Jeffrey Saut: A Rally in the Works?

Includes: EWJ, MUE, NVG
by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (December 15th):

...[T]he stock market “sprang back” after last Friday’s early morning mauling, leaving the DJIA (8629.68) better by 64 points for the session. It was the second Friday in a row that the senior index demonstrated such resiliency, as following the previous Friday’s horrific employment report the DJIA closed “up” by nearly 260 points. Such action only serves to reinforce our view that the stock market wants to rally.

Manifestly, since the October 10th psychological “low,” where 93% of the stocks traded on the NYSE that day recorded new yearly lows, we have opined that the markets were in “bottoming mode.” In addition to the often mentioned reasons for that view [the downside non-confirmation by the DJIA and DJTA (3245.40), the fact that we can find nowhere in history where the major averages have fallen by 50% and not experienced a subsequent SUBSTANTIAL rally even if the average eventually went lower, the experience to know that it is tough to push stocks lower in the ebullient month of December, etc.], it’s worth considering that today’s asset allocation disciplines call for a rebalancing out of Treasury notes/bonds and into stocks now that dividend yields are well above Treasury yields. This rebalancing favors high quality, dividend-paying stocks, and should become an increasing trend into year-end, as well as into the first month of the new year.

Further buoying stocks in the near term should be additional quantitative easing by the world’s central banks (read: lower interest rates), the economic benefits from the huge drop in energy prices, and another economic stimulus package from the Obama administration.

... I think the U.S. economy is likely going to experience its worst numbers in the current quarter. Indeed, driven by the worsening economic statistics, our economist, Dr. Scott Brown, had to lower his 4Q08 GDP forecast last week to a negative 6% estimate. I realize that I am just guessing, but my sense is that 4Q08 will mark the nadir of the economic malaise, with the GDP numbers becoming less austere in the coming quarters and then turning positive by 4Q09. If this scenario proves anywhere close to correct, investors should consider this quip from Ernie Ankrim, Ph.D. and Chief Investment Strategist at Russell Investments:

“Many people have lost a great deal of wealth. If they need income now, they may have lost the option to hold risky equities or investments without further distress. I don't chide anyone for getting sufficient cash together for the next year. You have to live. People with a longer horizon—at least three years—will do best to consider retaining some exposure to the market. I remember the period of January 1973 through September 1973 when the markets went south by 47%. My father-in-law swore off equities for the rest of his life. He kept to it and lost out on a lot of potential returns over the years.

Getting overly conservative—and most investors are doing so—is also very risky. This is especially true when the yields to the safest assets are close to zero, while the dramatic explosion in injected liquidity may well bring us inflation concerns after we're through this recession. Protection against inflation almost always requires taking more risk (like in stocks or riskier bonds) than the most conservative investments. Real buying opportunities are found when everyone else is selling. There are also opportunities outside of the riskiest assets; investment-grade bonds are on sale, as well. I have no doubt that present conditions offer great buying opportunities for stocks, although only the most iron-willed investor would stroll calmly into equities. If you're a long-term investor, hold as much risk as you can tolerate, recognizing that the current volatility may make a slight reduction in risk appropriate. No doubt, the going will be very tough in the short-term. However, for those of us with many tomorrows ahead of us, joining the crowd as it runs for the exits might end up compounding the pain of this ordeal.”

Plainly I agree, which is why after being pretty cautious for most of the year I have recently been recommending committing some of the outsized cash reserves that we raised around this time last year. I also agree with Mr. Ankrim on investment grade bonds, which “foots” with Carlyle Group’s co-founder David Rubenstein who said, “The two best places to invest in right now are in debt markets and Asia.”

Verily, when investors can potentially garner equity-like returns from distressed debt we think it is worth considering. Two such closed-end funds would be BlackRock MuniHoldings Insured (NYSE:MUE) and Nuveen Insured Dividend Advantage (NYSEMKT:NVG), both of which have tax-free yields north of 7% and are trading at more than a 20% discount to their net asset value. Speaking to Asia, we added the iShares MSCI Japan (NYSEARCA:EWJ) to the ETF portfolio last week. Japan is just plain “cheap.” Not only is the Nikkei 225 trading where it was in 1982 (how about that for buy and hold?!), but it is trading at a mere 4 times cash flow.

The call for this week: The two questions du jour are: 1) when will the credit crunch end? and 2) how long will the economy remain weak as it attempts to correct the housing situation? Speaking to the first question, participants need to monitor the credit spreads, which so far have not improved.

As for question two, delinquencies and bank repossessions appear to finally be stabilizing. If the stock market is a discounting mechanism, the 50% decline in the S&P 500 may have already discounted everything. Moreover, my sense is that just like participants were conditioned to believe that any decline would not gather much traction back in 1999 and 2000, they are now being conditioned to believe that any rally will not sustain. With stocks’ aggregate value currently below the year’s GDP, we continue to think a rally of some import is in the works.

Disclosure: None

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