Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (February 23rd):
Paine Webber’s Edward Kerschner and Thomas Doerflinger wrote an excellent strategy report back in the early 1990s entitled “Alphabet Soup…Recovering from Recession: I, V, W or U?” They advised investors to decide which letter of the alphabet the 1990-91 recession would resemble before picking the stocks they want to own over the next year. They pointed out that the economic history suggests that the pattern could be:
“I” When economic recovery failed to materialize, the recession of 1929-30 turned into the Great Depression of 1929-33. Almost the only good investment during this deflationary collapse was long-term Treasury bonds.
“V” A sharp decline in GDP followed by a robust recovery within 12-18 months. Consumer stocks generally do well in a V-recovery, especially if the recession ratchets down the inflation rate, as occurred in the downturn of 1974-75.
“W” The pattern of the back-to-back recessions of 1980 and 1981-82. Energy stocks and high-tech small cap stocks performed wonderfully in the 1980, but by the spring of 1981 it was time to scale into bonds to wait out the second and much longer dip of the “W.” As the economy finally recovered in 1983, the best stocks to own were autos, retailers, S&Ls, homebuilders and technology.
But more likely, in their opinion, the 1990-91 recession would resemble a “U” because of: “Destimulative fiscal policy, a long-term squeeze on consumer spending, structural weakness in the banking system, and heavy corporate debt loads.” So, the best stocks for this unusual recovery would be global cyclicals and world class growth stocks . . . companies that would “benefit from the economic expansion within the U.S. but are also gaining market share in the slowing, but still relatively prosperous, foreign economies.”
Keeping with the “Alphabet Soup” theme, for the past number of months we have been suggesting the shape of the current recession might resemble the letter “L,” which also seemed to be the pattern embraced by a number of economists. However, one particularly bright portfolio manager made this argument last week. The discussion began with the comment, “What if Ben Bernanke is closer to healing the economy than anyone thinks?”
Consider this: the nation’s monetary base had been on a gradual rise since the 1960s. However, last summer it exploded, as can be seen in the attendant chart on page 3. What if the esteemed Chairman sensed what was coming and ramped the monetary base in order to move out in front of these events? We have long argued that money is the “oil” that makes the economic engine run; and clearly Ben Bernanke has the “pedal to the metal!” Ladies and gentlemen, there is a time lag between the expansion of the monetary base and when that money begins to spread into the economic system. Moreover, there are other metrics at work thanks to Mr. Bernanke.
In past missives we have referred to negative “real” interest rates (interest rates minus the inflation rate) given the headline inflation numbers and the fact that the Federal Reserve has effectively reduced the Fed Funds rate to zero. History shows that negative real interest rates tend to stimulate the economy as people are encouraged to borrow. But, here again there is a time lag.
Additionally, we have opined that with money market funds yielding virtually nothing participants are taking their money out of such funds and moving it back into higher yielding bank CDs. This is not an unimportant point, for banks make loans with their deposits, not with their equity. Hereto, there is a time lag.
Then there are the obscure, yet far reaching, powers our forefathers granted the Federal Reserve upon its creation (1913), which until Chairman Bernanke have rarely been used. This week we will learn more about such powers as the Term Asset-Backed Loan Facility [TALF] is expected to get underway providing a $1 trillion conduit for credit to consumers and small businesses. Again, there has been a time lag between the announced TALF and when it actually begins to impact the economy.
All of this begs the question, “What if, after the aforementioned time lags, these herculean efforts start impacting the economy all at once, dispelling the belief that this is the worst economy since the Great Depression?” If so, the much envisioned “L”-shaped recession could take the pattern of a “V” with a concurrent economic recovery much stronger than most currently believe.
Meanwhile, Friday’s stock market took the shape of an ominous “M” pattern when, after a 130-point Dow Dive in the first 5 minutes, the senior index rallied to off 40 points by the end of the first hour, then fell 216 points, only to rally back to a +3 at 3:00 p.m. Regrettably, it slid again into the closing bell, ending the session down 100.28 points. Whether Friday’s pattern was due to the options/futures expiration will likely be revealed this week, but we are hopeful Friday’s fade will constitute a successful retest of the DJIA’s 2002 and 2003 “lows” clustered around the 7200 – 7400 level, which is also associated with the 50% “retracement rule” we mentioned in Friday’s verbal strategy comments (a 50% retracement of the DJIA’s rally from its August 1982 “low” into its October 2007 “high” equates to roughly 7470 on the DJIA). More importantly, we find it extremely interesting that the S&P 500 (SPX/770.05) never breached its November 2008 “lows” despite the Desultory Dow’s violation of its November 2008 “lows.” Also worth mentioning, our proprietary oversold indicator is within 2 points of being as oversold as it was at the November 2008 “low.”...
...Consequently, about the only macro sector investments that are working on the “long side” year-to-date are the precious metals. Fortunately, we have been bullish on gold since 4Q01 even though we recommended rebalancing (read: selling) 30 – 40% of ALL positions in November / December 2007 because they had grown into too large a “bet” in portfolios. Last Friday gold traded above $1000/ounce for the first time since March 2008. The recent surge has lifted the ratio of gold to the S&P 500 some 60% above its 200-day moving average, or the most overbought relative to the S&P since gold’s parabolic peak in January 1980. That’s why rather than adding to gold positions we recently recommended the purchase of platinum for the reasons stated in our letter dated February 6, 2009. Interestingly, while gold is challenging its old cycle highs, platinum is more than 50% below its 2008 high, as can be seen in the chart on page 3 from the invaluable service “Thechartstore.com.”
The call for this week: While many pundits argue “Dow Theory” has become an irrelevant indicator (see Barron’s Online article “Be Leery of Dow Theory” dated 2/19/09), it did indeed give participants a “sell signal” in November 2007. Regrettably, it reconfirmed that “sell signal” last week. Interestingly, however, despite the Desultory Dow the S&P 500 continues to reside above its November 2008 “lows.” Still, other than precious metals, not much is working on the “long side” year-to-date.”
Verily, of all the indices we track the NASDAQ 100 is performing the best with negative returns of a -3.2% YTD, while the D-J Transports are the worst performing at -23.7%. In fact, in my universe, in addition to the precious metals, only Coffee (+2.65%), Sugar (+7.22%), Copper (+8.55%), Lead (+7.01%), Tin (+4.30%), and the U.S. Dollar Index (+6.50%) are showing positive returns year-to-date.
Consequently, while we would like to be as positive as our portfolio manager friend, we need to see more technical evidence that last week’s breakdown is a false breakdown before committing more capital to stocks. We do, however, still like the strategy of accumulating distressed debt; and one of the vehicles we are using is Lord Abbett Bond Debenture Fund (LBNDX/$5.94).