Monday, March 1, 2010

Be Conservative Not Conventional

Investment Strategy: "Be Conservative Not Conventional"

By Jeffrey Saut | 1 March 2010

We think 2010 is a transitional year where being "conservative not conventional" is the preferred investment strategy. Accordingly, we like high quality "growth" over "value" and are avoiding companies with highly leveraged balance sheets. We are also looking for companies whose earnings forecasts are being revised upwards, as well as companies with dividend yields. We prefer large capitalization stocks because the drag on relative performance from narrowing credit spreads is waning.

Moreover, the current economic, and credit, environments are worse for small/mid-caps; and, large caps tend to outperform when the economic momentum peaks as it appears to be doing. Further, large capitalization companies' P/E multiples are 20% below those of the small/mid-cap complexes. That said, we are always interested in special situations, no matter what their capitalization flavor.

If indeed this turns out to be a transitional year, we think investors should employ a more dynamic strategy in part of their portfolios. This does not mean we favor the "rapid fire" strategy of trying to day-trade, or even trade on a week-to-week basis. Rather, we favor waiting until the risk/reward ratio is tipped so far in our favor that if we are wrong, we will be wrong quickly with a de minimis loss of capital. For example, we entered 2010 in a pretty cautious mode, worried that the first few weeks of the new year have historically been tricky.

Subsequently, we determined the equity markets had fallen into a "selling stampede". Knowing that such stampedes tend to last 17 to 25 sessions we remained cautious, but continue to add stocks to our "watch list". Following the climatic downside deluge of February 4th and 5th, we opined the stampede was abating and recommended tranching into (read: buying partial positions in) some of the stocks on our various lists. We still feel that way.

That positive view was reinforced last week when the 10-day exponential moving average (EMA) crossed above the 30-day EMA. Additionally, the 50-DMA is turning up and on February 5th the number of S&P 500 stocks above their respective 50-DMAs had shrunk from 92% to ~19%. While that oversold reading has been somewhat corrected by the ensuing rally, roughly 50% of the S&P 500 stocks still remain below their 50-DMAs. Then there was this insight from Minyanville professor Tony Dwyer:

"One indicator that has proven to be an excellent short and intermediate-term buy signal for the S&P 500 is when the percentage of NYSE issues trading above their 10-DMA drops below 10%. The most recent signal was (on) 2/18/10, which represents only the 8th unique instance (rapid multiple signals following the first signal are ignored) in the past 30 years. The average one month gain following the first signal was 5.4%, with a maximum gain of 11.2% and the worst case (and only) loss of 1.31% in 1991."

Hence, we continue to believe the "selling stampede" is over. To us the question then becomes, will we extend the current rally off February's "hammer lows," or will the pattern resemble that of the 1978 and 1979 "October Ouches" whereby the DJIA lost between 10 - 12% in a few short weeks and then based for a month, or two, before giving investors a decent rally. Worth noting is that the DJIA never went decidedly below those "hammer lows," as can be seen in the attendant chart.

In past missives we have suggested many names for your consideration like CVS (CVS), Cenovus Energy (CVE), Home Depot (HD), Alpha Natural Resources (ANR), and numerous others that can be retrieved from previous reports. And as an aside, China reported last week that it has spent record sums on the importation of coal and liquefied natural gas, which is clearly positive for coal names like Walters Energy (WLT). This morning we give you yet another special situation, namely Goodrich Petroleum (GDP) using its 7.5%-yielding convertible preferred (GDPAN/$35.60). As always, terms and details should be vetted before purchase.

The call for this week: Recently, various economic reports have softened. Why this should come as a surprise is a mystery to us given the stock market's decline, the employment situation, a political environment that is disgusting on both sides, and a winter that is now legend. However, "Life isn't about waiting for the storms to pass. It's about learning to dance in the rain"! Clearly, we are currently "dancing," thinking the "selling stampede" is over with the only question being, "do we extend the rally off of the February 4th and 5th 'hammer lows,' or do we base for awhile as in the aforementioned 1978/1979 examples"? What does concern us was best written by East Shore Partner's creditable Joan McCullough. To wit:

"George Will said it best when he talked about the equality of opportunity vs. the equality of outcomes. Where the former requires self-determination, the latter requires dependence on the government. Make no mistake about it, we are now all about the 'equality of outcomes,' where it only matters, for example, that all adults by age 21, will have 4-year college degrees regardless of ability to write a coherent sentence or multiply 3 x 2."

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