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A Conversation With Warren Buffett

January 15th, 2013

by Jeffrey Saut

of Raymond James

“I asked Buffett whether he worried about the trade deficits and budget deficits and all the other problems that upset the financial community.

‘We would certainly be happier and our growth rate would be higher if we could close the deficits,’ he said, ‘We’ve traded consumption – those cars and VCRs – to the foreigners and they have claim checks on us and they can cash those claim checks. So every few weeks the Japanese buy another office building. When they bought the ABC building in New York, that one hundred and seventy-five million dollars was one day’s trade deficit. So we’re trading real estate for trinkets like VCRs, but there’s a certain amount of justice in that because Peter Minuit originally got Manhattan by trading trinkets for it. It took just three hundred years to complete the circle.’

So how will we come out, then?

‘Either we will make the IOUs the foreigners hold considerably less valuable by having a lot of inflation, or eventually we will produce more than we consume.’

‘I like the gas tax because oil is a resource we’re running out of. We keep sucking it out of the ground like a giant soda we’ve stuck straws into. If we don’t close these gaps, there’s real intergenerational unfairness. We consume more than we produce, the foreigners have the claim checks, and they can present them to the next generation.’

So for the moment you’re not pessimistic?

‘It’s an enormously rich country, and we can continue trading it away for a very long time. It’s a powerful machine, and it can take a lot of abuse’.”

Adam Smith, THE ROARING ’80s

Our friend Jerry Goodman, whose nom de plume is Adam Smith, authored the book “The Roaring ’80s” in 1988. The aforementioned quip is a quote from that book; I find it interesting that if you substitute the word “the Chinese” for “the Japanese,” the aforementioned quote is as valid today as it was 25 years ago. To be sure, “It’s an enormously rich country, and we can continue trading it away for a very long time. It’s a powerful machine, and it can take a lot of abuse.”

I revisit said quote this morning because today we are releasing this month’s Gleanings report where we try to discuss what could actually “go right” with the economy and the stock market. The “we” involved are Scott Brown (Chief Economist), Art Huprich (Chief Technical Analyst), and myself. As for me, I have remained constructive on stocks for some time, a stance that was called naïve by certain folks as we approached the “orchestrated drama.” Nevertheless, I remained convinced that a last minute solution would be achieved because that is the way Washington works. As stated in previous missives, it was interesting to me that the media, once the drama passed, immediately refreshed the headlines to focus on the next Armageddon regarding the “debt ceiling.” What was lost in “the cliff’s” aftermath was that Congress came together and consequently our government became just a little bit less dysfunctional. Having railed against the government’s dysfunction, this is not an unimportant observation. Accordingly, if our elected leaders can show the same resolve in the “debt ceiling” debate, a lot of things could go right in the months ahead.

Clearly, the stock market “thinks” something good can happen given the action so far this year. To wit, we ushered in the New Year with a 90% Upside Volume Day on December 31st followed by another 90% Upside Volume Day on January 2nd (90% of total volume traded came in on the upside). Such back-to-back Upside Days are pretty rare, especially at the beginning of the year. Two weeks ago, when this occurred, I wrote that my notes show the last time this happened was in 1987 right before the D-J Industrials (INDU/13488.43) commenced a 24.5% rally that would peak in early April, not that I am predicting a similar sequence here. However, the history of 90% back-to-back Upside Volume Days is that the average gain one month later for the S&P 500 (SPX/1472.05) is 6.8% (83% of the time) and an average gain of 12.8% three months later 100% of the time.

Following the 90% two-day two-step, the SPX went into a five-day consolidation pattern between roughly 1455 and 1465, forming what our technical analyst called a “bullish flag” formation. Bullish flag formations are typically found in stocks, or indexes, that are in a strong uptrend. They are called bull flags because the pattern looks like a flag on a pole. It becomes “bullish” when the price is resolved out of the topside of the “flag,” which is what happened last Thursday. Not only did the SPX break out of its flag formation, but in the process punched to a five-year closing high. It also may have completed a breakout above the neckline of a head and shoulders bottom (see chart on page 3). While all of this is pretty bullish in the intermediate term, there are some issues in the short-term.

First, the SPX has travelled into my 1465 – 1475 overhead resistance zone. As stated last week, the SPX likely will not make it through that level on its first try, just like it couldn’t surmount the 1420 – 1430 level on its first attempt. Recall, it took multiple tries to travel significantly above 1430. Second, the D-J Industrials and D-J Transports (TRAN/5572.62) failed to better their previous reaction high of October 2012 and July 2011, respectively. Potentially that could be a giant upside non-confirmation. Third, the McClellan Oscillator is overbought. Fourth, all of the macro sectors have pushed into overbought territory for the first time since last September. Fifth, the Volatility Index (VIX/13.36) has fallen to a five-year low (read: too complacent). Sixth, according to Investor’s Intelligence the bull/bear ratio, at 51.1% bulls and 23.4% bears, is at its most bullish spread since the SPX was making its reaction high of 1475 last September. And seventh, ALL of the world markets I monitor are overbought except for Indonesia.

On the positive side is that there are many more advancing stocks than declining stocks (positive breadth), ditto stocks making New Highs are expanding, there is no evidence that the Selling Pressure Index is increasing (it’s at its lowest level since July 2011) while the Buying Power Index is at its highest level since May 2012, select indices have made new all-time highs (RUT/880.77), the Dollar Index is breaking down (bullish for stocks and commodities), China’s economic statistic improved last week, Euroquake is off the “front burner,” and the list goes on.

So what does this mean for the markets? Well, while I don’t expect the SPX to break through its September 2012 “highs” (1475) on the first attempt, I think those highs will eventually give way. So far most of U.S. indices are up some 3% YTD with Midcaps (IJH/$105.50) and Smallcaps (IJR/$80.69) outperforming large caps while growth outperforms the value complex. The leading sectors YTD are Financials, Materials, Healthcare, and Industrials. Meanwhile, crude oil is up (USO/$34.06), gold is marginally lower (GLD/$161.06), and the fixed income ETFs I track are down across the board. I think when the SPX convincingly breaks above its September high of 1475 the large caps will play catch up. One of the ways to play that theme is using the ~3%-yielding Powershares S&P 500 Low Volatility ETF (SPLV/$28.38). As always, terms and details should be vetted before purchase.

Speaking to individual stocks, since the Financials have been one of the top performers YTD, I screened our bank stock research universe looking for stocks under $10 per share that are strong buy rated and look good technically. Two names surface, those being Huntington Bancshares (HBAN/$6.59) and Regions Financial (RF/$7.24). Of course for a broader brush, I own, and recommend, my friend Davis Ellison’s Hennessy Small Cap Financial Fund (HSFNX/$20.57), formerly FBR Small Cap Financial Fund.

The call for this week : Last week saw the highest flows into stock funds in six years. Those flows, over the past two weeks, have lifted the broadest-based index, the Wilshire 5000, by $500 billion! That rally has caused the Wilshire to make a much clearer upside breakout than the SPX; it is closer to its all-time 2007 high than the SPX (see chart on page 3). I think the Wilshire is eventually pointing the way higher, despite the current near-term overbought condition. This week should tell if it is a true upside breakout, or if we will need to spend some more time consolidating before trading higher.

© Raymond James

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