“The Virtue of Necessity”
by Jeffrey Saut, Chief Investment Strategist, Raymond James
July 2, 2012
Mikhail Gorbachev understands this rule of political survival: Make what you must do appear to be what you want to do. His economic reports this summer showed the Soviet Union’s desperation deepening, his perestroika failing. With top-level support crumbling, he staged a September coup. In the name of democratization, he concentrated government and party power in himself. That bought him time, but did not solve the most pressing problem: the huge chunk of Soviet production devoted to the military, now approaching 25 percent, four times greater than the U.S. share. Moreover, the cohort of draft-age Russians was shrinking, making military conscription more difficult. With no choice but to cut military spending, “President” Gorbachev turned that sour lemon of declining power into the most delicious lemonade. He came to the U.N. and told the world proudly that he was unilaterally reducing Soviet troop strength by a half-million. Not because he had to, you understand – purely motivated by idealism – [but] because “the use or threat of force no longer can or must be an instrument of foreign policy.”
What a combination of audacity and mendacity. Only the use of force keeps Communist regimes in power; only the “threat of force” from Soviet tanks keeps the people of Eastern Europe from overthrowing their hated puppet regimes. But the U.N. and the watching world heard what it wanted to hear – an uplifting, peaceful speech from an all-powerful Soviet leader that might have come from a freely elected American leader. The more gullible viewers thought they heard a genuine yearning for an end to Soviet expansionism instead of a rationale for a temporary retreat caused by economic necessity.
... William Safire, New York Times, 12/8/1988
“Economic Necessity” was a phrase replete in the media late last week and it brought back memories of the aforementioned quip by William Safire written in 1988. In the current case it is not economic necessity for Russia, but rather the European Union (EU). For months I have opined politicians, bureaucrats, and bankers are the same in Europe as they are here in that they do not want to lose power. And, if the EU implodes they all lose their power. Therefore, my sense has been the powers that be will continue to “paper over” Euroquake and buy time in hopes time will allow the EU to heal itself, just like we did with our Financial Fiasco (2007 – 2009). Manifestly, that “paper over” event is exactly what happened Friday morning with the EU summit announcement and the world’s markets soared. To be sure, some of the upside fireworks came from short-covering because participants have been rewarded for getting “short” in front of previous EU summits where the post-summit announcements have disappointed. This time, however, that was not the case, the announcement was substantial. Still, I think there was more at work than just short-covering.
Indeed, “your father’s” recession, and subsequent recovery, saw the two sectors that pulled the economy out of recession, namely autos and homebuilding, recording strong rebounds. Beginning in 2009 autos have done their job since we have gone from roughly a 9 million unit seasonally adjusted annual rate (SAAR) to nearly a 15 million run rate. The laggard has been homebuilding, but that appears to be changing. The Homebuilder’s Index is breaking out of a four-year base to the upside, suggesting the worst has been seen and discounted. Meanwhile, one of the things that got us cautious on housing was the rise in For Sale Inventory that began in mid-2005. Now, For Sale inventories have collapsed (see chart on page 3). The second thing that got us cautious on housing was the rise in the cost of a house at the same time inventories were increasing. Affordability, however, is currently at record levels (see chart on page 3). Such metrics have caused a noticeable improvement in sales. Recent reports indicate new home sales continue to accelerate. The seasonally adjusted annualized pace of new home sales (contract signings) rose 7.6% month-over-month to 369,000 units. Drilling down to the unadjusted data, May sales jumped 25% y/y and increased 6% sequentially, indicating that the positive momentum in housing has continued to build in recent weeks. Moreover, these results came as prices rose, with the median new home price climbing 5.6% y/y to $234,500 in May, which was an acceleration from +5.0% y/y in April. These are not unimportant data points because a pickup in homebuilding would not only add jobs, but should strengthen future GDP numbers. Also helping the economy is gasoline, which has fallen from $3.43 per gallon in April to $2.63 currently (basis the August futures contract). That decline is tantamount to a huge tax cut since every one penny decline in price adds approximately $1 billion to consumers’ purchasing power.
Given such metrics, I expect the same outcome that occurred for the past two summers. That being, recession fears, which caused those previous mid-year declines in equity prices, should give way to no recession with an attendant rise in equity prices. And, the rise may have already begun. Said view would gain traction if the S&P 500 (SPX/1362.13) can sustain an upside breakout above the ~1360 level that has contained recent rallies. If that happens, it would lift the SPX out of the trading range between 1290 and 1360 it has been mired in since mid-May. I think this scenario has a decent chance of playing since my weekly internal energy indicator has a full load of energy. My daily indicator’s energy level, however, was largely used up in Friday’s Fling, so maybe we see a pause and/or pullback attempt early this week that doesn’t get very far. Additionally, despite last Monday’s 138-point Dow Dive, following the previous Thursday’s Trouncing (-250 points), none of my risk and money flow indicators turned negative; and not getting bearish over the past few weeks has been a pretty good strategy.
Nevertheless, bearishness is in the “air” with participants in “panic mode” just like they were the past two summers. CALM DOWN, we have had a panic declines in each of the last two years and survived them. Verily, panics represent opportunity for the well prepared investor because the surest action in the stock market following a panic is the subsequent recovery. It’s almost a rule that after a panic there will be an advance that recovers roughly one-half of the points lost during the panic. Recall, last summer the SPX declined from its early July high (1356) into its “panic low” of August 9th (1101) and from there the bottoming process began. Remember that “bottoms” are a function of not just “price,” but “time” as well. In 2011’s “panic decline” the bottoming sequence took from August 9th until October 4th and from there not only did we recover half of the price decline (19%), but we experienced a 32% rally.
Consistent with these thoughts, if the SPX has a decisive and sustained breakout above 1360, we recommend putting some more cash back to work. Over the past few weeks we have featured non-market correlated situations, with decent yields and favorable ratings from our fundamental analysts, like: Covanta (CVA/$17.15/Strong Buy); Johnson & Johnson (JNJ/$67.56/Outperform); and Rayonier (RYN/$44.80/Strong Buy). This morning we revisit the long-standing theme that the master limited partnership (MLP) complex, which trades on average between 9 – 10 times EBITDA, is likely going to acquire select E&P C-corporations that trade at roughly 4 – 5x EBITDA because it is accretive to do so. Some names from our research universe with favorable ratings from our fundamental analysts that play to this theme, include: Denbury Resources (DNR/$15.11/Outperform); Plains Exploration (PXP/$35.18/Outperform); and Whiting Petroleum (WLL/$41.12/Outperform). And since the Energy sector is the most oversold of the 10 macro sectors, speculators might want to consider some our favorably rated, and thoroughly beaten up, coal stocks that presented at the fourth annual Raymond James Coal Conference. For ideas see analyst Jim Rollyson’s Industry Brief dated June 21, 2012.
The call for this week: In my opinion, last week the Commodity Index bottomed and the Dollar Index topped. If so, recession fears should abate in the months ahead. Moreover, if a recession was really on the horizon “junk” bond yields would be rising on worries of increased defaults and that is not happening with the iShare High Yield Fund (HYG/$91.29) attempting to make a new reaction high (i.e., lower yields). Further, if we are heading into a recession, why is the Market Vector Retail ETF (RTH/$42.26) within 1% of new all-time highs? Meanwhile, investors are frozen by the negative narrative of world and economic events and investors have been liquidating domestic mutual funds for about 30 months, investment sentiment is dour, NYSE short interest versus the SPDR S&P 500 ETF (SPY/$136.43) is rising, and there is a huge amount of cash on the sidelines, all of which is inconsistent with a stock market that is vulnerable to a big decline. With the aforementioned proprietary metrics, and the tons of internal energy built up in the markets, if the SPX can sustain a breakout above 1360 the upside could surprise even the “bulls.”
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