Investing: What to Do When the Music Pauses

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (Sept. 14th):

The actual private object of most skilled investment today is to ‘beat the gun.’ As Americans so well express it, to outwit the crowd and to pass the bad, or depreciating halfcrown, to the other. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs – a pastime in which he is the victor who plays ‘snap’ neither too soon nor too late, who passes the old maid to his neighbor before the game is over, who secures a chair for himself when the music stops. Or to change the metaphor slightly, professional investment may be likened to those newspaper competitors in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors, as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

Bet it surprises you that the aforementioned quote is from John Maynard Keynes’ legendary book “The General Theory of Employment, Interest, and Money,” written back in 1935. Read it a couple of times away from the maddening crowd, and reflect on it, because certain phrases will grab you with their wisdom. Bet you it also brings back memories of last year’s market machinations, and a wish that – if I had only “beat the gun,” or passed the “old maid” in time to avoid the final “snap.”

Currently, however, fear of the “music stopping” worries most investors. Indeed, last week we received this email, which typifies many of our emails over the past few months. To wit:

Jeff, as I watch the equity markets go higher and treasury yields plummet, I can't help but think that something strange and potentially troublesome is happening here. I just can't understand why, if the economy is on the way to recovery and the treasury is poised to issue billions and billions of debt out as far as the eye can see, why anyone would buy a 30-year treasury at a 4.1% yield. All this while the interest paid on these bonds is worth less and less (to foreign buyers) as the dollar falls further and the equity markets, seemingly in la-la land, ignore this situation and continue to go higher. Are we headed for another October 1987?

Over the past few months we have attempted to address such questions. In last week’s letter we suggested that the nation currently is experiencing both inflation AND deflation. Consider this, it appears that the country’s top quintile of wage-earners (the folks with the most assets) are experiencing deflation as their house prices have collapsed, their 401(k)s are substantially below where they were in October 2007, their bonuses have been “whacked,” and the list goes on. Meanwhile, the lower income households are experiencing inflation with their healthcare costs rising, food prices escalating, insurance premiums climbing, etc. In such an environment it is logical that Treasury Bonds would rally in the short-run. Longer term, however, we continue think inflation will win out over deflation, which is why we agree 30-year Treasury Bonds are a “bad bet.”

On the dollar, after being bearish from 4Q01 until 4Q07, we turned neutral to moderately bullish on the “buck” in November 2007. At first that “call” was wrong, then it was right, yet all said the Dollar Index is no lower, or higher, now than it was in November 2007. Hereto, over the longer term we think the greenback is likely headed lower. But as the economy recovers, so too should the dollar. Accordingly, in the short term, we remain neutral to slightly positive on the U.S. dollar.

Speaking to the stock market, we have, and continue, to argue that at the March 2009 “lows” stocks were three to four standard deviations below “norms;” and that all we have done is rally back to normalized valuations. Given the severity of the 17-month decline (October 2007 to March 2009), there is no reason why the equity markets can’t rally to one, or two, standard deviations above “norms.” Moreover, stocks don’t necessarily need outsized economic growth to rally. All they need is growth. As our friends at the consummate GaveKal organization, whose service we highly recommend, note:

The reality is that equity markets do not need high growth to thrive – they just need some growth. In fact, one could argue that a low-growth environment is preferable to one of stellar growth, since low growth is often accompanied by low interest rates and plentiful liquidity. Today, this is the environment which we will likely face for years to come. The latest Beige Book does a good job of summing up this story: the quarterly Fed survey reported that wage and price pressures were non-existent, that retail spending is lackluster in most areas, and that manufacturing activity has moderately improved. This will likely be the story for the foreseeable future. Consumers and banks will remain cautious, but interest rates will stay low, allowing for a gradual recovery in output. This is an ideal environment for corporate profit growth and also helps to explain why equities keep creeping higher.

And, last week stocks continued to “creep higher” with all of the indices we follow trading higher for the holiday-shortened week. That action left most of those indices at new rally reaction “highs,” putting even more pressure on underinvested money managers. A case in point was an article from a few weeks ago whereby a money manager disclosed that he still has 80% of his $850 million under management in cash. I read the article with both amazement and amusement. Amazement because I was surprised that any portfolio manager would admit he had that huge of a hoard of cash after more than a 50% rally from the March lows. Amusement because he probably allowed himself to be quoted believing that the September 1st Dow Downer, of 185 points, was the beginning of the long anticipated correction.

Ladies and gentlemen, there is still enough cash on the sideline to “buy out” the entire S&P 500, as can seen in the attendant chart from the insightful folks at Wood Asset Management. With many money management firms approaching their October year-end, the performance pressure, subsequent bonus pressure, and ultimately career risk, continues to increase geometrically as the equity markets rally. According to Jeremy Grantham,

In markets, where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes – keep your job. . . . Refusing, on value principal, to buy into a bubble will, in contrast, look dangerously eccentric. And when your timing is wrong, which is inevitable sooner or later, you will, in Keynes’ words – not receive much mercy.

Indeed, performance risk, bonus risk, and ultimately job risk.

Our answer to this dilemma, in the current environment, is to scale “buy” into large-cap, dividend-paying, stocks. Manifestly, stock returns are a function of corporate earnings, the price-to-earnings ratio investors are willing to pay for said earnings, and the dividends they receive over time from those stock investments. That’s all you really need to know about the stock market. 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/$27.34/Strong Buy), Chevron (CVX/$70.75/Strong Buy), CenturyTel (CTL/$31.51/Outperform), and Otelco (OTT/$12.72/ Outperform). Other favorably rated names from our research affiliates include Pfizer (PFE/$16.25) and Altria (MO/$18.14).”

We also like Raymond James’ new product on the Freedom 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: In last week’s “Call for this week” we wrote,

With the Pros’ return we should get a better idea of the stock market’s near-term directionality. Our sense is they will show up in ‘buy ‘em’ mode since stocks just won’t go down and the Pros are staring at their October fiscal year.

And, they did just that as,

each competitor has (been forced) to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.

The important point is that although this runaway rally is extended, the supply/demand, and sentiment situation, is still favorable. So while the “music” may pause this week on worries the U.S. tire tariff being imposed against China using the “safeguard mechanism” agreed to under China’s WTO entry conditions, the “music” is likely not going to stop.

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Comments

[Schneidehouse:]

Very insightful commentary. I have been trying like hell to figure out why the markets keep rising without a decent pullback. It will be interesting to see what people do when that pullback does occur - if they think we're headed back below March and dump (so they're not the last one standing), or ride it out. Unusual times for sure. Thank you for something else to consider.

Sep 15 08:19 AM

[redbaron:]

Good article, and one with which I completely agree. The funds on the sidelines gradually continue to come to the market, allowing the market to climb that wall of worry. The negative sentiment continues to fuel this rally, and I don't see what will change this behavior.

I still am cautious about October, and once we get beyond that there will be more emphasis on window-dressing portfolios going into the year end, or so I think. As a money manager, would you want to be 80% in cash, when the market was up 50%? I think not, and at some point, there will be some additional window dressing bringing more cash into this market, as we approach the end of the calendar year.

Sep 15 08:34 AM

[Mad Hedge F...:]

qqt Fed chairman Ben Bernanke say the recession is “technically” over. This will be great news for the people living in the tent city under short finals who I fly over when I land at Buchanan airport. It means “technically” they will eat tonight. It will also be welcome to the 18% of the workforce who are now unemployed in California, the 1.5 million who are losing unemployment benefits in the next three months, and one million college students who ran up and average $30,000 in debt to graduated this year so they could sleep on their parents’ sofa. Traders celebrated the news by running the S&P 500 up to 1,054, a positively nose bleeding 58% above the March 9 low. Apparently, the stock market thinks Obama is the greatest president in history, rising some 40% since the inauguration, compared to a 30% drop during the eight years of Bush rule. That is some report card. Too bad we can’t annualize that. The only thing I approve of today is that this love fest took silver to a new high this year of over $17. Wake me up when the party is over, and I’ll drag your drunken carcasses into the car and drive you home. Then I’m going to cash in a couple of my sliver dollars and take my significant other out for a Corona and some vegetarian burritos.

Sep 15 03:12 PM

[realold:]

Great article and skilled writing. Thanks for the thoughts. You may be right.

Sep 15 11:30 PM