The Great White Hurricane

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“Unseasonably mild and clearing,” was the weather forecast going into the Ides of March back in the year of 1888. And it was true, as temperatures hovered in the 40s and 50s along the East Coast. However, torrential rains began falling, and on March 12th the rain changed to heavy snow, temperatures plunged, and sustained winds of more than 50 miles per hour blew. The “Great White Hurricane” had begun! In the next 36 hours some 50 inches of snow would blanket New York City and the winds would whip that snow into 40- to 50-foot snowdrifts. Telegraph and telephone lines were snapped, fire stations were immobilized, New Yorkers could not get out of their homes, 200 ships were blown aground, and before the storm was over 400 people would die. The resulting transportation crisis led to the construction of New York’s subway system.

We revisit The Great Blizzard of 1888 this morning because of the weather that has crippled the Northeast corridor over the past few weeks. Fortunately, communities are more capable of dealing with such storms today than they were more than a century ago. Still, the loss of productivity is likely going to be impactful in some of the upcoming economic reports. That said, over the long weekend we studied the D-J Industrial Average (DJIA) chart from 1888 and found that March 11 – March 14 marked a bottom for the stock market. Also of interest is that today is session 18 in the envisioned “selling stampede” so often discussed in these missives. For new readers, “selling stampedes” tend to last 17 to 25 sessions, with only one- to three-day counter trend rally attempts before they exhaust themselves on the downside. While it is true that some stampedes have extended for 25 to 30 sessions, it is rare to have one last for more than 30 days. Accordingly, we are getting increasingly interested in stocks again, and have been adding names to our “watch list.”

As for Dow Theory, which we have often been asked to comment on over the last few weeks, so far there is no signal, at least as we were taught to interpret it. Indeed, for a “sell signal” to be generated it requires the following set up (as paraphrased by Mark Hulbert):

The Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a significant correction from joint new highs.

In their subsequent rally attempt following that correction, either one or both of the averages must fail to rise above their pre-correction highs.

Both averages must then drop below their respective correction lows.

Therefore, the stage is set because the DJIA recorded its closing high on January 19th at 10725.43, while the DJTA hit its closing high of 4262.86 on January 11th. Their subsequent lows came simultaneously on February 8th at 9908.39 (DJIA) and 3792.89 (DJTA), respectively. Thus, if the two indices can rally back above their aforementioned “highs,” it would reinforce the Dow Theory “buy signal” generated last summer. If, however, they fail to better those highs, and then break below their February lows, a “sell signal” will be rendered. Regrettably, there is no way to anticipate such signals.

We tend to use Dow Theory for the strategic side of the portfolio (read: investing). To that point, the “buy signal” registered last summer remains in force until it is negated. Optimistically, we continue to believe that negation is not in the cards. Indeed, with credit spreads back below pre-Lehman bankruptcy levels, we think there is no reason why the downside vacuum created in the S&P 500 (SPX/1075.51) chart by said bankruptcy cannot be filled to the upside, especially given the improving fundamental backdrop, suggesting targets of 1200 – 1250. Driving that sort of pricing action has been explained in past missives where we have exhorted that the typical economic recovery cycle is for corporate profits to boom, driving an inventory rebuild cycle that fosters capital equipment expenditures. As companies spend money on the capex, people are hired, and then consumption “reboots.” Importantly, hiring and consumption come on the backend of the cycle, NOT the front end.

Currently, companies have the greatest profit leverage they have seen in a generation and consequently profits are booming. So far, this has allowed cash to build on corporate America’s balance sheets. But with inventories plumbing historically low ratios, the nascent inventory rebuild should gain traction in the months ahead as sales improve. And, sales should indeed improve with stock brokerage accounts now up dramatically from their March 2009 lows accompanied by improving home prices. Moreover, as James Paulsen notes, the fixed-cost portion of household ledgers, which includes debt service and energy costs, topped out at 25% of disposable income and is now down to 22%. Ergo, many consumers are now in a position to return to the shopping malls. And, that increased spending mindset should be reinforced by surging income tax refunds.

Speaking to stock market valuations, while on a trailing 12-month measurement the SPX is neutrally valued at ~18x reported earnings, looking forward shows stocks at ~13x 2010 estimates and ~11x the 2011 forecasts. Moreover, the recent 10% correction has brought the “negative nabobs” back out of the woodwork with a concurrent swoon in investors’ optimism (read that as bullish). Meanwhile, there is more than $10 trillion on the sideline getting negative “real” returns (inflation-adjusted), some of which monies should eventually find their way back into stocks, particularly stocks with dividends. Inasmuch, we continue to add stocks to our “watch list,” and actually are accumulating some of those names in investment accounts. Additionally, we are getting pretty excited on a trading basis considering it is session 18 in our day-count sequence.

To review some the names that remain on the “watch list:” Walters Energy (WLT), O’Charley’s (CHUX), Select Comfort (SCSS), National Oilwell (NOV), CVS (CVS), Alpha Natural Resources (ANR), Cogent (COGT), Cenovus Energy (CVE), Radiant Systems (RADS), Dine Equity (DIN), North American Energy Partners (NOA), Allstate (ALL), Home Depot (HD), Inergy (NRGY), and last week we added Noble (NE). Noble operates one of the largest offshore rig fleets in the world with 63 mobile offshore drilling units. It has a ton of cash on its balance sheet and a low tax rate since it has moved its headquarters to Switzerland. Trading at attractive valuations, we find these shares compelling. And before I get a hundred emails, yes, we still like Celgene (CELG), which is followed by our research affiliate with an “Overweight” rating.

The call for this week: China is closed for the Chinese New Year this week (The year of the Tiger), so China is not going give us a hint as to if our markets are bottoming like it did last year. Still, we are pretty excited since today is session 18 in the envisioned 17- to 25-session “selling stampede” and we are looking for a bottom. Interestingly, so is the astute Lowry’s service. To wit:

“A well-known market analyst was said to have once remarked that every bull market has at least one pullback that fools investors into thinking a new bear market has begun. To create this deception, these pullbacks need to be severe enough to raise expectations a new bear trend is underway – such as might occur with a correction of 10% or more. But, to be deceptive, such declines should be relatively rare occurrences, which runs counter to the general perception. . . . So, rather than being commonplace, pullbacks of these magnitudes are relatively infrequent. . . . How then, are investors to differentiate between these corrections and the beginnings of a new bear market? One similarity in each of these cases of corrections reaching 10% or deeper is that they typically occurred well into the second stage (the Holding and Upgrading Zone) of the bull market. That is, profit-taking has already been well established, as reflected in a sustained uptrend in our Selling Pressure Index, thus setting the stage for deeper than normal corrections. In the present case, however, the Selling Pressure Index was recording an 18-month low in mid-January when the (stock) market correction began. Thus, based on the long history of the Lowry Analysis, the probabilities do not favor a 10% plus correction occurring at this relatively early stage of the uptrend.”

“Who framed Roger Rabbit?!”... except in this case we are referring to Roger Blough. Return with us now to those thrilling days of yesteryear. The year was 1962, John Kennedy was President, and Roger Blough, the then CEO of U.S. Steel, had signed an agreement with President Kennedy not to raise prices. However, just four days later he raised steel prices right in President Kennedy’s “face.” The outraged President went after Mr. Blough and when Roger Blough tried to argue his point, Jack Kennedy stated, “My father told me that all steel men are #@Q&%!” The battle lines were thus drawn; government contacts were switched from U.S. Steel in favor of steel companies that didn’t raise prices, and with that governmental incursion into corporate America, the D-J Industrial Average (DJIA) shed 26% in just six weeks. Fast forward to today. The major banks have paid outsized bonuses right in the “face” of President Obama; and, it appears he has gone after them. Accordingly, the stock market has gone into the dumper, as can be seen in the attendant chart (for the record, I am neither a Republican nor Democrat; so stated before I get another onslaught of hate mail). Whether the 1962 analogy continues to “fit” remains to be seen, but it is a very interesting comparison that participants should ponder since we continue to believe the markets are in “selling stampede” mode.

Recall that “selling stampedes” tend to last 17 – 25 sessions, with only one- to three-session counter-trend rallies, before they exhaust themselves on the downside. It just seems to be the rhythm of the “thing” in that it appears to take that long before everybody gets bearish enough to jettison their stocks and make a decent tradable low. While it’s true some stampedes have lasted 25 – 30 sessions, it is rare to have one extend for more than 30 sessions. Therefore, we “put blinders on” to last Friday’s late-day upside reversal, consistent with our mantra of “never on a Friday.” That mantra was learned from numerous Friday “head fakes” implying that markets rarely bottom on a Friday once they are into a downtrend. Rather, participants tend to go home over the weekend, brood about their losses, and show up the following week in “sell mode.” So, while the markets may attempt to build on Friday’s late reversal, we have little confidence that any rally will last more than one to three sessions since today is only session 14 from the trading top of January 19th. That said, the equity markets are pretty oversold; and, our proprietary indicators do indeed suggest that a rally attempt is due.

Last Friday’s reversal was likely driven by the fact that the various averages have corrected approximately 10% since history shows that in the first year of a “bull move” it is rare to see much more than a 10% correction. Consequently, the psychology of an underinvested portfolio manager goes like this: “The typical bull market lasts three to five years, so any correction is for buying.” While we certainly hope that is the way it plays, we remain suspect this is the first leg of a new secular bull market. Rather, we think it is just another “bull move” within the context of the range-bound stock market we have been mired in for the last 10 years. Another driver of Friday’s reversal could have been the “break” below 10,000 on the DJIA, which is also a psychological support level that should be respected. Then too, the White House’s statement that the Healthcare Bill is probably “dead” may have triggered a positive response from the equity markets. Nevertheless, we doubt the political maneuvering is over on healthcare. However, the loss of political momentum inside the Beltway is amazing and potentially worrisome for the markets.

Be that as it may, many of the exchange-traded funds (ETFs) we monitor tested, and held, their respective 200-day moving averages (DMAs) last week, which could be yet another reason for a rally attempt. For example, look at the financials, as represented by the Financial Select Sector SPDR ETF (XLF/$13.94) that tested (and held) its 200-DMA, giving hope to investors in this complex. Another ETF we monitor, in an attempt to glean an edge, is the Market Vectors-RVE Hard Asset Producers (HAP/$30.78). Hereto, after plunging from its mid-January price peak, it tested (and held) its 200-DMA last week. Interestingly, many of the “hard asset” names, particularly some of the precious metals stocks, showed upside reversals on Friday. However, while we continue to like “stuff stocks” for the long-term (energy, timber, cement, water, precious/base metals, agriculture, etc.), we have been, and remain, cautious on them coming into the new year, fearful the dollar carry-trade was unwinding and that a whiff of deflation might be in the air. Ergo, on January 19th we wrote:

“Then there is ‘Dr. Copper,’ the metal with a Ph.D. in economics, which recently recorded a 12-month rolling rate of return in excess of 150%. Historically such a ‘copper cropper’ has marked a ‘trading top’ in copper and telegraphed caution for the equity markets.”

More recently, in our verbal strategy comments, we have referenced the gold to silver ratio (the gold price divided by the silver price; currently ~71 to 1) by noting when that ratio has “spiked” like it has recently, it too has suggested caution. All said, we remain cautious until there are convincing signs that a bottom is in place for both stocks and commodities. We do believe, however, once this correction runs its course, the major averages will trade to new reaction highs. Inasmuch, we continue to monitor stocks for the investment account. In past missives we have mentioned a number of potential purchase candidates, most of which have actually declined over the past few weeks. That does not mean we have given up on them! Indeed, most of them remain on our “watch list.” And, last week we added a few more when North American Energy Partners (NOA/$8.62/Strong Buy) reported a very strong earnings number. Subsequently, our Canadian analyst (Ben Cherniavsky) raised his estimates, as well as his price target, on the company’s shares. NOA is a leading provider of earth-moving equipment, infrastructure, and construction services mainly in the Alberta Tar Sands area. As we understand the story, NOA has the largest fleet of Caterpillar equipment in Canada and is therefore the “swing provider” to the now improving Alberta Sands projects. For further information see Ben’s recent report.

Another stock we added to our “watch list” is Cenovus Energy (CVE/$23.70/Outperform), which is also followed by Canadian research team with an Outperform rating. CVE was created when EnCana (ECA/$30.45/Outperform) split itself into two companies. Our analyst Justin Bouchard notes that CVE holds some of the best “in situ” leases in the Alberta Tar Sands with roughly 40 billion barrels in place. With solid capital efficiencies, and a technological leader, CVE expects to add incremental oil sands production at a capital efficiency of approximately $20,000 per flowing barrel, the lowest in the industry. At an attractive valuation, and with self-funding growth, we find CVE interesting. Hereto, for further information see Justin’s reports.

The third name we added to our list was Walter Energy (WLT/$67.54/Outperform), which is followed by Jim Rollyson and our Houston-based energy team. As one of the leading exporters of metallurgical coal, as well as a producer of steam coal, coal bed methane gas, metallurgical coke, and other related products, Walter should do well as demand from the emerging/frontier markets continues to ramp.

The call for this week: Economist, historian, and savvy seer Eliot Janeway stated decades ago, “When the White House is in trouble, the markets are in trouble!” Plainly, we agree and would add that the January Barometer has registered a cautionary signal, as has Lucien Hooper’s December Low indicator. That said, Friday’s turnaround, accompanied by pretty oversold readings, should lead to some sort of one- to three-session rally attempt. To that point, the NASDAQ 100 (NDX/1746.12) was “up” last week (+0.29%), as was Info Tech (+0.72%), Materials (+0.83%), and Natural Gas (+6.7%); so they may lead the “bounce.” Luckily, we have investments in all of these complexes. However, at session 14, in the envisioned 17- to 25-session “selling stampede, we remain cautious.

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“The World MSCI has now fallen for six consecutive days and shed -5.6% in the process. Over the same period, 1-month T-bill yields have fallen into negative territory and the US$ index has broken back above its 200-day moving average (an upside breakout not seen since August 2008). This combination of events has undeniably re-hashed a lot of bad memories for some clients. As an old friend put it: ‘The last time I saw the MSCI fall for six days with no rally, UST yields in negative territory and the US$ shoot up simultaneously was in August 2008 . . . and I didn't like the rest of the movie!’ Just like in the summer of 2008, the fear of a debt crisis is at the centre of the current shakedown. Back then, it was of course Lehman. And today, it is obviously Greece.”

...GaveKal (1/28/10)

It should be noted, however, that in the summer of 2008 the leverage in the financial system was far greater than it is today; and, the derivative “spider web” that had been knitted into balance sheets was legend. As the brainy GaveKal folks observe, “Almost every financial market participant is now operating with far less leverage and there are risk managers looming behind every equity and bond trader.” Accordingly, we think the odds of another post-Lehman type of meltdown are de minimis. Further, we believe the decline that began on January 20th is merely the normal correction everybody has been looking for since July. Buttressing that view is the fact the advance/decline line is firm (read: the breadth is still good), the number of new annual lows on the NYSE is not expanding, the yield curve remains steep, none of our proprietary intermediate indicators have rendered a “sell signal,” and the list goes on. All of this suggests the cyclical bull-market is still intact and stock prices should find support at, or above, the 200-day moving average (DMA), which is currently at approximately 1013 basis the S&P 500 (SPX/1073.87). Moreover, readers of these missives should not have been surprised by the recent stock slide.

Indeed, we have repeatedly written about how the first few weeks of the new year are littered with examples of “head fakes,” both on the upside and the downside. As well, history shows early January is also littered with “trading tops.” Therefore, we counseled for caution upon entering 2010 and we have the hate mail to prove it. Additionally, the 2003/2004 template we have been using since May of 2009 also hinted that a stock market decline should be expected. Recall, the SPX bottomed in March 2003 and rallied. The first leg of that rally peaked in late-May/early-June. From there, stocks flopped/chopped around, but never really gave back much ground. Then stage 2 of the rally began, which carried stocks higher into January 2004. The first leg of that 2003/2004 rally was driven by liquidity, while the second leg was spurred by improving earnings and fundamentals. If that sounds familiar, it should, because that is pretty much the sequence we have seen since the March 2009 “lows.” If that pattern continues to play, it calls for roughly a 10% correction and then a resumption of the rally.

To be sure, we have (and continue) to opine that with credit spreads back to pre-Lehman bankruptcy levels, and improving fundamentals, there is no reason the SPX should not “fill” the downside vacuum created in the charts by said bankruptcy. As often stated, that gives the SPX an upside target of 1200 – 1250. Hence, while we hedged some long stock positions for a correction, and recommended cash in trading accounts, we continue to favor the strategy of holding fundamentally sound, long-term investment positions and adding to such positions when signs of a bottom develop. The question then becomes, “What type of stocks should be accumulated?” If global growth remains strong, deep cyclics, transports, materials, energy, etc. are likely the stocks of choice. If, however, the central banks begin providing less liquidity, or the U.S. dollar continues to strengthen (the Dollar Index broke above its 200-DMA last week), or China continues its monetary tightening cycle, then overweighting technology, healthcare, consumer staples, and select emerging/frontier markets is the preferred strategy. Since we are currently in “cautionary mode,” we are opting for the latter sectors.

Speaking to the strong economy point, Friday’s headline GDP figure of +5.7% was met with a Dow Delight that rallied the senior index 120 points within the first hour of trading. From there, however, stocks slid into the close, leaving the DJIA down 53 points for the session, and off some 6% since the decline began. The reason for Friday’s fade was likely in the details of the GDP report. As our economist, Dr. Scott Brown, wrote early Friday morning:

“Real GDP rose at a 5.7% annual rate in the advance estimate for 4Q09 (median forecast: +4.7%), boosted largely by inventories. A slower pace of inventory reduction added 3.39 percentage points to the headline GDP figure. Real Final Sales (GDP less inventories) rose 2.2%, better than expected (median forecast: 1.6%). Domestic Final Sales (GDP less inventories and net exports), the best measure of underlying domestic demand, rose at a 1.7% annual rate (about as expected). The bottom line is that it was a stronger than expected headline figure, but underlying domestic demand was relatively lackluster, consistent with a gradual economic recovery. Equity futures are higher, but the enthusiasm may not last as market participants sift through the details.”

Clearly, Scott’s – “Enthusiasm may not last as market participants sift through the details” – was an excellent observation! Yet while economic figures come and go, the real question for us remains, “Is this a rally within the ongoing trading range we have been mired in for the last 10 years, or are we in a new secular bull market?” Plainly, we would like to believe it is a new secular bull market. However, if we are going to err, we will err on the side of conservatism, leaving us with, “Only a rally within the context of a range-bound stock market.” Of course if we are wrong, accounts will still stand to benefit handsomely. If we are right, we should continue to accrue the type of portfolio returns, based on our range-bound strategy, that have afforded accounts respectable risk-adjusted results.

In last week’s letter we suggested the stock market’s recent decline has given us the ability to see which RJ&A research universe stocks have resisted the overall price decline the best (read: good relative strength). That list can be retrieved from you financial advisor. This morning, we offer you another name from one of our research correspondents, which is favorably rated. To wit, biotech leader Celgene (CELG/$56.78). Celgene is in year three of its rollout and has the fastest launch of a hematology product ever, which should exceed $2 billion this year. For the first time ever, three trials have been halted in less than a year due to hitting their “end points” and this should lead to higher sales. A real key for the story is March 4th, which is the company’s first R&D day in years, where it will review the 20 phase three trials. This is the fastest growing EPS story in the S&P 500. The company’s patent projection is solid. Its internal goal is for 25-30% earnings growth. Celgene appears unique since it owns its drugs, it has no debt, $3 billion in cash, gross margins exceed 90%, and it has hidden assets. For example, Celgene’s production plant in Switzerland was opened last year and the Swiss gave the company a ZERO percent tax rate for a decade. So to a major drug company, this could represent something else that would have it look at Celgene, which we think is the last of the true growth major biotechs as its patent protection on Revlimid goes until 2026. If Celgene gets another drug, and it has those shots on goal, it could become bigger than Amgen (AMGN/$58.48) in market capitalization.

The call for this week: Potentially, today is session 9 of a selling-stampede, which has often been chronicled in these reports. Recall that such stampedes tend to last 17 to 25 sessions, with only one- to three-session counter-trend rallies, before they exhaust themselves on the downside. The January “stock sprawl” has left all of the averages we follow down year-to-date, as well as below their respective December “lows,” thus evoking Lucien Hooper’s warning, “If the December low is violated any time in the first quarter of the new year, watch out!” Accordingly, we remain cautious.

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