Monday, July 12, 2010

A Man Lived By The Side Of The Road

¹²Investment Strategy: A Man Lived By The Side Of The Road …

By Jeffrey Saut | 12 July 2010

A Man Lived by the Side of the Road …

"… and sold hot dogs. He was hard of hearing, so he had no radio. He had trouble with his eyes, so he didn't read the newspaper.
But, he sold really good hot dogs. He put up a sign on the highway telling everyone how good they were. He stood by the side of the road and cried, "Buy a hot dog, mister".

"And people bought. He increased his meat and bun orders and he bought a bigger stove to take care of his trade. He got his son home from college to help him. But then something happened. His son said,
"Father, haven't you been listening to the radio? There's a big depression on. The international situation is terrible and the domestic situation is even worse".

"Whereupon the father thought, 'Well, my son has been to college. He listens to the radio and reads the papers, so he ought to know.' So, the father cut down his bun order, took down his advertising signs and no longer bothered to stand on the highway to sell hot dogs.

His hot dog sales fell almost overnight.
"You were right, son," the father said to the boy. "We are certainly in the middle of a great depression'."


Depressions, and recessions, are even more difficult to predict than the stock market. Yet, most economists agree the recession 'ended' around this time last year [[but not yet by the 'official' arbiter of such things, ie, the NBER: normxxx]]. Currently, the question du jour is whether the economy is going to slip back into recession; aka the dreaded 'double-dip'. While there is always the chance of a double-dip, they are pretty rare.

For example, using industrial production as a "measuring stick," there have only been three, out of the 38 recessions since 1880, which qualify as double-dips. Interestingly, all three of those double-dips were characterized by a mild first recession followed by a more severe 'secondary' recession. Plainly, what we experienced in the 2007 - 2009 recession was anything but mild. [[On the other hand, no previous recession, since at least WWII, has had such a large unemployment situation, housing depression, and near credit freeze at this point in its 'recovery'! : normxxx]]

Accordingly, I continue to think the odds of another recession are low. There is the risk, however, like the man "who lived by the side of the road," we can "talk" ourselves into a recession. At present, while the economy has hit a "soft spot," the odds of a sliding into recession are indeed low. To this point, our friends at Credit Suisse constructed a Six-Month Recession Probability Model that puts the odds at zero, as can be seen in the nearby chart. Said model is comprised of:

1) Real Fed Funds Rate (level). [[Meaningless, with QE in effect.: normxxx]]
2) S&P 500 (6-month % change).
3) Private Non-farm Payroll Growth (6-month % change). [[It may be getting better— but never before from such high levels— and we are currently not even employing the 250k or so new workers being added to the ranks of the employables each month.: normxxx]]
4) Single-Family Housing Permits (6-month % change). [[Can anyone pretend that this is showing a 'robust' recovery?: normxxx]]
5) University of Michigan Consumer Expectations Index (6-month % change).
6) Initial Jobless Claims (YoY% change). [[Stubbornly sticking above 450K.: normxxx]]
7) "TED" Spread (spread between 3-month LIBOR and 3-month T-bill yields). [[Can anyone pretend that this is meaningful, with just about all the CBs shamelessly and deliberately manipulating rates…?: normxxx]]
8) Relative Price of Energy (deviation from trend). [[Which do we consider: the drop from $140+ or the more recent doubling in the price?: normxxx]]

Dating back to 1964, the model has registered only one false signal. That signal occurred in 1984 and is likely attributable to the Continental Illinois banking crisis. As the model's title suggests, the average lead time from when a signal is registered and a recession begins has been 5.7 months. To reiterate, the model indicates there is zero probability[!?!] of another recession. Yet, over the past few months, the stock market has been transfixed by the possibility of a "double dip."

To be sure, Mr. Market has been manic this year, having peaked in mid-January and then sliding by over 9% into early February. Fortunately, I entered the year in a cautious mode with the mantra, "I think the trick in 2010 is going to be to keep the profits accrued to portfolios since the March 2009 lows". Also fortunate is that we identified those early February "lows" and tilted accounts appropriately.

Not so fortunate, I turned cautious in late-March, yet the S&P 500 (SPX/1077.96) continued to rally into my long envisioned 1200 - 1250 target zone. Nevertheless, during the rally over much of the month of April, I recommended the purchase of downside hedges, as well as "bets" on increased volatility, as a hedge for the "long" positions in investment accounts. Subsequently, I recommended selling those hedges in the weeks following the "flash crash" of May 6th. Therefore, coming into last week I opined:

"Since the 'flash-crash' low, we have had a Dow Theory 'sell signal,' a sell-signal from my proprietary intermediate trading indicator (the first since December 2007), the monthly stochastic-indicator has turned negative, a downside violation of the 12-month moving average has occurred, most indices have broken below spread triple-bottoms and in the process traced-out a head and shoulders topping pattern in the charts, and most recently we got a 'death cross' when the S&P 500's 50-day moving average (DMA) crossed below its 200-DMA.

"All of this suggests a cautious stance on stocks. Indeed, of all the vehicles I monitor, only the Yen, Gold, Silver, and Fixed Income are higher for the month of June, the 2Q10, and year-to-date. That said, such extreme downside readings typically imply stocks have been too compressed on a short-term basis and consequently a rally may be in order."

Obviously, we got that rally last week. And, the rally came within "spitting distance" of the 1080 - 1100 target zone I spoke of in my verbal strategy comments early last week. In the near term, I think any pullback will be contained in the 1040 - 1050 zone. In the intermediate/longer-term I remain cautious due to the aforementioned metrics. In such an environment I think risk adjusted stock selection, and risk management, will be the keys to portfolio performance.

I was particularly struck by a phrase a gentleman I know used on CNBC last week. Bill Fleckenstein remarked, "If you can't make money in stocks like Microsoft and Intel, then you probably can't make money in the stock market". Both Microsoft (MFST), and Intel (INTC), are names I repeatedly recommended for investment accounts during the bottoming process of October 2008 through March 2009.

At the beginning of July 2010, I revisited these names given their precipitous declines. You can read my analyst's reports for the story on INTC (Outperform). MSFT is followed by our research correspondent with a favorable rating. Hereto the story is simple. MSFT has $3.50 per share in cash, possesses a pristine balance sheet, throws off tons of cash flow, sports a 2% dividend yield, and ex-cash per share is trading at 10x this year's earnings estimate. If Raymond James is typical of corporate America, we are just now switching to Windows 7 (having skipped Vista), which implies a new upgrade cycle for MSFT.

Other names on my investment account "shopping list" include: Enterprise Product Partners (EPD 'Strong Buy'), Allstate (ALL 'Strong Buy') and Walmart (WMT 'Strong Buy'). Walmart's story is also simple: it is likely a high single-digit revenue grower, a low double-digit earnings grower, it adds 3 - 4% of floor space per year for as far as the eye can see, the company is buying back a lot of shares, and it trades at a discount to the group. Indeed, WMT is being valued as if it were a grocery store chain— despite the fact that 50% of its revenues are not food related. Even if it were only a grocery store, it should command a premium valuation because it "does it" better than anyone else! As a sidebar, there is a feature story in Barron's this week about how "cheap" Wal-Mart shares are. Note, all these recommendations have decent dividend yields.

Speaking of yields, I spent an hour last week talking with the head portfolio manager of Putnam's Fixed Income division. Rob Bloemker manages roughly $50 billion and has 70 professionals working with him. While pessimistic about many things, Rob is personally buying stocks. Because earnings tend to grow at the same rate as GDP, with the S&P 500 trading at a PE multiple of 13, and an earnings yield (earnings divided by price) of 6 - 7%, Rob believes stocks will return 6 - 10% above the rate of inflation.

"Wow," I said, "That's pretty bullish equity talk from a fixed income manager"! But of more interest was his discussion about Putnam's Diversified Income Fund (PDINX), which Rob thinks will give investors equity-like returns over the next three years without the concurrent risk of equities. With a duration of three years, and a 9 - 10% loss adjusted return, I would agree.

The Call For This Week: In a past life, I wrote fundamental research on container board companies. Currently, those companies are raising prices, which only happens when demand warrants. Then too, rail traffic is increasing and diesel fuel consumption is rising, another metric that is inconsistent with a double-dip recession. Moreover, the number of Manhattan apartment rentals doubled in 2Q10 on a YoY basis, while office vacancies in U.S. metro areas fell in 2Q10 vs. 1Q10 for its first drop since 2007.

Ladies and gentlemen, these are NOT the metrics of a double-dip recession! Meanwhile, since 2008 there has been almost NO difference between the forward PE of the S&P 500 Growth and Value composite indices. Obviously, this favors growth versus value, which is why I have been emphasizing Technology in these missives.

This morning, however, the pre-opening futures are lower on rumors that Deutsche Postbank had failed the stress test. Nevertheless, I think the selling will be contained and in the short— term be resolved with higher prices. The real upside challenge should come at the S&P 500's (SPX/'1077.96') 50-day moving average (DMA), which currently stands at 1100.30, and the 200-DMA at 1111.60. Longer term, I remain cautious.

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