Getting, Keeping, Losing! (Saut)

This article is a guest contribution from Jeffrey Saut, Chief Investment Strategist, Raymond James.

“... great fortunes are not insulated from risk: The same tides of economic change and progress that were creating these new fortunes were also destroying old ones. Since 1982 the economic and technological progress unleashed by supply-side policies has ousted some 60% of the incumbent tycoons from the Forbes Four Hundred.

There are, basically, two kinds of wealth: tangible and financial. Tangible assets already exist: real estate, buildings, mineral deposits, farmland, works of art, stockpiles of commodities, wares of the past. Financial assets consisting of stocks, bonds, and other securities represent not so much tangible wealth as a pledge of future production.

... The cycles between these two forms of wealth respond to public policy. Times of inflation and high taxes favor existing wealth over new wealth, tangible assets over financial assets, collectible capital over productive capital. Tangibles tend to yield a relative untaxable flow of benefits; housing jewelry, art and leisure mostly untaxable returns. Securities tend to yield a taxable and inflatable flow of income on a principal that dissolves with the decline of currency.

Put it this way: Financial assets do best in times of low inflationary growth. Hard assets do best in times of high inflation and high taxes.”

... The Slippery Slope of Wealth, George Gilder

“Getting, Keeping, Losing” is the title of the aforementioned quote and it is certainly consistent with one of my New Year’s resolutions, for as we entered 2010 one of my main mantras has been to try and “keep the profits accrued since the March 2009 bottom.” As touched on in last week’s letter, there are currently two major questions raging on Wall Street – is this a new bull market; or, is what we have experienced over the last 15 months just a rally in an ongoing secular bear market? Fortunately, secular bear markets are rather uncommon. More common are broad trading-range markets punctuated by numerous tactical bull and tactical bear markets. For example, in 1966 the D-J Industrial Average (DJIA) first approached 1000. By 1982 the DJIA was still hovering near 1000. Yet, over that 16-year time period there were 13 rallies/declines of more than 20% (see the nearby chart).

As often stated, since the Dow Theory “sell signal” of September 1999 I have suggested the equity markets were likely going to be in a trading range pattern similar to the 1966 – 1982 affair. Clearly, that is what has occurred over the last 10 years. Most recently, the 54% slide from The Dow’s October 2007 peak into its March 2009 low has been followed by a 70%+ rally that ended in April of this year. Subsequently, the senior index experienced it first double-digit decline since the March 2009 bottom, ushering in cries of “the bear market rally is over!” To me, however, all that’s transpired is another decline within the context of the broad trading range the Dow has been in since the turn of the century. Nevertheless, I must admit I am concerned because a Dow Theory “sell signal” was registered during the recent decline. Accordingly, I am back in a cautious mode, which is why investment accounts should have some cash, while trading accounts should be relatively “flat.”

I also have to admit I am worried about the weakening economic reports. To be sure, the number of economic indicators surprising to the downside is about equal to those surprising on the upside. According to the astute Bespoke Investment Group, “Of the eleven economic indicators released last week, only six came in ahead of expectations, while five surprised to the downside.” One of those downside surprises was Wednesday’s shockingly weak New Home Sales, which inked the weakest reading since the statistics began in 1963. That said, I don’t think housing is going to spin the economy into another recession, because going from 1.5 million housing starts to 400,000 is plainly impactful. But, going from 400,000 to 300,000, well who cares? To me participants should be much more nervous about the sharp decline in the Economic Cycle Research Institute’s (ECRI) weekly leading economic index (see the attendant chart). Readers of these missives should recall I often referenced this index as proof of the economic recovery when the index was ramping at its sharpest rate in history. Regrettably, it is now declining at one of its sharpest rates (see chart).

While I am indeed concerned about the ECRI’s weekly index of leading indicators, it should be noted that while the ECRI Index has been an excellent predictor of the economy, it has NOT been very accurate in predicting the stock market’s direction. Still, given the Dow Theory “sell signal,” the intermediate “sell signal” registered by my proprietary trading indicator, and the “hook down” in the monthly stochastic indicator (all of which can be seen in last week’s letter), I have no choice but to be cautious until circumstances change. I am also watching the interrelationship between the S&P 500’s 50-DMA (@1128) and its 200-day moving average (@1112). If the 50-DMA crosses below the 200-DMA, it would be a further cautionary signal.