Jeffrey Saut: Cautious Yes, Bearish No

Includes: BGR, DIA, PGM, QQQ, SPY
by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (June 8th):

The typical Fear, Hope, Greed cycle can be seen in the attendant chart. Beginning at the lower left, where the word “fear” resides, think of the summer of 1982 when everybody was afraid to buy stocks and the stock market began to rally. Accordingly, through much of 1983 – 1985 (halfway up the bell-shaped curve), investors were “hoping” stocks would retreat to those 1982 levels so they could comfortably buy, but the markets are never that accommodating. Then in 1986 “greed” overcame “fear” and investors “bit the bullet” and bought stocks. Beginning in the spring of 1987 most of the stock market’s internals began to weaken, many stocks were declining, and numerous indexes also started to “top out.” The major market averages “topped” in the summer of 1987, leaving investors “hoping” stocks rallied back to their “greed” levels so they could break even and get out. Again, the markets are not that accommodating, and stocks fall into the Crash of 1987 where participants are “fearful” and sell their stocks.

Surely, it was “fear” that took the S&P 500 (SPX/940.09) down to its panic low of 666 on March 6, 2009. At the time we were bullish, believing the bottoming process, which began in October 2008, was complete. While I didn’t call it a “generational low” like the savvy Doug Kass (I think the generational lows for most stocks came in 1974, or in 1982), I did repeatedly note that our proprietary oversold indicator was more “oversold” than it was at either the 1974 or the 1982 lows. Since then we have been pretty bullish, thinking the “lows” had been made and the worst of the economic news was at hand. That view was driven by the fact that Ben Bernanke has given us a huge increase in the “oil” that makes the economic engine run, namely money; decidedly negative real interest rates, which have ALWAYS been the mother’s milk of economic recoveries; and reintermediation at the banks.

This “reintermediation” is not an unimportant point. To wit, banks lend with their deposits, not with their equity. Therefore, as money flows out of negatively yielding (inflation-adjusted) money market funds into our depository institutions (CDs, passbook accounts, etc.) there should be an increased desire by the banks to lend money. As previously stated, all three of these trends have a time lag. Consequently, we have been posing the question over the past six months, “What if all of those time lags come together at once and participants go from talking about the worst economy since the great depression to an economy that is improving better than most expect?” Not your father’s typical “V-shaped” recovery, mind you (down hard followed by an equally sharp up recovery), but more like a “U” rather than the dreaded “L-shaped” lingering recession.

Moreover, as stated in last Monday’s letter, “the bulk of the economic stimulus monies (TALF, PPIP, etc.) are going to ‘hit’ between June and September. That could make the economic numbers look much better than most expect and cause businesses to restock inventories, buy equipment and actually hire some folks. The result could also compress credit spreads, which will allow corporations / individuals to ‘roll’ their debt. Not just long-term debt, but lines of short-term credit, working capital debt, etc.”

And that, ladies and gentlemen, could be what the rally has been all about. Whether this turns out to be a rally in an ongoing bear market, or a new bull market, remains to be seen (we are leaving that “call” to Dow Theory); but, if stocks don’t correct soon, I think you will see another leg to the upside that will be larger than most expect despite my wrong-footed cautious stance for the past month.

Therefore, we continue to think it is a mistake to get too bearish right here. Cautious yes, but bearish no! I talked to a lot of PMs in Europe over the last few weeks and they are WAY under-benchmarked to stocks (especially to U.S. stocks); and, they are close to being forced by their bosses to rebalance to at least a 60% stocks / 40% bonds weighting. If so, we could see an upside “sprint” into quarter’s end.

Nevertheless, we are maintaining our cautionary stance. While we think the recent rise in interest rates, and the dollar’s dive, are head fakes, there are some worrisome signs. Corporate equity issuance is one of them. Indeed, corporate equity issuance has surged to an all-time high and insider buying is abnormally low. Meanwhile, risk appetites have risen dramatically and market breadth is deteriorating.

Further, there are some inconsistencies with past initial “legs” of a new bull market. Firstly, the volume characteristics are lacking. Secondly, the number of stocks rising above their respective 200-day moving averages is short of historical precedence. And thirdly, Lowry’s Buying Power / Selling Pressure Indexes are short of all new bull market readings.

Meanwhile, precious metals remain on a “buy signal,” which is certainly positive for our investment positions, as well as our recently acquired holdings in platinum using the ETN iPath DJ-AIG Platinum (NYSEARCA:PGM). Sticking with exchange-traded funds, we recommended ING Risk Managed Natural Resource Fund (NYSE:IRR) when it was selling at a substantial discount to its net asset value [NAV]. It is now selling at a 2% premium to its NAV and we have lost our edge. Consequently, the idea of banking some of the gains in IRR and moving them to 7%-yielding Blackrock Energy and Resource Trust (NYSE:BGR), which sells at a 3% discount to NAV, makes some sense.

The call for this week: On May 18, 2009 I wrote, “So far any downside correction, since the early March lows, has been contained to between 5% and 6.4%. That suggests any correction of more than 6.4% could imply more of a correction than any we have seen since the demonic S&P 500 low of 666. Measuring from the May 8th closing high of 929.23, a greater than 6.4% price decline yields a ‘failsafe point’ of slightly below 870 on the SPX. If that level is violated, it would suggest a decline to at least 830 (the 50-DMA is near 832) and maybe more.”

As of yet neither the 6.4% correction level from the “highs” nor the 870 failsafe level has been violated. Today could provide another downside “test” since the mutual funds are now 90 days from the March “lows” and are able to get some kind of tax break on the sale of long positions bought more than three months ago. If, however, the selling doesn’t gain much traction we could see another rally into quarter’s end. Clearly, Friday’s upside breakout suggests that possibility. Yet, we still can’t decide if Friday was a breakout or a fake out that just widens the now four-week sideways consolidation. The next few sessions should resolve the divergences.