Friday, September 5, 2008


Investment Strategy: "context?!"

By Jeffrey Saut | 2 September 2008

"If you show an American an image of a fish tank, the American will usually describe the biggest fish in the tank and what it is doing. If you ask a Chinese person to describe a fish tank, the Chinese will usually describe the context in which the fish swim. Americans usually see individuals; Chinese and other Asians see contexts. What happens if collectivist societies, especially those in Asia, rise economically and come to rival the West?

A new sort of global conversation develops. The opening ceremony in Beijing was a statement in that conversation. The most striking features were the images of thousands of Chinese moving as one— drumming as one, dancing as one, sprinting on precise formations without ever stumbling or colliding. [It was] a high-tech vision of a harmonious society, performed in the context of China’s miraculous growth."
. . . David Brooks in The New York Times

I recommended "rigging" portfolios for "heavy weather" late last year, fearful of many of the events that have come to fruition. Clearly, the "Year of the Rat" has lived up to its name since "Rats" have a tendency to be opportunistic with an eye for a bargain, but are unwilling to pay too much for anything. Because of their intellect and observatory powers, Rat people possess prudence and perception, which is why the Chinese say others should always listen to the advice of the Rat.

"Rats" seem to be able to anticipate problems and are able to see the big picture. Like the "Rat," we too have been opportunistic this year, often commenting that it seems to be more of a trader’s, rather than an investor’s, environment; so this morning I thought we would take our lead from the Chinese and try to look at the "context" of the markets from a longer-term perspective. To this point our technical analyst, Art Huprich, penned an excellent report last Friday based on his talk at the National Conference titled, "A Long Term Perspective and More."

Art began by noting that when secular bull markets end (1982— 2000) history suggests that the major market averages can move sideways for a decade (or more) with very little upside progress. To demonstrate this tendency, he referenced the secular bull market from 1949 - 1966, which saw the DJIA peak at 995 for a gain of 514% from those 1949 lows. Art described this period as a "fat cycle" when all you needed to do was "throw a dart" to make money.

Following the DJIA’s secular price peak in 1966, however, came a "thin cycle" whereby there were a number of mini-bull and mini-bear markets, but by 1982 the senior index was actually 22% lower than it was in 1966. To readers of these missives such revelations should come as no surprise since we opined that following the decline telegraphed by the Dow Theory "sell signal" of September 1999, it was likely going to be a range-bound environment for the S&P 500 (SPX/1282.83). That did not, and does not, mean investors cannot make money.

Manifestly, investors have made a lot of money on our "call" in 4Q01 to make oversized investments to "stuff stocks" (energy, timber, cement, base/precious-metals, water, etc.), preferably stuff-stocks with a dividend yield. Similarly, we have favored small/mid-capitalization stocks over their large-cap brethren during that same timeframe; and, as Art observes, the outperformance of the small/mid-cap complexes has been noticeable. To wit, while the SPX gained 64% from 4Q01 into 4Q07, the S&P Small Cap 600 was up 149% and the S&P Mid Cap 400 was better by 132%. Both Art, and I, continue to favor the small/mid-cap complexes given their superior relative strength.

As for value versus growth, on this question I have always agreed with Warren Buffet’s comments that, "We view this as fuzzy thinking. In our opinion, the two are joined at the hip: Growth is always a component in the calculation of value. . . . In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?" Nevertheless, to placate our readers, both Art and I currently favor "growth" over "value" across the entire capitalization spectrum.

Speaking to the S&P Macro Sectors, at the present time there does not appear to be ANY particular leadership, which is one of the reasons investors, and the major market indices, are having such a difficult time. Still, in parsing the sectors, the three that look best are healthcare, consumer staples, and technology. Technology is particularly interesting since the tech sector has the largest exposure to foreign earnings and therefore should benefit from the dollar’s demise even though the greenback has firmed recently.

For the last eight years, however, we have avoided the marquee tech stocks, except for an occasional trading foray, often commenting that, "The leaders of the last cycle rarely lead the next cycle!" That stance has left us out of the Cisco’s (CSCO/$24.05/Market Perform) of the world; yet we have attempted to get at technology via "backdoor" investments in subsectors like Homeland Security via names like Cogent (COGT/$11.00/Strong Buy), L-1 Identity Solutions (ID/$16.48/Strong Buy), and Argon ST (STST/$24.97/Outperform), all of which are favorably rated by the respective fundamental analyst.

One of the more ubiquitous questions at the conference was about international investing. While we recommended substantially reducing international and "stuff stock" exposure at the end of last year for previously stated reasons, we have warmed to them again given the substantial declines they have experienced. That said, Art showed a particularly interesting chart in his presentation that was the S&P 500 divided by the SPDR MSCI AWCI ex-U.S. ETF (CWI/$34.15). The chart suggests that the U.S. (domestic) markets have been outperforming most of the world’s equity markets even though it doesn’t really "feel" like it (see chart below).

As Art concludes, "I would have a smaller slice of international exposure and increase my ‘slice’ of U.S. exposure." The intellectual argument for this view rests in America’s improving trade balance driven by the boom in exports. Interestingly, our nation’s large trade deficit has tended to serve as the financing mechanism for many emerging economies. The fact that "prop" is now shrinking is worth consideration. Nevertheless, for our international "slice" we still like open-end mutual funds like Quaker Global (QTRAX/$8.41), MFS International (MDIDX/$13.34), Ivy Asset (WASAX/$25.35), and Blackrock Global (MDLOX/$18.37), to name but a few.

Unsurprisingly, during many of the conference’s sessions we heard the phrase, "You can’t ‘time’ the markets;" to which we reply, "total sophistry." While true it is nearly impossible to day trade with any consistency [[ST market performance is indistinguishable from random: normxxx]], we argue that if you have patience, and wait until the trading odds are tipped so far in your favor that if you are wrong you are going to be wrong quickly with hopefully de minimis losses, you can indeed supplement the investing side of your portfolio with some opportunistic trading. [[IT and LT, the markets tend to discernably trend.: normxxx]]

This strategy is reinforced by many of Wall Street’s premier hedge funds that do "trade" with a portion of their capital and have consistently produced returns that substantially beat the major market averages. To be sure, this year has been more of a trader’s market than an investor’s market and we have attempted to act accordingly. For example, we were bullish at the January "lows," cautious at the February "highs," aggressively bullish at the subsequent downside retest of the January "lows" in March, yet cautious at the mid-May "highs" when we recommended shedding trading positions.

We got pretty bullish again around the beginning of July, sensing the "selling stampede" was nearing an end and recommended that trading types purchase those groups with the worst relative strength characteristics since they had been compressed the most and were likely to give us the biggest bounce-back rallies. Unquestionably, those groups turned out to be financials and real estate; and given the HUGE rallies they have experienced since those mid-July "lows," we have advised participants to reduce those "bets" accordingly.

The call for this week: The "Pros" return from holiday this week and with them the "volume" should also return, giving the SPX the ability to break out above its August 11th closing high of 1305. If that plays, our long-standing 1320 - 1330 price target comes into view and maybe more. But the time to be aggressively bullish was at the mid-July "lows," not here. Nevertheless, with the "Gustav Gotcha" in the rearview mirror, and crude oil down $7.00 per barrel [Monday] morning, the pre-opening futures are dancing higher.

Yet we’ve seen this act before over the past two weeks with the DJIA gaining 608 points, and losing 724 points, leaving the net change at a frustrating -116 points. However, there have still been ways to make money, like the NASDAQ Biotech Index that "tagged" a six-year high; as things continue to get 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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