"Wrong" (Saut)

October 18, 2011

7 minute read

“Wrong”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

October 17, 2011

In this business when you’re wrong, you say you’re wrong. And I was wrong when I wrote in last Monday’s missive, “As for ECRI’s (Economic Cycle Research Institute) statement that a recession is ‘imminent,’ while the folks at ECRI are very smart, they did call for a recession last year that never arrived.” I read that quip in some stock market advisory letter (which I can’t recall the name) and I did try to verify that alleged 2010 “recession call” on ECRI’s website, but I could not log on to the website. In point of fact, ECRI did NOT call for a recession in 2010, an error not only pointed out to me by numerous hedge funds, but by ECRI’s gracious Lakshman Achuthan, who had this to say:

“I would respectfully request that you make the necessary correction to your commentary. That said, some who were calling for a recession in 2010 certainly tried to use our Weekly Leading Index to support their views and that may be what you are thinking about. As you can understand, we don't want that myth unintentionally reinforced.”

Alas, when you publish you make mistakes and this one was clearly my error. So I’ll say it again, in this business when you’re wrong you say you’re wrong and I was plainly wrong. However, one instance where I have not been wrong is my “call” to buy the stock market’s “undercut low” two weeks ago. Recall that we have been using the October 1978 and October 1979 analogues for the past few months because of the striking pricing correlation between now and then, even though the economy, interest rates, world environment, etc. were different back then. While we are typically not big fans of analogues, because they tend to work until they don’t, we have to admit the similarity to the declines, and subsequent bottoming sequences of October 1978 and 1979, is pretty eerie. In both of those 1970s bottoming sequences the selling climax, or panic lows, were marginally violated before the bottoming process was complete. Consequently, we have suggested the same pattern might happen in the current process, which is what gave us the courage to recommend buying the index of your choice during the Dow’s Dive of 250-points the morning of October 4, 2011. Our premise was that if the index was firming into that day’s close you should hold those positions. The quid pro quo was that if we were falling late in that session you should sell the position and live to play another day. More recently, in last Tuesday’s verbal comments, we did indeed recommend selling partial positions of those index positions since the short-term NYSE McClellan Oscillator was about as overbought as it ever gets, as can be seen in the chart on page 3.

Overbought indeed, as the S&P 500 (SPX/1224.58) has risen nearly 14% since the October 4th “under cut low,” leaving 78.6% of the SPX’s stocks above their respective 50-day moving averages (DMAs). At the August 9th “selling climax” low only 4% of the SPX’s components were above their 50-DMAs. So, it is abundantly clear that in the short-run stocks are currently overbought. Even the Financials (read: banks) are no longer oversold, a fact that speaks to the near-term overbought condition. The two-week rally has also left the SPX challenging overhead resistance that stems from the broken support levels, as well as prior rally peaks, of late August and mid-September. Accordingly, we are inclined to raise stop-loss points on all remaining trading positions even though by our work Friday’s close above 1217 (basis the SPX) confirms a new uptrend has begun. Importantly, for the past two weeks we have been telling investors that in our opinion the low for the year was made with the “under cut low” of October 4, 2011. Interestingly, the winning sectors of the recent “upside romp” have been Technology, Consumer Discretionary, and surprisingly, the Utilities. Why surprising? Well, because interest rates have actually risen rather dramatically since October 4^th, likely driven by the string of improving economic reports. To be sure, the string of better than expected economic releases continued last week with seven of the eight reports above expectations punctuated by Friday’s retail sales report. To wit, retail sales rose more than expected in September (the median forecast was +0.7% overall, +0.3% ex-autos) and figures for July and August were revised higher. Core retail sales (sales ex-autos, building materials, and gasoline) rose 0.6% and the August estimate went from flat to +0.4%, a slightly slower pace than in 2Q11, but still respectable. Motor vehicle sales popped, as anticipated, while gasoline sales rose moderately (lower gasoline prices, but the seasonal adjustment expects that). The results are consistent with a moderate pace of consumer spending growth in 3Q11.

“So Jeff, you have told us traders should adopt a more cautious approach in the short-term, but what should investors do?” Well, while I think the intraday low of October 4th (1074.77) will stand as the low for the year, I am still bothered by the Dow Theory “sell signal” of August 4, 2011. Consequently, until that signal is reversed, if I am going to err it is going to be by being too cautious. For mutual fund investors this means sticking with fairly conservative funds. In addition to the often mentioned Goldman Sachs Dynamic Allocation Fund (GDAFX/$10.27), which has a risk-managed approach to asset allocation, last week we hosted a conference call with the keen-sighted folks at the GaveKal organization. The GaveKal Platform Company Fund (GAVIX/$10.60) was the topic of said call and its portfolio manager, Steve Vannelli, spoke after a brief strategy update from me.

Steve began by noting that for the past 12 months he has had the fund positioned very conservatively. However, the economic growth scare, the liquidity scare, and the panicky sentiment levels seen over the past few months have probably already been discounted by the SPX’s 20.8% decline from its July 7th intraday high into its recent low of 1074.77. Indeed, he thinks the “emotional low” was made in early August and it is now time for a more bullish stance. Accordingly, Steve has changed the fund’s asset allocation to where Technology is now a 20% weighting, and Consumer Discretionary is a 12% weighting, both of which are up substantially from only a 2% - 4% weighting a few months ago. He went on to impart that there is going to be a huge amount of quantitative easing in Europe combined with slower economic growth in China. Since Europe, China, and the U.S. are the three biggest “economic blocks” on the planet, Steve’s thesis is that the rest of the world will be “shoveling money” into the U.S. He then posed the question, “What will the U.S. do with that money?” He thinks, due to a decade of little fixed investment, the U.S. will experience a new investment cycle. And, as the dollar turns more positive, the economy accelerates, and there is a turn in the monetary cycle, he believes global companies will add capacity in the U.S., leading to an investment boom. That is why he is increasing his allocation to the Technology sector given that tech is flush with cash, possesses low valuations, and that many technology companies are turning into dividend stories, a theme very close to our hearts.

To this technology point, I asked Steve to discuss his “knowledge,” or intangible capital, theme. He responded by stating that our current accounting system doesn’t value “intangible capital accumulation” appropriately. Most certainly, intangible capital accumulations are “expensed,” not capitalized. Such accumulations increase productivity, foster more efficiency, and drive better financial money flows than are currently measured. Moreover, if you are not measuring such metrics correctly, you are also not measuring our country’s “economic output” correctly. For example, “What is Amazon’s (AMZN/$246.71/Market Perform) “search engine” worth? It is certainly worth something. But, it is currently carrying no value on AMZN’s balance sheet. Or, how about Apple’s (AAPL/$422.00/Not Covered) I-Tunes? Hereto, I-Tunes has no value on Apple’s balance sheet. Ladies and gentlemen, our current accounting system ascribes no value to companies building “intangible capital” and thus it is mis-valuing many companies. Manifestly, if you are not measuring a company’s accumulation of “intangible capital” correctly, you are undervaluing corporate America. Currently, Federal Reserve reports show that $1.5 trillion worth of intangible capital accumulation is being not being recorded, which means our nation’s GDP output is not being calculated correctly either. Our sense is the path ahead is going to be better than most economists expect. Companies from our universe that spend an oversized amount of money creating “intangible capital,” and are rated Strong Buy by the covering fundamental analyst, remain: Amyris (AMRS/$15.67); Ciena (CIEN/$12.37); LSI (LSI/$5.94); NVIDIA (NVDA/$15.72); SuccessFactors (SFSF/$26.22); Analog Devices (ADI/$35.82); Medidata Solutions (MDSO/$17.14); Semtech (SMTC/$23.79); and ADTRAN (ADTN/$31.87). While most of these names possess no dividend yields, if you “buy into” the knowledge theme, these companies are worth consideration.

The call for this week: Near-term overbought is our short-term “call,” yet we think the lows are “in” for the year. Regrettably, we also believe there has been so much technical damage that the May 2nd intraday high of 1370.58 marks the high for the year. Nevertheless, we are buyers of favored stocks on weakness given our sense that there will be no recession and that earnings will continue to surprise on the upside.

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