I'll Be Back
By Jeffrey Saut
November 19, 2012
Just like the line from the movie The Terminator, “I’ll be back,” I am back from a two-week jaunt to Europe. During that sojourn I saw more than 100 portfolio managers (PMs) in seven countries, spoke at a few conferences, spoke to a number of the print media, and co-hosted two TV shows. As always, traveling internationally provides interesting insights often not available in “the states,” which was especially true this trip since I was traveling during our presidential election. Most of the accounts I spoke to were pretty bearish, except for one particularly clever organization in Edinburgh that completely sold out of European stocks three years ago and over-weighted American equities. Obviously, they are outperforming their benchmark. At one of my meetings I asked one PM, who has been bearish for all of the 15 years I have known him, “How do you invest in stocks when you have been this bearish?!” His response was, “We don’t invest in stocks that we think are going to go up, we invest in stocks we think will not go down as much as the overall stock market if it declines.” “Wow,” I gasped, “That’s certainly not the way my father taught me to invest.”
So the mood in Europe was universally bearish, yet my message was fairly constructive on U.S. equities. In fact, I shared with various PMs that the only time I have come to Europe when everyone was universally bullish was in 4Q99 when I was talking about the Dow Theory “sell signal” of 9/23/99 and suggesting that the D-J Industrial Average (INDU/12588.31) was going to go into a wide-swinging trading range affair like it has always done after every secular bull market in history. At the time I likened it to the wide-swinging environment that follow the secular post WWII “bull run” that ended in 1965 with a Dow Theory “sell signal.” The subsequent sideways market lasted for almost 18 years with the Industrials range-bound between roughly 1000 and 600. Importantly, the nominal price low during that timeframe occurred on December 6, 1974 at 577.60 on the Dow. However, the valuation low, the cheapest the Industrials would get on a P/E, book value, price to sales, etc. basis didn’t happen until August of 1982. So fast forward to today; in my opinion there is a 20-25% possibility that we are in a new secular bull market and NOBODY believes it! That “call” rests on the premise that the nominal price low was made on March 6, 2009 when the S&P 500 (SPX/1359.88) printed at the “mark of the devil” level of 666. Subsequently, I think the “valuation low” was made on October 4, 2011 where the SPX was trading below 10x its forward earnings estimate, with an earnings yield of over 10%, rendering an equity risk premium above 8% for a valuation low not seen in decades.
Despite that message, in every meeting during the past few weeks the first question was, “What about the fiscal cliff?” My comment to that question was, “Over my 42 years in this business when e-v-e-r-y-o-n-e was asking the same question, it has typically not been the right question. While I am not certain what the right question is, my response to the “fiscal cliff” question was this. President Obama was beaten up pretty good in the debates, which looks to have made him more flexible, at least to me. Moreover, if you read his book you come to understand that not only does he want to leave a legacy, like every President, he wants to leave the image of the greatest President ever! Given that, and the fact the Republicans got crushed in the Electoral College, my sense is that both parties will be more flexible going forward, a point made in last Monday’s missive. Accordingly, I believe President Obama will make some major policy breakthroughs despite the usual Washington Waltz rhetoric.
Therefore, I think the “fiscal cliff” will be avoided, or if driven off the cliff will only last for a few days. Consider this, the Bush tax cuts foot to $265 billion per year, but only $55 billion of those cuts are for the rich. The other $210 billion are for the middle class. Somehow I don’t think President Obama wants to take that away from the middle class. So I think the Bush tax cuts will be extended, at least partially, if not entirely. I also believe the Payroll Tax comes back because nobody knows what it is anyway; as well, most of the mandated spending cuts will probably be postponed. Other potential breakthroughs would be a tax holiday for the $2 trillion worth of profits residing outside the country (a win/win for everybody), a fix for the broken entitlement programs, tax reform, well you get the idea. But, last week the equity markets did not embrace such thoughts as all of the major indices, and all of the macro sectors, that I monitor were down last week. The biggest losers were the D-J Transportation Average (TRAN/4891.27) and the S&P 600 SmallCap Index (SML/457.34) off 2.53% and 2.30%, respectively, while the Industrials (-2.34%), Materials (-2.27%) and Technology (-2.22%) were the largest losing sectors.
By Friday’s close the weekly wilt left all of those same indices below their respective 200-day moving averages (DMAs), as well as WAY below the lower band of their Bollinger Bands. It should be noted that prices typically don’t reside outside their Bollinger Bands for very long (read: rally attempt). Such antics also saw the McClellan Oscillator about as oversold as it ever gets before Friday’s intraday reversal to the upside alleviated some of that oversold condition (see chart on page 3). The reversal was driven by the more conciliatory tone out of both sides of the political equation referenced earlier in this letter. The question then becomes, “Was Friday’s intraday print low, and subsequent upside reversal, a real bottom?” While I would like to think it is, the fact we knifed through my all-important 1390 “energy level” like it wasn’t even there suggests not. As stated in last Monday’s missive:
I am still in Europe and unable to really follow the markets closely due to my travel schedule. But there is no way to escape it, the SPX fell through the 1390 level and if this really is an undercut low like the one we identified on October 4, 2011 the SPX needs to recapture 1390 quickly and then sprint above it. If not, it probably means we have to go through some kind of bottoming process in the 1300 – 1350 zone. Quite frankly, I don’t see how the SPX can travel much below that given President Obama’s reelection and with that the guarantee of low interest rates for as far as the eye can see.
Unfortunately, the SPX has yet to recapture the 1390 pivot point, which is not a good sign. If this was going to be an undercut low, like the one we identified on October 4, 2011, the SPX should have already recaptured 1390 and sprinted above it. So rather than ignore the market’s cautionary warning I am going to operate using Ben Graham’s sage advice, “The essence of investment management is the management of risks not the management of returns. All good portfolio management begins with this premise.”
The call for this week: Obviously, I am back from Europe and y’all have done a pretty poor job of holding the markets together in my two-week absence. Indeed, since the election the SPX has lost 6.28% from its intraday high to last Friday’s intraday low. The biggest losing sectors over that timeframe have been Energy (-6.2%), Financials (-5.9%), and Technology (-5.9%). Given the President’s views on energy and banks the weakness in those two sectors should not come as a surprise. Still, I think the surprise is going to be a more cooperative environment from our leaders going forward. And, maybe that is what the stock market sniffed out last Friday with its intraday upside reversal on heavy volume. If the SPX can travel above 1362 it may be able to recapture the 1390 level that I have deemed to be critical. However, until that happens I am going to err on the side of caution.
(c) Raymond James