Churn! Churn! Churn!

Churn! Churn! Churn!

By Jeffrey Saut | 4 October 2010

To everything— churn, churn, churn There is a season— churn, churn, churn A time to win, a time to lose, A time to stand around and be confused

Over the years I have often adapted the lyrics from The Byrds' classic song "Turn! Turn! Turn"! for the stock market's action. Currently, the equity markets are indeed churning slightly above their topside "breakout" levels, having pierced previous reaction highs. That begs the question, "Is this an upside breakout; or, an upside fake out?"

As stated in previous comments, I think it is an upside "breakout," implying there should be more upside to come. In fact, if we get through the next few weeks without some kind of major pullback, you are going to start hearing [much more about] about 'the strong upside seasonality' of November/December. If correct, participants need to know how to position themselves into year-end.

My friends at the sagacious GaveKal organization frequently say there are three ways to make money in the financial markets: "return to the mean trades," "momentum trades," and "carry trades". To wit:

1. Through Return to the Mean Strategies: The first way to make money in the financial markets is to buy what is undervalued/oversold and to sell what is overvalued/overbought and wait for the asset price in question to return to its historical mean. This is the strategy adopted by most 'value' managers, but also frequently a number of 'macro-funds', 'distressed-debt', 'special-situations', etc.

2. Through Momentum-Based Strategies: The second way to make money in the financial markets is to identify a trend and get in (and out) at the right time. Most money managers do try to invest following momentum, but it is especially prevalent amongst 'growth' investors, 'macro-funds', and 'long/short' hedge funds.

3. Through Carry Trade Strategies: The third and final way to make money in the financial markets is to play the yield curve intelligently (i.e., borrow at low rates and lend at higher rates and hope that the markets remain continuous). Most of the 'arbitrage' types of hedge funds run some kind of 'carry trade'.

To be sure, I agreed with the good folks at GaveKal, yet I was reminded of GaveKal's views by a research note from ISI's always insightful Jeff deGraaf, who writes:

"As the market breaks through 1131 it attracts two types of players: 'breakout' (momentum) buyers and 'overbought' (mean-reversion) faders (sellers) of strength. Much like the value investor sells to the growth investor on the way up, and the growth investor sells to the value investor on the way down, the interaction between momentum and mean-reverting is much the same. It is here that we find the current market battling between mean reverting sellers and momentum buyers. The market's reaction to news suggests (the) sellers will exhaust themselves, and buyers will dominate as they are forced to play, but a little momentum would sure be welcome (right) here."

From Jeff deGraaf's mouth to God's ears because a breakdown by the S&P 500 (SPX/1146.24) below its 10-day moving average (DMA) at 1141 could lead to a rapid downside test of the 200-DMA (1118) and maybe even a test of the 50-DMA at 1105. Whatever the near-term outcome, I don't think the equity markets have much downside in them. Indeed, just last week the D-J Transportation Average (TRAN/4509.08) confirmed the D-J Industrial Average (INDU/10829.68) by bettering its August 9, 2010 closing high, a feat accomplished by the Dow on September 20th. Accordingly, the Dow Theory "buy signal" that was registered in July was reconfirmed last week, suggesting the stock market's trend remains "up."

I heard from yet another friend last week when Sam Stovall appeared on CNBC. His topic was the correlation between the large cap SPX and the small capitalization Russell 2000 (RUT/679.29). Sam stated, as paraphrased by me:

We compared the correlation between the SPX and the RUT for the past 30 years on a rolling 36-month basis. In December 1987 the correlation was at an all-time high of 94. It subsequently fell to a low of 52 in February 2002. Since then, the correlation has again risen to a current high of 94. If you believe in reversion to the mean, as I do, it suggests correlation should fall from here implying small caps will underperform large caps going forward. Additionally, small caps tend to dramatically outperform in the first year of a bull move, while outperforming to a lesser degree in the second year. In the third year of a bull move large caps outperform.

Sam's conclusion was that you likely want to underweight small caps and overweight large caps. Obviously I agree.

Meanwhile, the weird weather conditions continue as reflected in a 113° day in Los Angeles last week, floods along the east coast, monsoons in Pakistan, and droughts in Russia/China. In fact, according to CNN:

"In northern China this month, farm fields have developed cracks up to 10 meters (32.8 feet) deep. Farmers in Chifeng city have had to delay harvests to avoid injury, the state-run Xinhua news agency reported. According to the Chifeng's hydrological bureau, 62 percent of the city's 51 reservoirs have run dry. More than 250,000 people are short on drinking water. In southwest China's Guizhou province in August, a drought affected more than 600,000 people and nearly 250,000 heads of livestock. Parched soil in rice fields was covered with cracks. Beijing's water shortage will soon reach 200 million to 300 million cubic meters, even as the city waits for a new diversion of water from southern China, according to state-run media."

Regrettably, these tragedies play to my longstanding investment themes of water and agriculture. The unusual weather, however, is not being caused by global warming but rather a 'La Niña weather pattern' combined with more volcanic activity than I can remember. Those eruptions have spewed huge amounts of volcanic ash into the atmosphere. That combination has caused the "tropics" (Tropic of Cancer and Tropic of Capricorn) to extend beyond their usual territories. In turn, the 'Hadley cell' winds, which are shaped by the tropics, are out of whack and thus so are the trade winds.

And that, ladies and gentlemen, explains the ongoing weird weather. I revisit this subject because the cold months are approaching; and, if you think last year's winter was unusually cold just wait for this year's. Consistent with this view, I continue to recommend overweighting energy stocks in portfolios.

My favorites in the energy space are: E&P company Clayton Williams Energy (CWEI/$50.68/Outperform); offshore driller Noble Corporation (NE/$33.50/Strong Buy); equipment provider National Oilwell Varco (NOV/$45.18/Strong Buy); coal company Alpha Natural Resources (ANR/$42.50/Strong Buy); and for yield I continue to like 6.9%-yielding Inergy L.P. (NRGY/$40.43/Strong Buy). For more adventuresome types, I suggest looking at the SPDR Metals & Mining ETF (XME/$54.50), which invests in precious metal and coal stocks, consistent with my longstanding bullish views on those sectors.

The call for this week: There is another reason the markets may continue to rally, Congress is set to adjourn. Remember, "No man's life, liberty, or property is safe while Congress sits". That old "saw" is particularly poignant this year as Congress passed a 2,100-page financial reform bill that didn't address the two serial financial offenders— Fannie Mae and Freddie Mac. Next was the 2,700-page healthcare bill, which nobody read, that didn't cover healthcare's biggest cost— frivolous law suits (read: tort reform).

Speaking of not reading, the Senate has passed a bill with no title. H.R. 1586 sailed through the Senate with the title "The ______ Act of ______"— oops! Meanwhile, contract law has been absolved, along with constitutional law (read: GM bond holders and the Healthcare Bill), causing one old Wall Street wag to exclaim, "Who's driving this boat"? The upcoming mid-term elections therefore become monstrously important. Whether it happens, I can make the argument that the Republicans "take" the House, and come close to retaking the Senate, causing politician President Obama to pull a President Clinton and move to the "center". If that happens, I think the SPX could be at 1300 quickly!