Will the Recent Rally Extend?

by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (March 16th):

...I think the answer to that question is “yes” because of the upcoming sequence of events. To be sure, investors should gain much more clarity this week as the TALF (Term Asset-backed Securities Loan Facility) is ramped-up in earnest, which might just lead to a rebound in the velocity of money.

Next are the potential changes in the uptick rule and suspension / softening of mark-to-market regulations on impaired assets. Then there are the G20 meetings that could provide more positive surprises. Finally, U.S. retail sales (ex autos) rose a stronger than expected +0.7% in February, suggesting that the U.S. consumer might be stabilizing. And that sequence, ladies and gentlemen, could be the “carrot in front of the horse” that keeps this rally going.

Whether it turns out to be just a bear market rally, or something more, remains to be seen. But, if the DJIA (7223.98) and the D-J Transportation Average (2419.90) can trade above their January 6, 2009 closing reaction “highs” of 9015.10 and 3717.26, respectively, it would be the first Dow Theory “buy signal” of the new millennium. In the interim, we remain “long” indexes in the trading account and are selectively recommending stocks for the investment account.

As for the economy, while the economic “roots” are clearly mangled, they are not totally severed in my opinion. In fact, in my presentations over the past three weeks I have asked the question, “What if Mr. Bernanke is much closer to healing the economy than anyone thinks?”

The argument goes like this: Last summer the growth in the nation’s monetary base went vertical. Since money is the oil that makes the “economic engine” run, the huge increase in the money supply is just what the doctor ordered; but, there is a time lag between when it is implemented and when it is impactful in the economy. Mr. Bernanke has also given us hugely negative “real” interest rates (inflation-adjusted interest rates). Hereto, however, there is a time lag.

Lastly, money is coming out of zero yielding money markets funds and flowing into bank CDs (reintermediation). This is extremely positive since banks lend with their deposits and not with their equity. Again, there is a time lag before reintermediation becomes impactful in the economy. I then pose the question, “What if all of these time lags come together at once and instead of people talking about the worst economy since the great depression (which is untrue by the way), we morph into an economic recovery that is stronger than most expect?” While I am not per se predicting a strong economic recovery, I do find the argument interesting since almost nobody believes it can happen.

In conclusion, as the astute GaveKal organization asks:

So could the U.S. consumer, buoyed by lower energy prices (putting $400bn back in his pocket), lower taxes ($300bn coming his way) and lower mortgage rates ($200bn coming his way) finally be finding a footing? And, if so, what will rebound first? Global trade? Commodities? Cyclical? Tech sales? Putting all of the above together, it seems to us that the most important development is the introduction of the TALF [this] week. If this new program provides a floor to the velocity of money, then the rally could very well continue into the spring given the cheap valuations and the unprecedented amount of wealth destruction we have witnessed in the past six months.

The call for this week: I have been traveling for the past three weeks, punctuated by last week’s Raymond James Institutional Conference, which was attended by some 700 portfolio managers with more than 300 companies presenting. While I was locked-up in the “war room” approving research from said company presentations for most of the week, I did manage to see some of the presentations. Of particular interest were Republic Services (NYSE:RSG) and Digital Reality (NYSE:DLR), both of which have 4% dividend yields. I also found this speculative idea from our restaurant analyst, Bryan Elliott, intriguing. To wit:

The four ‘scorched earth’ likely survivors for a package (in case I'm wrong on one of them) are: Ruth’s Hospitality Group (NASDAQ:RUTH); Morton’s (NYSE:MRT-OLD); Carrols (NASDAQ:TAST); and O’Charley’s (NASDAQ:CHUX). Each company has high leverage but at very manageable levels if cash flow remains anywhere near the current run rate, strong brands with very long-term histories, recently restructured credit agreements, and large private equity ownership so the ultimate backstop is they can get equity to retire debt as a last resort.

The last option of private equity only becomes necessary in a true soft depression scenario (e.g., if total restaurant demand goes from the current down 3-5% to something like down 15% quickly). Once valuations normalize, these are likely $5-7 stocks, and perhaps $10+, as each has $1.00 EPS power and sustained expansion potential in an economic recovery.

As for the overall stock market, while it is still too early to tell if this is a bear market rally or something more, we do agree with our friends at the must have “thechartstore.com” organization in that, “While our sense is that the rally has more to go on the upside in the weeks to come, we feel it is still too early to say the final bottom has been put in place.”