Friday, April 9, 2010

Investment Strategy: Dreamlike

¹²Investment Strategy: Dreamlike

By Jeffrey Saut | 29 March 2010

"The Berkshires seemed dreamlike on account of that frosting with ten miles behind me and ten thousand more to go."
James Taylor, Sweet Baby James, 1970

Interestingly, the institutional accounts want to know what retail accounts were "doing," while the retail accounts want to know what the institutions were doing. Accordingly, at least from my observations, order flow from retail investors suggests that they have under-played the current equity rally and are instead buying bond funds. In fact, ~70% of retail order flow into mutual funds has been into bond funds, and not short-term oriented bond funds, but long-duration bond funds.

In their attempt at "desperately seeking savings," in a perceived conservative manner, I believe retail investors have little idea of the risk they are incurring. Having seen a few market cycles, I can recall what happened to the price of long-term Treasury bonds when interest rates rose throughout the 1970s. While I feel somewhat better about corporate bonds and distressed debt than Treasuries, I am not nearly as aggressive on those vehicles as I was some 18 months ago. Instead, I have actually been counseling accounts to scale back (read: sell partial positions) in such vehicles now that yield spreads have narrowed so dramatically.

There is, however, one Boston-based family of mutual funds that is advising retail clients NOT to buy long-dated bond funds. That is a pretty rare message for any mutual fund family because selling funds is how they make money. Said company is MFS, and its mantra is— if you buy bond funds, they should be short-term bond funds— which we think is pretty sound advice.

During our meetings with some of MFS's portfolio managers (PMs) we espoused the market views so often chronicled in these missives. Yet, part of the fun of such sojourns is hearing what the PMs have to say. For example, our friend Thomas Melendez, captain of the MFS International Diversification Fund (MDIDX), which we continue to recommend, gave us an interesting sound bite.

He asked, "China has 1.3 billion people, so how many cars are on the road?" The answer is only 26 million! Thomas then concluded that the CEO of the Chinese car manufacturing company he recently met was not counting sheep to put him to sleep, but rather cars; as well as the money he was going to make from them. My takeaway from those comments reinforced the recommendation of the Chinese car and battery company BYD (BYDDF), which is followed by our research correspondent, and is 10% owned by Warren Buffett.

Another MFS portfolio manager, namely Jeffrey Morrison, was recently asked to assume oversight of the MFS Sector Rotational Fund (SRFAX), another fund we embrace. To be sure, for the market environment we envision going forward, sector rotation should have a place in most investors' portfolios. Some other comments that caught our ear were quips like:

1) "Don't tell me to buy Proctor & Gamble (PG) because Wall Street is going to expand Proctor's P/E multiple by one point. Just give me stock ideas that are turnaround situations, with operating leverage, like Atlas Pipeline (APL)."

2) "Be cautious on Brazil short-term because the upcoming elections could throw their markets a curve ball. As well, with 9%-yielding Brazilian bank CDs the hurdle-rate for Brazilian equities is high; and, Brazil looks as if it just might just raise interest rates."

3) "India is a great long-term investment. It has by far the best management teams I have ever seen! But in the near-term, valuations are expensive and inflation is running around 15%, which is why India has recently been raising interest rates."

4) "I like your insight that non-financial American corporations have over 5% cash on their balance sheets. But, did you know corporations ended last year with 11.4% of their ASSETS in cash? In fact, just to get back to 'norms' would require ~$500 billion to be spent?"

5) "I like your agriculture theme and particularly your 'spin' on soybeans."

To this last point, soybeans are a member of the legume family. Legumes, it should be noted, have an affliction called "nitrogen fixation". That means, unlike corn, you don't grow more soybeans per acre by throwing fertilizer on them. Manifestly, the only way to grow more soybeans is to plant more acres.

Enter China, which has a voracious appetite for soybeans given their protein content. Yet, China's farming acreage is shrinking due to the scarcity of water. Moreover, it takes a great deal of water to grow soybeans. China, therefore, imports roughly 50% of the world's production of soybeans, which is one of the reasons we have recommended Archer Daniels Midland's (ADM) convertible preferred shares for the past 18 months. Despite its rally, and the fact that there are no near-term catalysts, the convertible preferred shares continue to possess an attractive dividend yield and are followed by our research affiliate.

Coincidentally, Jim Grant, eponymous captain of Grant's Interest Rate Observer, recently wrote about Benjamin Graham's seven metrics for investing in a stock. While on December 12, 2008 there were eight such companies meeting Graham's requirements, today there is but one. That company is Archer Daniels Midland. Speaking to the stock market, while the intermediate/longer-term outlook remains positive, the shorter-term environment continues to counsel for caution.

Granted, we may be "talking" our position, having been too cautious since recommending that strategy on March 15th with the SPX at 1150. However, as Charles Dow stated— The successful investor needs to be able to ignore two out of every three money making opportunities. Or as Warren Buffett puts it, "The market is very efficient at transferring assets from the impatient investor to the patient investor". Anyhow, we are patient, and our indicators are still well overbought.

Also, the MACD indicator is on the verge of flashing a short-term "sell signal," the number of NYSE new highs has narrowed noticeably, the upward revisions in analysts' earnings estimates has narrowed while analysts' Buy ratings relative to Sell ratings is at an eight-year high, and a fortnight ago saw the S&P 500's (SPX) first 1% downside session in weeks— the longest such skein of the current "bull run". Further, last week [[week of 21 March: normxxx]] there were two sessions of "negative key reversals" (Thursday and Friday), which by our pencil is a sign of distribution of stocks (read: caution). [[And the VIX has just sent out some sell signals: For only the fourth time in two years, the Volatility Index on Tuesday, April 6, traded below its lower Bollinger Band and then closed back above it. That often leads to a sharp and sudden reversal. That was certainly the case in May and August 2008. The VIX rallied 75% and 300%, respectively, from levels below 20. And each of those VIX rallies coincided with sharp declines in the broad stock market.: normxxx]] As the technical analyst Art Huprich observes:

"Within the context of the current intermediate-term uptrend, on a short-term (trading ) basis, and similar to what occurred on September 23, 2009 and October 21, 2009, the S&P 500 recorded a negative key reversal formation (last Thursday and Friday)! The intraday high to intraday low decline for each previous instance was 5.6% and 6.5%, respectively."

The call for this week: The bond market is at kiss-and-tell levels as the 10-year Treasury yield approaches its reaction high of ~4%. As repeatedly stated, we think this "higher rates" mindset is what's behind the U.S. Dollar Index's strength as it broke out to new reaction highs last week. We also believe both of those events are responsible for the Reuters/CRB Commodity Index's weakness.

Still, we are able to find good risk/reward situations for the investment account, even though we are on the sidelines in the trading account. Last week three more stocks followed by our Canadian research team became of interest: North American Energy Partners (NOA); Northern Dynasty Minerals (NAK); and Fortress Paper (FTPLF). As always, Blue Sky issues should be checked before purchase.

No comments:

Post a Comment