Cautious in the Near-Term; Long on Volatility, Japan

Includes: DFJ, JEQ, JOF, VXX
by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay (published Monday, April 19th):

An old stock market “saw” states, “Sell in May and go away,” emphasizing that the worst part of the year for stock performance is the months between May and November. To be sure, a $10,000 investment in the DJIA purchased in November and sold in April grows to ~$480,000, while the same strategy employed between May – October shows a loss of ~$328 (study: between 1950 – 2003) . . . thus, “sell in May and go away.” Obviously we have modified that old axiom this morning given our statement – “Don’t wait for May to go away!” Nevertheless, despite having been too soon’ly cautious since S&P 1150 – 1160, which is tantamount to being wrong, we are “stepping up” our cautionary counsel this week.

Our increased caution is driven by a number of metrics. To wit, preliminary data suggests last Friday was the first 90% Downside Day since February, our sentiment gauges are back to as bullish as they were in 1987 (read that bearishly), the CBOE equity put/call ratio is at 0.32, for its heaviest “call volume” relative to “put volume” since August of 2000, stocks are the most overbought since the rally began in March 2009. Some of the leading stocks are not responding to good news, Thursday was session 34 in the “buying stampede” that began on February 26th (rarely do such skeins last more than 30 sessions), we’ve gotten that peak-a-boo “look” into the long envisioned target zone of 1200 – 1250, volatility is back to the complacent 2008 levels, and the list goes on.

Yet not only the empirical data is suggesting caution, there are inferential gleanings as well. Recently, Robert Prechter, of Elliott Wave fame, appeared on one of my favorite stock market shows with a number of my friends. Market participants will recall that Mr. Prechter has been forecasting doom for the equity markets for a decade. It is also worth mentioning that he correctly “called” the recent rally, which he now deems is over. Still, given Mr. Prechter’s strategic negativism, he was barely allowed to express his views by my panelist friends. Now while I too don’t agree with Mr. Prechter’s long-term bearishness, I have seen this act before. Ladies and gents, in the past when the cacophony of “bullish boos” became so deafening as to drown-out all of the negative nabobs it has spelled too much bullishness in the short-term.

As for the news backdrop reinforcing our caution, while Greece is likely off the “bankruptcy table” in the near-term, it is not off the table in the intermediate-to-longer term. Emphatically, we think Greece will eventually default; and, it will not be the only country to do so. Indeed, we tend to view Greece as the Bear Stearns of Europe with nobody really knowing how many countries will fail next. Then there is Iceland’s volcano, which currently has no end in sight, and will most certainly impact the world’s economic statistics. In fact, I heard one commentator suggest that if the eruption lasted long enough it could foster another “ice age.” Then there was last week’s Goldman gotcha’ that suspiciously materialized in front of the movement toward financial reform. Studying the storied history of Goldman shows that Goldman revelations tend to mark inflection points in the equity markets.

Interestingly, like the “thug tactics” used to pass the healthcare bill, the investigation of Goldman Sachs (NYSE:GS) is conveniently concurrent with the government’s push towards financial reform. In my view, such tactics once again are designed to pander to an uninformed electorate. As stated, regulations were already on the books to prevent the recent financial fiasco, but it was Congress that cajoled the regulators into not enforcing them, as can be seen in this video clip. All of this speaks to our worries about when government becomes an increasing “spend” in an economy that economy’s structural growth rate is lowered and price to earnings multiples compress. As our friends at GaveKal have astutely observed:

“A clear inverse relationship exists between the size of the public sector and economic growth in many countries. That such a relationship must exist is analytically almost undeniable. Productivity growth in the public sector is bound to be slower than in the competitive business sectors of the economy, partly because of the inherent inefficiency of bureaucratic management and also because of the difficulty of defining productivity growth in public services. . . . Thus, if government keeps expanding relative to the business sector, the economy’s potential for productivity growth is bound to suffer.”

GaveKal’s study centers on the United Kingdom (U.K.), posing the question – will the U.K. example “port” to America? Certainly that is a fair question, but if it does we should be concerned because it is imminently apparent our government has become an increased spender in the economy. Also, along the financial regulatory line, is the fact that a large share of corporate America’s 2009 – 2010 “profits boom” has come from the financial sector. Accordingly, the “body politic” should be very careful about tinkering with the nascent profit cycle recovery the economy is currently experiencing.

As for my trip through Michigan last week, the observation is that there are disparate economic readings. While Battle Creek, Flint, and Detroit are economically abysmal, Kalamazoo, Ann Arbor, and Grand Rapids appear to be doing pretty well. Similarly, one particularly bright portfolio manager, at the State’s “Bureau of Investments,” opined that there is a rapidity developing disparity in the employment picture for our nation. In his words – we appear to be evolving into a two class system; the unemployment rate for the top decile of wage earners is about 4%, while the unemployment rate for the bottom decile is roughly 30%. That, gentle readers, is a really good insight with amazing investment implications that will be discussed at another time.

As for the “here and now,” we are increasingly cautious, believing a near-term “top” in the equity markets has been registered. Longer-term, we remain bullish, thinking the profit-cycle recovery is alive and well. To that point, it’s worth considering that bottom-up operating earnings peaked in 2007 at ~$91 per share for the S&P 500 (SPX/1192.13). And, except for Japan, price-to-peak earnings power [PPE] has always made new highs, cycle after cycle. Again, as the good folks at GaveKal note, “Except during the bubble years of 1997 – 2001, the PPE for the SPX has fluctuated in a range of 10x to 20x (peak earnings); it currently stands at a moderate level of ~13x.”

The call for this week: Another new Dow Theory “Buy Signal” was recorded last week as the DJIA confirmed the über overly-extended DJTA (Transports). That said, many times a reconfirmed Dow Theory “buy signal” comes very late in the upside skein, having expended a huge amount of energy to achieve said feat. We think that is the case currently, and are recommending hedging accounts for a downside correction.

Yet, there are two “things” we are betting to the upside. One is volatility, which is why we bought the VIX iShare Short-Term Futures ETN (VXX/19.97) last Friday. The other is our controversial recommendation of “longing” Japan, a strategy we have employed for almost a year. Japan is “cheap” with its small-cap complex selling at roughly 50% of revenues, below book value, and with some 30% cash on its collective balance sheet. Moreover, Japanese economic data has been much stronger than expected recently. The investment vehicles repeatedly recommended in these missives have been: WisdomTree’s Small Capitalization Dividend Fund (DFJ/$42.00); Japan Small Capitalization Fund (JOF/$9.48); and the Japan Equity Fund (JEQ/$5.79), all of which took a downside “hit” in Friday’s Fade.