Market Outlook - Caution Advised

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (August 17th):

The following graph highlights our proprietary short-term technical indicator displayed with a chart of the Dow Industrials. You can see that it has done a very good job of identifying the March and July lows and turned bearish in June as the market was attempting a breakout through 950. It is now at a severe negative reading and this is why I am in a maximum defensive position. With the frenzied pace of buying that we've seen in the markets we could see an air pocket develop over the next several weeks. Caution and patience are recommended at this time.

Rob Robbins, Robbins Capital

So wrote Rob Robbins, eponymous captain of Robbins Capital, in last Friday’s missive. By studying the attendant chart one can see the justification for his concern. Clearly, the five-month stock surge has left Rob’s indicator, as well as most of the other indicators we admire, in their most overbought condition in years. Consequently, caution is advised. Indeed, in today’s letter we include yet another chart that counsels for caution. Said chart plots the S&P 500 (SPX/1004.09), the Baltic Dry Freight Index (BDIY/2752), and the Shanghai SE Composite Index (SHI/3046.97). In past reports we have referenced the Baltic Index’s ability to telegraph the future direction of the S&P 500. Recall, the BDIY fell below a key support level roughly one year ago, right before the stock market turned nasty. Last week, the Baltic breached another key support level at 3000. Also included in the chart is the Shanghai Index, which like the BDIY seems to have the ability to foretell the direction of the SPX. As the excellent King Report notes, the BDIY leads the U.S. stock market up and down by about one month, while the SHI leads by one or two weeks. Both of these indices turned down a few weeks ago.

Then there is our “day count” sequence. Friday was session 25 in the typical 17- to 25-session “buying stampede,” which is only interrupted by one- to three-session pauses/corrections before resuming the upside skein. Accordingly, the “melt up” is pretty long of tooth. Further, the leading index from the March “lows” has been the NASDAQ Composite (COMP/1985.52). On Friday the COMP decisively broke below its 10-day moving average. Since our “buy ‘em” trading “call” of July 14th we have been using the 10-DMA as a fail safe point, often commenting that when the 10-DMA was broken trading positions should be reduced and/or hedged. Yet while the COMP and SPX have violated their respective 10-DMAs, the Dow Jones Industrial Average (DJIA/9321.40) has not. For the record, the Dow’s 10-DMA currently resides at 9317.46.

Let us not equivocate, this is NOT a bearish “call,” it is just another call for near-term caution like the one we made at last May’s momentum peak. Following those cautionary comments the major indexes flopped/chopped around for two months, but never gave back more than 7%, before they reenergized and re-rallied. Hereto, we think there is the potential (repeat, potential) for another “window” of flop and chop before the equity markets re-rally with the carrot in front of the horse being easy third and fourth quarter earnings comparisons. As GaveKal suggests:

What investors will likely want to see going forward is stabilization in employment and a pickup in global trade. Confirmations of such could still be a few months off, leading to some nervousness in equities? ... Similarly, there is little doubt that investors will want to see more than efficient cost-cutting. Companies able to deliver a genuine pick-up in sales, and not just in profitability, will be richly rewarded. But will there be many such companies in the next three months?

Adding to the potential for a flop/chop “window” are rising inflation concerns. While we think such worries are misplaced, at least until the back half of 2010, the past few weeks have seen most commodities rally sharply. Combine that with surging fiscal deficits, and loose monetary policies around the world, and is it any wonder inflation fears are increasing? Hence, we are once again timid on a short-term basis and hope that we are wrong.

If you disagree with our current strategy, we reiterate what we said in last Monday’s report. To wit:

If, however, you don’t embrace our near-term caution, we suggest doing what the underinvested money managers are being forced to do – buy lower volatility stocks with dividends. From Raymond James’ universe of stocks we offer Home Depot (HD) (/$27.14/Strong Buy), Chevron (CVX) (/$68.63/Strong Buy), CenturyTel (CTL) (/$31.53/Outperform), and Otelco (OTT) (/$12.40/Outperform). Other favorably rated names from our research affiliates include Pfizer (PFE) (/$15.77) and Altria (MO) (/$17.56).

We also continue to like GaveKal’s “bull call” on Japan because bull markets begin from cheap valuation. To be sure, Japan’s current P/E multiple is high, but think of it like a cyclical stock that you want to buy when the P/E multiple is high. Yet on most other metrics Japan is one to two standard deviations undervalued. Indeed, according to Barron’s,

More than 400 stocks, or about 7% of listed companies, continue to trade below net current asset value (NCAV) in Japan. Trading below NCAV assigns zero value to the franchises of these businesses.

Secondly, it takes excess liquidity to drive stock prices higher. In Japan’s case foreign investors, and commercial/central banks, are/should provide that liquidity. Thirdly, it appears with more detente between China and Taiwan there is also more integration between China and Japan. Interestingly, Japan does more business with China than it does with the U.S. Thus, if China’s transformation toward “capital productivity” is successful, it could be hugely positive for Japan. Just think of the bull markets fostered by NAFTA (North American Free Trade Agreement) and the European Union (The Treaty of Maastricht). Finally, there are increasing signs the Democratic Party of Japan (DJP) is gaining traction over the long dominant Liberal Democratic Party (LDP), which could/should have positive ramifications for Japanese equities. Clearly, these views are “out of the box,” but that is where net worth changing ideas begin. And this morning the headline reads, “Japan Emerges From Recession.” To capitalize on the Japan theme, we are using The Japan Smaller Capitalization Fund (JOF) (/$7.78) and The Japan Equity Fund (JEQ) (/$5.46). Both of these closed-end funds continue to trade at more than a 10% discount to their net asset value (NAV). As always, terms and details should be checked before purchase.

The call for this week: As we said in last Tuesday’s verbal strategy comments before leaving for a road trip, “If past is prelude something BIG will happen in the equity markets during our sojourn.” Accordingly, the next day the equity markets rallied sharply, only to give back much of that on Friday’s shockingly bad consumer sentiment figures. And this morning Friday’s Fade continues as world markets worry about the durability of the economic recovery. As one particularly bright money manager notes:

In studying the charts I noticed the MACD on the daily chart of the Dow has crossed to the downside for the first time since the rally off the July low. This is another sign the rally is running out of steam. The support, short-term, is the 9200 area and if broken then a more substantial decline could get underway. One of my indicators on the daily chart, however, hints that this decline will be shallow and we will see a final surge over the next few weeks to the 9700 – 10,100 area. The ability of the market to continue to rally with volume continuing to decline does not mean it cannot go higher short term, but tells me that the calls for a new Bull Market are certainly suspect. If I am correct, the current pullback will only last until options expiration starts this week then the final rally will begin. Watch the 9200 area for clues for the market direction over the next few weeks.

Click here to enlarge

Click here to enlarge

Comments

[Old Trader:]

"Interestingly, Japan does more business with China than it does with the U.S. Thus, if China’s transformation toward “capital productivity” is successful, it could be hugely positive for Japan."

Interesting. I'd wondered about the relative strength of the recent numbers from Japan, since its considered the "weakest sister" of the developed economies. If the quote is correct, it seems to support a conclusion I've recently developed; that increasingly, the world will see the development of regional trading blocs, a development that will lead to an increasing marginalization of the US and the EU as drivers for global trade.

Aug 18 10:31 AM

[ain't no fo...:]

There has been very little reason to put up with the immature cetin annoyances, but in and of itself it wasn't the end of the world, and so I have complained to management and then kept on posting.

Recently, however, I've been getting virus and spyware warning messages and actual screens popping up trying to hijack my PC and force it into doing virus scans. They appear randomly when I access different articles on this site. They've been happening off and on for a week or two, no rhyme or reason to when they occur. They do not occur on any other programs of the hundreds I access weekly.

I have no idea whether others are receiving similar stuff but I have no interest in subjecting my system and my records to crap like that.

Hence, I will not be contributing comments to this site anymore - its just not worth it.

I've enjoyed reading and participating in what have usually been serious subjects and discussions that have taken place here, and I've developed respect for a number of authors and commenters, like swashbuckler, john gordon and trader mark, etal.

I wish you all good fortune on your investing and personal lives... and as the sarge used to say in Hill Street Blues, "Be careful out there!" because we are far from home and there are many miles to go before we sleep.

Aug 18 11:44 AM

[Old Trader:]

ain't no,

Fwiw, I've noticed the same thing...that is, various warnings and the pop up screen trying to force me to do virus scans.

Aug 18 02:30 PM

[Asbytec:]

It amazes me when a very marginal uptick in EU growth sparks a rally, especially when the US has had green shoots for months. The euro and pound rallied on the news.

I am convinced this recession is not over, even after the Fed comments. Anyone find the Chinese bear market a surprise? Oh well, at least the dollar benefits on bad news. <sigh> Hard to keep a ponzi scheme working on a strong dollar.

Aug 19 04:47 AM