Dow Remains Resilient Despite Calls for a Correction

by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, (published Monday November 9th):

... A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door that he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back into the box, which would scare away any turkeys lurking on the outside. One day he had a dozen turkeys in his box. Then one walked out, leaving eleven. ‘I should have pulled the string when there were twelve inside,’ he thought, ‘but maybe if I wait, he will walk back in.’ While he was waiting for his twelfth turkey to return, two more turkeys walked out. ‘I should have been satisfied with the eleven,’ he thought. ‘If just one of them walks back, I will pull the string.’ While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return.

... Why You Win or Lose, by Fred C. Kelly

“I should have bought at Dow 8000 when the DJIA broke above the downtrend line that was formed by drawing a descending line from the May 2008 high to the September 2008 high. Now we are probing another descending trend line that can be seen by drawing a similar line connecting the October 2007 high with the highs of December 2007, May 2008 and October 2009.” So exclaimed one disgruntled portfolio manager last Friday since the senior index again continued to not surrender much ground last week.

Indeed, despite all the “calls” for a correction (including ours) the Dow remains resilient. And, those “correction calls” are now legend with certain pundits trumpeting that the “bear market rally is over” and we are now going to re-test, and break, the March lows. Other mavens continue to opine that the 1937 – 1938 Dow déjà vu is the preferred pattern, which also suggests that new lows lay ahead.

We, however, don’t buy the idea that our nation is at the end of an era. While the U.S. is certainly in a “hard spot,” our sense is that economist Joseph Schumpeter’s notion of “creative destruction” will play once again. One can actually see it at work as labor and capital are moving from dying industries to growing industries like electric cars, biotechnology, green companies, infrastructure, etc. We have been on the infrastructure theme for years, with particular emphasis on electricity and water. Interestingly, much of the stimulus money earmarked for infrastructure is going to go for replacing our country’s aged water pipes. Obviously, that’s good news for pipe manufacturers and we have tilted portfolios accordingly.

As for the equity markets, while we have wrongly been looking for a correction since the beginning of the fourth quarter, the S&P 500 (SPX/1069.30) still hovers around the same level it was when we turned cautious. To us that’s pretty bullish, for as stated in last week’s letter:

While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish.

Indeed, despite the “bad mouthing,” all stocks have done over the past month is consolidate their July – September rally by moving sideways. Moreover, that sideways consolidation has seen the equity markets work off their overbought condition into one of being pretty oversold. Ladies and gentlemen, to an underinvested portfolio manager the current environment is a nightmare, especially if you believe as we do that we are going to see an upside celebration into year-end. Manifestly, we have argued that with credit spreads below their pre-Lehman (OTC:LEHMQ) bankruptcy levels there should be no reason why the equity markets can’t “fill up” the downside vacuum created in the charts by said bankruptcy.

As can be seen in the following chart, that gives the S&P 500 an upside target of 1200 – 1250. If correct, it implies that the cash rich, underinvested portfolio managers (PMs) will once again be forced to chase stocks higher. Our guess is the PMs will chase the “winners” since the March lows rather than buying the laggards. That suggests investments in emerging and frontier markets, technology, financials, base/precious metals, etc. should trade higher if the aforementioned scenario plays.

Along this “chase ‘em” theme, we have screened the Raymond James universe of stocks that have rallied more than 100% since the March lows, which were rated Strong Buys in March, and are still rated Strong Buy. If we get “melt up” stage 2, such a list should make a decent idea list. The names for your consideration are: RF Micro (RFMD/$4.02); Bank America (BAC/$15.05); Hughes Communication (HUGH/$24.60); Continental Resources (CLR/$37.17); AFLAC (AFL/$42.19); Whiting Petroleum (WLL/$61.30); ADC Telecommunications (ADCT/$6.52); NII Holdings (NIHD/$27.82); Micron Technology (MU/$7.08); JDS Uniphase (JDSU/$6.46); Motorola (MOT/$8.89); Encore Acquisition Co. (EAC/$44.74); Service Corporation (SCI/$7.55); BPZ Resources (BPZ/$6.84); and KVH Industries (KVHI/$10.99).

The call for this week: Time is running out for the bears if our year-end celebration is going to play. If the major averages break out above their recent reaction highs the party could commence. As for us, we are on the road again this week, so these will likely be the last strategy comments for the week.