Wednesday, January 13, 2010

Investment Strategy

Investment Strategy

By Jeffrey Saut | 11 January 2010


"It's tough to make predictions, especially about the future." So said Yogi Berra in an era gone by. Yet, every year, during the week of the Epiphany, we make predictions about the year ahead, write them down, and lock them up in our safety deposit box to be read the following year. This year was no exception. Accordingly, last week we opened the lockbox and placed this year's predictions in it and retrieved last year's list. Interestingly, a number of last year's "guesses" were smack on the mark. To share but a few:
  1. Roman Polanski will finally be arrested.

  2. Illinois Governor Rod Blagojevich will be impeached.

  3. A plane will crash into the Hudson River and everyone will survive.

  4. President Obama will conduct a "beer summit."

  5. General Motors' CEO Rick Wagoner will resign.

Of course we jest, yet we find it just as silly that Wall Street indulges in a similar charade as pundits pontificate on what is going to happen in the new year. Indeed, every December the media trots out the same "seers" to predict where the various markets will be 12 months later. Take Barron's as an example. For as long as we can remember Barron's has polled the same Wall Street strategists as to what they were forecasting for the year ahead. And, when the equity markets were in a secular bull market (1982-1999) those forecasts were generally correct.

However, beginning in December 1999 those forecasts have been pretty wide of the mark. The most glaring "misses" were scribed in the December 2007 Barron's edition when, despite the Dow Theory "sell signal" that had been registered in November of that year, said pundits were unanimously bullish. That same "crowd" correctly remained bullish in December 2008, albeit after losing another ~30% into the March "lows," before the second strongest rally in history (as measured by price and time) vindicated those predictions.

This year's Barron's panel, while containing some new faces, also has many of the same folks from yesteryear. As in the past they are bullish, but much less so than we can ever recall. As for us, we refrain from engaging in such shenanigans, adhering to our mantra— I would rather be generally correct than precisely wrong! Verily, to state that the S&P 500 (SPX/1144.98) will be at 1350 and profits will total to $80, as the most bullish panelists suggest, is sophistry in our opinion. They might as well say those metrics will be achieved on December 27, 2010 at 3:27 p.m. Or as one savvy seer exclaimed, "They might as well flip a lucky penny". To be sure, getting "things" directionally correct is far for important than attempting to be precise.

To that "generally correct rather than precisely wrong" point; while it's true that a number of serious problems lie ahead for the economy and the various markets, monetary policy typically trumps everything else. And, when interest rates are low and money is cheap, asset prices tend to rise. This was the observation we made when the powers that be made it crystal clear they wouldn't permit any more "Lehman Brothers" type of bankruptcies in October 2008.

They subsequently instituted the aforementioned low interest rate, massive liquidity monetary policy. Recall that was when we wrote that the bottoming process was beginning. It was also when on October 10, 2008 93% of the stocks traded on the NYSE made new annual "lows," a ratio not seen in a generation! While the equity markets traded marginally lower into their ultimate March 2009 "lows," we never gave up on the belief that the bottoming process began in October of 2008.

Accordingly, on March 2, 2009 we opined that the bottoming process was complete and urged investors to "buy". During the course of that five-month bottoming process we had little doubt that America's policymakers would do everything in their power to reflate the system, which in turn would ultimately cause asset prices to rise. It is also the reason we don't expect the bull market to end anytime soon. Surely there will be a correction, but all of our longer-term indicators suggest the primary trend remains "up".

Since those March "lows" we have turned cautious a few times, but we have never turned bearish. We most recently sounded the cautious alarm coming into 2010. Our concern was that if last Friday's employment figures were as strong as the whisper estimates had them we might see a replay of January 1988, when a strong non-farm payroll number caused interest rates to rise with an attendant ~9% stock slide. The quid pro quo was that if the numbers were too weak it might also break the back of the rally on a short-term basis. Come Friday's figures and, at least on the surface, they were neither "too hot nor too cold, but just about right" to be somewhat Wall Street friendly. Indeed, while there were 85,000 job losses in December, the headline unemployment number held steady at 10% by virtue of a shockingly large shrinkage in the labor force.

Drilling down into the numbers, however, reveals some more disturbing trends. Indeed, according to the household survey, jobs lost leaped to 589,000 for the month of December, while the broad-based U-6 measurement of unemployed and underemployed edged up to 17.3%. Moreover, there was an astounding rise in discouraged workers year-over year (929,000 vs. 642,000). Most troubling is Table A-9, which shows that the duration of folks out of work for 27 weeks (or longer) totals to 6.1 million. If the U-6 report is right (15.3 million unemployed) it implies that ~40% of the unemployed have been collecting benefits for a pretty long time. Adjusting for all the "noise" suggests the true unemployment rate should have been around 10.4%, not the reported 10%.

Nevertheless, the various markets didn't seem to care as the S&P 500 rose 3.29 points on Friday and finished the week better by 2.7%. The rise brought the SPX to within sneezing distance of our long-envisioned trading target of 1150-1160. Bettering that level would suggest our strategy of "since credit spreads are back to pre-Lehman bankruptcy levels there is no reason that the SPX can't trade back to the pre-Lehman levels of 1200-1250". That said, with ~94% of the S&P 500 stocks back above their respective 200-day moving averages (read: overbought), the S&P at the top of its Bollinger Band, and the MACD rolling over, we remain cautious. We worry about the first two weeks of the new year historically being littered with "head fakes," as well as trading tops.

Dynamically, participants should still be long half of the index trading positions recommended months ago, but with close trailing stop-loss points. Strategically, we think it is appropriate to hedge, or harvest, partial positions in the investment account. Take 8.5%-yielding Daylight Resource Trust (DAYYF/$10.60), which is followed by our Canadian affiliate Raymond James Ltd. When we initially recommended DAYYF the price target was $10.50 per share. Now that the shares have exceeded that target, we think selling partial positions is a prudent strategy.

As for new investment money, last week on CNBC we focused on three of this year's Analysts' Best Picks. They were CVS (CVS/$34.00/Strong Buy), National Oilwell (NOV/$47.11/Strong Buy), and coal company Alpha Natural Resources (ANR/$51.14/Strong Buy). Interestingly, our coal analyst, Jim Rollyson, penned an excellent report on metallurgical coal this morning. We continue to invest, and trade, accordingly.

The call for this week: The most important development in the last 30 trading days has been the rally in the U.S. Dollar, which has been swift and large, suggesting the greenback is now in an uptrend. However, this morning the Dollar Index (DX.1/77.09) has broken below its recent reaction low of 77.39, putting a "bid" back into the "stuff stocks" (energy, timber, precious/base metals, agriculture, etc.). It will be interesting to see if this dollar weakness is a head fake. If it is, and the "buck" strengthens again, it has significant implications for the various markets. Stay tune.


January 4, 2009

Year-end letters are always hard to write because there is a tendency to talk about the year gone by, or worse, attempt to predict the year ahead. Therefore, we are titling this year's letter "Lessons" in an attempt to share some of the lessons that should have been learned over the past year. We begin with this quote from an Allstate commercial featuring Dennis Haysbert:

"Over the past year, we've learned a lot. We've learned that meatloaf and Jenga can actually be more fun than reservations and box seats. That who's around your TV is more important than how big it is. That the most memorable vacations can happen ten feet from your front door. That cars aren't for showing how far we've come, but for taking us where we want to go. We've learned that the best things in life don't cost much at all."

Charles Dickens' classic novel A Tale of Two Cities begins with the quote, "It was the best of times, it was the worst of times". That quote is certainly reflective of the stock market in the year gone by as 2009 should go down in the books with that moniker. To be sure, 1Q09 was ugly with the S&P 500 (SPX/1115.11) surrendering nearly 30%. From those March "lows," however, the SPX has gained some 69%. For those that targeted the "lows" it has been a great year. For those that didn't, it has truly been "the worst of times," for after losing ~58% in the SPX from the intra-day highs of October 2007 into the intra-day lows of March 2009, they have not come close to recouping the monies lost in that downdraft.

The lesson that should have been gleaned is that if participants would have managed the risk (read: not allow positions to go too far against them before taking some kind of action; i.e., hedge, sell, etc.), they would have missed much of the SPX's 2008/2009 downside debacle and in turn done pretty well over the past two years. As often referenced in these missives, investors need to manage the risk, for as Benjamin Graham espoused in his book The Intelligent Investor, "The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept".

Investors should keep that quote on their walls so they don't forget the major lesson of 2008/2009. Yet, there are other lessons to be remembered. To that point, Merrill Lynch lost two of its best and brightest in 2009 as Richard Bernstein and David Rosenberg left for less constrained environments. During their final weeks at Merrill they wrote about lessons they have learned. To wit:

Richard Bernstein's Lessons:
  1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important than are capital gains.

  2. Most stock market indicators have never actually been tested. Most don't work.

  3. Most investors' time horizons are much too short. Statistics indicate that day trading is largely based on luck.

  4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.

  5. Diversification doesn't depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.

  6. Balance sheets are generally more important than are income or cash flow statements.

  7. Investors should focus strongly on GAAP accounting, and should pay little attention to "pro forma" or "unaudited" financial statements.

  8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.

  9. Investors should research financial history as much as possible.

  10. Leverage gives the illusion of wealth. Saving is wealth.

David Rosenberg's Lessons:
  1. In order for an economic forecast to be relevant, it must be combined with a market call.

  2. Never be a slave to the data— they are no substitutes for astute observation of the big picture.

  3. The consensus rarely gets it right and almost always errs on the side of optimism— except at the bottom.

  4. Fall in love with your partner, not your forecast.

  5. No two cycles are ever the same.

  6. Never hide behind your model.

  7. Always seek out corroborating evidence

  8. Have respect for what the markets are telling you.

There was another sage that left Merrill Lynch, but that was 18 years ago. At the time Bob Farrell was considered the best strategist on Wall Street, and while he still pens a stock market letter, his "lessons learned," written back then, are as timeless today as they were in 1992.
  1. Markets tend to return to the mean over time.

  2. Excesses in one direction will lead to an opposite excess in the other direction.

  3. There are no new eras— excesses are never permanent.

  4. Exponential rising and falling markets usually go further than you think.

  5. The public buys the most at the top and the least at the bottom.

  6. Fear and greed are stronger than long-term resolve.

  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chips.

  8. Bear markets have three stages.

  9. When all the experts and forecasts agree— something else is going to happen.

  10. Bull markets are more fun than bear markets.

With these lessons in mind, we wish you good investing in the New Year.
The call for this week: Last Monday we wrote, "As we enter the New Year, we are once again turning cautious because the Treasury market is breaking down (higher rates) and the U.S. dollar is rallying… . Therefore, we think it prudent to 'bank' some trading profits and hedge some investment positions as we approach the new year." Moreover, one of the lessons we have learned is that the beginning of a new year is often punctuated with head fakes, both on the upside as well as the downside. One of the greatest upside head fakes was in January 1973 when in the first two weeks of that year the DJIA rallied to a new all-time high of 1051.70 before sliding ~20%. While we are clearly not predicting that, what we have indeed experienced since the March "lows" is the second greatest percentage rally (69%), adjusted for time (nine months), since the 1933 rally. Following that 1933 explosion of 116% in just five months came a pretty decent downside correction. Since we tend to be "odds players," prudence suggests some caution is again warranted.

The Telegraph Market

December 28, 2009
  • It's The Telegraph Market; Stop.

  • We've Decided To Take Most Of This Week Off To Spend Time With Our Son; Stop.

  • Thinking of calling us; stop.

  • Thinking of emailing us; stop.

  • Thinking of shorting the U.S. dollar; stop.

  • Thinking of buying stocks; stop.

  • Thinking of buying commodities; stop.

  • Thinking of buying bonds; stop.

Indeed, we have been unabashedly bullish on most asset classes since March 2, 2009, although we have turned cautious a few times over the past eight months. To be sure, said asset classes were at least three standard deviations undervalued back in March. Since then, most have normalized to median valuation levels. Accordingly, as we enter the New Year, we are once again turning cautious because the Treasury bond market is breaking down (read: higher interest rates) and the U.S. dollar is rallying.

After being dollar-negative since 4Q01, we turned neutral to constructive on the "buck" in 4Q07 and recommended shutting down all negative U.S. dollar positions. More recently, we suggested the "greenback" might be in for a pretty decent rally. If so, the ubiquitous "dollar carry trade" is in jeopardy of unwinding with downside consequences for most asset classes. Therefore, we think it prudent to "bank" some trading profits and hedge some investment positions as we approach the New Year.

That said, we still believe the nascent economic recovery will gain traction in 2010, and that earnings comparisons will look good in 1H10. The question then becomes just how much of that has already been discounted by the 68% rally off of the March lows? Also worth consideration is if this is a rally in an ongoing trading range stock market, or the beginning of a new secular bull market. Currently, we don't have a clue, but are happy that we have enjoyed the eight-month rise. We think the trick from here, at least in the short/intermediate-term, is to protect the profits that have been made.

The call for this week: "Breakout, or fake out," is the question de jour on participants' minds this week as the new high recorded by the S&P 500 last week had a bunch of "hair" on it! We'll reserve our opinion until the troops return next week. Happy New Year everybody.

U.S. Dollar Index

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10-Year T'note

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