The Third Mouse Market!?!

Investment Strategy: "the Third Mouse Market?!"

By Jeffrey Saut | 27 October 2008

Ever since the House of Representatives failed to pass the 'Paulson Plan', we have suggested that the main theme for investors was "survival." Accompanying that theme has been our mantra of trying to be the second mouse that gets the cheese because the first mouse often gets caught in the trap. To be sure, over the last four weeks most participants who have attempted to be the "first mouse," and pick the bottom, have lost money; so given last week’s wilt, we have decided a "third mouse" is what’s needed!

Since the original Dow Theory "sell signal" of September 2001, our strategy has been to manage the risk by not letting ANYTHING go more than 15% - 20% against us. This is the constant message from none other than Warren Buffett. Buffet says it wasn’t his best ideas that gave him his tremendous track record. It was having a smaller number of bad ideas that resulted in a permanent loss of capital. "We haven’t taken two steps forward and one step back. We’ve taken two steps forward and a fraction of a step back. Avoiding the catastrophes is really important."

Avoiding, and/or managing for, the catastrophes is one of the biggest secrets on Wall Street, still very few pundits ever discuss it. Anyone in the real world, however, knows that you have to manage for the "risks!" Apple producers know they are going to lose 5 or 6 apples out of every 100 to spoilage and they manage for it. Light bulb manufacturers know they will lose 2 or 3 light bulbs out of every 100 to breakage and they manage for it.

Still, in the investment business, there are very few of us that often discuss managing risk on a continuous basis. Even some of the best operators on Wall Street have recently failed to adhere to this most basic rule of investing. Indeed, for years we have idolized Ken Heebner of CGM Focus Fund fame (CGMFX/$27.40), as well as Marty Whitman who captains the Third Avenue Value Fund (TAVFX/$31.44). Both of these brilliant investors’ track records are legend; but this year, both of them are down over 45%.

Speaking to this "managing the risks" point, I read this most insightful paragraph from author, investor, and psychologist Brett Steenbager, PhD:

"In times of stress, we tend to anchor our thinking in the most salient pieces of information; behavioral scientists refer to this as the availability bias. When volatile markets rise, we hear talk of ‘the worst is behind us;’ when they fall, we hear of repeats of the 1930s. Worse still, financial planning— even among supposed professional financial planners— becomes simplistic: either hold on and wait for the turnaround or bail out of everything and rescue what capital you can. "Little wonder that so many investors are uncertain, not knowing whether to stay the course or jump ship. Prudent investment planning, however, suggests that neither extreme is necessary. The important consideration is identifying which assets (stocks, bonds, etc.) are likely to outperform the general markets during any period of extended weakness and ground investment in those. Then, hedge your bets. If you think that some companies that offer value to consumers— or that offer necessities— will outperform those that do not, you can be long the attractive names and short the unattractive ones. "Or you can be long the attractive names and short the broad stock market. You hedge your bet by reducing your exposure to overall market risk. Your investment becomes a relative value play, rather than an outright directional one. I almost never hear financial planners talk about that, and I almost never hear of such strategies from the general investment public."

Yet, it is not just professional investors who have failed to manage the risk for as noted in last Thursday’s Wall Street Journal article titled "The Less Wealthy CEO," many of the country’s wealthiest CEOs are less wealthy now that their company’s share price has collapsed. Even more alarming is the number of CEOs, and corporate officers, that have been forced to sell their own company’s stock due to "margin calls," which was punctuated by Chesapeake Energy’s CEO being forced to sell 94% of his personal shares. The point of this diatribe is that asset prices are deflating worldwide! Ladies and gentlemen, these types of sequences are typical of "capitulation events" rarely seen in the scheme of things. Indeed, the stock market "low" of October 10, 2008 registered a Downside Capitulation reading not seen since 1966. As Bob Hoye wrote on 10-23-08:

Once Capitulation has registered the bottoming process could take up to three weeks. Also, ChartWorks noted that the market could decline by some 5% to 8% below the level that generated the Capitulation. Using a couple of counts, this phase of forced selling could complete by next week (read: this week). The initial rebound could be quick and signaled by the first day with a higher high. Then comes the test whereby most of the great crashes have completed in the latter part of October and tested in November, before moving to a few months rally in the first quarter.

Regrettably, capitulation selling begets more selling, and that is precisely what happened last week as the S&P 500 (SPX/876.77) shed another 6.78%, bringing its year-to-date loss to 40.3%. It was a democratic decline with all of the indices we follow lower for the week. In fact, the only "things" we saw higher on the week were the U.S. Dollar Index (+4.89%) and the Japanese Yen (+7.65%). The quid pro quo was that last Wednesday the British Pound suffered its worse one-day loss since Black Wednesday (September 16, 1992), when George Soros broke the Bank of England; and, the pound ended 8.45% lower last week.

Then came Friday with the preopening S&P futures locked down limit while the media trumpeted the "Bonfires of the Inanities" was coming on "no news". However, late Thursday the Federal Reserve reduced the value of Bear Stearns’ asset pool by some $2.7 billion, AIG had to increase its loan from the Fed by $7.4 billion and stated that the $122.8 billion loan may not be enough, WaMu’s Credit Default Swap portfolio settled for less than anticipated, GE said it would "tap" the Fed’s commercial paper facility, for the first time in history the 30-year "swap rate" traveled below the yield on the 30-year Treasury Bond (that should be impossible), and rumors swirled about major hedge funds in trouble.

Accordingly, the markets gapped lower early Friday morning, leaving the SPX trading more than 25% below its 50-day moving average (DMA) for the third time this month. As the good folks at the invaluable Bespoke Investment Group noted,

"Since 1928, there have only been five other periods where it (SPX) has been more than 25% below its 50-DMA. In the nearby charts we show the SPX during each of these periods. For each period we also calculated the maximum rally the SPX had in the 50-trading day period following the first occurrence. As noted in the charts, the minimum rally in these periods was 14% (1937), while the maximum gain was 66% (1932)."

Clearly, the equity markets are geared for some kind of rally; and if we could ever get the typical Monday/Tuesday downside washout, we would once again try committing some trading capital. Interestingly, as Doug Cass notes,

"When all else fails, look to astrology. Panic lows have historically occurred on day 27 or 28 of the seventh lunar cycle, which are this Sunday and Monday (today). The panics of 1857, 1907, 1929, 1987, and 1997 all marked their lows on these days in October."

As for the investment account, in the current environment companies that have low debt, high free cash flow, stable revenue growth, strong cash reserves on the balance sheet, and dividend yields, should fare the best. As Richard Russell observed,

"In a bear market, stocks that pay no dividends are at the complete mercy of the downtrend. As a dividend-paying stock declines, the yield on that stock increases, and if the dividend holds, the stock becomes more valuable. This is a critical point to understand if you are going to invest. Strong, dividend-paying stocks are better values as the stock declines. The corollary is that there is no more desirable stock than a stock that boasts a long record of increasing its dividend year after year. Studies show that dividends contributed as much as 50% of the total return on the S&P since WW II. The almost magical power of compounding can only be seen by holding stocks and reinvesting the dividends over the years."

10 great dividend-paying stocks

7 dynamic dividend-paying stocks

What to look for in Dividend Paying Stocks

High Dividend Stocks Counter Tough Market

Dividend Growth Investor (blog)

The call for this week: Despite all of last week’s carnage, the SPX still couldn’t take out the "capitulation low" reading of 839.80 that occurred on October 10, 2008, although today it looks like it might be broken. If not, last week’s low was at 852.85 and could be construed as a test of the October 10 low. As Walter Deemer wrote last week, "Even in 1929, the worst stock market crash of all time, the market managed to make a final low nine trading days after the 11.7% [capitulation low] record-volume decline and low of Tuesday, October 29" (see chart). Last Thursday was the ninth trading day after the recent October 10th record-volume decline and "capitulation low" reading. And then there is this Mannie Friedman quote, "When the market wants to bet that the world is coming to an end, the safe bet is to take the other side and bet the world won’t come to an end. After all, what have you got to lose?" Indeed, the "third mouse market!"

Stocks mentioned: Chesapeake Energy (CHK/$20.40/Strong Buy); American International Group (AIG/$1.70); Washington Mutual (WM/$0.06); General Electric (GE/$17.83)


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


First Steps

By Jeffrey Saut | 20 October 2008

"Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away. Economic activity had been decelerating even before the recent intensification of the crisis. The housing market continues to be a primary source of weakness in the real economy as well as in the financial markets, and we have seen marked slowdowns in consumer spending, business investment, and the labor market. Credit markets will take some time to unfreeze…" "…Inflation has been elevated recently, reflecting the steep increases in the prices of oil, other commodities, and imports that occurred earlier this year, as well as some pass-through by firms of their higher costs of production. However, expected inflation, as measured by consumer surveys and inflation-indexed Treasury securities, has held steady or eased, and prices of imports now appear to be decelerating. These developments, together with the recent declines in prices of oil and other commodities as well as the likelihood that economic activity will fall short of potential for a time, should lead to rates of inflation more consistent with price stability."

According to Merrill Lynch’s David Rosenberg, the passages above are the most important 'quips' from Ben Bernanke’s recent speech. Mr. Rosenberg concludes by noting:

"His view on the economy and on inflation can only lead us to one conclusion— these guys are not done cutting rates, and there’s still 150 basis points separating the current funds rate from where it ultimately went in Japan. Quantitative easing comes after that if financial conditions fail to improve. We’re not sure how many more rabbits policymakers have left in their hats outside of the Fed taking rates to zero and buying Treasuries outright."

As readers of these missives know, we have always thought the credit markets are smarter than the equity markets and therefore have been watching various credit spreads intently. The credit markets, ladies and gentlemen, will be the first "tell" as to when things will stabilize; and Mr. Bernanke is correct, "stabilization of the financial markets is a critical first step." Late last week looked to provide the "first steps" to some kind of stabilization.

For example, the November Eurodollar contract was sharply lower on Friday, as was the 3-month LIBOR interest rate. Rumors swirled that a major bank was lending heavily in the inter-bank market and the credit markets took a baby step toward thawing. We are hopeful that notion will spill over into the equity markets this week because the set-up for at least a trading bottom looks promising.

Indeed, as mentioned in previous missives, the equity markets are massively oversold and our downside day-count sequence is VERY long of tooth. Moreover, the Friday plunge of October 10th had all of the characteristics of a panic "low." If so, what typically occurs is a 1½ to 3-session sharp rally off of those "panic lows" and then the averages go right back down over the ensuing three to five sessions.

Roughly 60% of the time the averages hold above the previous low. The other 40% of the time they make lower lows, but not by much and the bottom is completed. Obviously, last Monday’s 936-point "Dow Wow" was a sharp rally that lifted the senior index some 1500-points above the previous Friday’s nadir (7882).

That strength spilled over into Tuesday morning, thus completing the perfunctory 1½-day throwback rally. From there the DJIA went straight back down into Thursday’s panic low of 8198 in what may have been a three-session slide that retested the lows of 10/10/08. If I could script it perfectly the downside retest sequence would have "timed" out into the first part of this week, but they don’t run the stock market for my benefit.

Accordingly, ever since that ill-fated Monday (9/29/08), when the House of Representatives turned down the Paulson Plan, we have told participants that the main theme is "survival." We have also suggested to "be the second mouse that gets the cheese" because the first mouse usually gets caught in the trap. Plainly, most folks who have attempted to pick the bottom over the last three weeks have lost money.

We think the odds of a bottom have increased. From a technical perspective that view is reinforced by the bottoming sequence already discussed. However, there are more fundamental factors at work.

Firstly, there is the noticeable improvement in the credit spreads. Secondly, the Fed is printing money at an unprecedented rate and money is the "oil" that makes the economic engine run. Thirdly, European leaders have taken the reins into their hands and crafted a rescue plan that makes much more sense than our ill-conceived [initial] reactive plans [[fortunately, we seem to have since shifted over to the 'European' plan: normxxx]].

Finally, there is tomorrow’s settlement for the recent Lehman credit-derivatives auction, which at nine cents on the dollar was a total bust [[settlement went off without a hitch; but hardly anyone seemed to have noticed: normxxx]] However, if tomorrow’s settlement goes off without a hitch it could soothe the markets and provide the "spark" that ignites a decent rally [[needless to say; it didn't.: normxxx]]

That said, even though the equity markets may stabilize and rally, as Mr. Bernanke notes, "even if they stabilize as we hope they will, broader economic recovery will not happen right away." Manifestly, the falloff in the economic data has been dramatic. Consumer confidence has plunged to 57.5 this month from 70.3 in September for the largest decline in the history of the data. Meanwhile, retail sales tagged a three-year low and single-family housing starts slid 12% in September to a 26-year low.

Not to be outdone, building permits skidded 8.3% on the month for a reading not seen since November of 1981; and industrial production, as well as the Philly Fed index, have come in well below forecasts. The good news comes on the commodity front, where prices have crashed. That commodity crash has ameliorated some of the inflation concerns and should allow the Fed to continue to expand its balance sheet and begin to act like a loan clearing house for many of the credit-derivatives awash in the system.

Interestingly, in theory the Federal Reserve can expand its balance sheet exponentially since it is a central bank with a sovereign currency that is NOT convertible into anything other than itself, a point Mr. Bernanke so eloquently made in his now famous "Helicopter Ben" speech of November 2002. We actual find this reassuring given the "toxic waste" that has infiltrated the country’s economic system.

In conclusion, we received a plethora of questions regarding the quote we used last week from The Wall Street Journal¹ (WSJ) that there are currently one in ten listed companies trading for less than the value of the cash and marketable securities on their balance sheets. To proof test this statement we ran a similar screen and found more companies than the WSJ did. Of course the screen they must have used was similar to ours in that "net debt" on the balance sheet was excluded. When we included "net debt" we come away with a much smaller number.

Still, this exercise goes to show that "things" are overdone on the downside and people like Warren Buffett are taking notice. Verily, when investors en masse attempt to adjust their portfolios toward more conservative investments, there is a negative feedback loop that leads to a decline in the price of less liquid assets, which in turn begets even more selling pressure, causing an overshoot on the downside. And that, ladies and gentlemen, is where we are currently.

The call for today: While we have not seen a crash, what we have seen is a series of crashetts that have left us with as good a chance for a bottom as we have seen since 55 B.C., which is why we told accounts in last Tuesday’s comments that the short-term lows were "in" and they could begin a buying program in the investment account. We reiterated that stance on Friday, repeating that a bottoming sequence was at work and participants should act accordingly. Consequently, we’ll leave you with this thought from Cicero in 55 B.C.,

"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance."

1"Strikingly, today’s conditions bear quite a close resemblance to what Graham described in the abyss of the Great Depression. Regardless of how much further it might (or might not) drop, the stock market now abounds with so many bargains it’s hard to avoid stepping on them. Out of 9,194 stocks tracked by Standard & Poor’s Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year— or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash— an even greater proportion than Graham found in 1932." (The WSJ the week of October 6, 2008.)