Defensive in Short Term; Intrigued About Japan

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (July 13th):

I spent some time over the weekend reading more thoroughly some of the material I skimmed several months ago and put aside for later study. One such piece was the Forbes 400. While studying it a couple of things leaped out at me. First, staying rich is nearly as difficult as getting rich. Remember the oil tycoons like the Hunt brothers who dominated the list in the early 1980s? Now such folks don’t even make the list. Plainly, it’s one thing to make a fortune and another to keep it. You know what happened to Bunker Hunt and the oil patch people. You also know what happened to many of the late-1980s trophy real estate crowd. New fortunes replace old. New industries surge as others slide. New people top the list as the old drop out. Indeed, it’s one thing to make a fortune and another to keep it!

Now, while investors likely didn’t make a fortune off of the March 2009 stock market “lows,” there was a handsome amount of money made from those “lows.” Accordingly, since the “momentum peak” of May 8th, we have suggested that the trick going forward was going to be keeping those profits. And that, ladies and gentlemen, has pretty much been the story over the past two months as most of the major averages we follow are below where they were back in early May. More recently, that “keeping” theme has become increasingly important as many of our indicators have been counseling for caution.

Combined with those deteriorating indicators has been a decline by the various stock market averages below some pretty key support levels. Over the past few weeks the D-J Industrial Average (DJIA/8146.52) has sequentially fallen below its 10/30/50/200-DMAs, and in the process broken below a number of key Fibonacci levels. The result is a near-term head-and-shoulders “top” formation in the charts with the senior index now residing below the “neckline,” as pointed out by our technical analyst Art Huprich in last Tuesday’s report (see attendant chart). Ditto, most of the other indices we follow are negatively configured. In such a bifurcated market we continue to opt for caution.

The second thing that leaped out at me while studying the Forbes list was the increasing number of people making the list from the emerging market countries. Places like Brazil, China, Russia, Malaysia, Argentina, etc. Hereto, this is in keeping with our theme of investing in the emerging and frontier markets.

To be sure, while the U.S. recession is abating, the country most likely to “pull” the world out of recession is China. China’s manufacturing surveys suggest its recovery is sustainable, China’s output is at the year’s high as overseas orders are at an 11-month high, the Chinese government’s subsidies have helped its auto makers (record sales in June), the export tax cut is becoming impactful, new loans are surging, and the list goes on. That said, one of the best indicators on the short-term direction of the Chinese stock market has been the 25-day moving average [DMA] juxtaposed to the 50-DMA. Back in March the 25-DMA crossed above the 50-DMA, which was a “buy signal,” and the rally from there to the June “top” encompassed 65%. While currently the 25-DMA has not crossed below the 50-DMA, the Halter USX China Index (HSX/4452.13) has knifed below both of those moving averages and consequently is negatively configured in the short-term and we are cautious.

We have, however, become increasingly intrigued about investing in Japan since our visit with the astute GaveKal organization. Reinforcing that view was Credit Suisse’s recent upgrade on Japan. To wit:

“(1) Japan is a late-cycle play. It typically starts to outperform four months after the trough in lead indicators. We believe this is because Japan is a high-cost producer and has the economy that is closest to deflation globally.

(2) Japan industrial production (IP) has had a beta of 3 with global IP. Both the economic surprise index and purchasing managers' indexes (PMIs) are recovering more strongly in Japan than elsewhere. Japan's heavy-manufacturing bias (manufacturing as a share of GDP is 21%, versus 13% for the U.S.) means that Japan should be particularly sensitive to the global inventory rebuild that has considerably further to run. As a result, relative earnings momentum is improving.

(3) A lagging non-Japan Asian play. More than half of Japan's exports go to non-Japan Asia -- and nearly 20% to China. Japanese equities are now 16% below their (down) trend line relative to non-Japan Asia.

(4) Japan is the world's largest creditor (net-foreign assets are 54% of GDP and household net wealth to income is the highest globally at 4 times). In our view, investors should be refocusing on creditors (not debtors), now that credit spreads have fallen to neutral levels (i.e., implying a reasonable default rate).

(5) Since 1990, when Japan has outperformed, it has done so by an average of 37% over seven months. This is because many investors are structurally short of Japan [as confirmed by Europe, Australasia, and Far East (EAFE) data].

(6) Valuations are, as usual, mixed. Japan looks 5% cheap on Credit Suisse HOLT (methodology) [but then again, we assume cash-flow returns on investment (CFROIs) will partially normalise]. Cash on balance sheet is 25% of market cap (compared with 17% in Europe excluding the U.K. and 11% in the U.S.). Price-to-book and price-to-sales are at a 32% and 43% discount to global markets, respectively, but none of this is particularly new.

This is a tactical call (i.e., three to six months) not a strategic call (one to two years). We remain concerned about: (a) bad demographics; (b) very limited restructuring of domestic services; (c) huge government debt (199% of GDP); and (d) the general inability of the corporate sector to improve return-on-sales or return-on-equity levels.”

We would note, however, that many strategic “calls” begin as tactical ones.

The call for this week: Even though we remain defensive in the short-term, we continue to think it is a mistake to become too bearish. Still, the DJIA has been in a downtrend since its June 11th intraday high of 8877, we are not oversold, new lows have been expanding, we’ve had three 90% Downside Days, we have broken below the neckline of a head-and-shoulders “top” rendering downside targets 7791[DJIA], and senior index resides below most of the moving averages we watch. Using our “day count” sequence suggests the situation should be resolved this week.

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Comments

[whidbey]

One would never know you sell stock. China pull the world out of recession? Were these comments written late at night? Your advice is to be taken very lightly and disregarded at every turn. But you may be right about this week. Bradley and Phi Mate turn dates are due and they may be up, for a while.

2009 Jul 14 05:40 AM

[LR European]

Not sure why the sarcastic comment on Saut's statement about China pulling the world out of recession.

I am sure you too must have noticed that China has been emerging as a significant sized economy. Sure, it is premature to talk about it being the largest economy in the world (though it will be soon enough), but it is certainly already large enough and integrated enough in the global system (trade, money flows) to be able to pull (or push for matter) the global economy.

Jeffrey Saut's article is a good read and well argued on uncontroversial facts. Thank you.

On Jul 14 05:40 AM whidbey wrote:

> One would never know you sell stock. China pull the world out of
> recession? Were these comments written late at night? Your advice
> is to be taken very lightly and disregarded at every turn. But you
> may be right about this week. Bradley and Phi Mate turn dates are
> due and they may be up, for a while.

2009 Jul 14 02:55 PM