Jeffrey Saut: "Poker Mentality?!"

“Poker Mentality?!”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

April 21, 2014

I learned how to play poker at a very young age. My father taught me the concept of playing the percentage hands. You don’t just play every hand and stay through every card, because if you do, you will have a much higher probability of losing. You should play the good hands, and drop out of the poor hands, forfeiting the ante. When more of the cards are on the table and you have a very strong hand - in other words, when you feel the percentages are skewed in your favor - you raise and play that hand to the hilt. If you apply the same principles of poker strategy to trading, it increases your odds of winning significantly. I have always tried to keep the concept of patience in mind by waiting for the right trade, just like you wait for the percentage hand in poker. If a trade doesn’t look right, you get out and take a small loss; it’s precisely equivalent to forfeiting the ante by dropping out of a poor hand in poker. On the other hand, when the percentages seem to be strongly in your favor, you should be aggressive and really try to leverage the trade similar to the way you raise on the good hands in poker.

... “Market Wizards” by Jack D. Schwager, explaining Gary Bielfeldt’s analogy between trading and poker.

I have often stated that the rarest trait on Wall Street is “patience.” I have also repeatedly reprised Charles Dow’s quote that, “The successful investor/speculator needs to ignore two out of every three potential money making opportunities.” Sometimes these old stock market axioms have hurt me, but more often they have saved me a lot of money. Indeed, “Waiting for the right pitch,” as Warren Buffet terms it, is the key to successful investing and trading. Plainly, for much of this year I have tried to wait for the “right pitch.” Last Wednesday that strategy caused me to get accused of, “Not telling us what to do” by one of Raymond James’ complex managers. I replied, “That is blatantly not true for the past few years I have been adamant we are in a secular bull market!” Moreover, during January I was pretty verbose about raising some cash. As I recall, the operative phrase was, “If you have certain stocks in your portfolio that have not performed in the 40%+ rally from June 2012, you might consider selling them to raise some cash for what historically calls for a 5% - 7% pullback in the first three months of this year, and potentially a 10% - 12% decline sometime in 2014.” Subsequently, we got a 6.2% decline into the first week of February, and when it looked like the market was not going to fall into a full-fledged 10% - 12% affair, I recommended putting some of that cash back to work.

The past two weeks I opined I did not know if this was the start of the historically based 10% - 12% decline, but with last Wednesday’s intraday upside reversal I wrote this for Thursday’s Morning Tack. The Tack began with this quote:

“In an uptrend, if a higher high is made but fails to carry through, and prices dip below the previous high, the trend is apt to reverse. The converse is true for downtrends.”

... Victor Sperandeo (Trader Vic, Methods of a Wall Street Master)

It went on to read:

I have heard Victor Sperandeo’s name ever since I entered this business in 1971. In fact, it is legendary hedge fund manager Paul Tudor Jones who said, “Victor Sperandeo is gifted with one of the finest minds I know. No wonder he's compiled such an amazing record of success as a money manager. Every investor can benefit from the wisdom.” So when I was looking at the S&P 500’s (SPX/1864.85) recent pricing action, I recalled the aforementioned quote. The last sentence particularly came to mind – the converse is true for downtrends – because that looks like what we have just experienced. To wit, reverse the word ‘uptrend’ for ‘downtrend,’ as well as ‘low’ for ‘high’ etc. in that quote and this is the phrase you get: in a downtrend, if a lower low is made but fails to carry through, and prices pop above the previous low, the downtrend is apt to reverse. Now study the nearby chart. The SPX has been in a downtrend since its intraday high of ~1897 on 4-4-14. Then on 4-10-14 it fell through its previous “lows” in the 1835 – 1840 support zone and made a lower low of ~1814, but failed to carry through on the downside. Then the SPX popped above those previous ‘lows’ of 1835 – 1840, which is why I wrote in yesterday’s Morning Tack, “In this business price is reality, and with the S&P 500’s close above 1840, I am recommitting some capital here; but I will feel a lot better if the SPX can clear 1860.” Well, from my lips to God’s ears because that is exactly what happened yesterday (last Wednesday) with the SPX close at 1862.31.

With the holiday-shortened week, Thursday was the last trading session before Good Friday, but the equity markets were already on holiday as they limped through the session, leaving the SPX better by a mere 2.54 points and within 1.6% of its all-time high. Interestingly, the strength of SPX is masking the internal correction that has been occurring. For example, the average stock in the S&P 1500 is off 12.5% from its high, while the average small-cap is down roughly 16%. The small-cap weakness was reflected in the Russell 2000 (RUT/$1137.89) that tagged its 200-day moving average at 1108.19 last week. It was the first time in 17 months the RUT has done that and such an event is worth noting. Worth noting because there have been 11 times when the RUT closed below its 200-DMA after spending about seven months above that moving average and such a breakdown has almost always led to lower prices. For me, however, the real event of the week came from the bond market.

Indeed, interest rates went up last week with the yield on the 10-year and 30-year Treasuries rising about 12 basis points, leaving the 10-year’s yield above its 50-DMA and very close to traveling above its 200-DMA at 2.726%. The rate ratchet was likely induced by the strengthening economic data with reports such as retail sales coming in at a stronger than expected +1.1%, with the previous month revised upward, bring sales growth to + 3.8% YTD. That should help lift GDP growth. Also hinting at stronger growth were March’s +0.4 of a percentage point capacity utilization (to 79.2%), as well as the +0.7 of a point rise in industrial production; and don’t look now, but the Citi Economic Surprise Index is moving sharply higher. All of this suggests that as the weather thaws, the consumer is starting to spend. The question then becomes, “How much of this is already priced into the stock market?” But, that is a question for the weeks ahead.

The call for this week: In terms of an update, the two bond funds I have recommended (and both of which I own) for the higher interest rate environment I envision have been the Putnam Diversified Income Trust (PDINX/$7.98) despite its $0.005 reduction in the monthly dividend of $0.032. The other bond fund is the Lord Abbett Bond Debenture Fund run by my friend Chris Towel (LBNDX/$8.27). And following our Institutional Investors Conference, on March 10 I highlighted our fundamental analyst’s recommendation on Goodrich Petroleum (GDP/$24.36/Outperform), and consequently its convertible preferred (GDPAN/$48.30). Despite last week’s 32% leap in the common stock, said shares continue to look higher based on the story laid out in our company comment released last Monday. Speaking to the overall stock market, if this is a counter trend move, followed by another leg to the downside, the current overbought conditions are capable of turning things lower. Yet, if the market can “hang in there” until mid-week, especially if it can make a higher high, this should be a confirmation that this is not the start of the 10% - 12% pullback slated for some time this year.

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