Sunday, May 4, 2008

Growth In The Spring?

Investment Strategy:
"As Long As The Roots Are Not Severed… There Will Be Growth In The Spring." ... Chauncey, 'The Gardener'

By Jeffrey Saut | 28 April 2008

For the past few years, as spring has sprung and market pundits have expressed conviction about a return to robust economic growth, we have referenced the book "Being There" by author Jerzy Kosinski. The story revolves around a simple-minded man named Chance, "the gardener," who knows only gardening and what he sees on television. Indeed, for his whole adult life Chance has not ventured outside the grounds of his employer’s Washington D.C. manor. Eventually, however, the employer dies and Chance is cast out onto the streets, where through a mishap he encounters the wife of a D.C. powerbroker. Thinking her car was the reason for the mishap, she insists that Chance "the gardener," who she interprets to be Chauncey Gardiner, come with her to her husband’s estate. Benjamin Rand (the husband) is completely taken with Chauncey’s simple, direct approach to things, and mistakenly attaches profundities to Chauncey’s ramblings about gardening. Viewing him somewhat as a savant, Rand introduces Chauncey to Washington’s elite, including the President. In one verbal exchange regarding current economic conditions Chauncey remarks, "As long as the roots are not severed there will be growth in the spring."

Well, here we are. It’s spring again, yet this year instead of the typical cries of "As long as the roots are not severed there will be growth," many Wall Street pundits are worried. Their worries center on the worsening housing/real-estate situation, and the resultant financial debacle, which has been magnified by the over-leveraged weaving of mortgages into a spider web of recondite "structured investment vehicles (SIVs)." As housing prices have fallen, and foreclosures have risen, said vehicles have collapsed with an attendant "hit" to the financial sector’s balance sheets that is now legend. Consequently, many financial institutions are currently in a "capital building" phase as they re-liquefy their balance sheets, implying major dilution for existing shareholders. Clearly, this is a negative backdrop for investing in the financial sector. We spoke of another negative implication for the sector in last week’s missive. To wit:

"Focusing on individual bank stocks (to buy) might be a bit myopic when the potential ‘real’ insight is that the past 28 years of financial market deregulation has reversed. Plainly something has changed, and changed materially. To be sure, the tidal wave of zaitechism began reversing with SARBOX and the reversal has been accelerating ever since. Recently the ebb tide has turned into a ‘rip tide’ as the spider web of financial engineering (our Japanese friends call it "zaitech") was exposed by the collapse of many toxically structured investment vehicles (SIVs, SPIVs, VIEs, etc.) and punctuated by Bear Sterns’ bouleversement (BSC). Consequently, the tide is now flowing ‘out’ after nearly three decades of financialization, which will no doubt crimp financial sector profitability with a concurrent compression in P/E multiples."

Fortunately, we have been WAY under-weighted in the financials for years, and have totally avoided investing in the large-cap banks for nearly 10 years. Regrettably, we still feel that way despite the fact the financials could have a pretty decent trading rally as the short-sellers cover their shorts driven by the steepening yield curve. Indeed, many of the financial-related exchange-traded funds (ETFs) have broken-out to the upside in the charts, and in the process, closed above their respective 50-day moving averages (DMAs). Clearly this is a positive development. Similarly, many of the housing-related ETFs have done the same amid the near ubiquitous disbelief that this was impossible. While we agree that longer-term such rallies are likely a "bull trap," and that the fundamentals will worsen, in the near-term we expect the price-strength to extend.

That same dis-belief is rampant with regards to the major market averages, yet hereto we are short-term positive. Manifestly, we turned bullish at the January 2007 "lows," cautious at the subsequent February "highs," and aggressively bullish on the March downside re-test of those January "lows" believing the re-test would be successful; and, that the ensuing rally would carry the averages above the February highs, eventually scooting into the 1400s basis the S&P 500 (SPX/1397.84). From there, if the envisioned pattern continues to play, we should see a decline. To reiterate, that decline should be measured by "if" the U.S. economy spills into a recession (we seem to be the only ones left that doubt it); and that then, the extent of the decline should be measured by if the recession is short-and-shallow or long-and-deep.

To take advantage of the aforementioned potential stock market pattern, we have recommended numerous trading and investment positions. Speaking to the trading positions, we have continued to move stop-loss points "higher" as the rally has progressed; and would look to sell many of these positions into any "blue heat" upside type of hour toward SPX 1440. As for investment positions, while some of our recommendations have been stopped-out (read: sold), due to our "sell discipline" designed to manage the downside risk, others have done just fine. One that did okay until last Friday’s earnings "hairball" is Microsoft (MSFT). We have often spoken about MSFT since hearing its story (see previous missives) from a particularly prescient portfolio manager (PM) at our March institutional conference. At the time the shares were changing hands around $28. If participants followed our strategy of scale-buying, they should have an average-weighted cost basis of around $29. Given that our fundamental research correspondents are re-thinking their ratings, we are using a $26 stop-loss point for this investment recommendation.

Clearly this year has proven to be a difficult investing environment. Still, we continue to fare pretty well with our trading recommendations, as well as our investment names like Delta Petroleum (DPTR/Strong Buy), Schering-Plough’s (SGP/Strong Buy) 8%-yielding convertible preferred "B" shares, Covanta (CVA/Outperform); and don’t look now, but Strong Buy-rated Cogent (COGT) "gapped" above its 50-DMA last Friday on big volume. We have liked the Cogent story for the past few months, believing this homeland security "play" should do well even if the U.S. economy slips into recession. With $5.00 per share in cash, Cogent appears "cheap," and remains one of our individual stock recommendations. Yet while we love individual stocks, we also like ETFs, closed-end funds, closed-end notes, and particularly open-end mutual funds managed by PMs that have the skill-sets to navigate ALL investing environments.

To this point, we had dinner last week with Manu Daftary, captain of the Quaker Strategic Growth Fund (QUAGX). We "warmed" to Manu’s investing style roughly four years ago when we first encountered Quaker Strategic. What really piqued our interest was that like us, Manu does not want to be "painted" into a "style box" (large cap growth, value, etc.). Rather, he wants to invest in any sector that he thinks will make his clients money. To quote him, "If we don’t like it, we don’t own it!" Moreover, Manu is always looking to manage the downside risk and is unafraid to hold "cash." Clearly that "foots" with our investment philosophy, for as repeatedly stated in these missives since 1999, "Don’t let ANYTHING go against you by more than 15%20%!" Further, like Manu, we are always re-balancing positions (read: selling partial positions as they rally to keep their weightings in-line with the portfolio’s original objective).

This technique allows profits to accrue and gives us cash for other opportunities as they present themselves. Indeed, to believe that the investment opportunity "sets" that present themselves today are as good, or better, than any that will present themselves next week, next month, or next quarter is naïve. To take advantage of those opportunity sets, you need to have some cash! On average Manu maintains roughly a 15% cash weighting; but at times, like in 1999, has as much as 40%. Furthermore, like us, Manu is willing to take a "stand," as seen by the fact that he currently owns NO financials, NO consumer discretionary, and NO tech/telecom in his portfolios. He continues to search for "alpha generators" that can generate growth without balance sheet issues, as well as in any kind of economic environment. Clearly, we are a big fan.

The call for this week: For the past few months we have fallaciously suggested that interest rates were going to rise, the U.S. dollar was going to firm, crude oil was subsequently going to decline (along with most other commodities), and that the major U.S. indices, led by the financials, were going to rally; emboldened by the steepening yield curve, which implies the economy is going to recover. While we are often early, over the years we have tended to be generally correct. And last week, that envisioned sequence materialized with the financials, and early-cycle stocks, coming to the fore.

Even though we believe it is a "false move," the difference between perception and reality is where investors’ opportunities lie! Verily, we think the real surprise, going forward, may be that inflation rears its ugly head in 2009, as seen in the nearby chart from our friends at the "must have" web site, "," of how many work-hours it takes to buy a barrel of crude oil. Just yesterday, we filled the tanks of our boat to the tune of $1,000 ($4.50/gallon for regular gas); as well, we bought steaks on the way home at $27.00 per pound, yet the Fed tells us there is NO inflation! Clearly, this is sophistry, and we continue to invest/trade accordingly . . .

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

"Ebb Tide" . . . The Righteous Brothers (1965)
April 21, 2008

Hanging on the wall of my office is a plaque. The inscription reads "Financial Mania." Above the inscription resides an old 45-speed record titled "Runaway" that was a hit song recorded by Del Shannon in 1961. The plaque was a gift in honor of a strategy report I penned in the 1980’s talking about the financial mania that was about to take place, likely causing a "runaway rally" in the stock market. It was a heady time as Paul Volcker had raised short-term interest rates to a yield-yelp high of over 20% in order to choke off the pervasive double-digit inflation. Our sense was that Mr. Volcker’s actions would be successful, thus allowing interest rates to decline, which in turn would usher "in" an age of financial mania that would carry the equity markets substantially higher.

Reinforcing the financial mania theme was a series of events that would change the financial landscape for decades. Indeed, the age of financial deregulation began in the early 1980’s with the implementation of the Depository Institutions Deregulation and Monetary Control Act. Banks were now able to compete against brokerages and insurance companies. Credit Unions began to flourish to compete with banks. Best known: Sears Roebuck and Company took advantage of deregulation during this time by offering financial services, including the Discover Card credit card, at its many retail locations. Stocks subsequently took flight with only "the crash" of 1987 interrupting their upside stampede.

The financial mania accelerated in the 1990’s as worldwide deregulation began. Accompanying the financial engineering (our Japanese friends would call it "zaitech") were international trade booms and new trade agreements. Additionally, technological advancements created new business efficiencies. Emerging markets took off as said events allowed the instantaneous movement of capital, driving an influx of foreign investment into nascent markets. In November of 1999, the Financial Services Modernization Act was signed into law, which seemed to mark the peak of financial deregulation. Beginning in the early 2000’s, financial re-regulation began to trickle back into the financial industry after a series of corporate scandals shook the investment world. And with the signing of the Sarbanes-Oxley Act of 2002 (SARBOX), a broad law that encompasses 11 criteria ranging from accounting oversight to analyst conflicts of interest, the process of re-regulating financial institutions began.

We revisit these series of events because currently the media is replete with the question, "Is now the time to buy financial stocks?" Indeed, I did a number of media appearances last week and the question du jour was, "Do we buy Citigroup (C) on today’s awful earnings report?" Our answer was that focusing on individual bank stocks might be a bit myopic when the potential "real" insight is that the past 28 years of financial market deregulation has reversed. Plainly something has changed, and changed materially. To be sure, the tidal wave of zaitechism began reversing with SARBOX and the reversal has been accelerating ever since. Recently the ebb tide has turned into a "rip tide" as the spider web of financial engineering was exposed by the collapse of many toxically-structured investment vehicles (SIVs, SPIVs, VIEs, etc.) and punctuated by Bear Sterns’ bouleversement (BSC). Consequently, the tide is now flowing "out" after nearly three decades of financialization, which will no doubt crimp financial sector profitability with a concurrent "hit" to PE multiples.

Ladies and gentleman, investing environments tend to change at the MARGIN. Yet since life can only be understood in retrospect, but must be lived going forward, most investors fail to notice tectonic changes until it is too late. The current case in point is that I have avoided large capitalization banks for years, and continue to avoid them, since their fate was sealed when financial deregulation ended. Here is what the brilliant Peter Bernstein recently had to say on the subject:

"Three months ago, we wrote, ‘[T]he economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture— drip by drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up.’ This metaphor should now form the basis for all decisions, strategies, and analysis. Recessions matter, but the important features of the problems faced by the American economy are not in the short run. The crucial issue is the nature of the new longer-run environment that we are convinced is now a reality. This environment is still in its infancy, but its principal features are already identifiable. Too few people are thinking along these terms. The short run always tends to dominate mass thinking in any case, but in an odd way the short run is irrelevant to the current situation. The short run is a creature of the immediate past. The longer run will be a profound break from the past. Indeed, the longer run in this instance is going to evolve as it is going to evolve whether we have a perceptible recession in 2008 or whether we squeeze by with a minimum of negative numbers.

"Why are we so emphatic about this viewpoint? As Goldilocks shreds, we have to start thinking about what kind of long-term environment is going to replace it. Shifts to new environments are always attenuated. They are also rare across time, which means most of us have limited experience with this phenomenon. New environments often tend to sneak up on us and do not announce themselves with a fanfare. Most of us are unaware of what has happened until enough time passes to provide good perspective. . . . The sequence of events that caused the economy to lose its forward momentum over the course of 2007 was unique. This fact is central to our entire argument here. The cause was not too much inventory, not overexpansion in industrial capacity, not a sustained burst of inflation requiring a determined move to tight money and higher rates at the Fed. The root of today's problems in the financial markets and in the economy as a whole is the household sector.

"The point needs no elaboration, but its significance cannot be minimized. As we have argued on more than one occasion,
the shrinkage in the personal savings rate is not the result of consumer profligacy, as other commentators persist in describing it. Rather, the savings rate has been suppressed by a slowdown in the growth of household incomes. The shortfall between income and outlay has been met by borrowing, and in particular by borrowing against the family real estate. Now the opportunity to borrow has shrunk dramatically, an outcome that will profoundly change the household's spending power and spending patterns. But the impact is not just on the household. A slowdown in the growth of consumer spending has ominous implications for the entire global economy— and, along the way, the U. S. federal deficit, soon to be overburdened by spiraling benefit obligations. This predicament is not a short-run matter, unless home prices abruptly reverse themselves and head back into the stratosphere— which is hardly likely."

Since the 4Q01 we have repeatedly spoken of a sea-change, commenting that the beneficiary of said change was likely the "stuff stocks" (energy, timber, cement, water, electricity, agriculture, base/precious-metals, etc.) driven by the demand metrics from the "Chindias" of the world. How long this trend will potentially last can be seen in the nearby chart. Surely there will be slowing growth "scares" that will cause inevitable pullbacks in this theme, but longer term the trend should extend. And last week was just such an occurrence as many "stuff stocks" retreated, while conventional stocks rallied. Fortunately, we anticipated such a short-term sequence and positioned accounts accordingly. Our short-term strategy has remained steadfast in that we thought the S&P 500 (SPX/1390.33) would break out above the February "highs" and scoot into the mid-1400’s. From there we expect a decline that will be measured by "if" the U.S. economy enters a recession (we doubt it), and then whether that recession is shallow/short, or long/deep. Whatever the result, we think trading positions should be "scale sold" into ANY blue-heat upside-type hour above 1400 on the premise that there should be a subsequent decline irrespective of the economic outcome.

The call for this week: The lyrics to the song "Ebb Tide" read like this: "First the tide rushes in; Plants a kiss on the shore; Then rolls out to sea; And the sea is very still once more." Unfortunately, we think the tide is now going out for many of the financial stocks after nearly three decades of financialization, which should crimp the sector’s profitability with a concurrent compression of PE multiples. The quid pro quo is that we believe the tidal wave has rolled on to "stuff;" and that wave has a long way to go. If correct, Alaska’s vast amount of undeveloped natural resources will eventually be developed. A circumvential "play" on this is 7% yielding Outperform-rated Alaska Communications (ALSK). And, don’t look now but last Monday the 10-year T’Note (TNX/3.74%) was yielding 3.43%, but at last Friday’s high was yielding 3.85%, which is pretty strange action in front of the widely anticipated recession. Indeed, curiouser and curiouser.

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

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


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