Monday, May 19, 2008

"Throw Deep!?!

Investment Strategy: "Throw Deep!?!"

By Jeffrey Saut | 19 May 2008

Back in the late 1980s a newspaperman visiting the Oakland Raiders football training camp in California had just returned from the Jack London Historic Monument. He read a sample of London’s prose to the colorful Raiders’ quarterback, Ken "The Snake" Stabler:

"I would rather be ashes than dust! I would rather that my spark should burn out in a brilliant blaze than it should be stifled by rot!

I would rather be a superb meteor, every atom of me in magnificent glow, than a sleepy and permanent planet. The proper function of a man is to live, not to exist. I shall not waste my days in trying to prolong them. I shall use my time."

The newspaperman asked the quarterback,
"What does this mean to you?"

"Throw deep," said Stabler.

Throwing Deep, the Long Bomb, the Hail Mary, are all phrases usually associated with football. It is the spectacular play with the possibility of a quick score, as opposed to the Woody Hayes three-yards-and-a-cloud-of-dust "grind it out" strategy. Throwing Deep is also an attitude, and emotion, that has recently reappeared on Wall Street. Indeed, a mere seven weeks ago the S&P 500 (SPX/1388.28) retested its January 2007 "low" of 1270, traumatizing participants into inaction as the threat of "financial contagion" echoed down the canyons of Wall Street. We, however, were bullish, opining that said retest would be successful and the ensuing rally would carry the averages above their respective February "highs" into mid-May, where a "trading top" should occur in the 1420-1440 zone (basis the SPX). From there, we suggested, a decline would commence that should be measured by "if" the U.S. economy spills into recession (we still doubt it); and then, by if the recession would be short/shallow, or long/deep.

And, isn’t it amazing how fear has morphed into greed in a mere seven weeks, for now the cry on the "Street of Dreams" is about the new bull market that has emerged! We, on the other hand, have turned cautious. Our caution centers on the belief that our economic problems are NOT all behind us, the Dow Theory "sell signal" of November 21, 2007, the double-top chart configuration of the SPX at 1560-1570, and "The Snake;" except in this case we are not referring to Kenny "The Snake" Stabler, but rather the 20-month moving average (MMA) (aka "The Snake") that has often represented the demarcation line of bull and bear markets. As can be seen in the nearby chart, the 20-MMA tends to mark the difference between the "bull" and the "bear." When the SPX is above its 20-MMA stocks are in an "up" phase. Even when "the snake" is marginally violated to the downside, but then quickly recaptured to the upside, the bull trend remains in force. However, when it is violated decisively to the downside, and stays there, caution is warranted.

Clearly, "the snake" has been decisively penetrated to the downside. Even the past seven-week rally has done nothing more than bring the SPX back toward the "belly" of "the snake." While we are certainly hopeful this will be a false technical breakdown, for the past eight years, whenever the "hair" on our neck has been standing up, like it is now, we have tended to err on the side of caution, consistent with Warren Buffet’s two rules of investing: 1) Don’t lose money; and rule number 2) Don’t forget rule number one!

Yet another observation has us worried, that being the price action in crude oil. We are old enough to remember a similar sequence of events that occurred in the 1990-1991 timeframe. As now, the price of crude oil was surging and smart money was selling crude oil short around its then double-top of $24 per barrel. Fundamentally those short sellers were right; oil was clearly overpriced. But then the Persian Gulf War began and in a mere two months oil spurted from $17/bbl. to more than $41/bbl. Long-time readers of these missives know that we are ALWAYS respectful of price action. And while crude is currently fundamentally overpriced, its price continues to elevate. Whether this means another geopolitical event is in the works is unknowable, but crude oil should not be doing what it is doing and it worries us!

Consistent with these thoughts, we are recommending rebalancing energy positions in portfolios (read: selling partial positions to bring weightings back in-line with the portfolio’s original objectives). While longer-term we remain bullish on energy, crude oil is currently 37% above its 200-day moving average, a level that has historically suggested it is well overbought and due for a correction barring some unforeseen geopolitical event.

That said, we are increasingly bullish on the oilfield services complex, believing that the huge cash flows accruing to the exploration & production oil companies (E&P) will result in increased capex spending. Bolstering that view has been unusually bad weather in the Gulf of Mexico this spring, where high winds and choppy waters have curtailed contract awards. Over the past week ocean winds have "laid down," however, and our sense is contract awards will start to flourish. We think this will make pleasant reading for oilfield services companies like Cal-Dive (DVR/$14.00/Outperform) and Superior Energy (SPN/$52.60/Outperform), both of which broke out to the upside in the charts last week.

As for the recent "financials fascination," like the E&P complex we are currently shy of financials after their spectacular rally, driven by the belief that their problems are all in the rearview mirror. We don’t believe it; hello AIG (AIG/$40.28), whose Friday revelations shocked Wall Street participants. As repeatedly stated, we think that after 28 years of financial deregulation the financials are now being re-regulated, which implies a crimp in their profit margins with an attendant P/E multiple compression. And that, ladies and gentlemen, is why we have avoided the financials.

So what should we do? Well, our trading strategy has been to sell trading positions into strength on any rally above 1420 (basis the SPX). This is especially true now that we have entered our cluster of trading-top "timing points" in the May 7th— May 14th timeframe. If you followed that advice, you have "lost" (read: sold) two-thirds of your trading positions and raised stop-loss points on the remaining one-third. As for the investment account, we remain opportunistic buyers of fundamentally sound, favorably rated, dividend yielding, hopefully non-economically sensitive situations on price weakness as they approach support levels in the charts.

In past missives we have recommended names like 7.7%-yielding Alaska Communications (ALSK/$11.11/Outperform), 6.3%-yielding Embarq (EQ/$43.59/Strong Buy), as well as Schering-Plough’s 8%-yielding convertible-preferred "B" shares (SGP+B/$181.79); SGP is still favorably rated by our correspondent research affiliates, as is 3.8%-yielding GE (GE/$32.27). And this morning we offer for your consideration, even though it is currently rated Market Perform by our fundamental analyst, 11%-yielding LINN Energy (LINE/$22.59) with a stop-loss point of $18.57, which is its recent reaction low. Additionally, the dry bulk shipping complex is worthy of consideration given the recent strengthening shipping surveys, and rising Baltic freight rates, which suggests emerging markets remain strong. Verily, our favorite "country play" over the past few years has been Brazil, whose bourse has broken out to the upside in the charts. Yet for bulk shipping ideas, we defer to our correspondent research affiliates along the lines of DryShips (DRYS/$91.96).

The call for this week: Sometimes you "throw deep," and sometimes you "grind it out." We were cautious entering 2008 fearful of a "selling stampede," but turned bullish at the late January "lows." Again we were cautious at the February "highs," suggesting that a re-test of the January "lows" was in order, but became aggressively bullish at the subsequent downside re-test of those January "lows" in March, believing said re-test would be successful. And that the ensuing rally would carry the major averages above their respective February "highs." Regrettably, once again we are "grinding it out" (read: cautious) now that we have rallied 12%, entered our cluster of topside "timing points," and traveled into our upside target zone of 1420-1440. Indeed, it’s never the snake you see that bites you!

S&P 500 with 20-month Moving Average

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

Source: Reuters.



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