Investment Strategy from Jeffrey Saut, chief investment strategist, Raymond James
“Rules are Rules?!” (An email from Grandma)
The Good news: It was a normal day in Sharon Springs Kansas, when a Union Pacific crew boarded a loaded coal train for the long trek to Salina.
The Bad news: Just a few miles into the trip a wheel bearing became overheated and melted, letting a metal support drop down and grind on the rail, creating white hot molten metal droppings spewing down to the rail. The Good news: A very alert crew noticed smoke about halfway back in the train and immediately stopped the train in compliance with the rules.
The Bad news: The train stopped with the hot wheel over a wooden bridge with creosote ties and trusses. The crews tried to explain to higher-ups, but were instructed not to move the train! They were instructed Rules prohibit moving the train when a part is defective! REMEMBER, RULES are RULES! (Don't ever let common sense get in the way of a good disaster!)
Hard and fast “rules,” I have argued against them since entering this business some 40 years ago because in the stock market you have to be flexible. The reason for flexibility is that markets tend to be driven by, “fear, hope and greed only loosely connected to the business cycle.” I used to get into arguments with finance professors about this point. While it’s true over the long run investing is all about earnings, many investors lose money in the short/intermediate term (even if earnings are improving) adhering to that “it’s all about earnings” rule because sometimes Mr. Market decides “he” is unwilling to put a high price earnings multiple (PE) on those earnings. For example, if you bought McDonalds stock (MCD/$75.10) in 1972, earnings increased for the next 10 years. In fact, McDonalds never had a down sequential quarter over that timeframe, still shareholders lost money for nearly a decade because Mr. Market was unwilling to capitalize that improving earnings stream anywhere near the PE multiple he was willing to pay in the early 1970s. To be sure, in the short/intermediate term, the stock market is, “fear, hope and greed only loosely connected to the business cycle!”
Most recently, rule-centric investors have been listening to far too many rants about double-dips, death crosses, Hindenburg Omens, Roubini Revelations, Prechter Prognostications, et al. Consequently, they have avoided my advice to buy blue-chip, dividend paying stocks, as well as special situations. So far, that “shun equities” mindset has been wrong-footed. Granted, I have underplayed the trading side of the current rally, however I have not underplayed the investing side having recommended over 30 stocks in these missives during the past few months. Additionally, I have been steadfast of the opinion that “it is a mistake to get too bearish here.” I still feel that way. Indeed, I was on a conference call with some institutional accounts in Zurich last week.
Those portfolio managers were quite concerned about being underinvested in equities, particularly U.S. equities, which are a huge weighting in the EAFE Index. During that call I suggested that with quarter’s end approaching, performance risk, bonus risk and ultimately job risk will drive stocks higher. Verily, I believe performance anxiety is going to cause PMs to buy stocks right into quarter’s end.
Meanwhile, as stocks rallied last week, the U.S. dollar dove. The result left the Dollar Index below 80, a level not seen since January of this year. That action caused one Wall Street wag to exclaim, “Are stocks rallying, or is the ‘measuring stick’ declining?” Certainly a fair question, yet it is consistent with my long-term belief one of the metrics needed to get us out of the “debt box” we have painted ourselves into is the debasement of the dollar. If correct, you want to have your investment dollars in vehicles that hopefully retain purchasing power and keep up with the inflation that is most surely coming. I think quality stocks with dividends play to that theme, as does my “stuff stock” theme. To that point, most commodities, as well as many commodity-based “stuff stocks,” broke out to the upside in the charts last week concurrent with the dollar’s dive. I have been adamant on investing in “stuff” ever since 4Q01 when China joined the World Trade Organization suggesting Chinese per capita incomes were going to rise with an attendant rise in the price of “stuff” (energy, water, electricity, timber, cement, agriculture, metals, etc.). I continue to feel that way because as per capita incomes rise people consume more “stuff.”
My more orthodox investment strategy is to buy a tranche of a distressed debt fund like Putnam’s Diversified Income Fund (PDINX/$8.01) and buy an equal amount of some equity income fund that invests in blue-chip, dividend paying stocks. Then, purchase a tranche of an international fund like MFS’s International Diversification Fund (MDIDX/$12.54). Add to this portfolio a “slice” of something like Raymond James’ Asset Management Services “Alternative Completion Portfolio,” which contains investment vehicles in Currencies, Managed Futures, Arbitrage, Commodities, Real Estate, Long/Short Funds, etc. Finally, in an attempt to add Alpha to the portfolio, I would judiciously purchase special situation stocks like cloud computing company CA Incorporated, which has a Strong Buy rating from our fundamental analyst (CA/$21.15).
The call for this week: Last week most of the major stock market averages I follow broke out of their May – September trading ranges to new recovery highs (small cap indices did not). Confirmatorily, said break-out occurred on a 90% Upside Day (Septembe 20th). According to the invaluable Lowry’s service, “There have been three consecutive confirmed 90% Upside Days since the beginning of September. That’s the first time there have been more than two consecutive 90% Up Days since the March 2009 market bottom.” While I am not looking for a repeat of the 2009 stock market rally, the S&P 500’s (SPX/1148.67) April “highs” seem achievable. Meanwhile, the bears continue to growl, “Where’s the volume?” My reply to that question is that the whole 2009 rally came on declining volume, as did this year’s May mauling, begging the question – does volume really matter? I think it does; yet, I can make the argument that declining volume is actually bullish because it implies most participants just don’t believe the rally is for real. When volume finally arrives, it would suggest the naysayers have finally capitulated, and bought stocks, which I would interpret bearishly as in – who’s left to buy?!
P.S. – Speaking to “rules,” Rule #1: “Don’t lose money.” Rule #2: “Don’t forget rule number 1.” . . . Warren Buffett
Summary of TrimTabs Weekly Liquidity Review
We are remaining neutral (0% long) on U.S. equities. For the most part, our macroeconomic and supply-side indicators are not encouraging:
Wages and salaries are flat sequentially, which does not bode well for the economy or corporate actions in the U.S. stock market. We estimate that wages and salaries rose 2.8% y-o-y in the past two weeks, little changed from 2.5% y-o-y in the past three months even though year-over-year comparisons are becoming easier in September. While our employment indicators have improved a bit, they are still consistent with private sector job growth that is not strong enough to absorb new entrants into the labor force.
Companies have stopped shrinking the float. New offerings of $21.0 billion in the past week were the highest this year, while the Netezza buyout and the Texas Instruments buyback were the only substantial float shrink announced. The float has increased $9.4 billion in September, putting this month on track to be the first this year in which the float has expanded. The float could expand further this week because underwriters already have $3.8 billion in new shares lined up to sell.
Corporate insiders have virtually stopped buying shares. Insider buying in September has amounted to $150 million, putting this month’s amount on track to be less than one-third of this year’s monthly average of $600 million.
We are not turning bearish because our demand-side indicators are still mostly favorable:
The TrimTabs Demand Index, which uses 21 flow and sentiment variables to time the U.S. stock market, stood at 78.7 on Thursday, September 23. While this reading is below the interim high of 92.4 on Monday, August 30, it is well above the neutrality line of 50.
Leveraged U.S. equity exchange-traded fund flows are still bearish, which is encouraging from a contrarian perspective. In the past week, leveraged long U.S. equity ETFs redeemed 4.6% of assets, while leveraged short U.S. equity ETFs issued 4.0% of assets.
Even before Friday’s big rally, investor sentiment was becoming worryingly upbeat. The American Association of Individual Investors reports that 45.0% of the respondents to its sentiment survey were bullish, almost double the 25.4% who were bearish. Also, Investors Intelligence reports that 41.1% of advisors it surveyed were bullish, far exceeding the 29.3% who were bearish. But retail investors are not putting their money where their mouths are, which is encouraging. U.S. equity funds have lost an estimated $11.6 billion (0.3% of assets) in September even though the average fund is up 6.7%.
In our model portfolio, we are 50% short XLE (SPDR Energy) and 50% long XLK (SPDR Information Technology).
Fed Gears Up to Print Lots More Money. We Expect Fed to Announce $1+ Trillion Treasury Purchase Program on November 3.
We wrote on our August 30 issue, “In the next couple of years, we expect the Fed to print trillions of dollars to buy everything from Treasuries to mortgage-backed securities to credit card securitizations to corporate bonds. We think Mr. Bernanke will print as much as he feels is necessary.”
The Federal Open Market Committee statement last Tuesday did nothing to change our view. The statement declares, “The Committee. . . is prepared to provide additional accommodation if needed to support the economic recovery.”
We expect the Fed to announce a $1+ trillion Treasury purchase program at its next meeting on November 3. The federal budget deficit in the past three months was $1.3 trillion annualized, so there will be no shortage of Treasuries for the Fed to buy.
The current Fed is the most accommodative in history, yet even it seems hesitant to print more money because it fears the longer-term consequences. After all, if money printing could solve the economy’s problems, the Fed could print trillions right now and be done with it. We think the Fed realizes that money printing will not solve the economy’s problems but that it does not know what else to do.
There are plenty of well-informed people on both sides of the deflation/inflation debate. We think whether deflation or inflation ultimately prevails depends on how much the Fed and the government are willing to intervene in the markets and the economy. We think they will be willing to intervene a lot, so we lean toward inflation over the longer term. But we acknowledge that deflation is also possible, particularly over the near term. We think investors would do well to have insurance against both deflation and inflation and brace for lots of market volatility.
Commentary from Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication, LLC
Performing the retirement calculation – how much to save each month to build a nest egg that will last as long as it needs to – is a common but complex exercise involving many factors. Included are the dates of retirement and termination, income needed (including any legacy), expected returns, current savings, and assumed inflation. Other factors may also play a role, but these are the ones most often incorporated into online calculators.
An obvious question is: which factors have the greatest impact?
Answering this question involves what decision-modelers refer to as “sensitivity analysis.” It tests how sensitive the end result - the amount needed to be saved in this case – is to changes in each factor. The factor that produces the largest change in the result is considered to have the greatest impact. The concept is identical to what economists refer to as “elasticity.”
A sensitivity analysis of the retirement problem suggests that the two most important factors are the 1) number of years until retirement, and 2) the income level desired. Fortunately, these are also the two factors that people have the most control over – when they retire and how much they will spend.
Let’s look at someone who’s 57 years old, planning to retire in about 10 years, and wants the portfolio to last until age 100. This client had a target nest egg of $700,000, of which $200,000 had already been saved. The expected return was assumed to be 10 percent per year before retirement, 8% thereafter, and a required withdrawal of $30,000 plus 3% inflation with no legacy. Using this example, let’s examine our two factors.
Years until retirement: It is easy to see why postponing retirement has the greatest impact. It affects the savings calculation in two ways: it allows more savings to accumulate and, assuming the terminal date remains constant at age 100, it will not have to last as long.
To reach $700,000 in 10 years, the client would have to save about $900 per month. But delaying retirement by one year (to 11 years from now – a 10% increase) would cut the size of the nest egg needed to about $650,000 and allowed their existing nest egg to grow another year. As a result, their required saving rate drops to about $400 per month, a 60% decrease. None of the other factors could match such dramatic an impact.
Income Level Desired: In second place was the size of the withdrawal. If it declined 10% to $27,000 (assuming all other factors remain constant), the required nest egg drops to about $625,000, and monthly savings to about $540 per month, a 40% decrease. Ten percent improvements in returns and existing savings reduced the required savings rate by 29% to 33%. A 10% reduction in inflation protection (to 2.7%) caused the savings rate to decline by 24%. Note that all the factors create elastic responses, but the retirement delay and income requirement change clearly created the largest impact on the retirement calculation.
While these responses apply only to someone whose situation fits the assumptions mentioned, the results are nevertheless revealing for the general case. The two most important factors can be controlled directly by the client, which is good news. And it explains why there is a trend toward advisors becoming more familiar with the psychological issues of life planning – when to retire and longevity estimates - in addition to strictly financial issues when advising clients on the question of retirement.
FDIC Bank Failure Update from Keefe Bruyette & Woods: Two Failures Announced Last Week
Two Bank Failures—The FDIC announced 2 additional bank closings on Friday, located in Florida and Washington. This weekend’s 2 failures brings the total number year-to-date to 127 and cycle-to-date to 295 institutions including 140, 25, and 3 in 2009, 2008 & 2007, respectively (Exhibit 1). In total, last weekend’s failed banks held $437 million in assets and $410 million in deposits. The estimated losses to the FDIC totaled $105 million or 24% compared to the 2009 loss rate of 21% ($36.4 billion in losses on $171.9 billion in assets).
Concentration of Failed Assets & Deposits—Relative to the industry, last week’s failed banks had a higher concentration in commercial real estate loans at 54% of total loans, compared to an average of 34% for the industry (Exhibit 4). On the liability side this week’s failed banks relied more heavily on time deposits at 78% versus the overall industry at 69% (Exhibit 5).
Roll-Up Group—We continue to believe that our roll-up group, those banks with capable and willing management, sufficient capital, above average credit quality and regional opportunities, are likely to benefit by rolling up failed banks . Please see our July 6, 2009 note entitled "FDIC: Failures and Losses Mount, but Stress Creates Opportunity" and Exhibit 6 for additional detail on the complete group.
Performance of Roll-Up Group- In terms of performance (Exhibit 7), the roll-up group has produced a cumulative return (since we introduced the group on July 6, 2009) of 8.05%, which is below the BKX’s return of 14% and below the KRX’s return of 12.9%.
Potential Opportunities—In Exhibit 8 we attempt to map out potential opportunities for the roll-up group to gain market share by identifying banks, by region, with Texas ratios in excess of 100%. After incorporating this week’s failures, our potential opportunities table currently has 455 institutions with a Texas ratio over 100% with total assets of $236 billion. This compares to the FDIC “Problem List” of 829 banks with assets of $403 billion.
Location of Potential Opportunities—The majority of the assets we have identified in our potential opportunities list are located in the Southeast and Midwest with 28.4% and 23.2%, respectively, followed by the West with 18.5%. The Mid-Atlantic is not far behind offering 17.6% of total assets and the Southwest currently holds 11.5%. Additionally, the Northeast region presents the fewest opportunities with less than 1% of these assets.
Tuesday, Sept 28:
S&P Case-Shiller HPI home index.
Wednesday, Sept. 29:
MBA Purchase Applications from the Mortgage Bankers' Association
Thursday, Sept 30
Corporate Profits, from the Bureau of Economic Analysis (BEA)
Friday, Oct. 1:
Consumer Sentiment, from the Reuter’s/University of Michigan Consumer Sentiment Index.
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