Back in Cautious Mode

Includes: BTUUQ, CVX, HD, WMT
by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay (published Monday, June 28th):

...As touched on in last week’s letter, there are currently two major questions raging on Wall Street – is this a new bull market; or, is what we have experienced over the last 15 months just a rally in an ongoing secular bear market? Fortunately, secular bear markets are rather uncommon. More common are broad trading-range markets punctuated by numerous tactical bull and tactical bear markets. For example, in 1966 the D-J Industrial Average [DJIA] first approached 1000. By 1982 the DJIA was still hovering near 1000. Yet, over that 16-year time period there were 13 rallies / declines of more than 20% (see the chart below).

As often stated, since the Dow Theory “sell signal” of September 1999 I have suggested the equity markets were likely going to be in a trading range pattern similar to the 1966 – 1982 affair. Clearly, that is what has occurred over the last 10 years. Most recently, the 54% slide from The Dow’s October 2007 peak into its March 2009 low has been followed by a 70%+ rally that ended in April of this year.

Subsequently, the senior index experienced its first double-digit decline since the March 2009 bottom, ushering in cries of “the bear market rally is over!” To me, however, all that’s transpired is another decline within the context of the broad trading range the Dow has been in since the turn of the century. Nevertheless, I must admit I am concerned because a Dow Theory “sell signal” was registered during the recent decline. Accordingly, I am back in a cautious mode, which is why investment accounts should have some cash, while trading accounts should be relatively “flat.”

I also have to admit I am worried about the weakening economic reports. To be sure, the number of economic indicators surprising to the downside is about equal to those surprising on the upside. According to the astute Bespoke Investment Group, “Of the eleven economic indicators released last week, only six came in ahead of expectations, while five surprised to the downside.” One of those downside surprises was Wednesday’s shockingly weak New Home Sales, which inked the weakest reading since the statistics began in 1963. That said, I don’t think housing is going to spin the economy into another recession, because going from 1.5 million housing starts to 400,000 is plainly impactful. But, going from 400,000 to 300,000, well who cares? To me participants should be much more nervous about the sharp decline in the Economic Cycle Research Institute’s [ECRI] weekly leading economic index (see the attendant chart). Readers of these missives should recall I often referenced this index as proof of the economic recovery when the index was ramping at its sharpest rate in history. Regrettably, it is now declining at one of its sharpest rates (see chart).

While I am indeed concerned about the ECRI’s weekly index of leading indicators, it should be noted that while the ECRI Index has been an excellent predictor of the economy, it has NOT been very accurate in predicting the stock market’s direction. Still, given the Dow Theory “sell signal,” the intermediate “sell signal” registered by my proprietary trading indicator, and the “hook down” in the monthly stochastic indicator (all of which can be seen in last week’s letter), I have no choice but to be cautious until circumstances change. I am also watching the interrelationship between the S&P 500’s 50-DMA (@1128) and its 200-day moving average (@1112). If the 50-DMA crosses below the 200-DMA, it would be a further cautionary signal.

Because of the envisioned broad trading range, since 1999 I have advised participants to divide equity portfolios such that 80% of the portfolio is for investment stocks. The remaining 20% of the portfolio should be used in an attempt to take advantage of the various mini-bull / bear markets. Currently, that 20% portion of the portfolio, aka the trading account, should be relatively “flat.” Investment accounts, however, should always be on the prowl for decent risk / reward situations.

To that point, the Bespoke Group penned a study titled “Bespoke’s Custom Portfolio Trading Range Screen.” The report highlights a number of stocks that are oversold as measured by the distance (in standard deviations) each stock is below its 50-DMA. Of the 30 stocks mentioned, 12 are part of the Raymond James research universe. Of particular interest were: Chevron (CVX/$70.06/Strong Buy); Home Depot (HD/$30.20/Strong Buy); and Wal-Mart (WMT/$48.80/Strong Buy). Wal-Mart, under $50 per share, is pretty compelling given the fundamental metrics expressed by our analyst Budd Bugatch. And on a completely separate note, I was intrigued by Peabody Energy’s (BTU/$43.55/ Outperform) article regarding the “Supercycle for Coal,” which can be viewed on the company’s website. You can also read Raymond James’ opinion on the subject in the most recent report by our coal analyst Jim Rollyson, dated 6/21/10.

The call for the week: I continue to attempt to “keep” the profits accrued since the March 2009 bottom. Accordingly, I remain cautious in the short-run for the aforementioned reasons. Longer-term I continue to think the equity markets are okay into the mid-term elections, which as stated should be a referendum between the progressives and their more fiscally conservative counterparts. If the progressives “win,” I think it puts a HUGE headwind into the economy and the markets. The quid pro quo would suggest easier “sailing” going forward. Until then, the yield-curve is still relatively steep, credit spreads have not leaped, the Advance / Decline Line appears steady, and earnings comparisons should remain favorable; so unless it is different this time, the recent correction in the equity markets should resolve itself with higher prices.

ECRI Weekly Index of Leading Indicators