The Magic of Compound Interest (Saut)

Tuesday, August 21st, 2012

“The Magic of Compound Interest”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

August 20, 2012

There was a king who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third – and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels, or enough, if each kernel is a quarter-inch long (which it may not be; I’ve never seen wheat in its pre-english-muffin form), to stretch to the sun and back 391,320 times. That was nothing more than one kernel’s compounding at 100 percent per square for 64 squares.

… “Money Angels” by Andrew Tobias

When compound interest works in your favor, it is a blessing. But when it works against you, it is a curse. Just ask Washington Mutual, or General Motors. More recently ask Greece, whose “debt chickens” have come home to roost. For example, Greece’s 10-year sovereign note sported a yield of around 5% back in 2010. Subsequently, it soared to more than 30% earlier this year, and currently changes hands around 24%. When yields are double-digits the power of compound interest working against the borrower is awesome. Consider the following example from the same book by Andrew Tobias illustrating the term of interest and return on interest:

Say you borrowed $1,000 from a friend and paid it back at the rate of $100 a month for a year. What rate of interest would that be? A lot of bright people will answer 20 percent. After all, you borrowed $1,000 and paid back $1,200, so what else could it be? Forty percent? No [it’s] more. If you’d had use of the full $1,000 for a year, then $200 would, indeed, have constituted 20 percent interest. But you had full use of it for only the first month, at the end of which you began paying it back. By the end of the tenth month, far from having use of $1,000, you no longer had use of ANY of the money. So you were paying $200 in the last two months of the year for the right to have used an average of $550 for each of the first ten [months]. That comes to a bit more than a 41.25 percent effective rate of interest. (Trust me).

I revisit this compound interest theme this morning because the recent rise in interest rates has been one of the most important events that have occurred over the past few weeks. The rate rise is important because this week the U.S. Debt Clock will cross above $16 trillion (excluding off balance sheet items), and if we stay on the same debt course by 2015 the U.S. will have accumulated $20 trillion in debt. Accordingly, the increase in the 10-year T’note’s yield, from 1.38% on July 24th to last week’s high of 1.86%, is significant. Consider this, by 2015, if our debt is at $20 trillion, an aggregate yield on that debt of 2.5% means the cost of servicing the debt is roughly $500 billion per year. At a yield of 5% our debt service cost would be $1 trillion; and at 10%, the yearly debt service would be $2 trillion, or nearly all of the $2.3 trillion our government receives in revenues! Unsurprisingly, most of the folks I talk to inside the D.C. Beltway realize we are on an unsustainable path; and that’s why I think no matter who is elected in November my sense is we are going to get smarter policy makers, more practical policy, and more productivity out of government. Currently few believe this is possible, but if you look at what’s happening at the grassroots level there are a lot of good things happening on both the “left” and the “right.” One entity that appears to embrace this more positive scenario is Mr. Market.

Indeed, while there are some pundits commenting on the recent increase in interest rates, there is NOBODY expounding on the fact that the S&P 500 Total Return Index is probing new all-time highs (see chart on page 3). To be sure, I am aware of all the bearish arguments swirling down the canyons of Wall Street, but the bears continue to misunderstand there is not a linear relationship between the fundamentals and the movement of the markets. Manifestly, it takes a massive deflationary shock, like what we experienced in 2008, to cause a waterfall decline in stock prices; and, I just don’t see that on the horizon. Actually, I think the rise in interest rates is more about the improving economic backdrop and the inflation that should accompany it. As the invaluable Bank Credit Analyst organization wrote back in 2007:

The history of the U.S. is characterized by a long-run increase in indebtedness, punctuated by occasional financial crises and subsequent policy reflation. The sub-prime blow-up is the latest installment in this ongoing Debt Supercycle story. During each crisis, there are always fears that conventional reflation will no longer work, implying the economy and markets face a catastrophic debt unwinding. Such fears have always proved unfounded, and the current episode is no exception. A combination of Fed rate cuts, fiscal easing, and a lower dollar will eventually trigger another upleg in the Debt Supercycle, and a new round of leverage and financial excesses. The objects of speculation are likely to be global, particularly emerging markets and resource related assets. The Supercycle will end if foreign investors ever turn their back on U.S. assets, triggering capital flight out of the dollar and robbing U.S. authorities of any room to maneuver. This will not happen any time soon.

“Not any time soon,” says the Bank Credit Analyst and I agree, which is why my mantra has been, “You can get cautious, but do not get bearish!” Importantly, I have likened the March 2009 “low” to the nominal price low of December 1974, which was the “print low” of the 1966 – 1982 wide-swinging, trading range stock market. Further, I have suggested the October 4, 2011 “undercut low” might be the equivalent of the “valuation low” of August 1982 before the 1982 – 2000 secular bull market began. Whether we are now into a new secular bull market is questionable, but secular “bull” markets typically arise when valuations are parsimonious, the economy is a mess, politics are leaning to the left, and individual investors have abandoned stocks. If that sounds familiar, it should for that is precisely the environment we have had for awhile.

Over the longer-term I will let Mr. Market tell us if we are in a secular bull market. As for the here and now, I have been treating the June 4th low as THE daily/intermediate-term cycle low. More recently, I opined that while the S&P 500 (SPX/1418.16) may pause, or pull back, around the 1400 level, but that any pullback should be shallow with the real bull/bear battle coming at the April highs of 1420 – 1422. And, that is where we were late last week. Typically the initial assault on a key resistance level like 1420 fails. It tends to take two or three attempts before a key level is surmounted. For example, the Reuters/Jeffries CRB Commodity Index (@CR/303.48) made a reaction high on May 1, 2012 at 307.95. Subsequently, it has tried to better that high on July 19th, August 9th, and is currently trying for the third time to close above its May 1st high (see chart on page 3). My sense is this time it makes it because triple tops rarely hold. That view is reinforced by the recent sell-off in the Dollar Index (@DX/82.54), which closed below its 50-day moving average on Friday. If the U.S. dollar keeps falling it should put the wind at the back of the CRB, as well as gold, which is also trying to break out above a triple top around $1630.

The call for this week: The S&P 500 Total Return Index (&SPXT/2469.00) is trying to break out to new all-time highs, as can be seen in the chart on the next page. It may also be pointing the way for the S&P 500 because if the SPX can decisively break out above its April highs of 1420 – 1422 it potentially brings into view targets above 1500. And while it is doubtful the SPX can breakout above those “highs” on its first try, I think it will indeed eventually break out. Of course, the grind higher from the June 4th low has been accompanied by total disbelief among individual and professional investors. That is reflected not only in the flow of funds by individual investors out of equity-centric mutual funds, but in the latest Commitment of Traders report that shows the “pros” have been caught heavily on the short side into a rising equity market. So the fuse is burning and I think it is just a matter of time until the SPX travels above 1422.

Click here to enlarge

Click here to enlarge

Copyright © Raymond James

Tags: Andrew Tobias, Chess Tournament, Chickens, Chief Investment Strategist, Curse, Double Digits, English Muffin, General Motors, Humility, jeffrey saut, Kernel Of Wheat, Kernels, Million Trillion, Peasant, Peasants, Power Of Compound Interest, Rate Of Interest, Raymond James, Saut, Squares, Washington Mutual
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Invest with the Best?! (Saut)

Tuesday, August 14th, 2012

Invest with the Best?!

by Jeffrey Saut, Chief Investment Strategist, Raymond James

August 13, 2012

“Finding the best person or the best organization to invest your money is one of the most important financial decisions you’ll ever make. It’s also one of the toughest. The right manager for someone else may not be the right manager for you, nor can you reasonably expect to find many objective, or even reliable, sources to help you narrow your choices. You will be bombarded with figures, charts, and statistics that seek to sell you on each adviser’s services … the sad fact is that too often you cannot even believe what has been presented to you.”

… Claude N. Rosenberg, Jr.

I have been a “fan” of the astute Mr. Rosenberg ever since hearing him speak back in the 1970s. Many will remember him as the founder of the San Francisco-based money management firm that used to bear his name, Rosenberg Capital Management, before changing its moniker to RCM Capital Management. Others will remember him as the author of numerous books on financial matters, one of which was Investing with the Best, which holds the above quote and deals with the daunting task of selecting an investment manager. Given the plethora of investment managers, each with their own investment philosophy and style, picking a manager is difficult. That’s why many individuals’ selection process consists of nothing more than looking at a portfolio manager’s track record for the past few years. We think such a simplistic approach is a mistake.

Apparently, Jeremy Grantham, eponymous captain of the money management firm Grantham, Mayo, Van Otterloo & Co., agrees. To reprise some of his thoughts: “Ninety percent of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (i.e., growth, value, foreign vs. domestic, etc.). Since opportunities by style regress, past performance tends to be negatively correlated with future relative performance. Therefore, managers are often harder to pick than stocks. Clients have to choose between fact (past performance) and the conflicting marketing claims of various managers. As sensible businessmen, clients usually feel they have to go with the past facts. They therefore rotate into previously strong styles, which regress [to the mean], dooming most active clients to failure.”

This is where Raymond James’ Asset Management Services (AMS), as well as our Mutual Fund Research Department, can help. As unbiased intermediaries, these departments are committed to aiding clients in the hiring of an investment manager who most closely aligns the manager/mutual fund with the client’s views on the various markets, as well as their risk tolerance. To this point, I journeyed to the cooler climes of Boston last week to escape the Florida heat, speak at a national conference, and visit with over 20 portfolio managers (PMs). My first visit was with the folks at Pioneer Funds where I met with Marco Pirondini (Head of Equities) and his team, as well as Ken Taubes (Chief Investment Officer). I have spoken with Ken a number of times and find his wisdom both on stocks and bonds to be invaluable. Because of his long tenure as a bond manager, I was surprised when he opined that interest rates should bottom between now and year end. Given that “higher interest rate” view, I was particularly interested in speaking with Jonathan Sharkey who manages the Pioneer Floating Rate Fund (FLARX/$6.88) and the Multi-Asset Ultrashort Income Fund (MAFRX/$10.04). In a rising rate environment these two funds should fair pretty well. I discussed Jon’s investment style/strategy over dinner and found it to be closely aligned with mine. I was also interested in the Pioneer Research Fund (PATMX/$10.64) and will be vetting it, along with other Pioneer funds, over the coming months.

After a few more meetings with hedge funds that afternoon, I spent most of Wednesday with Fidelity. My first meeting was with Jurrien Timmer, co-portfolio manager along with Andrew Dierdorf, of the Fidelity Global Strategies Fund (FDYSX /$9.18). To me, FDYSX is tantamount to a global macro fund because it can “go anywhere” and “do anything.” That means it can invest in just about everything. Moreover, I like the fact that the fund has a technical analysis overlay to it, as well as a tactical leaning, since tactical is what has been working in this manic depressant market. Next was Charles Myers, captain of the Fidelity Small Cap Value fund (FCPVX/$15.27). Chuck told me that while he is really good at picking stocks, he is less confident with his market timing and sector selection abilities. Accordingly, he spends his days looking for good companies and thinking about portfolio construction. Indeed, he adds value to the investment equation through portfolio construction. He does run a concentrated portfolio (~70 names) and does adjust his turnover rate to take advantage of when the markets are more dynamic.

Fidelity Select Health Care Fund (FSPHX/$136.14) is managed by Edward Yoon and has provided very good risk adjusted returns over time. My meeting with him was informative as he thinks insurance companies and PBMs are part of the healthcare solution. Strategically, Eddie thinks the healthcare system has never let customers know what things cost, but that’s changing because employers are moving healthcare risks from their balance sheets to the employee’s balance sheet. This should be a boom for companies that provide consumers with the ability to analyze price competition between vendors. He also suggested there is going to be a shift from public to privatized Medicare. A couple of names he mentioned covered by our fundamental analysts were: Cerner (CERN/$71.12/Outperform) and Nuance (NUAN/$23.53/Strong Buy). My last meeting was with Steve Wymer, who told me the S&P 500 investment style is too conservative for a growth fund and the Nasdaq Composite Index is too aggressive, so he runs The Fidelity Advisor Growth Opportunity Fund (FAGOX/$40.87) somewhere in between. He thinks we are somewhere in the mid-cycle of a recovery provided Euroquake doesn’t derail us. Dinner Wednesday was with the good folks from Fidelity.

The next morning I arrived at MFS, which is an active global asset manager that employs a uniquely collaborative approach to build better insights for our clients. Their investment approach has three core elements: integrated research, global collaboration, and active risk management. Of course, “risk management” is a big thing with me for the essence of portfolio management is the management of risk, not the management of returns. My meeting was with Jim Swanson (Chief Investment Strategist) and eight PMs/analysts. Jim began by stating that people he meets in everyday life talk about how bad the stock market is. He then “closed” that comment by noting the S&P 500 is up nearly 12% YTD, while the NASDAQ Composite is better by ~16%. Moreover, when you impact those returns for the almost non-existent inflation, the “real” returns are awesome. The rest of the conversation was about the topics du jour (government, Euroquake, the fiscal cliff, etc.). Regrettably, I did not have the time to meet with my friend Thomas Melendez, who manages my favorite international fund, MFS International Diversified Fund (MDIDX/$13.27), or the PM of the MFS New Discovery Fund (MNDAX/$20.15), but that will happen next trip.

My final meeting was with Putnam to reconnect with Bill Kohli, portfolio manager of the Putnam Diversified Income Trust (PDINX/$7.65) that has so often been featured in these comments. It is one of only two bond funds I have featured over the years because I think PDINX is positioned for a higher interest rate environment. The fund has a 5.8% yield with zero duration. The fund employs 70 – 80 different strategies to pursue a diverse range of opportunities. For example, the fund is “long” non-agency RBMS (Residential Mortgage Backed Securities), but hedges that position with agency IOs (Interest Only). Hence, to lose money on those positions would require home prices to collapse over 50% from their already depressed prices. And then there was David Glancy and his Putnam Equity Spectrum Fund (PYSAX/$28.04). Hereto David thinks a lot about portfolio construction and combines stocks, bonds, bank loans, convertibles, opportunistic short-selling, and cash to produce returns. To this cash point, I was taught early in this business that cash is indeed an asset class for to assume the investment “opportunity sets” that are available today are as good as those presented next week, next month or next quarter is naive; and, you need to have some cash to take advantage of those opportunities. Evidently David thinks that as well because his cash position has varied from 44.4% in 2Q09, to 14.8% in 3Q10. David loves stocks and I could talk individual companies with him for hours. As always, all of these mutual funds should be vetted before purchase.

As for the stock market, not much really happened in my absence as the D-J Industrials (INDU/13207.95) experienced their tightest weekly trading range since January 2007. Of course, that was not the case a year ago when our sovereign debt was downgraded and equities collapsed 6.66% (the mark of the devil as well as the intraday low of March 6, 2009 where the new bull market began). Indeed, what a difference a year makes. Nevertheless, the rotation away from the defensive sectors and into Materials (+2.83%), Energy (+2.34%), and Technology (+2.10%) is an interesting observation because when the defensive sectors lead it is not indicative of a healthy and sustainable rally. Said rotation reinforces my belief that the upside breakout above the 1360 – 1366 level is for real and suggests we are finally setting up for another push to the upside. The real battle should be waged at the April highs of 1422. That said, the rally that began on June 4th has left ALL of the macro sectors overbought in the short term. It has also left the SPX at the top of the parallel chart channel (read: resistance) referenced in last Monday’s letter. Consequently, a pause or pullback attempt is not out of the question. Support remains in that 1360 – 1366 zone for the SPX.

The call for this week: The good: stocks are hanging in pretty well after an 11% rally from the June 4th low, earnings are still beating estimates by ~60%, earnings revisions are rising again, economic reports are strengthening, European equities have rallied while their sovereign yields have declined, the SPX continues to track the typical election pattern (see chart from the sagacious Bespoke organization), and there was a rare “buy signal” from the Bob Farrell sentiment indicator. The bad: all sectors are overbought, companies are beating revenues estimates by only 48.3%, the number of new highs is shrinking, upside momentum has waned, we are at the top of a parallel channel in the SPX chart. The ugly: forward earnings guidance is negative by 5.5%, the presidential election rhetoric is getting nastier, commercial hedgers have moved close to their most extreme short position in years, the Volatility index (VIX/14.74) is below 15 (read: no fear), gasoline had its largest two-week rise this year (+$0.18), and the list extends. Nevertheless, I think this is the pause that refreshes and not the start of a big decline.

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Copyright © Raymond James

Tags: Capital Management, Chief Investment Strategist, Claude N Rosenberg, Daunting Task, David Rosenberg, Ebb And Flow, Financial Decisions, Gluskin Sheff, Grantham Mayo Van Otterloo, Investment Manager, Investment Managers, Investment Philosophy, Investment Style, jeffrey saut, Money Management Firm, Moniker, oil, Portfolio Manager, Raymond James, Relative Performance, Reliable Sources, Rosenberg, Rosie, Sad Fact, Saut, Simplistic Approach
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Yogi Berra? (Saut)

Tuesday, August 7th, 2012

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“Yogi Berra”
August 6, 2012

“It’s hard to make predictions, especially about the future.”… Yogi Berra

To be sure, “It’s hard to make predictions, especially about the future,” and last week was no exception. I began the week, as stated in Monday’s missive, noting that there would be a trifecta of potentially market moving news events. The first was the two-day FOMC meeting where I thought the Fed would change its policy statement with a lean toward more accommodation. My reasoning was that the Fed would appear too political by waiting until the September meeting, just a few short weeks before the election. WRONG; and that was pointed out to me in spades on Thursday because while Wednesday’s “no change” policy announcement only produced a stutter step for the S&P 500 (SPX/1390.99), by Thursday the SPX swooned. Indeed, by mid-session the SPX had shed more than 20 points from Wednesday’s closing price (1375), and in the process tagged its intraday low of 1354. By the close, however, the index had recouped about half of those intraday losses, ending the sloppy session at 1365. Actually, Thursday’s late in the day recovery was yet another surprise to me because hereto my early week prediction was there would be no surprise from the European Central Bank meeting. But, a surprise it was with Mario Draghi unwilling to make good on his previous week’s market moving statement that, “Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough.”

WRONG; and I had to suffer through that night’s, and early Friday morning’s, parade of pundits talking about how bad the employment number might be. Such musings should have had a dilatory effect on the preopening futures, but that wasn’t the case as a number of other rumors swirled down the canyon of Wall Street with positive implications. Still, everyone awaited the numba’! And as stated in Thursday’s verbal strategy comments, I had no idea as to what the number was going to be given the wide dispersion of previous reports; yet, my sense was it was going to be close to consensus. WRONG again because Friday’s number was much better than expected with nonfarm payrolls rising to 163,000 versus the median forecast of +100,000. Lost in the euphoria, however, was that the unemployment rate rose from 8.216% to 8.253%.

So it was three “strikes” and “out” for me and my predictions last week. About the only thing I got right was saying in Thursday morning’s verbal strategy comments that any pullback should be contained in the 1360 -1366 zone so often mentioned in these comments; and contained it was, with Thursday’s close of 1365. Given Friday’s surprise number, the SPX sprinted to its highest closing price since May 3rd and reinforced my more bullish stance of the past few weeks (as opposed to my previous trading range, but not bearish, stance). Friday’s Fling took the SPX up to the top of a parallel channel, as can be seen in the chart on page 3 from the astute Bespoke organization. If it can break out above that channel, last April’s reaction high of 1422 should be the next objective.

Regrettably, a strong earnings season has not been the driver of the upside breakout. Verily, of the 1,702 companies that have reported, the earnings beat ratio stands at 59.9%, well behind the S&P 500’s beat rate of 67.3% (376 companies have reported). Meanwhile, the revenue beat rate stands at only 48.2%. Yet by far the most troubling metric is the company’s forward earnings guidance, which is currently negative. Despite that forward guidance, the bottom up consensus earnings estimates for the SPX remain around $102 for this year and near $115 for 2013. If those estimates are anywhere near the mark, it means the SPX is trading at 13.6x this year’s estimates, and at 12x next year’s estimates, with concurrent earnings yields (earnings ÷ price) of 7.3% and 8.3%, respectively. Using the yield on the 10-year Treasury Note of 1.6% as your risk free rate of return produces what an analyst terms an equity risk premium of 6.7% basis next year’s estimates (earnings yield 8.5% – 1.6% risk free return = 6.9% equity risk premium, or ERP). Investopedia defines an ERP as:

“The excess return that an individual stock, or the overall stock market, provides over a risk-free rate [of return]. This excess return compensates investors for taking on the relatively higher risk of the equity market.”

QED, investors are being “compensated” by 6.7% (ERP) to own the SPX instead of the 10-year T’note.

While the aforementioned valuations are not as parsimonious as they were at last year’s October 4th undercut low (we were very bullish), they are still pretty inexpensive, offering the long-term investor a decent risk/reward ratio when combined with the SPX’s 1.9% dividend yield. Yet, I understand investors’ reluctance to commit capital since it seems like the trading of the “headline” < i>du jour is creating too much volatility. Interestingly, one vehicle that attempts to damp down some of that volatility is the PowerShares S&P 500 Low Volatility ETF (SPLV/$28.05), which consists of the 100 stocks in the S&P 500 with the lowest realized volatility over the trailing 12 months. This ETF currently yields 2.9%; as always, details should be checked before purchase.

Another strategy that has been working for the past few quarters has been to consider companies that have beaten quarterly earnings estimates, as well as revenue estimates, and guided forward estimates higher. Some names from the Raymond James research universe that have recently met these three criteria, are favorably rated by our fundamental analysts, and have “greened up” on indicators, like the SPX chart on page 3 shows, include: BioMed Realty Trust (BMR/$18.76/Outperform); Extra Space Storage (EXR/$33.45/Outperform); Kimco Realty (KIM/$19.94/Outperform); Power-One (PWER/$5.13/Outperform); Post Properties (PPS/$51.23/Strong Buy); and Wabtec (WAB/$78.38/Outperform).

The call for this week: As a sidebar, be sure to look at this month’s edition of < i>Gleanings for further insights from our economist, technical analyst, and my additional thoughts. As far as the stock market, last Friday’s rally extended the upside breakout by the SPX above the often mentioned 1360 – 1366 zone; and at this point, that breakout looks sustainable. The rally has also broken the index above the “neckline” of what a technical analyst would term a reverse head and shoulders bottoming pattern (read: bullishly). That said, the rally has left the SPX at the top of the parallel channel previously mentioned, as well as leaving every macro sector I follow pretty overbought in the short term. Also of note is that while the D-J industrials, the S&P 500, and the D-J Utilities bettered their June reaction highs, the S&P 400 MidCap, the S&P 600 SmallCap, the NASDAQ Composite, the Russell 2000, and the Value Line Arithmetic Index did not (read: potential non-confirmation). Still, the stock market’s internal energy continues to look strong, my proprietary indicators have been “green” on the S&P 500 for six weeks (see chart on page 3), the Dollar Index got crushed on Friday (lower dollar means the “risk trade” is back on), short interest on the NYSE is high, the equity markets survived a potential “flash crash” from the Knight Capital (KCG/$4.05/Market Perform) fallout, the recent investor sentiment figures were about as negative as they ever get, the public liquidated another $2.7 billion of domestic equity mutual funds last week (the highest weekly redemption of the year), the Spanish market rallied 7.41% on Friday, well y’all get the idea. Recently participants have been conditioned to sell each marginal breakout to a new reaction high because it has been followed by a pullback. I am not so sure this breakout plays that way. Indeed, I expect at least a test of the April highs (1422) over the next few weeks before a corrective phase begins.

P.S. – I will be in Boston all week spending time with portfolio managers, seeing accounts, and speaking at a conference. I will try and do my verbal strategy comments, but they are likely going to be abbreviated.

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Tags: Chief Investment Strategist, ECB, Friday Morning, Futures, jeffrey saut, Mandate, Mario, Missive, Musings, Numba, oil, Policy Announcement, Pundits, Raymond James, S Market, Saut, Spades, Spx, Stutter Step, Trifecta, Wall Street, Yogi Berra
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“One Way Pockets” (Saut)

Tuesday, July 10th, 2012

“One Way Pockets”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

July 9, 2012

“When a market fluctuates for several weeks or months within a narrow range, one of these three things is happening: pools and large operators are accumulating securities by absorbing the offerings of tired holders; or they are distributing certain stocks under cover of artificial strength in others; or the market is actually in a state of uncertainty and waiting a fresh impulse.”

… One Way Pockets by Don Guyon (1917)

This quote was taken from the book One Way Pockets, first published in 1917. As stated in the book’s more recent introduction – the author, who assumed the nom de plume of “Don Guyon” to avoid being identified with his wealthy clients – was associated with a boutique brokerage firm that had sizeable business with investors in all sections of the country. In 1915 he began an analytical study of the orders executed for certain active traders with the idea of determining the fundamental weakness, if any, in their speculative methods. The results were illuminating enough to afford corroborative evidence of general trading faults, which persist to this day. While I have found many of the book’s insights helpful to my investment process, and urge investors to study said book, there have been other investment methods of interest.

Perhaps the best way is to emulate some of the trading principles used by yesteryear’s legends, who beat the market no matter the emotions and mechanics of the institutional herd, is to study them. To wit:

Bernard Baruch – Eighty some years ago, he would research a stock, buy it, and then each time the stock rose 10% from his purchase price, buy an additional amount equal to his first purchase. If the stock began declining he would sell everything he had bought when the drop equaled 10% of its top price.

Baron Rothschild – His success formula was centered on the famous quote attributed to him – “I never buy at the bottom and I always sell too soon.”

Jesse Livermore – This legendary speculator profited enormously by calling the vigorous 1921 and 1927 advances correctly. In 1929 he reasoned that the market was overvalued, but finally gave up and became bullish near the top in the fall of that infamous year. He quickly cut his losses, however and switched to the short side. Livermore listed three major points for success: Sensitivity to mob psychology, willingness to take a loss, and liquidity (meaning that stock positions should not be taken that cannot be sold in 15 minutes in the market).

Addison Cammack – A broker from Kentucky, who swore by the two-point stop-loss. “If you’re wrong,” he said, “You might as well be wrong by two points as ten.” He followed this method successfully, and was one of the few bears to make a fortune on Wall Street and keep it.

Have we got you thinking about what trading strategy to follow? Well, we’ve been holding the best system for last. Here is the sure-thing formula for success, “Don’t gamble – take all savings and buy some good stocks, and hold them until they go up, then sell them … if it don’t go up, don’t buy them!” – Will Rogers

I first heard about One Way Pockets in the early 1970s when Merrill Lynch’s Chief investment Strategist referred to it as his “investment bible.” Since then, I have read the 64-page book a number of times and have always found it insightful. Obviously, the quote I began this report with has stuck in my mind and I think that quote is applicable for the current stock market because the S&P 500 (SPX/1354.68) has indeed been locked in a pretty narrow range since May 5th. Beginning with the June 29th Dow Delight (+277 points), however, it felt like the resolution of the two-month trading range might be to the upside because the SPX traveled not only above its 50-day moving average (DMA @1339.28), but broke above the 1360 – 1366 level that has contained recent rallies. Moreover, the trading action produced a fairly rare event in what a technical analyst would term a “bowtie.” Now a “bowtie” is created when there is a confluence of moving averages into what looks like a “bowtie” (see chart on page 3). In the current case the moving averages in question would be the 10/30/50-DMAs. While such a configuration does not tell us which way the stock market is going to go, it does tell us there is the potential for a move of some substance. For example, studying the attendant chart shows the “bowtie” of August 2011 preceded a ~14.5% decline. The quid pro quo is that the “bowtie” of mid-December 2011 kicked-off an ~18% rally. Regrettably, Friday’s employment numbers clouded the previously improving backdrop, yet participants should still not give up the bullish “ship” because one day does not make a trend. As stated in Friday’s verbal strategy comments, the upside breakout by the SPX had lifted it back into minor resistance and left it somewhat overbought in the very short-term. Therefore, a shallow pullback was not out of the question; and, the employment numbers served as the causa proxima for that pullback.

By Friday’s closing bell the disappointing employment report had pressured the SPX lower by 12.90 points, but off only 7.48 points for the holiday-shortened week. While the selling pressure increased during Friday’s session, it did not turned any of my macro models negative, at least not as of yet. Moreover, my intermediate-term model on the SPX has turned “green” over the past two weeks. As can be seen in the chart (page 3), once this indicator begins to “trend” it does not give you very many false signals (BTW, green is good and red is bad). Ergo, as of now I expect any pullback to be shallow and hence contained by the support level visible between 1335 and 1345 basis the SPX. That said, we still have NOT had the decisive/sustained upside breakout I was hoping for, which continues to leaves the equity markets mired in the now two-month trading range. While I expect the markets to resolve themselves to the upside, they don’t run the various markets for my benefit. Accordingly, I think the best strategy is to continue to accumulate the non-market correlated stocks so often mentioned in these missives. Those names are favorably rated by our fundamental analysts and posses decent dividend yields. That list now includes: Allstate (ALL/$34.79/Strong Buy); Covanta (CVA/$17.28/Strong Buy); Johnson & Johnson (JNJ/$67.64/Outperform); Plum Creek Timber (PCL/$40.00/Outperform); Rayonier (RYN/$45.66/Strong Buy); and Stonemor (STON/$26.25/Outperform).

The call for this week: This morning I awoke to headlines “Asia Signals Drop In Global Demand,” “Euro Zone Fragmenting Faster Than EU Can Act,” “European Worries Send Shares Lower,” and “Investors Brace For Shaky Earnings Season.” Such musings have the S&P 500 futures off about six points. Somewhat offsetting these negative quips are these headlines, “Fed Officials Favor QE3” and “Obama To Seek One-year Extension For Some Of Bush Tax Cuts;” but alas, this morning the negatives are outweighing the positives. If the futures open where they are indicated it would push the SPX into the upper part of the 1335 – 1445 support zone. While I expect that level to “hold,” if it doesn’t more defensive action is warranted.

Click here to enlarge

Click here to enlarge

Tags: Active Traders, Baron Rothschild, Bernard Baruch, Brokerage Firm, Chief Investment Strategist, Don Guyon, Famous Quote, Faults, Fundamental Weakness, Herd, Investment Methods, jeffrey saut, Nev, Nom De Plume, One Way Pockets, Raymond James, Saut, Success Formula, Urge, Wealthy Clients, Yesteryear
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“Happy Birthday America” (Saut)

Wednesday, July 4th, 2012

“Happy Birthday America”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

July 3, 2012

This is my annual “Happy Birthday America” report, a tribute to Independence Day, because tomorrow our nation celebrates its 236th birthday. Yet, it was actually on July 2^nd when America broke from Great Britain. Two days later the Declaration of Independence was signed, which is why we celebrate the occasion on the 4^th of July. I always commemorate the day by re-reading the lyrics from the “Star-Spangled Banner” in honor of our forefathers’ courage. While most citizens know the first stanza of said anthem, few know the other three. Nor do they know the history leading up to the crafting of its words.

The year was 1812 and the United States was at war with England over freedom of the seas. It was a tumultuous time as Great Britain was struggling with Napoleon’s invasion of Russia. In 1814, however, Napoleon was beaten and England turned its attention to the United States. While many naval battles were fought, the fight eventually centered on the central part of the U.S. as the British attempted to split this country in half. Washington, D.C. was taken and then the Brits “marched” toward Baltimore, where a mere 1,000 patriots manned the cannons at Fort McHenry, whose guns controlled the harbor. If Baltimore was to “fall,” the British would have to take Fort McHenry.

The attack commenced on the morning of September 13, 1814, as 19 British ships began pounding the fort with rockets and mortar shells. After an initial exchange of fire, the Brits withdrew to just outside the range of Fort McHenry’s cannons and continued their bombardment for the next 25 hours. Surprisingly, on board one of the British ships was 35-year-old poet-lawyer Francis Scott Key, who was there arguing for the release of Dr. William Beanes, a prisoner of the British. Even though the captain agreed to the release, the two Americans were required to stay aboard until the attack on Baltimore was over. It was now the night of September 13th as the bombardment continued.

As twilight deepened, Key and Beanes saw the American flag flying over Fort McHenry. And, as reprised by famed author Isaac Asimov:

“Through the night, they heard bombs bursting and saw the red glare of rockets. They knew the fort was resisting and the American flag was still flying. But toward morning the bombardment ceased, and a dread silence fell. Either Fort McHenry had surrendered and the British flag flew above it, or the bombardment had failed and the American flag still flew.

As dawn began to brighten the eastern sky, Key and Beanes stared out at the fort, trying to see which flag flew over it. He and the physician must have asked each other over and over, ‘Can you see the flag?’

After it was all finished, Key wrote a four stanza poem telling the events of the night. Called ‘The Defense of Fort McHenry,’ it was published in newspapers and swept the nation. Someone noted that the words fit an old English tune called, ‘To Anacreon in Heaven’ – a difficult melody with an uncomfortably large vocal range. For obvious reasons, Key’s work became known as ‘The Star Spangled Banner,’ and in 1931 Congress declared it the official anthem of the United States.

Now that you know the story, here are the words. Presumably, the old doctor is speaking. This is what he asks Key:

Oh! say, can you see, by the dawn’s early light,
What so proudly we hailed at the twilight’s last gleaming?
Whose broad stripes and bright stars, through the perilous fight,
O’er the ramparts we watched were so gallantly streaming?
And the rocket’s red glare, the bombs bursting in air,
Gave proof thro’ the night that our flag was still there.
Oh! say, does that star-spangled banner yet wave,
O’er the land of the free and the home of the brave?

(‘Ramparts,’ in case you don’t know, are the protective walls or other elevations that surround a fort.) The first stanza asks a question. The second gives an answer:

On the shore, dimly seen thro’ the mist of the deep
Where the foe’s haughty host in dread silence reposes,
What is that which the breeze, o’er the towering steep
As it fitfully blows, half conceals, half discloses?
Now it catches the gleam of the morning’s first beam,
In full glory reflected, now shines on the stream.
’Tis the star-spangled banner. Oh! long may it wave
O’er the land of the free and the home of the brave!

‘The towering steep’ is again, the ramparts. The bombardment has failed, and the British can do nothing more but sail away, their mission a failure. In the third stanza I feel Key allows himself to gloat over the American triumph. In the aftermath of the bombardment, Key probably was in no mood to act otherwise? During World War I when the British were our staunchest allies, this third stanza was not sung. However, I know it, so here it is:

And where is that band who so vauntingly swore
That the havoc of war and the battle’s confusion
A home and a country should leave us no more?
Their blood has washed out their foul footstep’s pollution.
No refuge could save the hireling and slave
From the terror of flight, or the gloom of the grave,
And the star-spangled banner in triumph doth wave
O’er the land of the free and the home of the brave.

(The fourth stanza, a pious hope for the future, should be sung more slowly than the other three and with even deeper feeling):

Oh! thus be it ever, when freemen shall stand
Between their loved homes and the war’s desolation,
Blest with victory and peace, may the Heaven – rescued land
Praise the Power that hath made and preserved us a nation.
Then conquer we must, for our cause is just,
And this be our motto –“In God is our trust.”
And the star-spangled banner in triumph doth wave
O’er the land of the free and the home of the brave.

I hope you will look at the national anthem with new eyes. Listen to it, the next time you have a chance, with
new ears. Pay attention to the words. And don’t let them ever take it away . . . not even one.”

The call for tomorrow: “There is nothing wrong in America that can’t be fixed with what is right in America” … President Bill Clinton

Tags: Bombardment, British Ships, Cannons, Chief Investment Strategist, Declaration Of Independence, Dr William, Forefathers, Fort Mchenry, Francis Scott Key, Freedom Of The Seas, Happy Birthday America, Initial Exchange, Invasion Of Russia, jeffrey saut, Mortar Shells, Naval Battles, Raymond James, Saut, September 13 1814, Star Spangled Banner, Tumultuous Time
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“1-800-GET-ME-OUT?!” (Saut)

Monday, June 4th, 2012

“1-800-GET-ME-OUT?!”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

June 4, 2012

The “S” word makes most investors uneasy. They find the “B” word, “buying,” much more pleasant. Why is perhaps best explained in a book written by Justin and Robert Mamis titled “When to Sell.” Following are several poignant excerpts from that book:

“Stocks are bought not in fear but in hope. No matter what the stock did in the past it assumes a new life once a purchaser owns it, and he looks forward to a rosy future – after all, that’s why he singled it out in the first place. But these simple expectations become complicated by what actually happens. The stock acquires a new past, beginning from the moment of purchase, and with that past comes new doubts, new concerns, and conflicts. The purchaser’s stock portfolio quickly becomes a portfolio of psychic dilemmas, with ego, id, superego, and reality in a state of constant battle.”

“The public is most comfortable when they are sitting with losses. Because if their stocks are down from where they bought them, they don’t have to worry about them. Once he’s got a loss, the typical investor is sure he isn’t going to sell. He bears the lower price because in his mind it is temporary and ridiculous; it’ll eventually go away if he doesn’t worry about it. So selling at a loss becomes absolutely out of the question. And since it is out of the question, and his mind is made up for him, the struggle of any potential decision vanishes and he is able to sit comfortably with the loss.”

“To the public mind, selling is never sound. It always conveys the possibility of being wrong twice: first, admitting that they’ve made a buying error; second, admitting that they might be wrong in selling out. And if the stock has actually gone up, they are tormented; should they take a profit or hold for a bigger one? That creates anxiety, and anxiety breeds mistakes. But as long as they’ve got losses, and never have to decide, they can sit back comfortably and dream instead.”

“Through the entire market cycle lurks the fear of finalizing the deed, of taking it from dream to reality by selling. By not selling, by tightly holding on to his stocks, the investor never has to face reality.”

Yet, “selling” seemed to be on the market’s mind late last week punctuated by Friday’s Dow Dive of ~275 points. Said decline left the senior index down 8.74% from its May 1st closing high (13279.32) into Friday’s close (12118.57). While not all that big of a decline, it brought back memories of the past two years’ May – July corrections of 17% and 20%, respectively. Yet, investors should keep in mind that since 1928 there have been 294 pullbacks of 5% or more. Ninety four of them have been moderate (>10%), 43 have been severe (>15%) and 25 have been bear markets (>20%). What is interesting to me is that since last October 4th’s “undercut low” the chant from most investors has been, “We want a pullback to become more fully invested.” Now that we have the pullback everyone is in panic mode (again). To borrow a line from George Bernard Shaw – There are two tragedies in life; one is not to get your heart’s desire, the other is to get it! The “heart’s desire” for the bulls since last October has been the fact the markets have ignored all of the bad news. Verily, the senior index has turned a deaf ear to the worsening Euroquake situation, Iran, softening economic trends, deflationary dives in commodities, etc. Of course that “deaf ear” stance has changed over the past four weeks.

Indeed, the Dow’s decline is now 22 sessions long. Such “selling stampedes” typically last 17 – 25 sessions before they exhaust themselves; it just seems to be the rhythm of the thing. This has been my observation over the years in that it takes this long to get participants bearish enough to finally panic and throw in the towel by selling their stocks. While it is true some stampedes have lasted more than 25 sessions, it is rare to have one run more than 30 sessions. Today is session 23 on the downside. Obviously Friday’s Fade took out my failsafe point of 1290 on the S&P 500 (SPX/1278.04), leaving the DJIA (INDU/12118.57), the S&P 500, and the NASDAQ Composite (COMP/2747.48) all below their respective 200-day moving averages (DMAs). The bears will be quick to point out this is what happened right before the crashes of 1929 and 1987. However, the bullish argument is that over the past 20 years a break below the 200-DMA by the SPX, after it has stayed above it for three months, has typically led to a rally. Also worth noting is the decline has left most of the oversold indicators I rely on pretty oversold. Nevertheless, I told “callers” on Friday that when markets get into one of these selling squalls they rarely bottom on a Friday. What tends to happen is participants go home and brood about their losses over the weekend and “show up” on Monday in selling mode, which often leads to “turning Tuesday” (read: recoil rebound). Accordingly, the SPX needs to quickly recapture 1290, and stay above that level, if a rally is to commence. On the other hand, if the SPX merely bounces back up to 1290, and then falls sharply back, I would view that as a bearish sign requiring more downside hedging and/or the raising of some more cash. Fortunately, we recommended raising cash in February – April. Unfortunately, we recommended judiciously putting some of the cash back to work (but not much of it) into somewhat more defensive names like 3.8%-yielding Rayonier (RYN/$42.18), which has a Strong Buy rating from our fundamental analyst.

While Euroquake has been on center stage for weeks, Friday’s shockingly weak employment report brought the focus back to the economy and jobs. The 69,000 private sector payroll growth figure was well below the estimate of 150,000 and just to add pain to injury the unemployment rate ticked up to 8.2% from 8.1%. Still, investors should remember unadjusted private-sector payrolls have risen by 1.983 million over the trailing 12 months for roughly a 165,000 monthly average jobs gain. As our economist, Dr. Scott Brown, notes, “That’s not bad, but it is far short of what’s needed to make up ground lost during the economic downturn.” Now for weeks I have been discussing the weakening economic reports. That string of weakness continued last week given that of the 21 economic releases, 18 were weaker than expected, two were in line, and only one exceeded the estimate (that would be Continuing Claims). This softening trend could still just be a weather-related issue combined with skewed seasonal adjustments; the next few months will decide.

The call for this week: Friday was the first day of hurricane season here in Florida, yet the storm didn’t hit our beaches but rather blew onto the Street of Dreams with a 275-point “storm surge.” The media attributed Friday’s Flop entirely to the disappointing employment numbers, but the truth was the market was already headed down before the release of those numbers. And when the SPX’s 1290 level was breached, the rout was on. The result left all of the indexes we monitor near their lows of the day and the three major market indices (INDU, SPX, COMP) below their respective 200-DMAs for the first time in about five months. The bears will be quick to point out this is what happened right before the crashes of 1929 and 1987. However, the bullish argument is that over the past 20 years a break below the 200-DMA by the SPX, after it has stayed above it for three months, has typically led to a rally. And despite the break below my 1290 pivot point I can’t shake the feeling that all of this is just part of the bottoming process.

P.S. – I am on the road again this week seeing accounts and speaking at conferences.

Copyright © Raymond James

Tags: Anxiety, Book Stocks, Chief Investment Strategist, Conflicts, Doubts, Ego Id Superego, Excerpts, Fear, Investors, jeffrey saut, Losses, Purchaser, Raymond James, Saut, Stock Portfolio, Struggle, Typical Investor
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I Should Have?!? (Saut)

Monday, May 21st, 2012

“I Should Have?!”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

May 21, 2012

“… A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door that he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back into the box, which would scare away any turkeys lurking on the outside. One day he had a dozen turkeys in his box. Then one walked out, leaving eleven. ‘I should have pulled the string when there were twelve inside,’ he thought, ‘but maybe if I wait, he will walk back in.’ While he was waiting for his twelfth turkey to return, two more turkeys walked out. ‘I should have been satisfied with the eleven,’ he thought. ‘If just one of them walks back, I will pull the string.’ While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return … ”

… Why You Win or Lose, by Fred C. Kelly

“I should have sold when the S&P 500 broke below its rising trendline on April 9th at 1397” (see chart on page 3). “I really should have sold on May 11th when the S&P 500 (SPX/1295.22) traveled below its April 10th intraday reaction low of 1357.38.” So exclaimed one disgruntled portfolio manager last Friday since the SPX continued to surrender ground. Plainly, the “I should have” crowd surfaced again last week as the SPX knifed through my envisioned support zone of 1320 – 1340, causing one savvy seer to exclaim, “Markets always go further than most pundits believe, both on the upside and the downside.” Yet the recent downside dive from May 1st’s 1415 level into last Friday’s close of 1295.22 has caused many of my indicators to register readings not seen in a long time. For example, the McClellan Oscillator is now at oversold readings not seen since the recent April 10th trading bottom (see chart on page 3). Then there is the CBOE Equity Put/Call Ratio, which is flashing a “buy signal” that has proven profitable at every downside inflection point since 1994; or, as the astute folks at Bespoke write:

“Following today’s 0.44% decline (5/16/12) in the S&P 500, the 10-day Advance/Decline line for the S&P 500 has now dropped down to –1,930. This is an extreme oversold reading based on historical standards. For those unfamiliar with the indicator, the 10-Day A/D line is simply a rolling 10-day total of the daily net number (of similar readings) shows that equities have historically rebounded after hitting such extreme oversold levels. Over the next week, the S&P 500 averages a gain of 1.21% with positive returns two-thirds of the time. Over the next month, the S&P 500 averages a gain of 5.58% with positive returns 83% of the time. Going out three months, the S&P 500 averages a gain of 7.68%, and over the next six months the index averages a gain of 13.35%.”

Adding to the litany of downside inflection-point indicators is the AAII (American Association of Individual Investors) survey that recorded its lowest bullish reading (23.6% bulls) since August 2010. Moreover, my parade of short/intermediate-term indicators shows a composite reading that is at historic levels. To wit, there have only been only four other times when my indicators have combined to show such negative inclinations. More than seventy percent of the time, given such readings, the major market averages have been higher a week later, while 92% of the time they have been higher a month later. Accordingly, unless we are in “crash mode,” and I don’t believe that, it is time to ready your “buy list” and begin judiciously recommitting some of that cash to stocks; and, that is what I have been recommending. Indeed, over the past week I have been recommending recommitting some of the cash we suggested raising in February – April. One of the techniques we have used to accomplish this at similar inflection points was first proffered by our friends at Riverfront Investment Group back in 2009. As stated:

“First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And six, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.”

I think Riverfront’s strategy is appropriate since the SPX is probing its next downside energy level. Further, the stock market’s internal energy level is totally exhausted on the downside, implying a tradable bottom is likely at hand unless we are involved in a mini-crash. The real question thus becomes, “If we get a rally from this oversold condition is it the start of a new “up leg,” or is it just a compression rally that will be brief followed by still lower prices?” Speaking to that point, it is worth considering the SPX is currently trading at a P/E ratio of 13.1x earnings. Since record keeping began there have only been five occasions when a bear market began with the SPX’s P/E ratio below 15x. Another timely question is, “Will the recent Dow Dive trigger QE3, Operation Twist II, or targeting GDP?” While equity markets can clearly do anything, at worst we should at least get a relief rally from here and at best it could be the start of a new “up leg.” Therefore, I think the gradual re-accumulation of investment positions is the correct strategy. For those participants not wanting to try and “catch a falling knife” by purchasing the exchange-traded product of your choice, a more conservative approach would be to accumulate dividend-paying stocks. Some that screen well technically, and have a Strong Buy rating from our fundamental analysts, for your potential shopping list include: 3.0%-yielding Automatic Data Processing (ADP/$51.98); 3.8%-yielding Rayonier (RYN/$42.08); 4.3%-yielding Digital Realty Trust (DLR/$68.48); 5.2%-yielding Enterprise Products Partners (EPD/$48.48); and 8.2%-yielding Linn Energy (LINE/$35.24).

Tags: Amp, Chief Investment Strategist, Corn, Crowd, Downside, Fred C Kelly, jeffrey saut, Last Friday, Mcclellan, Nbsp, Osc, Portfolio Manager, Pundits, Raymond James, Saut, Seer, Spx, Support Zone, Trendline, Turkeys, Twine
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Balance, Grasshopper (Saut)

Tuesday, May 15th, 2012

by Jeffrey Saut, Chief Investment Strategist, Raymond James

May 15, 2012

I received so many requests to put last Tuesday’s verbal strategy comments into written form, and that’s exactly what I have done this morning. To wit, I was always entranced with the 1970’s TV show “Kung Fu” starring David Carradine as Kwai Chang Caine. The show centered on an orphaned American boy (Kwai Chang) that is admitted as a student to the Shaolin temple in China. There his mentor, Master Po, teaches him the ways of the Shaolin priests. In addition to learning the martial arts Kwai Chang, affectionately named “grasshopper,” is also instructed in the ways of life. In one such lesson Master Po says, “Balance, grasshopper, balance” – implying that everything in life needs to be “in balance.” Similarly, investors’ portfolios need to be “in balance,” or more appropriately rebalanced periodically.

Portfolio rebalancing, when done correctly, is an art form. Simply stated, portfolio rebalancing is the strategic redistribution of asset classes within a portfolio to keep said portfolio’s objectives in line with its original objective. As John Valentine, of Valentine Capital, notes:

To provide a simplified allegory, think of investment planning for the future as an automobile, conveying an investor to his or her financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture and the assets invested are the fuel. The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momentum. … Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank. … Rebalancing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously. … The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercussions associated with a compromised allocation. Being overexposed to the downside and underexposed to the upside. Don’t let this happen to you!

Regrettably, most individual investors don’t have the discipline, or the skill sets, to actively rebalance their portfolios. That’s why individuals are best advised to seek professional assistance in rebalancing their portfolios, or for that matter seek a professional advisor to help them with all of their investment needs. Manifestly, correct asset allocation can increase investment returns and lower risk when “bets” are scaled to the advisor’s skill level. Most good investment professionals have successful “hit rates” of around 60%. That means they make a lot of mistakes and therefore should make smaller allocation bets. History suggests that large bets will eventually cause large losses and the end of an asset allocation program. Nevertheless, most clients and many advisors want to make bigger bets than their provable skills justify.

Clearly, asset allocation plays a key role in the investment process; however, I have some other thoughts I think you should consider. For example, a lot of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (growth, value, foreign, small cap, etc.) and/or sector performance. Since opportunities by style and sectors tend to regress, past performance is often negatively correlated with future relative performance. Still, many investors feel compelled to go with past performance and therefore rotate into previously strong styles, and strong sectors, which then regress leaving them with losses. A good advisor can mitigate this tendency, but a good advisor is harder to pick than a good stock.

To this point, good advisors often internalize decisions while amateurs learn all the rules and procedures. It follows that amateurs can often precisely explain what they are doing and why they are doing it. An expert, however, often just knows when they are right. Since investors typically want to hear a logical and clear-cut investment process, many tend to end up with an eloquent amateur rather than a sometimes-incomprehensible expert. Ladies and gentlemen, never underestimate the effectiveness of an eccentric or unusual advisor since “knack” tends to win out over learned skill in the investment arena. Most important is getting the big picture right and the best long-term predictor of future “big picture” equity returns is the current value of the market – things like, price/earnings, price/dividends, price/sales, price/replacement cost (Tobin’s Q ratio), etc. Currently, all of these measurements indicate the equity markets are reasonably priced.

To this rebalancing portfolios point, I recommended doing so after the “buying stampede” ended in late January. My suggestion was to raise some cash before the envisioned 5-8% correction. At last Wednesday’s intraday low the S&P 500 (SPX/1353.39) was off 5.5% from its April 2 high, and in my verbal strategy comments I recommended starting to put some of that cash back to work in equities. While the “set up” wasn’t perfect, because we never got that pornographic plunge type of hour into the 1320-1340 support zone, at Wednesday’s low of ~1343 the SPX was close enough for government work. Moreover, the NYSE McClellan Oscillator was probing oversold territory (see chart on page 3) and there was a huge downside non-confirmation. Verily, last week the SPX broke below its April 10 reaction low of 1357.38, yet all of the other indices I monitor did not violate their respective recent reaction lows (read: downside non-confirmation). Then there is the continuing divergence between the McClellan Oscillator and the pricing action of the SPX, which often occurs at an intermediate-term bottom. And, then there was this from my friend Jim Kennedy, captain of the astute Atlanta-based hedge fund consulting firm of Divergence Analysis, whose proprietary stock market analyzing software I use and embrace:

After we sent out our email prices continued to slide last Friday. At the close, our S&P 500 and NYSE models closed the day with some divergence bottoming signals. Monday should be the test as to whether prices hold here and rally, or fail (see his charts on page 3).

Plainly, I agree with Jim’s comments for as stated, “While the ‘set up’ wasn’t perfect, it was close enough for government work.” I too think the first part of this week is critical because the SPX has tested overhead resistance at 1366 twice and has not had any success in traveling above that level. This lack of rebound energy suggests the SPX could drop into the often mentioned 1320-1340 support zone, which should mark the bottom for this correction and provide another good entry point for long stock positions. Last week, however, the only major index that was positive was the D-J Utility Index ($UTIL/472.01). Meanwhile, of the 10 macro sectors only Healthcare, Utilities, and Telecommunication were up on the week. The strength in Telecommunication was likely driven by the upside chart breakouts in AT&T (T/$33.59/Market Perform), Verizon (VZ/$41.16/Market Perform), and Centurylink (CTL/$39.52/Strong Buy). Speaking to industry groups, of the 63 groups I monitor the ones currently on “buy signals” for the short/intermediate term are: REITs, Insurance P/C, Banks, Restaurants, Building Materials, Specialty Chemicals, Food, Healthcare Supply/Equipment, and Pharmaceuticals. Some names from Raymond James’ research universe that screened positively on both their fundamental and technical metrics according to my work, and are favorably rated by our fundamental analysts, include: Allstate (ALL/$34.83/Strong Buy), Simon Property (SPG/$156.08/Outperform), Abbott Labs (ABT/$62.04/Outperform), Cerner (CERN/$79.92/Outperform), Intuitive Surgical (ISRG/$558.95/Outperform), Huntington Bancshares (HBAN/$6.54/Strong Buy), and Kimco Realty (KIM/$19.61/Outperform).

The call for this week: The stock market has been consolidating its huge gains from the October 4 undercut low for roughly three months in a ~75 point range (1350-1420). That consolidation has allowed the market’s internal energy to be rebuilt and the oversold condition to be worked off. Because of that process, I continue to think the odds that we will see a move below the 1320-1340 zone remain pretty dim. Accordingly, I suspect the stock market is going to put in an intermediate bottom probably this week.

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“Truth or Consequences?” (Saut)

Monday, April 30th, 2012

by Jeffrey Saut, Chief Investment Strategist, Raymond James

April 30, 2012

“I have opted for more conservative ideas and not aggressive ones.”

After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.

The aforementioned quote, from the brilliant Peter Bernstein (author, historian, economist, and investor), hangs on the wall of my office, for in this business one is often wrong. But, as Bernstein notes, “Being wrong comes with the franchise of an activity whose outcome depends on an unknown future.” My redeeming feature is that when I am wrong, I tend to be wrong quickly. Or as stated by William O’Neil, “The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and [that] costs them dearly.”

Indeed, we are always trying to manage the “risks&rdquo inherent with investing (or trading), for as Benjamin Graham wrote, “The essence of investment management is the management of risks, not the management of returns.” And that, ladies and gentlemen, is why we often “wait” on an investment until its share price is at a point where if we are wrong, we will be wrong quickly, and hopefully the incidence of “loss” will be small and manageable. To be sure, we always consider the consequences of being wrong. This is when risk management lives up to its real meaning. Again as Peter Bernstein wrote in a New York Times article:

The key word is ‘consequences.’ I learned this lesson many years ago from studying Blaise Pascal, a French mathematical genius in the 17th century who spelled out the laws of probability more clearly than anyone before him. This was a thunderclap of an insight that, for the first time, gave humanity a systematic way of thinking about the future. Pascal was both a gambler and a religious zealot. One day he asked himself how he would handle a bet on whether ‘God is or God is not.’ Reason could not answer. But, he said, we can choose between acting as though God is or acting as though God is not. Suppose we bet that God is, and we lead a life of virtue and abstinence, and then the day of reckoning comes and we discover that there is no God. Well, life was still tolerable even if less fun than we might have liked. Here, the consequences of being wrong would be acceptable to most people. Suppose, however, we bet that God is not, and lead a life of lust and sin, and then it turns out that God is. Now being wrong has put us into big trouble.

RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal – encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall.

To this “truth or consequences” point, after being wildly bullish at the October 4, 2011 “undercut low” I turned cautious on the equity markets in late January when the “buying stampede” ended. Since then I have been waiting for a price decline that would produce another good risk-adjusted “buy point” like the ones identified on August 8th and 9th of last year, as well as the aforementioned “undercut low.” That does not mean I have not been featuring certain investments when the risk/reward metrics were deemed as being tipped decidedly in our favor. Rather, I have opted for more conservative ideas and not aggressive ones. Case in point, in last week’s verbal strategy comments 3.5%-yielding Rayonier (RYN/$45.51/Strong Buy) was again featured with these comments from our fundamental analyst:

We are upgrading REIT Priority List member Rayonier to Strong Buy (from Outperform) as we believe RYN shares currently offer one of the most compelling risk/reward profiles in our REIT coverage universe. In our view, the underperformance of RYN shares year-to date (RYN shares are down 1%, while the RMZ and S&P 500 are both up 10%) present an attractive entry-point for investors ahead of the company’s highly accretive cellulose specialties expansion project, which is on track to come online in mid-2013.

Another name featured was 7%-yielding LINN Energy (LINE/$39.86/Strong Buy). As stated by our fundamental analyst:

The partnership delivered another strong quarter beating our EBITDA and distribution coverage forecast, proving that not only does it know how to buy assets but it does a good job of operating them too. Speaking of operations, lightning has now struck twice in the Granite Wash with the partnership’s horizontal Hogshooter play having the potential to be one of the highest rate of return oil plays in the country. Based on our continued bullish outlook for the acquisition market, our forecasted distribution growth (5%+), and its solid hedge book, we reiterate our Strong Buy rating.

Last week this conservative strategy looked somewhat foolish (again) with the D-J Industrials (INDU/13228.31) up 1.53% and the S&P SmallCap 600 Index (SML/462.02) better by 2.58%. The real weekly winner, however, was Natural Gas’ 9.67% sprint. The best performing macro sectors were: Financials (+2.21%); Technology (+2.56%); Energy (+2.67%); and Consumer Discretionary (+2.76%). The Consumer Discretionary performance is interesting because last week’s economic reports continue to soften as of the 15 reports released only six were above estimates. Also disappointing were earnings reports with 65.6% of reporting companies beating earnings estimates and 65.1% bettering revenue estimates. This was a pretty big drop from the previous week’s ratio. Even more troubling is that forward earnings guidance turned negative, which was a decided negative swing week over week. The two sectors that have telegraphed the best forward earnings guidance are Healthcare and Industrials. Meanwhile, many of the indices I follow are breaking down from what a technical analyst would term a rising wedge chart pattern (read: negatively), the D-J Transportation Average (TRAN/5267.39) continues to struggle with its double-top often referenced in these comments (that would be negated by a move above ~5390), the NYSE McClellan Oscillator is back in overbought territory (see the chart on page 3), the Buying Power/ Selling Pressure Indicator suggests the rally from the April 10th low has been more about reduced selling pressure rather than increased demand, the Operating Company Only Advance/Decline has never confirmed the upside, and my weekly internal energy indicator still does not have enough energy to support a new leg to the upside. Regrettably, all of this continues to leave me in cautious mode.

The call for this week: In this business when you’re wrong you say you’re wrong; at least that’s what the pros do. Clearly, I have been somewhat wrong by being conservative, but not wrong by much because the INDU is actually 70 points lower than where it was at the April 2, 2012 intraday high. Given the aforementioned litany of cautionary indicators, my sense remains the S&P 500 (SPX/1403.36) will spend some more time below 1425 while the short-term overbought condition is alleviated and the stock market’s internal energy is rebuilt. Friday’s market action only reinforced that belief with the indices gapping higher and then closing well below those highs on lower volume.

Click here to enlarge

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“Dow Direction Dictates” (Saut)

Tuesday, April 24th, 2012

“Dow Direction Dictates”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

April 23, 2012

“The absolute price of a stock is unimportant. It is the direction of price movement which counts.”

During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.

In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price—by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.

Stock Profits Without Forecasting – by Edgar S. Genstein

These are two of the most important paragraphs I have encountered in 45 years of studying markets. DO NOT read them just once. Go off to a quiet spot that invites contemplation and READ THEM SEVERAL TIMES. Then reflect on all of the mistakes you have made in trading and investing. Bells will ring, and curses will be uttered, if you are truly honest with yourself. My advice is to keep this quote handy, read it over, and study it every time you get ready to make an important buy or sell decision; especially if your emotions reign.

Obviously, I agree with Mr. Genstein’s advice, but over the years have added a “twist” to his sage strategy. That twist has been to be a scale-up seller in select stocks that have appreciated when I think I should raise some cash. This does not mean I sell the entire position if I continue to find the fundamentals to be favorable. But, scale selling partial positions accomplishes a number of things. Firstly, it allows capital gains to accrue to the portfolio (sometimes long-term capital gains and sometimes not). Secondly, it rebalances said stock position back towards the original portfolio weighting intended. Thirdly, it tends to give me the “margin of safety” mentioned in Benjamin Graham’s book “The Intelligent Investor.” To wit, this strategy allows me to hold some of my original investment positions until I “wish I would have sold them sooner.”

I revisit this topic this morning after spending last week in Colorado speaking at several events and seeing institutional accounts. Unsurprisingly, most of the institutions have had a difficult time over the past few months. As one portfolio manager put it, “While we make money in one position we give more than that back in another.” Indeed, since the “buying stampede” ended on January 26th it has been a market in which it has been pretty easy to lose money. For example, at the intraday high of January 26th the D-J Industrial Average (INDU/13029.26) traded at ~12842. Last Friday the senior index closed at ~13029 for a 12-week gain of 0.015%. Meanwhile, many individual stocks have fared far worse. As for retail investors, my presentations to them last week found most frozen like a deer in the headlights of a car buffeted by the recent decline and the negative “spin” from the media; so let me address the recent action.

Recall that we advised raising some cash following the cessation of the “buying stampede” in anticipation of a 5% – 8% pullback in the major averages. That said, our mantra was, “You can be cautious, but do not get bearish.” Some took that “raise cash” advice, but most did not, imbibed by the Dow’s 14.3% rally from mid-December, and its 23.4% rally since the October 4, 2011 “undercut low” that we actually recommended buying. Now, however, the Dow’s 4.4% decline from its April 2nd peak into its April 10th reaction low has brought back memories of last year’s May to August angst, which lopped 17.6% off the Industrials. While the recent news backdrop is less appealing than that of October – February, it is still not a reason to believe we are going to see another May through June swoon of over 17%. Let’s examine why.

In the last tactical bull market of October 2002 through October 2007 (60 months) there were nine such 4% or greater pullbacks, yet stocks traded higher after each correction. In the current tactical bull market of March 2009 to present (37 months) there have already been eleven 4% or greater pullbacks and each time stocks have also subsequently traded higher. Clearly the frequency of corrections/pullbacks has increased in the current cycle likely driven by memories of the Dow’s 54.4% massacre between October 2007 into the March 2009 bottom that at the time we deemed would be similar to the “nominal” price-low of December 1974 (that was the “nominal” price low of that wide-swinging, trading-range 1965 – 1982 affair). More recently, we have likened last year’s October 4th “undercut low” to the valuation-low that occurred in August 1982 since valuations last October were at levels not seen in decades. Whether we have begun a secular bull market like that of August 1982 – January 2000 is debatable, but we doubt last October’s low will be violated.

Nevertheless, since the beginning of February there have been a number of gleanings that left us in cautious mode. The parade looks like this: an upside non-confirmation by the D-J Transports (TRAN/5234.25), the small-caps also failed to confirm the upside with the Russell 2000 (RUT/804.05) subsequently experiencing a 7.5% decline, weakness in the market-leading Financial SPDR Fund (XLF/$15.18), worsening Advance/Decline and New High/New Low figures, a 90% Downside Day on April 10th, waning Buying Power, an exhaustion of the stock market’s weekly internal energy, softening economic reports, and the list goes on. On the positive side: the stock market’s daily internal energy has a full charge of energy, an 8.53% drop in the price of gasoline last week, an earnings reporting season that has so far seen 72% of companies beating estimates and 70% beating revenue estimates (more importantly, after two quarters of reducing guidance companies are now raising future earnings guidance), late Friday the IMF announced it has raised another $430 billion to be used if Euroquake worsens, a U.S. dollar that looks like it is breaking down (read: a positive for stocks), and hereto the list goes on. All of this continues to leave us chanting, “You can be cautious, but do not get bearish!”

This week we will see more major companies reporting earnings. From our research universe, stocks that are favorably rated by our fundamental analysts and appear positive on our proprietary algorithms are: Brinker (EAT/$27.90/Strong Buy); Baidu (BIDU/$144.91/Strong Buy); Pultegroup (PHM/$8.37/Outperform); and Caterpillar (CAT/$107.73/Outperform – covered by Raymond James Ltd.).

The call for this week: For the past few weeks I have wrongly suggested that my sense is the S&P 500 (SPX/1378.53) will remain mired in the 1385 – 1425 consolidation zone. As paraphrased:

I think the SPX needs to convalesce in the 1385 – 1425 zone while the short-term overbought condition is alleviated and the market’s internal energy is rebuilt. Interestingly, while my daily internal energy indicator now has more than a full charge of energy, the weekly energy indicator is nowhere near being fully recharged. The implication is that the downside should be contained, but the SPX is also not likely to breakout above 1425 without spending more time consolidating. … Importantly, all of the pullbacks in the SPX this year have been between 25 and 35 points. Accordingly, measuring from the recent reaction high of ~1419 produces a level of 1394 for a 25-point correction, and 1384 for a 35-pointer. Hence, anything more than a 45-point pullback would put the SPX below the bottom of our 1375 – 1385 support zone and suggest something has changed, potentially bringing into view the 1320 – 1340 zone.

Subsequently, the SPX dropped below that envisioned zone, yet has rallied back into the 1375 – 1385 zone, which has now become an overhead resistance level. And for these reasons we counseled for caution before leaving for Colorado last week. Our advice was not to sell short, not to add to existing long positions, not to raise cash since we have already raised cash, but rather to sit tight because the downside should be contained in the 1320 – 1340 zone. Confidence that downside objective will be achieved grows if the April 10th intraday low of 1357.38 is violated. And this morning that pivot point looks like it is going to be tested with the preopening futures off some 14 points. Indeed, “The absolute price of a stock is unimportant. It is the direction of price movement which counts.”

Copyright © Raymond James

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