Market Takes a Licking and Keeps on Ticking

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (Aug. 24th):

“It takes a licking and keeps on ticking” is a phrase lionized by pitchman John Cameron Swayze in the Timex watch commercials of an era gone by. Similarly, the same can be said about the current state of the stock market, as despite the Asian Angst, the overbought observations, the vitriolic violation of the 10-DMAs, and all the other negatives mentioned by the “bears,” we keep chanting “Cautious yes, bearish no.” Consider this: at the March 2009 “lows” the equity markets were at least three, and possibly four, standard deviations below norms.

Remember that a three standard deviation event is something that is supposed to occur once every 750 years, while a four standard deviation event happens every 31,750 years. Accordingly, at the March 2009 “lows” we were aggressively bullish; and, even though over the past two weeks we have been wrong-footedly cautious, we have never given up on our 1050 target for the S&P 500 (SPX/1026.13). Indeed, the nearly six-month rally has left the major market averages only neutrally valued based on historic metrics. Therefore, it is not too much of a stretch to think the “averages” could actually achieve a reading of one, or even two, standard deviations above norms to achieve the “greed factor” so often mentioned in these missives.

That would obviously imply targets above our long-standing 1050 target. And last week, the equity markets defied all of the cautionary comments by rallying another 2.2%. Said rally lifted the S&P 500 above the upside top of the “flag formation” that has developed in the charts over the last three weeks, causing one old stock market wag to exclaim, “Is it a breakout, or a fake out?!”

Manifestly, “Cautious yes, bearish NO,” because the equity markets are merely fear, hope, and greed only loosely connected to the business cycle. Now, if the typical sequence continues to play, the negative nabobs, who opined that the world was coming to an end last March, will continue to espouse that this is just a “short covering” rally in a bear market. To which we constantly remind them that in the beginning of every new bull market most participants believed that it was/is just another rally in an ongoing bear market. Such consensus views tend to be wrong (just like they were wrongly bullish at the October 2007 “top”) because consensus view is based on a more-or-less extrapolation of past trends and does not effectively incorporate change into expectations. Verily, most investors, being human, are “social” creatures, preferring herd-like instincts to stand-alone behavior. As legendary investor T. Rowe Price opined,

Most (investors) fail to appreciate that change really does occur at the margin. If one can learn to think clearly about the margin, change becomes less surprising, timing improves, and better investment results are sure to follow.

Subsequently, last March the equity markets bottomed, amid consensus “cries” of an oncoming economic depression, and built into the explosive rally we have experienced over the past six months. Since then the “bears” have steadfastly maintained that this is just a rally in a bear market, despite the recent bull market Dow Theory “buy signal.” Currently, the bears’ banter du jour is that the improving economic environment is merely an unsustainable “inventory rebuild.” Yet if past is prelude, as inventories rebuild, capital expenditures will follow. Further, those capital expenditures tend to lead to improving employment readings that in turn foster consumption growth. Such a sequence expands corporate profitability and drives more capex. And that, ladies and gentlemen, is the typical economic cycle. However, while we remain bullish in the intermediate term, we continue to question how strong the economic recovery will be.

For months we have stated that the economic recovery would likely be stronger than most expect, but less than your father’s typical recession/recovery sequence. That belief is based on the fact that autos and housing have typically been the engines that have “pulled” the economy out of past recessions. Since housing/autos are debt-driven sectors, it is difficult to envision them leading this “charge” given the consumer’s current deleveraging mindset. Moreover, as Andy Xie notes in his report titled, “New Bubble Threatens a V-Shaped Rebound:”

This discussion may seem to digress from the analysis of sustainability in the current economic recovery. But it brings out two points: The old equilibrium cannot be restored, and many structural barriers stand in the way of a new equilibrium. The current recovery is based on a temporary and unstable equilibrium in which the United States slows the rise of its national savings rate by increasing the fiscal deficit, and China lowers its savings surplus by boosting government spending and inflating an assets bubble. This temporary equilibrium depends on government action. It does not have a market foundation that would support sustained and rapid growth. Nevertheless, improving economic data will excite financial markets.

Clearly, Andy’s gleanings about “exciting financial markets” have been correct in the intermediate term. Whether he turns out to be correct over the long-term only time will tell, but his points are certainly worth pondering.

As for the here and now, we were surprised by last week’s late stock surge. Early in the week, however, both the DJIA (9505.06) and the SPX broke down out of the sideways “flag formations” they had been forming in the charts for the past three weeks. Obviously, that was a false breakdown as the indices gathered themselves together and rose back above their respective 10-day moving average (DMAs) that we have been using as our failsafe points to reduce trading positions. Fortunately, we have not recommended doing much with investment positions. Yet, the 4.8% rally in the SPX from last Wednesday’s intra-day “low” into Friday’s “high” was unexpected, at least by us. Consequently, for underinvested accounts, we continue to embrace the strategy proffered by our friends at Riverfront Investment Group. To wit:

First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and forth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And sixth, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.

Whether you use a well regarded mutual fund – we like Quaker Strategic (QUAGX/$13.73), which broke out to the upside in the charts last week – or an exchange-traded fund – we like the iShares MSCI ACWI “all world” Index (ACWI/$39.14) – is clearly your choice. We also like the individual yield-oriented stocks mentioned in these reports over the past few weeks. To reiterate,

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/$27.50/Strong Buy), Chevron (CVX/$69.73/Strong Buy), CenturyTel (CTL/$31.73/Outperform), and Otelco (OTT/$12.90/Outperform). Other favorably rated names from our research affiliates include Pfizer (PFE/$16.64) and Altria (MO/$18.04).

We also like Raymond James’ new product on the Freedom Account platform. Said product is an amalgamation of three separate money managers that are employing an equity income strategy that produces an aggregate yield of roughly 6%. Their respective portfolios look like the “who’s who” of the Fortune 500.

The call for this week: “Breakout or fake out?” is the question du jour. Yet as market maven Arthur Zeikel wrote decades ago,

Despite what theoreticians tell us, investing – particularly at the margin – is not the product of rational and objective analysis, but an emotional relative analysis – anxiety about the future. My colleague Bob Ferrell put it this way: ‘Emotions are simply stronger than reason; people do not change and people make markets!’

Indeed, fear, hope, and greed only loosely connected to the business cycle. And, at session 30 in the “buying stampede,” we are clearly in the “greed phase.” We continue to invest, and trade accordingly.

Comments

[JMBishop:]

Is summertime trading then setting the pace for economic recovery? What about volume? What about more bank failures? What about the commercial real estate bust? Couldn't we still be living in that once in a 10,000 year event? Does a financial crisis of this eventful magnitude only last for a year? I like your strategy, but I'll take my own advice. Thanks

Aug 25 10:46 AM

[Kup:]

4 SD events are every 31,750 years??! What "model" is that pulled out of? Do the collapses of every failed countries equity market in the history of the world not equal 4 SDs? Not a fan of the black swan I take it. Any model that says what we just experienced was a once in 31,750 years event should be burned in effigy. However since I doubt any model would be so bold as to extrapolate a 31,750 year claim based on 150 year sample, I assume this is totally made up.

Aug 25 12:02 PM

[thiazole:]

"Yet if past is prelude, as inventories rebuild, capital expenditures will follow. Further, those capital expenditures tend to lead to improving employment readings that in turn foster consumption growth."

There are many here who LITERALLY do not believe in history as a guide (for example: seekingalpha.com/autho...). I, on the other hand, agree completely and have been making this same argument for months. I've yet to see an inventory report that showed that inventories are rising or even leveling off for that matter. If we are getting back to 0% GDP growth without even stopping the bleed in inventories, what will be the effect of restocking them? It will be much more significant than anything we've seen so far.

Aug 25 03:05 PM

[The Economi...:]

This market is breaking all the rules. Never before has so much spin influenced everything. Say it enough and we're believing our own lies.

Not without mention to HFT, which clearly INFLUENCING the market and stretching momentum in either direction.

This market of yours does not reflect the real freaking world, where the economy sucks. When it comes to its senses, it will crash hard.

Aug 25 03:36 PM

[untrusting ...:]

Kup,
Exactly right. Saut is talking about March lows being 3 or 4 standard deviations below norms? What norms is he talking about-seems like total nonsense to us. The Central Limit Theorum asserts that 1SD=68%, 2SD=95%, 3SD=99.7%, 4SD=99.99%. There is no way that the March lows are even remotely close to a 3 or 4 SD occurrance. If one for example plotted all the closing lows on any index since say 1900, then the March 2009 closing lows would not even be close to a 3 or 4 SD occurance. Clearly for example, the types of percentage declines in the market averages (at March/09) have happened many more times since 1900 than just .3% (3SD) or .1%(4SD), so his statement is just statistical nonsense.

He also talks about the current rally at this point being "neutrally valued" based on historic metrics. Again he must be living in Nanaland or attempting to justify his positions. We know of no "historic metrics" that show neutral valuations for the market at current levels. In fact probably the most consistent metrics, being PE10 metrics, show that current market levels are very substantially overvalued compared to any previous serious recessions.

Jeremy Grantham (May/09 newsletter), who is far more credible than Jeffery Saut, estimated that in his view fair values in the current environment were at best 880 on the S&P. Further Grantham's best estimates going forward were: 1) 15% probability of a new bull market over next 3-4 years, 2) 85% probability of a long drawnout period, 3) 56% probability of new lows after March/09. Grantham's May newsletter is well worth reading and far more credible than Jeffery Saut.

In short, there is no doubt that this has been a great trading opportunity and perhaps even a great investment opportunity (provided one purchased in Mar-Apr/09). But to assert that the current market is even a good long trading opportunity or worse a good long investment opportunity, seems downright dangerous to us. It certainly seems that the odds favor much better buying opportunities somewhere in the relatively near future and with far less risk.



On Aug 25 12:02 PM Kup wrote:

> 4 SD events are every 31,750 years??! What "model" is that pulled
> out of? Do the collapses of every failed countries equity market
> in the history of the world not equal 4 SDs? Not a fan of the black
> swan I take it. Any model that says what we just experienced was
> a once in 31,750 years event should be burned in effigy. However
> since I doubt any model would be so bold as to extrapolate a 31,750
> year claim based on 150 year sample, I assume this is totally made
> up.

Aug 26 01:28 AM