Jeffrey Saut: "Terminator 3: Rise of the Machines"

Terminator 3: Rise of the Machines

by Jeffrey Saut, Chief Investment Strategist, Raymond James

August 15, 2011

I was in Chicago last week seeing portfolio managers (PMs), doing media “hits,” and presenting at seminars for our retail investors. The most ubiquitous question I received was, “Who is selling all this stock?” Clearly that’s a valid question since the parade of PMs on CNBC insisted they are not selling stocks, statistics show hedge fund managers are already pretty “light” on stocks, the international institutions I talk to are so underweight U.S. equities it is doubtful they are selling, and order flows show retail investors aren’t really selling individual stocks either (they are, however, liquidating mutual funds). So who’s selling? I think it is the “machines,” driven by high-frequency trading (HFT) and Exchange Traded Funds (ETFs). As defined by Wikipedia:

“In high-frequency trading, programs analyze market data to capture trading opportunities that may open up for only a fraction of a second to several hours. High-frequency trading uses computer programs and sometimes specialized hardware to hold short-term positions in equities, options, futures, ETFs, currencies, and other financial instruments that possess electronic trading capability.”

Exacerbating the situation are ETFs that are leveraged 2:1, or even 3:1, which if bought on margin implies 4 to 6 times leverage. Moreover, when ETFs buy or sell, they do so across the spectrum of stocks within their universe with NO regard for the fundamentals of any individual stock. So yeah, I think it is the “Rise of the Machines” that has compounded the “selling stampede” that began on July 8th, and hopefully ended on August 9th with what a technical analyst would term a long-tailed “bullish hammer” candlestick chart formation. If correct, that would make the stampede 23 sessions long. Recall, stampedes typically last 17 – 25 sessions, with only 1 – 3 session pauses/corrections, before they exhaust themselves. It just seems to be the rhythm of the “thing” in that it takes that long to get participants either bullish, or bearish, enough to act. Obviously, in this case, it would be bearish enough. Consistent with this thought, it is worth noting that in July retail investors liquidated $23 billion worth of U.S. stock mutual funds for the largest liquidation since October 2008’s $27 billion. My sense is even more liquidation is taking place this month.

Yet, it is not just mutual fund liquidation indicating the selling skein is over. Corporate insiders are buying shares at the highest rate since the March 2009 bottom; at last week’s lows the dividend yield on the S&P 500 (SPX/1178.81) exceeded the 10-year T’note’s yield (read: historically bullish for stocks); and if you believe 2012’s consensus earnings estimates, last Monday the SPX was trading at a PE under 10x with an Earnings Yield of ~10%, leaving the Equity Risk Premium around 8%. Ladies and gentlemen, those are valuation metrics not seen in years. To that value point, since the first Dow Theory “sell signal” of September 1999, I have opined the equity markets were likely going into a wide-swinging trading range akin to the 1966 – 1982 affair where an index fund made you no money for 16 years. In December 1974 the D-J Industrial Average (INDU/11269.02) made its “nominal” price low of 577.60, but its “valuation” low (the cheapest the INDU would get on a PE, book value and dividend basis) didn’t occur until the summer of 1982. Fast forward, I have argued the “nominal” price low for this 11-year range-bound market took place in March 2009 and have added, “I don’t know when the ‘valuation’ low will come.” But maybe, just maybe, if next year’s estimates are right, and we don’t go into a recession, we may have made the “valuation” low over the past few weeks.

Whether that “valuation low” thought is correct or not, I am fairly confident the selling squall has compressed stocks so much a short-/intermediate-term bottom has been, or is being, made. To wit, over the past week I have repeatedly stated the equity markets were epically “oversold.” To be sure, finding a session as bad as last Monday’s, when less than 2% of all the stocks traded closed “up” on the day, one has to go back to May 1940. At that time, the markets believed the world was ending when the Germans punched a ~60 mile wide hole in the Maginot Line and poured into France. Another way to look at last Monday is to measure how far the SPX is below its 50-day moving average. While not as massively compressed as in the 1987 Crash’s 5.5 standard deviation, at 4.3 the SPX is very oversold as can be seen in Figure 2 on page 3 from our brainy friends at Bespoke Investment Group. Additionally, the astute Lowry’s organization writes:

“This week will go down in the record book as one of the most manic of all time, with four alternating negative and positive 90% Days, each generating changes in the DJIA of more than 400 to 600 points. There is nothing even close to this frenzy in the 78 year history of the Lowry Analysis. The causes of the week’s mass confusion will be debated for years to come, but the immediate question is, what should investors do now?”

Lowry’s concludes:

“As of Friday’s market close, all of the requirements of Buying Control No. 1 were completed, calling for a 25% invested position. The 2nd stage of the buying program will be completed if Buying Power rises ten points to 391 or higher, confirmed with a ten point drop in Selling Pressure to 358 or lower.”

While we agree with Lowry’s, and have recommended the cash raised last February/March gradually be recommitted to stocks, we think there will be a bottoming process over the coming weeks. In all my talks last week, I likened the current decline to those of October 1978 and October 1979 (Figure 1 on page 3). Both of those “stampedes” came out of the blue with no fundamental reasons. Following the initial selling-climax low, there was a sharp rally that peaked with a subsequent retest of those “climax lows.” The 1978 bottoming process took seven weeks to complete, while in 1979 it took only four weeks. Still, while the stock market’s bottoming process should take weeks, many individual stocks have probably already bottomed. That sense was reinforced last week with our fundamental analysts’ comments on names like: Linn Energy (LINE/37.86/Strong Buy), EV Energy Partners (EVEP/$66.21/Strong Buy), Healthcare REIT (HCN/$45.88/Outperform), First Potomac Realty (FPO/$12.99/Strong Buy), CenturyLink (CTL/$34.61/Strong Buy) to name but a few.

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