Expect Near-Term Pullback - Buying Opportunity for Tech, Energy, Industrials

by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay (published Monday, October 25th):

...In the stock market, many mavens... follow the calendar ... you play the summer rally “long,” then around Labor Day you “sell” because of the look-out-for-October historical haunts. Said mavens read the calendar and not the temperature of the stock market. Following such dogmatic rules (see my letter of 9/27/10 titled “Rules are Rules”) has left many investors underperforming this year, for if you sold the S&P 500 (SPX/1183.08) on September 1st (at 1050) you have “missed” a 133-point rally in the SPX (or 12.7%). To be sure, going calendar-contrary, and observing the temperature-trend, has saved us from this syndrome. Categorically, my mantra going into September had been, “I think it is a mistake to get too bearish right here.” However, that rubric changed at the margin last Monday when I wrote, “I am again cautious, a state I have not found myself in since April. Still, I think any pullback will be contained.”

Almost on cue, the SPX celebrated the 23rd anniversary of the October 1987 “crash” by surrendering 3.7% last Tuesday, only to make most of that loss back by Friday’s close. Still, I can’t shake the feeling the equity markets are searching for some kind of trading peak between now and the FOMC meeting. Such a timid trading strategy would be consistent with the old stock market saw, “Buy on the cannons and sell on the trumpets” because I think the “trumpets” will be the Republicans taking back the House and the Fed announcing QE2 (quantitative easing two). Both of those events should be stock-market friendly, but are likely already discounted. Clearly, we bought on the cannons last June. Accordingly, selling on the trumpets seems like an appropriate short-term trading strategy.

Nevertheless, the proverbial “carrot in front of the horse” remains good earnings, momentum, and performance anxiety as many portfolio managers (PMs) are materially underweight in equities. Speaking to earnings, according to my friends at the invaluable Bespoke Investment Group:

“Of the 377 companies that have reported earnings, 74% have beaten estimates. Of the 132 S&P 500 companies that have reported, 81.8% have beaten estimates. . . . (Yet) While earnings have been largely better than expected, the top-line revenue numbers haven’t been as strong. As shown, 62% of companies have beaten revenue estimates this earnings season. This is a bit higher than the 58% reading we saw earlier in the week, but it’s still lower than each of the prior three earnings seasons.”

Importantly, however, is that 4Q10 earning’s guidance has been particularly strong, implying favorable earnings comparisons should continue into the first part of next year. Ladies and gentlemen, to an underinvested PM, such upside earnings guidance is a nightmare. Bespoke goes on to produce a list of companies that have beaten both earnings and revenue estimates and guided estimates higher for 4Q10. Favorably rated names from Raymond James’ research universe making that list were: Polaris Industries (PII/$70.21/Strong Buy); Select Comfort Corp. (SCSS/$8.24/Strong Buy); Stanley Black & Decker (SWK/$61.11/Strong Buy); Tempur-Pedic (TPX/$35.04/Strong Buy); The Chubb Corp. (CB/$57.92/Outperform); UnitedHealth Group (UNH/$37.26/Outperform); and Altera Corporation (ALTR/$29.46/Strong Buy). I offer these names as a potential “shopping list” on any upcoming pullback. Additionally, the three sectors beating estimates by the widest margin are Technology, Energy, and the Industrials.

For months I have opined that Technology was as cheaply priced relative to the SPX as it has been in nearly 20 years. I have also been adamant on favoring energy stocks. The recent announcement by CNOOC (China National Offshore Oil Company) to purchase a ~33% interest in Chesapeake Energy’s (CHK/$21.20/Market Perform) Eagle Ford Shale project only reinforces my enthusiasm.

The Industrial sector is interesting because those companies with strong balance sheets have the ability to refinance their debt at lower interest rates, and thus grow earnings, even if revenue growth remains muted. And as Peter Drucker noted, “Almost everybody today believes that nothing in economic history has ever moved as fast as, or had a greater impact than, the Information Revolution. But the Industrial Revolution moved at least as fast in the same time span, and had probably an equal impact, if not a greater one.”

The call for this week: Eight of the S&P 500’s macro sectors are currently overbought. The two that are not, Financials and Telecom, are a neutral value by my pencil. Meanwhile, 88% of the SPX’s stocks are above their respective 50-day moving averages, leaving the index well overbought. Further, the SPX is at the top of its Bollinger Band, a chart configuration that occurred right before the January – February and the April – July declines of this year (see the nearby chart). Moreover, the D-J Industrial Average has traveled into formidable overhead resistance as it tested the April “highs” last week; and, today is session 37 in my day-count sequence without anything more than the perfunctory one- to three-day pause / pullback in the upside skein (read: pretty extended).

Accordingly I am cautious, but not bearish, believing the equity markets are going to make some kind of trading top over the next few weeks. I also believe any pullback is a buying opportunity. Therefore, instead of randomly “buying” right here, I prefer to wait and see which stocks resist the envisioned decline. As for where to “park” cash, in addition to the often mentioned Putnam Diversified Income Trust (PDINX/$8.09), over the past few months I have had numerous fixed income PMs suggest that Bank Loans are the most undervalued “space” in the fixed income arena. Typically, Bank Loan maturities are five years or less, ameliorating much of the interest rate risk. Further, corporate cash flows are at all-time highs, suggesting the best credits out there are corporations.

Drilling down into this strategy, I had lunch with a PM from Pioneer Funds recently (Ken Taubes) who agreed that Bank Loans are the place to be in fixed income. Unsurprisingly, the fund he recommended was the 4.8%-yielding Pioneer Floating Rate Fund (FLYRX/$6.87). Another such fund, for your consideration, was recently recommended by Raymond James’ mutual fund research department, namely Mainstay’s Floating Rate Fund (MXFAX/$9.40). I continue to invest, and trade, accordingly.