cash to stocks; and, that is what I have been recommending. Indeed, over the past week I have been recommending recommitting some of the cash we suggested raising in February – April. One of the techniques we have used to accomplish this at similar inflection points was first proffered by our friends at Riverfront Investment Group back in 2009. As stated:
“First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And six, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.”
I think Riverfront’s strategy is appropriate since the SPX is probing its next downside energy level. Further, the stock market’s internal energy level is totally exhausted on the downside, implying a tradable bottom is likely at hand unless we are involved in a mini-crash. The real question thus becomes, “If we get a rally from this oversold condition is it the start of a new “up leg,” or is it just a compression rally that will be brief followed by still lower prices?” Speaking to that point, it is worth considering the SPX is currently trading at a P/E ratio of 13.1x earnings. Since record keeping began there have only been five occasions when a bear market began with the SPX’s P/E ratio below 15x. Another timely question is, “Will the recent Dow Dive trigger QE3, Operation Twist II, or targeting GDP?” While equity markets can clearly do anything, at worst we should at least get a relief rally from here and at best it could be the start of a new “up leg.” Therefore, I think the gradual re-accumulation of investment positions is the correct strategy. For those participants not wanting to try and “catch a falling knife” by purchasing the exchange-traded product of your choice, a more conservative approach would be to accumulate dividend-paying stocks. Some that screen well technically, and have a Strong Buy rating from our fundamental analysts, for your potential shopping list include: 3.0%-yielding Automatic Data Processing (ADP/$51.98); 3.8%-yielding Rayonier (RYN/$42.08); 4.3%-yielding Digital Realty Trust (DLR/$68.48); 5.2%-yielding Enterprise Products Partners (EPD/$48.48); and 8.2%-yielding Linn Energy (LINE/$35.24).
The call for this week: The brilliant Lee Cooperman, captain of hedge fund Omega Advisors, quoted Joe Rosenberg on CNBC last week, “You can have cheap equity prices, or you can have good news, but you can’t have both!” Clearly, we currently have “bad news,” which in my opinion has resulted in “cheap equity prices.” Playing to that quote, my father always told me, “Good things tend to happen to cheap stocks.” So, unless we are involved in a “mini crash,” my sense is at least a short-term bottom is due. As stated, the real question is, “If we get a rally from this oversold condition is it the start of a new ‘up leg,’ or is it just a compression rally that will be brief followed by still lower prices?” And now that the Internet distraction is behind us, the stock market’s focus should turn to the declines last week of 4.3% for the SPX and 5.3% for the NASDAQ, marking their worst weekly performance since last November, leaving the markets severely oversold. Indeed, most of the major indices I follow are down 13 out of the last 14 sessions, while Technology is down 12 days in a row. Such downside skeins are at historic proportions since markets tend not to go more than 11 sessions in any one direction. Interestingly, the big winners last week were wheat (+15.2%) and corn (+9.3%), possibly because the Intercontinental Exchange (ICE/$123.59/Strong Buy) began trading grain future contracts for the first time. To celebrate, pop the top on a box of “The Breakfast of Champions” and enjoy!
“Balance, Grasshopper”
May 14, 2012
... Master Po
I received so many requests to put last Tuesday’s verbal strategy comments into written form, and that’s exactly what I have done this morning. To wit, I was always entranced with the 1970’s TV show “Kung Fu” starring David Carradine as Kwai Chang Caine. The show centered on an orphaned American boy (Kwai Chang) that is admitted as a student to the Shaolin temple in China. There his mentor, Master Po, teaches him the ways of the Shaolin priests. In addition to learning the martial arts Kwai Chang, affectionately named “grasshopper,” is also instructed in the ways of life. In one such lesson Master Po says, “Balance, grasshopper, balance” – implying that everything in life needs to be “in balance.” Similarly, investors’ portfolios need to be “in balance,” or more appropriately rebalanced periodically.
Portfolio rebalancing, when done correctly, is an art form. Simply stated, portfolio rebalancing is the strategic redistribution of asset classes within a portfolio to keep said portfolio’s objectives in line with its original objective. As John Valentine, of Valentine Capital, notes:
To provide a simplified allegory, think of investment planning for the future as an automobile, conveying an investor to his or her financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture and the assets invested are the fuel. The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momentum. ... Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank. ... Rebalancing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously. ... The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercussions associated with a compromised allocation. Being overexposed to the downside and underexposed to the upside. Don’t let this happen to you!
Regrettably, most individual investors don’t have the discipline, or the skill sets, to actively rebalance their portfolios. That’s why individuals are best advised to seek professional assistance in rebalancing their portfolios, or for that matter seek a professional advisor to help them with all of their investment needs. Manifestly, correct asset allocation can increase investment returns and lower risk when “bets” are scaled to the advisor’s skill level. Most good investment professionals have successful “hit rates” of around 60%. That means they make a lot of mistakes and therefore should make smaller allocation bets. History suggests that large bets will eventually cause large losses and the end of an asset allocation program. Nevertheless, most clients and many advisors want to make bigger bets than their provable skills justify.
Clearly, asset allocation plays a key role in the investment process; however, I have some other thoughts I think you should consider. For example, a lot of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (growth, value, foreign, small cap, etc.) and/or sector performance. Since opportunities by style and sectors tend to regress, past performance is often negatively correlated with future relative performance. Still, many investors feel compelled to go with past performance and therefore rotate into previously strong styles, and strong sectors, which then regress leaving them with losses. A good advisor can mitigate this tendency, but a good advisor is harder to pick than a good stock.
To this point, good advisors often internalize decisions while amateurs learn all the rules and procedures. It follows that amateurs can often precisely explain what they are doing and why they are doing it. An expert, however, often just knows when they are right. Since investors typically want to hear a logical and clear-cut investment process, many tend to end up with an eloquent amateur rather than a sometimes-incomprehensible expert. Ladies and gentlemen, never underestimate the effectiveness of an eccentric or unusual advisor since “knack” tends to win out over learned skill in the investment arena. Most important is getting the big picture right and the best long-term predictor of future “big picture” equity returns is the current value of the market – things like, price/earnings, price/dividends, price/sales, price/replacement cost (Tobin’s Q ratio), etc. Currently, all of these measurements indicate the equity markets are reasonably priced.
To this rebalancing portfolios point, I recommended doing so after the “buying stampede” ended in late January. My suggestion was to raise some cash before the envisioned 5-8% correction. At last Wednesday’s intraday low the S&P 500 (SPX/1353.39) was off 5.5% from its April 2 high, and in my verbal strategy comments I recommended starting to put some of that cash back to work in equities. While the “set up” wasn’t perfect, because we never got that pornographic plunge type of hour into the 1320-1340 support zone, at Wednesday’s low of ~1343 the SPX was close enough for government work. Moreover, the NYSE McClellan Oscillator was probing oversold territory (see chart on page 3) and there was a huge downside non-confirmation. Verily, last week the SPX broke below its April 10 reaction low of 1357.38, yet all of the other indices I monitor did not violate their respective recent reaction lows (read: downside non-confirmation). Then there is the continuing divergence between the McClellan Oscillator and the pricing action of the SPX, which often occurs at an intermediate-term bottom. And, then there was this from my friend Jim Kennedy, captain of the astute Atlanta-based hedge fund consulting firm of Divergence Analysis, whose proprietary stock market analyzing software I use and embrace:
After we sent out our email prices continued to slide last Friday. At the close, our S&P 500 and NYSE models closed the day with some divergence bottoming signals. Monday should be the test as to whether prices hold here and rally, or fail (see his charts on page 3).
Plainly, I agree with Jim’s comments for as stated, “While the ‘set up’ wasn’t perfect, it was close enough for government work.” I too think the first part of this week is critical because the SPX has tested overhead resistance at 1366 twice and has not had any success in traveling above that level. This lack of rebound energy suggests the SPX could drop into the often mentioned 1320-1340 support zone, which should mark the bottom for this correction and provide another good entry point for long stock positions. Last week, however, the only major index that was positive was the D-J Utility Index ($UTIL/472.01). Meanwhile, of the 10 macro sectors only Healthcare, Utilities, and Telecommunication were up on the week. The strength in Telecommunication was likely driven by the upside chart breakouts in AT&T (T/$33.59/Market Perform), Verizon (VZ/$41.16/Market Perform), and Centurylink (CTL/$39.52/Strong Buy). Speaking to industry groups, of the 63 groups I monitor the ones currently on “buy signals” for the short/intermediate term are: REITs, Insurance P/C, Banks, Restaurants, Building Materials, Specialty Chemicals, Food, Healthcare Supply/Equipment, and Pharmaceuticals. Some names from Raymond James’ research universe that screened positively on both their fundamental and technical metrics according to my work, and are favorably rated by our fundamental analysts, include: Allstate (ALL/$34.83/Strong Buy), Simon Property (SPG/$156.08/Outperform), Abbott Labs (ABT/$62.04/Outperform), Cerner (CERN/$79.92/Outperform), Intuitive Surgical (ISRG/$558.95/Outperform), Huntington Bancshares (HBAN/$6.54/Strong Buy), and Kimco Realty (KIM/$19.61/Outperform).
The call for this week: The stock market has been consolidating its huge gains from the October 4 undercut low for roughly three months in a ~75 point range (1350-1420). That consolidation has allowed the market’s internal energy to be rebuilt and the oversold condition to be worked off. Because of that process, I continue to think the odds that we will see a move below the 1320-1340 zone remain pretty dim. Accordingly, I suspect the stock market is going to put in an intermediate bottom probably this week.
“Toto, I have a feeling we’re not in Kansas anymore.”
May 7, 2012
... Dorothy; The Wizard of Oz
While most people know “The Wizard of Oz” as one of the most popular films ever made, what is little known is that the book was based on an economic and political commentary surrounding the debate over “sound money” that occurred in the late 1800s. Indeed, L. Frank Baum’s book was penned in 1900 following unrest in the agriculture arena due to the debate between gold, silver, and the dollar standard. The book, therefore, is supposedly an allegory of these historical events, making the events easier to understand. In said book, Dorothy represents traditional American values. The Scarecrow portrays the American farmer, the Tin Man represents the workers, and the Cowardly Lion depicts William Jennings Bryan. Recall that at the time Mr. Bryan was the official standard bearer for the “silver movement,” as well as the unsuccessful Democratic presidential candidate of 1896. Interestingly, in the original story Dorothy’s slippers were made of silver, not ruby, implying that silver was the Populists’ solution to the nation’s economic woes. Meanwhile, the Yellow Brick Road was the gold standard, and Toto (Dorothy’s faithful dog) represented the Prohibitionists, who were an important part of the silverite coalition. The Wicked Witch of the West symbolizes President William McKinley; and the Wizard is Mark Hanna, who was the chairman of the Republican Party and made promises that he could not keep. Obviously, “Oz” is the abbreviation for “ounce.”
It should be noted that before 1873 the U.S. dollar was defined as consisting of either 22.5 grains of gold or 371 grains of silver. This set the legal price of silver in terms of gold at a ratio of roughly 16:1 and put the country on a gold/silver bimetallic standard. Since both metals had other uses than just coinage, whenever the ratio got out of whack rational people would buy the cheaper metal and take it to the mint for coinage. That provided a natural stabilizing arbitrage. With the 1873 Coinage Act, however, the silver dollar was omitted, effectively shifting the country from a bimetallic to purely a gold standard. Other countries soon followed, and as tons of silver was unloaded, the market price of silver to gold rose from 16:1 to a ratio of 40:1. The result was that the dollar was now linked to a metal that was getting scarcer. Particularly hurt by these events were the net debtors, among them the farmers because they had to face a rising real value of their dollar/gold denominated debts combined with declining agricultural prices. Now, while there was a bunch of “noise” in between (The Sherman Silver Purchase Act of 1890, the panic and depression of 1893, etc.), the situation hit its zenith in 1896 culminating with William Jennings Bryan’s “Cross of Gold” speech at the Democratic National Convention.
Plainly, the turmoil following the “1873 Coinage Act,” the “Sherman Silver Purchase Act of 1890,” and the subsequent panic, and depression, of 1893 left the phrase “time for a change” swirling across the country as citizens struggled to correct the numerous wrong-footed schemes that were so hastily conceived by the country’s elected leaders. While I have digressed, I find monetary history truly fascinating and would note that the value of our current dollar, measured in 1900 dollars, is worth roughly $0.03. And that, ladies and gentlemen, is why you want to have your dollars in productive assets that have healthy cash flows, hopefully pay dividends, and will keep up with the inflation that is most certainly coming our way.
I revisit the dollar/gold topic this morning because I think the most important chart in the world may be in the process of breaking down. The chart in question is that of the U.S. Dollar. Since January of this year the Dollar Index ($DXY/79.59) has reversed its pattern of making higher highs and higher lows, as can be seen in the chart on page 3. Interestingly, the last short-term dollar “top out” occurred on last month’s bad employment report, so given Friday’s poor employment report the dollar’s path this week should be watched closely. Moreover, despite the official line from the powers that be, I think Ben Bernanke actually wants a lower dollar. Not only would it bring about the whiff of inflation that is needed, it also would increase our exports and allow us to pay back our debts with cheaper dollars. A breakdown below February’s intraday reaction low of 78.12, which would also break the index below its 200-day moving average (DMA) at 78.36, would likely confirm the dollar’s downside. The quid pro quo is I think a weaker dollar would be bullish for the equity markets.
Speaking to gold, I have been bullish on gold, and stuff stocks in general (energy, cement, timber, agriculture, water, electricity, precious metals, etc.), ever since China joined the World Trade Organization (WTO) in 2001 on the assumption that when per capita incomes rise people consume more “stuff.” We rode that theme to large profits until the Dow Theory “sell signal” of November 2007 where said investments had grown into such large “bets” that we recommended selling 30% - 40% of our stuff stocks to rebalance portfolios. The strategy was to allow long-term capital gains to accrue to portfolios, and raise some cash, going into what we thought was going to be a difficult 2008. Since the stock market’s bottoming process began in October 2008 (actually on 10/10/08 when 92.6% of all stocks traded made new annual lows, a statistic I have not seen in more than 40 years in this business) gold has been on a tear, having rallied from $681 into last summer’s closing reaction high of $1891.90. At that time I warned investors I was putting “in” gold’s short/intermediate high, and recommended adjusting precious metals positions accordingly, when I bought six of our son’s gold coins to help fund his summer excursion to Europe. The result was I paid slightly over $1900 per coin; and, so far that has proven to be the peak price. While I think gold is in a consolidation pattern that will eventually be resolved with higher prices, I don’t think that will happen for a while.
Turning to the stock market, the S&P 500 (SPX/1369.10) and the NASDAQ Composite (COMP/2956.34) suffered their worst week of the year, falling 2.44% and 3.68%, respectively. The weekly wilt left both indices near their lows for the week, as well as below their 50-DMAs. Such action brings into view the intraday April reaction lows of 1357.38 for the SPX and 2946.04 for the COMP. A confirmed close below those levels would represent a break below what a technical analyst would term a “spread triple bottom” with short-term negative implications. That caused one old Wall Street wag to exclaim, “Triple bottoms rarely hold!” This week should hold the key for that statement. Last week’s consternations centered around economic and earnings reports. As we have been warning since the beginning of April, the economic reports have taken a decided turn towards the softer side. Last week that skein worsened since of the 21 reports released only seven came in better than expected. Likewise, the 1Q12 earning report “beat rate” has been softening over the past three weeks, having fallen from a 73% reading to last week’s 61% level for the S&P 1500. Even worse is the decline in companies giving positive forward earnings guidance. Of course, that is causing analysts to reduce their expectations. Accordingly, of the 10 S&P macro sectors the best upward earnings revision ratios are in Consumer Discretionary (+19.1%), Financials (+18.6%), and Industrial (+17.7%). Meanwhile, Energy has the worst ratio (-36.3%), likely driven by falling energy prices and bulging inventories.
The call for this week: If the spread triple bottom around SPX 1358 holds this week there should be another rally attempt, albeit still within the range-bound environment we have seen for the past eight weeks. If the 1358 level fails to hold, then we might just get what I have been looking since the beginning of February, a quick dip into the 1320 – 1340 support zone. If that occurs, it would most certainly leave the NYSE McClellan Oscillator very oversold, as well as finally raise my daily and weekly stock market internal energy indicators back to levels that would register a full load of energy, something I have been waiting for the past eight weeks. And this morning, given the “throw the bums out” election results in the EU, it looks like the SPX’s 1358 is at least going to be tested if not violated. Personally, I would like to see a plunge into the 1320 – 1340 zone, but they don’t run Wall Street for my benefit. As for vehicles under consideration for your “buy list,” in addition to the index exchange-traded product of your choice, in last week’s verbal strategy comment we listed three companies that are favorably rated by our fundamental analysts and are “triple plays.” Triple plays are companies that have beaten earnings/revenue estimates and have raised forward earnings guidance. Those names were: Abbott Labs (ABT/$62.41/Outperform); Equinix (EQIX/$158.94/Strong Buy); and Intuitive Surgical (ISRG/$565.16/Outperform).
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