Jeffrey Saut: I Continue to Cautiously Favor the Upside

by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay (published Monday, November 22nd):

Obviously I’m back in the country after a 10-day hiatus from watching the markets. So what has occurred in the markets in my absence? Well, the “buying stampede” that began on September 1st is still intact since the D-J Industrial Average (DJIA/11203.55) has yet to decline for more than three consecutive sessions before resuming its upward onslaught. Recall that “buying stampedes” typically last 17 to 25 sessions with only one- to three-session pauses and/or pullbacks before exhausting themselves. It’s true that some have extended for as many as 30 sessions, but it is rare to have one go for more than 30 days. In fact, I can count on one hand the stampedes that have lasted for more than 35 sessions.

That day-count sequence, when combined with the short-term overbought condition of late October, is why I turned cautious (but not bearish) before the mid-term elections. Clearly that stance was wrong-footed, yet in these markets it is better to “lose face and save skin.” Interestingly, the overbought condition that existed at the beginning of November has been corrected by the ~4% pullback in the DJIA, as can be seen in the chart of the McClellan Oscillator (overbought and oversold indicator) on page 3. Said pullback also saw the DJIA successfully test its 50-day moving average (currently at 11009). Moreover, I have learned the hard way it is tough to turn the equity markets down between Thanksgiving and Christmas.

That jubilant seasonality becomes especially true in mid-term election years, for as the good folks at Bespoke Investment Group note, “The S&P 500’s performance following mid-term elections is quite positive. One year after election day, the S&P 500 averages a gain of 15.8% with positive returns every year (since 1946)!” Bespoke goes on to comment about comparisons between now and the 1994 stock market environment. While many people remember the stock market rallying right after the 1994 mid-term elections, the rally didn’t actually begin until mid-December. A more apt comparison might be 1966 when the Democrats lost 48 seats in the House, and three seats in the Senate, leaving the DJIA range-bound between 780 and 824 into year-end before embarking on a rally that would lift the senior index 26.7% from its pre-election low (744.32) in October of 1966 into its September 1967 high (943.08).

Speaking of seasonality, while our energy analysts have been correct in their negativity on natural gas, history shows that NATGAS tends to make a price low in the September / October time frame. And despite both supply and demand dynamics currently skewed bearishly, NATGAS appears to have bottomed last month around $3.21 per MCF and currently changes hands at $4.16 basis the December 2010 futures contract.

Moreover, I have to ask the question, “What do they know that we don’t know?” Plainly this is a reference to CNOOC (Chinese National Offshore Oil Corporation), which entered into a billion dollar deal with Chesapeake Energy (CHK/$22.64/Market Perform) on its Eagle Ford Shale project. While Eagle Ford contains oil, it is largely a natural gas play. As well, what does Chevron (CVX/$83.94/Outperform) know that caused it to purchase Atlas Energy ATLS/$43.58/Not Covered) last week, which is another largely natural gas company. Of course both of these deals follow last year’s Exxon Mobil XOM/$70.54/Market Perform) $25 billion takeover of NATGAS producer XTO Energy.

Obviously over the long-term some industry heavyweights believe natural gas is a viable investment. Still, in the intermediate-term our energy analysts are likely right in their negative stance. However, in the short-term NATGAS prices look higher to me (please see the second chart below); and it’s worth mentioning that of the more than 100 markets I monitor on a weekly basis NATGAS was the largest gainer last week with a 4.8% rally (basis the Henry Hub spot price). That near-term bullish view of natural gas also “foots” with my forecast of a colder than anticipated winter due to the strengthening La Nina weather pattern and the large amounts of volcanic ash in the atmosphere. That combination has played havoc with the Hadley Cell Winds, causing the “tropics” to expand (see previous reports for details). For these reasons I would continue to overweight energy stocks in portfolios.

As for the economy, ...recent reports suggest real GDP for 3Q10 is on track to be revised upwardly to approximately 2.7%. While that’s not great, it’s not bad either! The “bad” remains employment; and while that looks to be at “steady state” rate, private sector job growth is not strong enough to lower our unemployment rate. Here’s the problem, in my opinion. The first two-thirds of this decade saw production employment decline by approximately 2.4 million jobs. Most of those displaced workers found jobs in the construction industry. However, in 2007 the construction industry’s “bubble burst,” with an attendant loss of those jobs, exposing the structural unemployment problems we are currently experiencing. Unfortunately, the U.S. is ill-equipped to deal with this in the short / intermediate-term. Over the longer-term I am confident “creative destruction” will cause labor, and capital, to move from dying industries to growth industries, thus ameliorating the employment situation. Yet the risk is our politicians won’t wait long enough for this sequence to occur. Indeed, for political reasons they may take the route of “caving” to the employment figures due to an outbreak of populism that leads to protectionist policies aimed at China. Ladies and gentlemen, while politically popular, slapping punitive trade tariffs on countries like China is a dangerous road to travel.

Meanwhile, China is attempting to cool its economic growth rate, and pace of inflation, at least that is the official spin. A “right brain” observation of China’s recent interest rate ratchets, and increased reserve requirements, might suggest China is actually attempting to raise the value of its currency. If true, such a revaluation would be HUGE in terms of rebalancing the World’s economies, as well as huge for our economic recovery. Indeed, China needs to consider Brazil’s example whereby Brazil decided to move (at the margin) from a manufacturing, and export driven business model towards creating more domestic demand.

Accordingly, between 2005 and 2007 Brazil raised the value of its currency, yet its economy remains pretty spunky. I believe China will eventually adopt a similar strategy, realizing that its manufacturing / export driven model will eventually fade as the Vietnams of the world inherit said model (I am bullish on Vietnam). Further, I think a deal will be struck to achieve such “ends” since China’s food supplies have been severely hurt by the shift in the “tropics.” This may imply America subsidizes China’s food shortfall for an accord regarding the revaluation of China’s currency. I realize such thoughts are unconventional, but they could be net worth changing since winning investments come from unconventional thinking. Recall, I proffered similar unconventional thoughts in 4Q01 when China was joining the WTA. Subsequently, I opined China’s per capita incomes would rise, driving a secular bull market in “stuff” (energy, base/precious metals, water, electricity, timber, cement, agriculture, etc.). I continue to think rising per capita incomes in the emerging and frontier countries will foster profitable investments in “stuff”; and I continue to invest, and trade, accordingly.

The call for this week: Well, today is session 58 in the September – November “buying stampede,” making this stampede the longest I have seen in more than 40 years of market observations. It is also Thanksgiving week and history shows the DJIA has ended this week higher in 38 of the past 59 years (or 64% of the time). Additionally, over the last eight years the Dow has gained in six of those years with its best performance (since 1950) coming in 2008 with a 9.73% weekly rally. Its worst week was in 1973 with a drop of 4.2%. Hence, I continue to cautiously favor the upside. Meanwhile, the “oil” that makes the “economic engine” run, namely the M2 money supply, has increased for the past six months (+6.2% annualized rate). Such increases only reinforce my recommendations on “stuff stocks” (preferably with yields). As for my views that the waning inventory-rebuild cycle will give way to a capex cycle, recent CFO surveys show intentions to boost capital equipment expenditures (capex), and hiring, are increasing. Therefore, my longstanding strategy that a “profits boom” will give way to an inventory rebuild, and then a capital expenditure cycle followed by increased hiring, and then a pickup in consumption, remains “stirred,” but not shaken. As for the strongest sectors, they remain Energy, Basic Materials, and Information Technology, while the best performing market capitalization class is the mid-caps. I think those areas are “buys” on any weakness and continue to think any near-term selling will be contained, leaving the major indices higher into year-end provided the 1130 – 1160 zone on the S&P 500 (SPX/1199.73) is not breached to the downside.

McClellan Oscillator - 2010

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Source: Thomson Reuters.

Natural Gas NYMEX

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Source: Thomson Reuters.