Investment Strategy: "GE’d!"

Investment Strategy: "GE’d!"

By Jeffrey Saut | 15 April 2008

We began last week thinking the S&P 500 was poised to finally break out above the often discussed 1370 pivot-point and scoot into the mid-1400s. And that was the way it looked like it was going to play last Monday until the early session surge, which took the S&P up to 1386, failed to sustain, leaving the index back at that "sticky" 1370 level by the closing bell. "Oh well," we thought, "If at first you don’t succeed try, try, again!" Here too, that was the way it looked to play as the indices backed and filled into last Thursday’s session as they stored up "energy" for another assault on 1370, or at least so we thought. Indeed, Thursday seemed to be the set-up for the envisioned upside sequence, but early Friday morning we got GE’d!

Readers of these missives know that after shunning General Electric (GE/$32.05) since 1998, for the past few quarters we have periodically recommended purchase of these shares. GE was rated Outperform by our various research correspondents, and our sense was, and remains, that the sector-spanning conglomerate plays to a number of themes we embrace, its shares are statistically cheap, it possesses a bond-like dividend yield of 3.9%, it is a proxy for international growth, and it appeared to be a consistent "grower" and despite that growth its share price was 40% below where it was in the spring of 2000. On Friday, however, GE shocked the investment world by "missing" its earning’s estimate as the cry erupted, "If you can’t trust GE, who can you trust?!" And with that, the market mauling was "on," causing a Dow Dump that would leave the senior index 257 points lower for the session.

Speaking to GE’s ill-fated earnings report, 1Q08 EPS were reported at $0.44 versus expectations of $0.51. Most of the shortfall was attributed to its financial-services unit, GE Capital, which accounted for $0.05 of the $0.07"miss." Also on the softer side were GE’s Healthcare and Industrial divisions, all of which offset double-digit growth at the Infrastructure division. GE’s shares now trade for a reasonable 14.2 times 2008 estimated profits ($2.25E), and just 13 times 2009 estimates, making the risk/reward ratio look pretty attractive given the 3.9% dividend yield. Fortunately, our investing strategy is always, and everywhere, to not buy ANYTHING all at once, but rather to scale buy into a situation three or four times. We think this is just such a time, for as Barron’s noted, "General Electric’s First-Quarter profit shortfall Friday shocked Wall Street, embarrassed the company and hurt the credibility of CEO Jeff Immelt. But it doesn’t kill the investment case for the company, whose shares now trade about where they stood a decade ago."

Speaking of "things" that trade where they stood a decade ago, there was an interesting article in the Wall Street Journal titled, "Stocks Tarnished By [the] Lost Decade." The article pointed out that atypically, the S&P 500 has made NO progress over the last nine years. To wit, "When dividends and inflation are factored in, the S&P 500 has risen on average 1.3% a year over the past ten years, well below the historic norm"[[NOT true! that IS the historical norm, inflation adjusted: normxxx]]. The article further notes, "Over the past nine years, the S&P 500 is the worst-performing of nine different investment vehicles tracked by Morningstar, including commodities, real-estate investment trusts (REITs), gold and foreign stocks." Of course, this should come as no surprise to clients of Raymond James since we first wrote about the Dow Theory "sell signal" in Q4 of 1999 and advised participants not to let anything go more than 15%— 20% against them, reduce high beta stocks in portfolios, and overweight REITs, as well as defense-related stocks. We modified that strategy following the tragedies of 9-11-01 by suggesting the bear market was ending, but we were likely entering a trading range environment and NOT a new secular bull market. And that, ladies and gentlemen, is why we have eschewed index investing since the late 1990s in favor of a more proactive approach using select money managers, mutual funds, exchange-traded funds (ETFs), closed-end funds, and yes, individual stocks. Moreover, in 4Q01 we adopted the strategy of overweighting "stuff stocks" (energy, metals, timber, cement, agriculture, etc.), which certainly "foots" with what the good folks at Morningstar are referencing.

Interestingly, however, the trading range environment could be coming to an end over the next few quarters, for as the insightful "Bespoke Investment Group" wrote in an piece titled "Rolling 10-Year Market Return Hits 30-Year Low:"

"In early March [2008], we performed a similar analysis in our "The Lost Decade" post that highlighted the weak performance in equities since the new millennium began. We took the 10-year total return performance of the S&P 500 back to 1900 (non-inflation adjusted) and charted the results below (see the nearby chart). When the line is highlighted in red, 10-year returns were lower than they are now. As shown, periods where returns were lower occurred in 1914, 1921, 1932, 1938, 1974 and 1977. We also highlight years where returns peaked— 1929, 1959, 1992 and 2000. While the returns could easily get worse, periods that have been this bad have not lasted longer than 4 years (1937-1941) before they've started to get better."

As for the short-term direction of the equity markets, while GE’s 13% session swoon contributed only 36 negative points of the Dow’s 257-point Friday Flop (because the DJIA is a price-weight rather than market-capitalization weighted), GE’s psychological impact was much more severe. As Barron’s put it, "If GE got stung, how will lesser companies fare?" With the parade of upcoming earnings reports that question will likely get stress-tested this week. Unfortunately, the stock market has the right to change its mind on a dime and GE’s "hairball" could be the linchpin that swings sentiment back to the negative side of the equation. While only time will tell, we are still hopeful that the late-January "lows," and the subsequent March retest of those "lows," will prove to be the intermediate-term lows.

Reinforcing that view is the fact that despite all the consternations, last week’s wilt merely pulled the major averages back into the middle of their respective three-month trading ranges. Moreover, while the DJIA (12325.42) and S&P 500 (SPX/1332.83) ended below their 50-day moving averages (DMAs), the D-J Transportation Average (DJTA) (DTX/481.39), the NASDAQ (2290.24), and the Semiconductor Index (SOX/358.68) remain above their 50-DMAs. Further, the DJIA is some 350 points above its January closing low, while the DJTA is a whopping 642 points above its January low. This is pretty amazing given soaring crude oil prices and all the bad news that has been thrown at the equity markets over the past few months.

Nevertheless, last week’s failure by the S&P 500 at the 1370 level leaves a glaring upside failure in the charts, suggesting the rectangle formation of the last three months continues with the potential, repeat potential, of a downside retest of the lower-end of said rectangle. Consequently, we are raising stop-loss points on ALL trading positions. As for our investment positions, we remain comfortable with those positions, thinking our averaged-in prices on names like Schering-Plough’s (SGP/$17.21/Strong Buy) 8%-yielding convertible preferred "B" shares, Covanta (CVA/$29.15/Outperform), Delta Petroleum (DPTR/$26.03/Strong Buy), Johnson & Johnson (JNJ/$66.00/Strong Buy), et all, afford attractive risk/reward levels for investors. We continue to invest, and trade, accordingly.

The call for this week: Gee . . . no GE; we got GE’d last Friday, and the psychological damage has the potential to change the near-term investment sentiment. Combine that with this morning’s negative Wachovia (WB/$27.81) news, and what is likely a 90% "down day" last Friday (I just got back from the conference in Palm Springs and have not had a chance to run the numbers), and is it any wonder the pre-opening S&P 500 futures are off 8 points?! Therefore, it is important for the S&P 500 to gather itself "up" quickly, and rally, to regain its former health. If that doesn’t play, the averages should revisit the lower end of the rectangle formation in the charts.


Click Here, or on the image, to see a larger, undistorted image.
Source: Bespoke Investment Group.


Click Here, or on the image, to see a larger, undistorted image.
Source: Reuters.

"The Letter"
April 7, 2008

. . . The Box Tops (1967)

Last Monday we received "The Letter" except in this case it wasn’t The Box Tops’ hit tune of 1967, but "the letter" from one of our financial advisors. Said letter read like this:

"Jeff, what a dilemma we advisors face these days. Now about to enter my 10th year, I'm experiencing a truly perplexing market. Sure, 2000-2002 was tough, but there were asset classes that held up in that time. Stuff stocks, large-cap value, small-cap, REITs . . . you know the story. Now in 2008 nothing seems to be the ‘it’ asset class. Most all stocks (any cap), beaten up REITs (even the new international REITs), and deep-discounted closed-end funds can’t find any upside traction. Adding to misery, the defensive healthcare and utilities sectors are languishing. The news on Merck (MRK/$40.00/) and Schering-Plough (SGP/$16.12/) was surprising and a brutal hit to two stocks that you'd think investors could find safety in in these times. Treasuries are spooky with inflation and future higher rates a real threat. One financial advisor in our office, with over 35 years of experience, told me today that I'm living through one of the worst (if not the worst) market illness' he can remember. With all this frustration and concern, one has to wonder if we are close to the turnaround. I agree with your pro-dollar, pro-U.S. stock stance. The crowd is heavily occupying the other side of these trades. But, what about inflation? All the fiscal stimulus and rate-dropping may soon come back to haunt us. Being only 5 years old or so when the mid-70s bear market was going on, I have little street cred for such a repeat. Alas, I cannot imagine a return to such dismal times in light of the global growth that has occurred. As for our team, we continue to rely upon Raymond James’ Freedom Account for a diversified approach for our clients' core money and a controlled use of annuities for protection. So far that strategy has been a good one! As for tactical plays, we have been investing in a number of the more nimble mutual funds you have been recommending and nibbling on municipal bonds due to the recent spike in spreads. No big bets, but a way to further diversify clients. Cash and short-term CDs play a role too, but both are producing negative ‘real’ returns when inflation and taxes (non-qualified, of course) are factored in. Quite the dilemma and I apologize for the diatribe. As always, Jeff, I look forward to your guidance and thank you in advance for your time."

As I read the letter, I reflected back on the era between 1973 and 1974 thinking, "boy that was by far THE worst time I can recall in the equity markets." The DJIA had peaked on February 9, 1966 at 995.15 and in the process ended the great bull market of 1949 through 1966. At the time the Dow’s P/E ratio was 24x, and despite the ubiquitous belief that the bull market would continue, stocks began to decline. It was a deceptive decline, for while many of the previously "hot" stocks (the "onics" stocks, which were the internet issues of their day) shed more than 50% of their value; the DJIA vacillated between roughly 800 and 1000. That vacillation lasted into 1972, but when the Apollo Astronauts walked on the moon in April 1972 a "cry" was heard on the Street of Dreams that the sideways market was over and a new bull market had begun. Emboldened by such sentiment, the Dow stutter-stepped higher into November of that year and breached the 1000 barrier for the first time. The celebration continued into January 1973, where the senior index closed at 1051.70, a peak that would not be bettered for eight years.

From that January 1973 high the DJIA would lose some 45% of its value by December 1974 (1051 to 577). And while the 1973/1974 Dow Dive was only the sixth worst percentage decline in history, when impacted for double-digit inflation the erosion of "real value" in investors’ portfolios was more like 80% plus. Indeed, it was an era where ALL interest rates rose, punctuated by T’bill yield yelp from 3% in 1972 to over 10% in 1974. Similarly, crude oil surged from $3 per barrel in 1972 to more than $10 by 1974. Consequently, there were not a lot of places to "hide," or as our letter writer notes— there weren’t many "it" asset classes. As I recall, it was a heavy weighting of precious metals securities, energy stocks, a few special situations, and some "shorts" that kept me in this business back then.

Eerily, in today’s Barron’s, there is an article titled "Everything Looks Up From Here," with the subtitle, "It was just plain ugly for mutual funds in the first quarter. With the exception of gold, bonds and short-selling, no strategy worked well." Ugly, indeed, for save bonds and precious metals most other asset classes (large-cap growth, large-cap value, small/mid-cap, etc.) had negative returns last quarter. Yet, we are hopeful that things will get better from here and evidently we are not the only ones, for surprisingly perma bear Doug Kass, President of Seabreeze Partners, turned positive last Tuesday, which was dubbed one of the reasons for the April Fool’s pyrotechnical pop (+391 DJIA). More specifically, Doug announced that stocks would rise 26% by year-end, the housing slump had bottomed, oil prices would fall by 50%, and corporate earnings will surge. Whether it was just an April Fool’s joke or not, we sure hope that’s the way it plays in the short/intermediate-term. As for the longer-term, we remain cautious due to the November 21, 2007 Dow Theory "sell signal."

Whether it was Doug, or the myriad of other positive developments, last Tuesday’s "jubilee jump" further reinforced our conviction that the near-term lows are "in." Verily, it was the best April Fool’s fling since 1938. Coincidentally, the year 2008 likewise experienced the most 1% daily price movements since 1938, so we "dialed up" that year only to find the Dow bottoming at the end of March and leaping on April 1st to begin a rally that would leave the senior index 20% higher by mid-month. Is this déjà vu all over again? We doubt it, but the stock market’s ability to shake off the worst employment report since Hurricane Katrina last Friday further emboldens us. "So what are we to do?" asked one of our friends at last weekend’s Grand Prix of St. Petersburg.

Speaking to that, as well as our frustrated letter writer, we have a cadre of mutual funds that we believe can be bought ANY day of the week. The list begins with Quaker Strategic (QUAGX/$25.61), captained by the adroit Manu Daftary, who by our pencil is one of Wall Street’s most gifted stock pickers. Also from Quaker is the more conservative Quaker Capital Opportunities (QUKTX/$9.77), managed by our friend Charlie Knott. Two long/short funds also remain high on our "hit" list, those being Diamond Hills (DIAMX/$18.64) and Icon (IOLIX/$16.56), since such funds have the ability to make money in both "up" and "down" markets. As always, there are a number of mutual funds managed by the skilled Ivy Funds, as well as the Pimco organization, which embrace our "stuff stock" theme. And while they are not managers of a mutual fund, our friends at Atlanta-based Equity Investment Corporation (EIC) released this prose, which we find politically timely and investingly compelling:

"If it's 3 AM, and the Asian markets are collapsing, who do you want making your investment decisions? There have been 253 rolling 12-month periods since our firm's inception in 1986, and the S&P 500 declined double-digits in 27 of them, versus 6 for EIC. Those aren't just words, but fewer painful experiences like today, when most indices are down double-digits year-to-date, but EIC is not."

As for our individual stock selection, for the last few quarters we have tried to emphasize large-cap, dividend yielding, international earning, thematically selective type stocks. Some names often mentioned in these missives have been General Electric (GE/$37.56), Microsoft (MSFT/$29.16), and Wyeth (WYE/$41.56/Strong Buy), which "caught" a bullish write-up in this week’s Barron’s based on its Alzheimer’s drug. Yet by far the most questions we received last week centered on our "buy" recommendation of controversial Strong Buy-rated Schering-Plough’s convertible preferred "B" shares. Given last week’s downside consternations, is it any wonder our phones lit up? Still, we recommended yet another one-third purchase of those convertible shares that should leave longer-term investors "averaged in" around $175 per share with an 8% yield. Our analyst thinks SGP is worth mid-$20s even if ALL the sales of Vytorin and Zetia go away.

The call for this week: Rally time!

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Normxxx    
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