The Philosophy of Tops (Saut)

The Philosophy of Tops

by Jeffrey Saut, Chief Investment Strategist, Raymond James
March 7, 2011

“Everyone kept saying ‘a top is not in place yet.’ They persistently pointed to the ‘normally reached’ levels of this or that statistic that were not yet there to reinforce their desire to remain bullish. Apart from statistical measures of increasing blindness, this unwillingness to acknowledge what they themselves were already feeling revealed a comfortableness, a confidence, a conviction that whatever was happening – short-term survivable dips – would continue until ‘the top,’ like a strip tease artiste of our youth would with decorum appear on stage, bow, and then, accompanied by applause from all the bulls eager to cash in on their excitement, would begin to twirl its statistical tassels in front of everyone.

I’ve gotten so old I can’t remember the names of those ladies at the Old Howard, but I can remember that all you got was a flash of this or that, before they waltzed off. Stock market tops are like that. You know it’s there somewhere if you squint hard enough, but you never quite see it, so you keep waiting for more. And then, in the end, as the curtain comes down on the bull market you realize that the one rule about tops is not that they provide this or that signal, but that they come before anyone is ready.”

... Justin Mamis, Insights, 1987

He said, “We are getting a lot of calls about why Jeff Saut has been so bearish the last few weeks.” I said, “I am not bearish, I am cautious and have done what prudent portfolio management calls for, I have sold partial positions, raised some cash and allowed long-term capital gains to accrue to portfolios.” He said, “That is being interpreted as bearish.” I said, “Not my problem.” In this case the “he” is Harry Katica, director of Raymond James’ Retail Liaison Desk, which fields questions from our financial advisors.

As for the aforementioned quote, long-time stock market observers will remember Justin Mamis as one of the most respected authors, philosophers, market pundits, and investment advisors of all time. His “Mamis Letter” frequently appeared in Barron’s and The Wall Street Journal, as well as many other publications. I was reminded of Justin’s quote while perusing various stock chart recently because I saw more “rounding top” chart formations on individual companies’ stocks than I have encountered in some time. In fact, the past few months remind me a lot of the “topping” environment that took place between December 1968 and the first quarter of 1969. Back then, while the major indices moved higher driven by a few favored stocks, there were similar “rounding top” formations on the majority of stocks. Verily, in early 1969 Wall Street was focused on but a few stocks that had captured participants’ fantasies. Back then it was any technology stock with a futuristic name: Xerox; Telex; Itek; University Computing; Control Data, etc. Meanwhile, as these fantasy stocks swirled higher, the broad base of stocks were traveling lower (read: being distributed; aka, being sold by smart money).

Fast forward to the last few months, Wall Street’s attention has again been captured by names like Apple, Netflix, Baidu, First Solar, etc., which were streaking higher while many other stocks were being distributed beneath the headline excitement of the darlings du jour. Indeed, since the first of the year I have felt like I was in the trading “twilight zone” as the major indices danced higher despite the numerous cautionary signals often mentioned in these missives. Yet the “dance” continued, that is until the past few weeks. Clearly, the last two weeks have felt like a change in the market’s tone punctuated by February 22nd’s 90% Downside Day (90% of total points lost and volume occurred on the downside) with a near 90% Downside Day last Tuesday (-168 DJIA). It was the second official 90% Downside Day of the year accompanied by the two nearly Downside Days of 3/1/11 and 1/28/11. Counter-balancing Tuesday’s near Downside Day was last Thursday’s nearly 90% Upside day, but alas that was erased by Friday’s Fade of 88 points (DJIA). Accordingly, I continue to think we are at/near a “tipping point,” As highlighted by the always insightful GaveKal organization:

“Now if the US$ bounces from here, it is likely that oil will follow food prices into their recent consolidation, allowing for equities to once again bounce back. However, if the US$ melts down, or if oil shoots up on further Middle-East unrest, then it is hard to see how equities will maintain the past few months' uptrend. So it does seem that we are at an important tipping point not just for the US$, but for most asset prices as well, which should not come as such a surprise since most assets in the world are priced off of the US$. (That) reality brings us back to a point Charles has been very vocal about over the past couple of months: we are rapidly reaching the stage in the cycle where the Fed needs to start tackling the weakness of the US$, and the surge in commodities, or risk undermining the very (economic) recovery it managed to jump-start. With that in mind, we would not be surprised if, in the coming days and weeks, various Fed directors come out to sound somewhat more hawkish in a bid to prevent commodities from further undermining the current recovery. ... Anyway, with so many unanswered questions, it is not surprising that equity markets are taking a breather.”

From GaveKal’s lips to God’s ears because late last week Fed Governor Thomas Hoenig suggested just that when he opined that short-term interest rates should be higher.

To be sure, the stock market’s changed tone over the past few weeks has been palpable, raising the question – does the recent sell-off, from S&P 500 (SPX/1321.15) 1344 to 1294, represent the sum total of the long anticipated correction? To answer said question we turn to the excellent Lowry’s service:

“Perhaps a better question to ask is, did market conditions prior to the recent rebound suggest adequate preparation for a renewed and sustainable rally? An examination of Lowry’s measures of the forces of Supply and Demand suggests the answer to both questions is likely no. . . . Strong rallies that experience weak and short-lived corrections are typically characterized by expanding Demand and contracting Supply. However, that has not been the recent pattern. . . . The market deals, however, in probabilities, not certainties. Thus, while conditions over the last few weeks were such that the probabilities suggested a correction longer than 3 days, investors should still be alert for signs a new, sustained rally has begun. The key element for any renewed rally is likely a pattern of strong, sustained Demand. Probably the clearest indication of this strong buying would be provided by two or more 90% Up Days, or a combination of a 90% Up Day and back to back 80% Up Days. The near-90% Up Day on Feb. 25 proved a 1-day wonder, so evidence of more sustained buying will likely be needed to indicate the start of a new rally.”

Indeed, cautious, but not bearish. That said, I can still find decent risk-adjusted investments that should be scale-bought, especially on weakness. In previous reports I have discussed names like Williams Company (WMB/$30.84/Outperform), as well as the closed-end fund Royce Value Trust (RVT/$15.19), both of which are special situations. This morning I offer another, namely Campus Crest Communities (CCG/$11.79/Strong Buy), which “missed” its quarterly earnings estimate last week with an attendant 18% decline in its share price, bringing the dividend yield to 5.4%. I like the strategy of buying fundamentally sound companies when one-off accidents happen because I think it takes much of the price risk out of the investment equation. For further details please reference our fundamental analysts’ recent research note on CCG.

The call for this week: This week I am celebrating the two-year anniversary of the stock market’s bottom by attending our institutional conference where more than 300 companies will be presenting to nearly 600 portfolio managers. It’s a great conference, as well as an appropriate time to reflect on the past 24 months. Recall, the bottoming process began on October 10, 2008 when 93% of the stocks traded on the NYSE recorded new annual low prices. It was then I declared, “The bottoming process has begun.” However, some five months later, on March 2, 2009, I stated, “The stock market bottoming process is complete and we are – all in!” Since then I have not really “backed up” on that call, although I have turned cautious at times. My best cautionary call was in late March 2009. My worst has been coming into this year for while my short-term caution on the emerging markets proved correct (long-term I remain very bullish), my caution on the U.S. markets has been wrong-footed, at least up until the last few weeks.

P.S. These will be the only strategy comments for the week.

Notes: Prices are as of the most recent close on the indicated exchange and may not be in US$. See Disclosure section for rating definitions. Stocks that do not trade on a U.S. national exchange may not be approved for sale in all U.S. states. NC=not covered.

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