Current Rally Phase May Have Legs, But Protecting Profits Is More Crucial

by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (April 27th):

...[W]hile we are cautious in the short term, we think the current rally phase has “legs” and will likely, after some kind of near-term peak and subsequent correction, reassert itself and travel higher. Whether this turns out to be a new bull market we will leave to Dow Theory, but we have made some pretty decent trading profits over the past eight weeks and therefore continue to recommend harvesting some of those gains. For example, in our March 16, 2009 report we wrote:

“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 (RUTH/$0.99/Outperform); Morton’s (MRT/$2.29/Outperform); Carrols (TAST/$2.99/ Outperform); and O’Charley’s (CHUX/$2.62/Outperform). 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.” (Prices and ratings as of 3/16/09)

Since that date (3/16/09), Bryan’s “scorched earth” package has gained over 100%, and we recommend selling one-third to one-half of those positions to rebalance the portfolio. Likewise, we recommend harvesting some profits in the trading account, or at least raising stop-loss points. To be sure, the trick from here is to protect the profits that have been accrued while hoping the rally will extend for “9½ weeks.”

As for new ideas, at this juncture we are not really in a buying mood. If you are, we suggest a scale-buying approach in anticipation of a subsequent correction. We also agree with Jason Trennert in this week’s Barron’s where he states,

The enormity of the fiscal and monetary stimuli makes the reflation trade the most likely [scenario]. . . . But I expect it to be somewhat different than the inflation rate you saw in the 1970s. So it is very possible that out of this policy, which is essentially focused on creating jobs and creating nominal GDP growth – as opposed to real GDP growth – that you get commodity-price inflation. That would be energy and basic-materials sectors – and gold. So these types of companies should do well over the longer term.

Also in Barron’s “The Striking Price” column, John Marshall notes,

In periods of increased market volatility, it is important to watch trends in related asset markets, not just the stock market. For equity investors, the option and credit markets are extremely rich sources of information. . . . Energy bonds have rallied sharply, especially in the past month. This rally can be seen in the credit-default swaps market. Energy five-year CDS spreads have tightened by 38% in the past three months, dwarfing the 3% tightening for the weighted average of the S&P 500 companies.

Obviously, we agree with the Barron’s folks and if we had to buy something right here we would scale buy into the energy sector, preferably energy situations with a yield. In past comments we have mentioned the 11% yielding ING Risk Managed Natural Resource Fund (NYSE:IRR). Other energy centric names from Raymond James’ research universe would include 9% yielding Enterprise Products (NYSE:EPD) and 11% yielding Inergy (NRGY).

Speaking to gold, we have thought gold was in a secular bull market since embracing our “stuff stock” theme in 1Q01, even though we rebalanced all stuff-stock positions (read: sold partial positions) in November of 2007. We still think portfolios should have some precious metals holdings and would note that gold tested, and held, its 200-day moving average recently and looks poised for a breakout on the upside.

We have also liked the idea of scale-buying into the emerging markets since we believe they will become one of the leading groups if this turns out to be a new bull market. In past missives we have mentioned a few MFS mutual funds that accomplish this, as well as 4% yielding iShares MSCI Brazil (NYSEARCA:EWZ).

The call for this week: Last week the D-J Transportation Average (TRAN/3137.76) rallied to a new reaction high. Unfortunately, the D-J Industrial Average (INDU/8076.26) did not. Whether this upside non-confirmation is meaningful remains to be seen, but at session 35 in the upside skein we are pretty cautious. Moreover, as the astute Dines Letter observes, “April has been a month with a pivotal reversal of the March trend 67% of the time since 1963; and, at least a semi-important Top has been reached in virtually every April or May since then.”

Consequently, while we don’t think the old stock market “saw” of “sell in May and go away” is going to play in 2009, we do believe the trick from here is harvesting trading profits and hedging some of your investment positions using various option strategies. As for that piece of bad news that comes out of nowhere, which breaks the back of the buying stampede, that we have been warning about. Well, we may have just gotten it – swine flu.