by Jeffrey Saut
Myths: Past, Present, and Future
September 29, 2014
“If you don’t change your indicators for the changing causal relationships you are doomed!”
In past missives I have discussed why I do not believe the Cyclical Adjusted Price Earnings Ratio (CAPE) is a good measure of valuations. The problem is that the CAPE uses a 10-year backward looking average of earnings. In the current case that means it incorporates the 2008 earnings disaster, which in my opinion was a six standard deviation event that is not supposed to happen in our lifetimes. Therefore if you want to use the CAPE as a valuation tool it probably makes sense to wait until 2019 when the 10-year trailing average of earnings normalizes. Similarly, Warren Buffett’s Market Capitalization to GDP analysis also does not make sense to me as a valuation tool. As previously stated, the problem here is the U.S. government adjusts the GDP numbers for five years. I used to use the attendant slide in presentations. It lists all the changes made to GDP for five years after the initial report (see chart 1 on page 3). By the way, I include 1985 as it is my all-time favorite on how wildly the numbers swing. In 1985 the GDP number was revised from +0.3% to +4.9% five years later. Therefore, anyone who sells or buys on what the U.S. government tells you happened in the first or second quarter of this year is putting way too much emphasis on near-term noise. If you want to know what GDP was for 2014, ask me in 2019.
Last week I received a number of calls from the media about the much heralded Hindenburg Omen. Those calls resulted from the triggering of the Hindenburg signal that occurred on September 18th and 19th. Given its ominous name, the media loves to trumpet such a signal. For the signal to be valid four properties need to happen. First, the D-J Industrial’s (INDU/17113.15) 50-day moving average (DMA) needs to be rising. Second, the number of new 52-week lows has to be at least 2.2% of all issues traded and changed in value. Third, the number of new 52-week highs must also be at least 2.2% of issues traded and changed in value. And fourth, the NYSE McClellan Oscillator must be negative. All of those metrics were met six sessions ago. Over the last three decades the odds of a major stock market crash following such a signal stand at around 30%, while the odds of a sharp decline of 10% are pegged at roughly 50%. However, while in the past the Hindenburg Omen has a decent track record, in more recent history it does not. For example, in August 2010 a Hindenburg signal was registered, yet the S&P 500 (SPX/1982.85) tripled following said signal. The problem with this indicator is that the number of closed-end funds, exchange-traded funds, preferred shares, and other fixed income centric securities masquerading as equities skews the new high/new low statistics. Nevertheless, the Omen brought on numerous questions not only from the media, but from many of our financial advisors and their clients about, “Is this the beginning of a bear market?” So rather than continue to respond to each question, I decided to write about it in this report. I like this story.
The year was 1971 and I had just been hired into this business on Whitehall Street in New York City. It was Camelot when we used to walk down the stairs from the American Stock Exchange floor into Harry’s at the Amex Bar & Grill. The exchanges used to begin trading at 10:00 a.m. and stopped trading at 3:30 p.m. I was dutifully sent out every morning at 9:30 a.m. to fetch coffee and danish for the traders on the desk. As I walked out of the trading room I would pass by my CEO’s office. It didn’t take too many passes for me to notice there was a big red number 4 artfully painted behind his desk roughly half way up the wall. After six months I finally summoned the courage to ask him what the “red 4” meant. As he tilted back in his chair, and with a fatherly smile, he said, “Kid, that’s the number of bear markets you will experience in your career. Don’t ever forget it!” And, I have never forgotten those sage words. So let’s count. I have lived through the 1973-1974 bear market, the 1981-1982 affair, the 2000-2002 debacle, and the 2007-2009 crashett. That makes four bear markets. Therefore, if my first boss was anywhere right there will not be another bear market until I retire, which should be no time soon.
Still, last week the “bears” came out of their caves emboldened by the back-to-back Monday/Tuesday two-step of -107 and -117 point sessions. Wednesday saw a 154-point gain for the INDU, but I told trading types to ignore the dead-cat bounce rally. Comes Thursday and the Bear Boos reached a crescendo with a Dow Dive of some 264 points, which brought the senior index down to its 50-DMA (16939.19), but it did not break that moving average. However, the SPX did break below, and closed below, its respective 50-DMA (1976.76), setting up a downside non-confirmation. Thursday’s Thumping also registered an extreme oversold reading from the NYSE McClellan Oscillator and qualified as a 90% Downside Day. Recall a 90% Downside Day is when 90% of all points traded, and all volume traded, comes in on the downside and is indicative of panic selling. This was the first 90% Downside Day since this year’s January/February 6% decline that occurred during its bottoming process. Often such 90% readings are associated with a short-term trading bottom and that’s what happened on Friday as the SPX gained 16.86 points, and in the process the SPX recaptured its 50-DMA. Typically, 90% Downside Days are followed by a recoil rally lasting two to seven sessions. Also of interest is that the Short Term Trading Indicator registered a signal of extreme oversold conditions of 50. Then too, the Volatility Index (VIX/14.85) spiked higher last week, suggesting the potential for a change of trend.
To me, the equity markets have not felt right since July despite the Dow Theory “buy signal” of a few weeks ago. In past missives I have written about the negative divergences and particularly about the junk bond market crash. As can be seen in the nearby charts, the correlation between the two has been remarkably high until recently. The junk bond complex began declining in July, and while the Russell 2000 (RUT/1119.33) has fallen pretty much in lock-step with junk bonds, the SPX has not until last week. Also of note has been the U.S. dollar strength. Since 46% of the SPX’s revenues are international, the greenback’s strength has caused forward earnings estimates to be reduced (see chart 4). Hereto it is worth mentioning that a stronger dollar is an effective tightening of monetary policy. Speaking to the sectors, the only macro sector that is short-term oversold, at least by my work, is the Energy complex. The energy space has been bludgeoned since July with a number of stocks off more than 30%. One stock from Raymond James’ research universe that has been particularly punished has been Goodrich Petroleum (GDP/$15.33/Strong Buy), which has declined significantly from its recent high, prompting our fundamental analyst John Freeman to write the following in his company comment of September 2, 2014:
We reiterate our Strong Buy on Goodrich as the Tuscaloosa Marine Shale (TMS) picture becomes clearer with each subsequent well result. Our rating upgrade last month was predicated on our belief that the core of the play had been defined following a series of step-out wells. ... The upcoming Bates 25-24H-1 well can potentially expand the acreage credit we are giving Goodrich as that well is being drilled right at the 11,000’ depth horizon (natural fracturing will be better, but the shale will be thinner than what is present in the core). The other three upcoming well results are all being drilled right in the fairway of the play. These wells should provide further support for the core of the play (and where all of our current NAV value lies).
The call for this week: I will be in NYC, Montreal, and Toronto seeing accounts and speaking at various events this week. If past is prelude something big will happen when I am out of the country. My guess is that it will be the U.S dollar. Ever since the dollar got strong commodities and precious metals have been socked, and the SPX has basically been stuck around 2000 for three months. The dollar is currently the most overbought it has been in decades. Watch the Dollar Index, if it makes a trading top and begins a pullback look for a rally in stocks, as well as commodities. This morning the SPX futures are down again (-9.00) as U.S. air raids in Syria kill civilians, seven Ukraine soldiers are killed despite the alleged ceasefire, and the Swiss show the good sense to vote down the equivalent of Obamacare (http://news.yahoo.com/public-versus-private-swiss-mull-health-system-shift-073917245.html;_ylt=AwrBJSAxZihUJXUA8YHQtDMD). I continue to think 1965 to 1970 is the key level for the SPX.
September 22, 2014
“In Greek mythology Sisyphus was a king of Ephyra who was punished for chronic deceitfulness by being compelled to roll an immense boulder up a hill, only to watch it roll back down, and to repeat this action forever.”
I have been reminded of the Greek mythology character Sisyphus since mid-July as investors tried to “roll an immense boulder up a hill, only to watch it roll back down.” In this case the “boulder” in question has been the D-J Industrial Average (INDU/ 17279.74), which since late July has tried seven times to better its all-time high of 17138.20 made on July 16th of this year. Each of those attempts failed, only to see the “boulder” roll back down the hill. Last Wednesday, however, Sisyphus succeeded as the Industrials vaulted above their mid-July closing high along with a new all-time closing high from the D-J Transportation Average (TRAN/8633.83). The dynamic duo notched new all-time closing highs the next day as well (see chart 1). Simultaneous new highs between the Industrials and the Trannies are a pretty rare event. Typically what happens is one of the indexes makes a new reaction high and then shortly thereafter the other index follows. In 2013 it was the Transports that made new highs in January, but it wasn’t until March the Industrials confirmed that high with a new high of their own. In the current case we got back-to-back Dow Theory “buy signals” last Wednesday and Thursday. Since I have been on the road, I have not had time to review my notes of the past 50 years, but off the top of my head I can’t remember the last time that happened. I did, however, have time to run an overbought/oversold analysis on the 30 components of the Industrials and found that only Caterpillar (CAT/$102.51/Market Perform), Chevron (CVX/$124.80/Strong Buy) and Exxon (XOM/$97.12/ Outperform) are currently short-term oversold.
Nevertheless, according to Dow Theory, the primary trend of the equity markets remains “up,” as Dow Theory has opined since the summer of 2009. Does that mean we will never have the 10% - 12% pullback the historical odds call for this year? Obviously I don’t know because I thought we had commenced such a pullback last July. But, when the S&P 500 (SPX/2010.40) refused to break below 1900, and then traveled above its overhead resistance zone of 1940 – 1950, I had to give up on that view. Still, there is some “hair” surrounding the stock market’s current situation. As one of the portfolio managers in San Francisco asked me last week, “I was happy to see the Dow Theory Buy signal on Wednesday but am puzzled by an analyst (whose name will go unmentioned as his material is for purchase) who discussed the McClellan Oscillator’s action on Tuesday – the day before the Dow Theory buy signal. Because you pay attention to the McClellan Oscillator, here is a small piece of this analyst’s research for your reflection:
‘Here is one of the remarkable divergences that existed today [Tuesday, September 16] at the market close. The Dow was at or within 0.2% of a two-year high on a closing basis at the same time the ratio adjusted McClellan Oscillator was closing at an oversold level of -35 or lower. Would you care to venture a guess as to how many times that has happened over the past 85-90 years? The answer is there have been only 8 prior days over the past 90 years where such a great divergence has occurred. Not all of them have marked market tops of any importance but several of them have marked definite danger zones for the market. Similar coincidences occurred on June 3 and June 8, 1948. The latter date was within 0.2% of the high that was registered five trading days later on June 15. That high lasted for almost the next year and a half. It happened again on June 6, 1950 which was within one week of the June 12 high which marked the highest point for the next four months. It happened again on March 9 and March 10, 1976. The closing prices on those dates were not exceeded by more than 2.1% over the next 5½ years. The most recent appearance prior to the current one on September 16 occurred on July 15, 2014. That was one day before the all-time high close on the Dow which has held through today’s action. We believe the fact that such a rare coincidence occurred again this Tuesday, September 16, could well be a warning sign that a market top of some importance has formed.’
“My question is [the PM speaking]: If this is a similar pattern, will this week’s occurrence be followed by a Dow market top on Wednesday/Thursday; and is this anything, or does the Dow Theory ‘trump’ concern about the action in the McClellan Oscillator on Tuesday?”
My response was that I think Dow Theory “trumps” everything because it tells us the primary direction of the equity markets, although whoever wrote about the adjusted McClellan Oscillator is very astute and has notes going back a lot farther than my notes. That said, I am not quite sure what an “adjusted” McClellan Oscillator is. I will say, however, that the NYSE McClellan Oscillator I have used for years is not oversold, but more neutrally configured (see chart 2). I would also add that whoever the analyst is, his analysis foots with a number of the negative divergences I have written about over the past few months. Then too, we are now at session 31 in the “buying stampede” and the typical stampede tends to last only 17 – 25 sessions. A few have extended for 25 – 30, but it is rare to have one go for more than 30 sessions.
Yet while the Industrials were doing their thing, I was in the San Francisco Bay area. Last Sunday I had dinner with some portfolio managers (PMs). On Monday I saw accounts and finished the day at Franklin Templeton’s world headquarters seeing PMs and then presenting in their tiered classroom. Tuesday saw more of the same until that evening when I spoke to a group of high net-worth investors at the Toll House Hotel in downtown Los Gatos, which was the highlight of the week, at least for me. The affair was a sit-down dinner with a wine tasting. Now anyone who knows me knows that I know a lot about wine, but the winemaker at this event I had never encountered. Surprisingly, the wine was as good as the best I have ever tasted and was called Patland (www.patlandvineyards.com). It was probably the excellent wine because the verbal exchange between the investors and me was invigorating. The next day it was more of the same, as was Thursday. Friday was spent in Carmel speaking at a conference. Throughout all of my meetings was the ubiquitous question about when the Fed would begin raising interest rates. I think the consensus now pegs a rate ratchet at about nine months from now. Accordingly, I have included a chart in this report chronicling the S&P’s 10 macro sectors’ historical performance nine months prior to a rate rise. I do find it interesting that the Financials are at the top of said list because the KBW Bank Index (BKX/$73.69) is making new reaction highs. One of the ways we have been investing in financials is via my friend David Ellison, who manages the Hennessy Small Cap Financial Fund (HSFNX/$23.65) and the Large Cap Financial Fund (HLFNX/$21.05). As a sidebar, I own HLFNX.
The call for this week: Last week we got back-to-back Dow Theory “buy signals” (Wednesday and Thursday), which is a pretty rare event and tells us the primary trend of the equity market remains “up.” According to Dow Theory, the primary trend of the market has been “up” since the summer of 2009, which is why I continue to believe we are in a secular bull market that has years left to run. Still, the move to new all-time highs has been selective and accompanied by many divergences like the one the unnamed analyst discusses. I think the current situation is best summed up by another friend, namely Don Hagen, who is also the PM at Day Hagen Asset Management, when he writes, “We remain mildly overweight equities, favoring US equities over international. However, within the international arena, our models favor Emerging Markets over Europe and Japan.” This morning the SPX preopening futures are down ~9 points on Chinese economic worries and as Syrian Kurds cross into Turkey.
Then and Now
September 15, 2014
At a meeting the other day, I was introduced as “a formerly notorious short seller.” A friend asked, “Whatever happened to the old Shad? You never seem to have anything mean to say anymore?” ... Could it have something to do with interest rates? In our short selling days in the 1980’s, we looked for poorly managed companies that burned cash, faced brutal competition, and engaged in dubious accounting. Interest rates were infinitely higher than today, and between interest on collateral and short credits, you could make high-teens rates of return if your short sales did nothing. All income was taxed at the same rates with no preference for long-term capital gains or dividends. Finally, if you sold short something that went to zero, you never had to close out your short sale and had the use of the money tax-free. All that has changed and new ways to make short sellers miserable seem to come along every day. With interest rates close to zero, it has become an almost impossibly difficult game. Conversely, the tax-efficiency of owning growing, brilliantly managed, cash generating, competitively dominant, global companies is an idea that has somehow been lost upon the investing public. I suspect the idea will be rediscovered, perhaps by the investment world equivalent of the Bedouin goat herders, who in 1947 recovered the Dead Sea Scrolls with all of their ancient biblical history.
... Frederick “Shad” Rowe, Greenbrier Partners
Dallas-based Greenbrier Partners is captained by my friend Frederick E. Rowe, who is fondly referred to as Shad. Now anyone from Virginia is familiar with the fish known as a shad, and are probably familiar with the political event known as the Shad Planking. Shad, the fish, is unique because it has developed the ability to detect ultrasound (frequencies greater than 20 kHz, which is above what humans can hear). Similarly, Shad, the man, has developed the ability to find “growing, brilliantly managed, cash generating, competitively dominant, global companies” and invest in them. I, however, am not as certain as Shad that his investing philosophy has “somehow been lost upon the investing public.” Rather I think it is the simple fact there are not many of us left that have experienced a secular bull market like the 1982 to 2000 affair. Shad clearly has since I first encountered him when he was a contributing editor to Forbes magazine some 30 years ago and scribed some of the most clever and keen-sighted commentaries on Wall Street. Shad understands that in a secular “bull market” one of the most important things to know is not to lose your entire position because stocks tend to go higher in such an environment than most investors think. Yes, you can trade around that position, but don’t lose the entire position! Over the years I have quoted Shad’s prose in many of my letters, just like I quoted some verbiage from his July monthly letter in today’s missive. I also remain impressed with Shad’s stock picking. In the aforementioned letter he discussed a few of his positions that are from Raymond James’ research universe and are all rated Outperform by our fundamental analysts.
He had this to say about Apple (AAPL/$101.66), “Apple has the most desired digital ecosystem in the world and it trades at a discount in comparison to its peers, the market, and its intrinsic value on virtually every metric. Two key investor worries were lessened: 1) gross margins do not seem to be cratering and 2) 28% revenue growth in China suggests that it is not too late for AAPL in the emerging markets. This is obviously not definitive, but it is encouraging and helped drive 20% earnings per share growth.” On Bank America (BAC/$16.79) Shad writes, “Bank of America represents a proxy on an improving domestic economy and a company that still has vast room for operational improvement. The company’s steady turnaround continued in the second quarter despite its continued legal/regulatory challenges. BAC remains cheap at 0.7x book value (1.1x tangible book value).” On Facebook (FB/$77.48) he notes, “Facebook is the backbone of the social media experience for more than one billion connected users around the world and provides the means for marketers to reach these potential customers with more efficiency and precision than has ever been possible. In the stupendously understated words of Mark Zuckerberg, Facebook ‘had a good second quarter.’ Revenue increased 61%, while 68% EBITDA margins drove 121% earnings per share growth compared to last year’s second quarter.”
I think these names should be on your “watch list” for any impending decline in the equity markets since this continues to be a secular bull market.
Speaking to the equity markets, the D-J Industrials (INDU/16987.51) have failed to confirm the new all-time high by the D-J Transports (TRAN/8552.28). As repeatedly written, that’s an upside non-confirmation under Dow Theory and a reason for caution in the short-term. While the S&P 500 (SPX/1985.54) has indeed recorded a new all-time high, it too has been unconfirmed by a number of other indices. Nevertheless, the SPX’s recent pullbacks have been able to stay above its 1980 – 1985 near-term support zone. I have written that I would be much more comfortable if the SPX would come down to its 1965 – 1970 support level so that I could see how it acts at this much more important level, but they don’t operate the equity markets for my benefit. Also of interest is that while the SPX managed to tag a new all-time high, the average stock in the SPX is 7.5% below its respective all-time high. Moreover, as previously written, the average stock in Raymond James’ research universe of more than 1,000 stocks is down 23.3% from its respective 52-week high. Outside of stocks, the yield on the 10-year T’note has risen to 2.61%, crude oil/gasoline prices have declined (bullish for stocks), commodities are swooning, and the U.S dollar is on its best upside tear in 17 years (bullish for small cap stocks). All of this is equity market friendly in the intermediate/long-term, even though in the short-term things are sketchy. In fact, as I wrote last week, there was a speculative trader’s very short-term “sell signal” registered on September 4th when the 14-day Stochastic fell below its moving average. That signal was reinforced last week when the short-term Trading Index lost six points. Keep in mind, however, none of these short-term signals impacts my secular bull market “call.”
The call for this week: I am in the San Francisco bay area speaking at various events and seeing accounts. I continue to find it fascinating that the portfolio managers (PMs) want to know what our advisors and their clients are thinking/doing, while our advisors/clients want to know what the PMs are thinking/doing. I believe this speaks to the fact that most are confused with the markets and that 77% of all active PMs are underperforming the S&P 500. This is likely because the surprise of the year has been the tremendous outperformance of the defensive sectors. To wit, Healthcare is up 14.70% YTD and the Utility sector has risen 10.35%. While we targeted Healthcare as a favored sector, we totally missed Utilities. I have also liked Technology, but recently I am hearing from tech companies their business with Russia has fallen off a cliff and I did not realize how big a consumer of U.S. technology Russia has become. This week investors will put on “rabbit ears” for statements out of the Fed meeting. Will Janet Yellen drop the phrase “considerable time?” Will she continue with “data dependent?” Or will she say “the FOMC’s view is that there is considerable slack that remains in place?” Accordingly, all eyes will be on the bond market to see its reaction to the Fed’s words. The other charts worth watching are crude oil, gasoline, and the U.S. Dollar Index. Also of note are Scotland’s independence vote and this week’s option expiration, both of which can be market moving.
Additional information is available on request. This document may not be reprinted without permission.
Raymond James & Associates may make a market in stocks mentioned in this report and may have managed/co-managed a public/follow-on offering of these shares or otherwise provided investment banking services to companies mentioned in this report in the past three years.
RJ&A or its officers, employees, or affiliates may 1) currently own shares, options, rights or warrants and/or 2) execute transactions in the securities mentioned in this report that may or may not be consistent with this reports conclusions.
The opinions offered by Mr. Saut should be considered a part of your overall decision-making process. For more information about this report to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy please contact your Raymond James Financial Advisor.
All expressions of opinion reflect the judgment of the Equity Research Department of Raymond James & Associates at this time and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets or developments mentioned. Other Raymond James departments may have information that is not available to the Equity Research Department about companies mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this presentations conclusions. We may perform investment banking or other services for, or solicit investment banking business from, any company mentioned. Investments mentioned are subject to availability and market conditions. All yields represent past performance and may not be indicative of future results. Raymond James & Associates, Raymond James Financial Services and Raymond James Ltd. are wholly-owned subsidiaries of Raymond James Financial.
International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.
Investors should consider the investment objectives, risks, and charges and expenses of mutual funds carefully before investing. The prospectus contains this and other information about mutual funds. The prospectus is available from your financial advisor and should be read carefully before investing.