"Can You Hear Me Now?" (Saut)

“Can You Hear Me Now?”
September 6, 2011

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage.”

So said Chairman Ben Bernanke a fortnight ago. He went on to state:

“The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.”

On the surface I think the esteemed Chairman is sending a message to our elected leaders that the Federal Reserve has done all it can do to resuscitate the economy. The implication, it is now up to those leaders to put forth market-based programs to solve our nation’s woes. Surprisingly, President Obama stated he actually wanted “market-based” solutions for the housing debacle before he left on holiday. In past missives I have written about one such program in Puerto Rico. Said program has sent sales of new homes surging by some 80%, while sales of existing homes have risen 24%, over the past 10 months. The story was in The Wall Street Journal on 8/13/11. We should find out if the President will adopt such practical, market-based solutions this Thursday when he addresses a joint session of Congress. Still, I have to admit suing the nation’s banks, and supporting the NLRB’s decision to send jobs to Mexico rather than South Carolina, are NOT practical market-based solutions. Accordingly, this Thursday’s address becomes increasingly important for the economy, as well equity prices.

However, if the stock market’s action is any indication, it is going to be more of the same political finger-pointing and blame game shenanigans inside the D.C. Beltway since the D-J Industrial Average (INDU/11240.26) has lost ground in five out of the past six weeks. The result has left the Doleful Dow down 11.8% from its 7/22/11 intraday high into last Friday’s close. The quid pro quo is that the senior index is up ~6% from its “selling climax lows” of 8/9/11. The resulting four-week range-bound chart formation continues to look eerily similar to the bottoming sequences of October 1978/1979 so often referenced in these reports (see chart on page 3). Studying those bottoming patterns shows at least three retests of the selling climax “lows,” and in both cases, those “lows” were actually marginally broken in the retests. Therefore, unless the “lows” of 8/9/11 are decisively violated, I am sticking with the October 1978/1979 bottoming themes. That said, while I am hopeful the 8/8/11 Dow Theory “sell signal” will prove false, like the one of May 6, 2010 (flash crash), I have learned the hard way to be respectful of ANY Dow Theory signal! Hence, if I am to err, it is going to be by being too conservative, which is why most of the investment recommendations noted in these comments recently have been fundamentally sound, statistically undervalued, dividend-paying situations that our fundamental analysts think have already made their “lows,” even if the Dow takes more time to complete its bottoming process.

So how do investors determine what’s undervalued? Well, one can begin by eliminating overvalued asset classes like sovereign debt, the Swiss Franc, the Japanese Yen, Hong Kong real estate, in the near-term precious metals, etc. and diversify among the asset classes that reside on the left side of the bell-shaped curve (read: undervalued). For years I have opined that water is the most undervalued asset I know, but water has become increasingly difficult in which to invest because “smart money” has been acquiring water-centric companies for more than 30 years. Another way to determine an undervalued asset is to observe what smart people are buying and try to understand why. Recently, however, individual investing titans have not been buying much despite the fact that as of last week Lowry’s Buying Power Index rose above its Selling Pressure Index. Yet another way of seeking undervalued investments is to watch what smart companies are buying; recently smart companies are buying intellectual property (IP) ... aka, knowledge. As the brainy folks at the GaveKal organization, whose mutual funds are worth your consideration, write:

“The reason ‘knowledge’ is such an undervalued quantity is that our accounting systems are completely obsolete in establishing where the value lies in a company. Indeed, as companies exit capital intensive manufacturing processes and concentrate more on design and distribution functions, they invest less money on capital expenditure and more on research and development. And, as companies go through this transformation, relying on GAAP-based accounting for information falls way short of painting an accurate picture. ... So basically, we live in a world where R&D spending gets a terrible deal: an investment in a tangible asset (e.g., a machine tool) is counted as a productive asset for years while, in accounting terms, the in-house development of a distribution network (e.g., Dell) loses the entirety of its value within a year. How does this make sense? Obviously it does not, which is why the market may start to move towards new valuation metrics. Remember the old ‘price per eye-balls’ or ‘price per clicks’ of the old late 1990s TMT boom? Who is to say that these will not be replaced by a ‘price per patent’ on which Google, or IBM, may no longer appear so expensive?”

We love the sagacious GaveKal folks for such “out of the box” thoughts, which is what drives superior investment results. Using the R&D prism (research and development) as a guide, I screened Raymond James’ research universe for stocks of companies that spend more than 15% of their revenues on R&D and are rated Strong Buy. The list includes: Amyris (AMRS/$18.89); Ciena (CIEN/$13.78); LSI (LSI/$6.59); NVIDIA (NVDA/$12.92); SuccessFactors (SFSF/$20.83); Analog Devices (ADI/$32.01); Medidata Solutions (MDSO/$15.75); Semtech (SMTC/$21.07); and Adtran (ADTN/$28.89). While most of these names possess no dividend yield, if you “buy into” the knowledge theme, these companies’ metrics are worth consideration.