"Down the Rabbit Hole" (Saut)

Down the Rabbit Hole

by Jeffrey Saut, Chief Investment Strategist, Raymond James

June 20, 2011

Alice in Wonderland: Sir, would you tell me, please, which way I ought to go from here?

The Cheshire Cat: That depends a good deal on where you want to get to.

Alice: I don’t much care where.

The Cat: Then it doesn’t much matter which way you go.

Like Alice, investors have lost their way following the “rabbit down the rabbit hole” for six weeks following the May 2 stock peak, as most of the indices I follow closed lower for each week over that timeframe. I referenced that six-week skein in last week’s strategy comments, noting the S&P 500 (SPX/1271.50) had fallen for six straight weeks for the only sixth time since 1995. If past is prelude, the SPX subsequently experienced decent gains over the ensuing six weeks every time! Worth considering, however, is that the SPX did not trade above its previous reaction high in any of those previous occasions. I also referenced how oversold the equity markets were with only 15.6% of the SPX stocks are above their respective 50-day moving averages (DMAs). Then there were other finger to wallet ratios, like the CBOE Equity Put/Call ratio, which at 0.99 (nearly one “put” traded for every “call” traded) was at its highest ratio (the most bears) in nearly two years. Additionally, the 10-day Put/Call ratio “tagged” 0.78 last week for its most bearish (contrarily: bullish) reading since February 2009. As for sentiment, hereto the numbers are eschewed too bearishly. Accordingly, I continue to think the equity markets are in the process of making a “low.” As stated, “The only question to me, at least in the near term, is if we get a selling climax or a selling dry up?!” The ideal pattern would be for some kind of “pornographic plunge” hour into the 1230 – 1250 zone, but given last week’s action, a “selling dry up” (where the sellers just run out of steam) can’t be ruled out.

Obviously, the drivers of the “stock slide” have been the Greek Gotcha combined with the softer economic numbers. But as repeatedly stated, I just don’t understand why participants were surprised by said numbers since they were telegraphed by Japan’s tragedy (supply chain disruptions), the weird weather (tornados/floods), and a 44% rise in the price of gasoline between January and May. Moreover, I continue to think the economy is “geared” to reset itself. Manifestly, vehicle production is scheduled to ramp 23%+ in July, Japan is doing better, the debt ceiling debacle will be resolved with the attendant outsized spending cuts I have been suggesting, gasoline prices have declined by ~15% from their May peak, U.S. bank loans are increasing, and capex should strengthen in 2H11. That improving capex view is reflected in the Business Roundtables CEO Capex Outlook Survey that also has a high correlation with CEOs’ hiring intentions (read: better employment figures). To be sure, I think the business cycle is still in play whereby profits explode, which drives an inventory rebuild, followed by a capex cycle, and then people get hired.

Reinforcing that view is this insight from our sagacious friends at the “must have” GaveKal organization. To wit:

“We would still attach a probability of well over 50% to our core scenario of strong US growth. Our reasons were presented in the Quarterly: huge corporate cash-flows and the weak US Dollar will keep investment and exports booming; bank lending is reviving and starting to trickle down to the crucial small business sector; and employment, retail sales and consumer confidence were all improving strongly, until the temporary setback in the latest figures. We believe this setback was due very largely to the shock of $120 oil. Indeed, we had been warning since January that the combination of the Fed’s easy money and Middle Eastern upheavals was causing severe economic damage. In our view the present global slowdown and correction in financial markets is thus largely an overdue reaction to the unexpected dangers that materialized in the Middle East (and to a lesser extent in Japan and Europe) at the start of the year. The good news is that the most important of these shocks—the oil crisis—is now almost certainly over as the biggest damage to the world economy came not from the direct effect of oil at $120, but from the possibility that the price would jump to $150 or even $200, if political chaos spread to Saudi Arabia, Kuwait or the UAE. With this risk now essentially removed, the Saudis are eager to teach the rest of OPEC (especially Iran) a lesson by maximizing their output and dumping it on the market to keep prices down. Thus a strong rebound is still much more likely than an extended soft-patch, never mind the outright recession for which the bond market is now priced. And that, in turn will probably mean the Fed starts its journey back to monetary normality much sooner than the markets expect.”

As for last week’s action, while it’s true the SPX tested, and held, its 200-day moving average (DMA) at ~1258 on Thursday, the SPX “missed” out on a prime opportunity to build on that upside reversal last Friday. Indeed, Friday’s opening salvo saw the SPX “tag” ~1280 (+13 points) in the first five minutes of trading. From there, however, the market zigzagged its way through the session and struggled to close only ~4 points higher. Disappointing – you bet it was because Friday’s struggle worked off some of the oversold condition and therefore leaves us with a pretty weak stock market trading pattern. In fact, this sort of set-up suggests further weakness into the aforementioned 1230 – 1250 zone. So unless the SPX can better the 1292 – 1296 level, the current configuration favors further downside probing.

The losing sectors for the week were: Materials (-1.96%); Energy (-1.65%); and Information Technology (-1.16%). The winners were: Consumer Staples (+1.20%); Industrials (+1.09%); and Utilities (+1.0%) as the restless rotation extends. Meanwhile the Financials continued to languish. Indeed, of the 10 macro sectors the Financials have been the worst performing, losing some 6.50% year to date. Unfortunately, that leaves my New Year’s “call” that “2011 should be the years of the banks” looking pretty foolish. Fortunately, I have avoided the underperforming marquee bank stocks, preferring the smaller names like IBERIABANK Corporation (IBKC/$57.09/Strong Buy). Speaking to this “small bank” theme, last week I had dinner with David Ellison, portfolio manager of the FBR Small Cap Financial Fund (FBRSX/$18.67). I used to chat with David back in the 1980s when he hung his hat at Fidelity and managed Fidelity’s Select Financial Fund. Interestingly, David currently owns a number of the smaller banks I have commented on in these missives. Even more interesting is that David is my kind of investor since when he can’t find attractive investment opportunities he is content to hold cash. Case in point, unable to find attractive investments going into the 2008 financial fiasco, David held 60% of his fund in cash. Indeed, my kind of investor. Accordingly, participants wanting to fill the financial sleeve of their asset allocation model should consider David’s fund.

The call for this week: In last week’s comments I noted the SPX had been down for six consecutive weeks for only the 17th time since 1928. As Bespoke Investment Group wrote early last week, “If there is any consolation for the bulls, it is that there have only been three weekly losing streaks of seven or more (weeks) for the index. (After six consecutive weeks down) in week seven, the SPX has risen an average of 1.03%.” While last week’s gain of 0.52% fell short of that average, the SPX did manage to avoid its seventh weekly wilt. Not so for the NASDAQ, which recorded its seventh down week with a loss of 1.03%? I am leery when the NASDAQ doesn’t confirm the SPX’s upside, so unless the SPX closes decisively above the 1292 – 1296 level I am cautious. And with that, I am leaving for a European tour to see accounts and speak at conferences. If history is any guide, the stock market will bottom in my absence. We’ll see what happens when I return in a few weeks.

Copyright © Jeffrey Saut, Raymond James