Promised Land? (Saut)

August 19, 2010

6 minute read

The mountain is high
The valley is low
And you're confused on which way to go
So I've come here to give you a hand
And lead you into the promised land

... Edgar Winter Group, Free Ride

The Edgar Winter Group was playing on The Street of Dreams last week, and the song was Free Ride, as the equity markets have certainly been “confused on which way to go.” Indeed, the McClellan Oscillator became extremely overbought a few weeks ago, which is why I have followed a neutral short-term trading approach to the equity markets. That said, I believe the downside is “measured” given that the earnings yield on the S&P 500 (SPX/1079.25) is 8.1% (based on current forecasts), versus an 8.3% yield for the high yield bond universe, for the narrowest spread e-v-e-r! Such metrics should afford select blue chip, dividend-paying stocks an attractive risk/reward ratio for investment accounts. Interestingly, that is the current strategy of legendary investor Jeremy Grantham. As reprised in Steve Sjuggerud’s always insightful True Wealth newsletter:

“In plain English, Grantham's predicting a 24% rise in the overall stock market; (even though) he's predicting seven lean years for the U.S. economy. But he believes high-quality U.S. stocks will outperform every other asset class over the next seven years.

(Grantham) High-quality stocks were left very much behind in the great rally last year, which was the biggest and most speculative since 1932. Much more surprisingly, they have underperformed this year . . .

Grantham offers up several explanations why high-quality stocks have underperformed, including this one:

(Grantham) In the last 10 years, institutions and even ultra-rich individuals have, in general, been increasing the share of their portfolios that is invested in private equity and hedge funds, commodities, and real estate. And even within their equities, they have been increasing their share of foreign equities, including emerging markets and small caps...

So what is being liquidated to buy all of this new stuff? Old-fashioned blue-chip U.S. stocks. Quality stocks might possibly spend much of the next several years underpriced, but from time to time will bounce back to fair value. (and) This is all that patient investors need.”

Yet, many investors do not want to buy individual stocks. To address that issue Raymond James’ Asset Management Services Department (AMS) is introducing two new investment platforms. The first is slated to commence on September 1, 2010 and is an extension of the current Unified Managed Accounts (UMA) array, which I have embraced since their inception. The new UMA platform is more of a “flex” model. This model uses three separate account managers, housed within a single account. The flex model deviates from AMS’s other UMA offerings in that it uses managers who are less constrained than the typical “style box” manager. A third of the portfolio will be allocated to Lord Abbett Multi Cap Value, a third to Clearbridge Multi Cap Growth, and a third to ING Global Equity Dividend. Lord Abbett and Clearbridge are free to move up and down in market capitalization, depending on where they see opportunities. ING Global Equity Dividend provides the portfolio with high dividend income by investing in global blue chip, dividend-paying companies.

While I personally tend to be more of an individual stock-specific investor, I like these kinds of UMA vehicles for previously stated reasons. Additionally, while Jeremy Grantham is underweighting private equity, hedge funds, commodities, and real estate, I continue to like the idea of investing in a number of such non-correlated vehicles. Unfortunately, the typical retail investor does not have access to such investments because most of them have minimums of $1 million or more. Speaking to this dilemma, AMS has already introduced an alternative investment-focused product called the Alternative Allocation Managed Completion Portfolio. It is a fee-based, turn-key portfolio comprised of 14 mutual funds in the alternatives space. Some of the sectors represented are: Commodities, Long/Short funds, Managed Futures, Arbitrage, Global Macro, and Hedge Fund Replication. The goal is to provide portfolios with a lower correlation, and lower beta, compared to the broader markets. Comprised of 1940 Act mutual funds, the platform has daily liquidity, while the underlying holdings are reported by the mutual funds. Expected returns should be in the realm of a balanced, 60/40 portfolio (7-9%), with a standard deviation around 7. This structure should allow for participation in rising markets, while providing downside protection when the market declines. The minimum investment for this platform is $50,000. Keep in mind, however, this account cannot represent more than 20% of a client’s portfolio at the time of inception.

As for the directionality of the stock market, while my intermediate-term trading indicator remains in the same cautionary mode it has held since the first week of May (see chart where the red lines overlaid against the S&P 500 represent caution), I still don’t envision much downside from here. Indeed, the McClellan Oscillator traveled into oversold territory last week and is almost as oversold as it was at the end of June, as can be seen in the attendant chart. Recall, an oversold reading from the McClellan Oscillator telegraphed the July rally. Further, despite last Wednesday’s 90% Downside Day (-265 DJIA), Lowry’s Selling Pressure Index remains in a well-defined downtrend and Lowry’s Buying Power Index is in a well-defined uptrend. Meanwhile, the New High/New Low, and Advance/Decline, indicators are healthy; and, while many of the indices fell below their respective 50-day moving averages (DMAs) last week, the D-J Industrials (DJIA/10303.15) did not. Either the DJIA will follow the other indexes to the downside by violating its 50-DMA of 10266.14; or, what we could have is a downside non-confirmation.

Speaking to one of our special situation stocks, I have previously addressed Fortress Paper (FTPLF/$27.44), which is followed by our Canadian research affiliate with a Strong Buy rating. Fortress is a growth-oriented specialty paper manufacturer. Yet, the exciting part of the story began in April 2010 when the company acquired the Fortress Specialty Cellulose Mill from Fraser Papers Inc. The envisioned plan calls for a green electricity facility (co-generation with Hydro Québec) to power the mill’s dissolving cellulose operations (read: dissolving pulp). The project should be completed in mid/late-2011. Last week our Canada-based analyst (Daryl Swetlishoff) raised his price assumption for “dissolved pulp” to C$1,100 per ton (from C$1000/ton). Accordingly, FTP’s price target was raised to C$40, which equates to about 10x his 2011 EPS estimate of C$4.07. However, the company suggests it can sell its output of dissolved pulp for C$1,200/ton. Interestingly, the current “spot price” is C$1,580 per ton. If either of those prices proves achievable, FTP’s shares should do well. For further information please see last week’s report. As always, Blue Sky laws must be check by U.S. citizens before purchase.

The call for this week:

Edgar Winter was right, “The mountain is high, the valley is low; and you’re confused on which way to go.” As for leading you into the Promised Land, I think that was done in March 2009 (I was very bullish); this year, however, my mantra has been, “the trick in 2010 is going to be keeping the profits accrued from the March 2009 lows.” I think the two new platforms from AMS have a good chance of accomplishing that, as well as potentially leading you into the Promised Land over the next few years. Last week, however, investors gave up on stocks, worried that Wednesday’s 90% Downside Day marked the end of the summer rally, punctuated by fears that another big decline was in the offing as we enter the dreaded months of September/October. While statistically those months tend to be the worst of the year, that wasn’t the way it played last year; and, I doubt that is the way it plays this year. While the equity markets may pull back, NONE of the characteristics that mark a major “top” are currently in place, including the one all of you folks “pinged” me about late last week; namely, the prematurely called “Hindenburg Omen.” The reporter that released that salacious indicator was clearly a headline seeker since not all of the metrics ascribed to said indicator have yet to be in place.

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