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“We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know at some moment the black horsemen will come shattering through the terrace doors wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time. So everybody keeps asking – what time is it? But, none of the clocks have hands.”
... “The Money Game” by Adam Smith (aka Jerome Goodman)
I met Jerry Goodman (nom de plume – Adam Smith) over lunch with my friend Craig Drill, eponymous captain of Craig Drill Capital, and one of the better risk adjusted money managers I know. There were other money managers there who were moaning over martinis about the good ole days in the late-1990s when they were “up” 50% (or more) in a year. These blue blood types manage really big bucks for many of the “White Shoe,” “Carriage Trade,” families in this country. Their remuneration is directly tied to how well they perform. Obviously, they have done well. However, over the past couple of years they have been “up” only 20% to 25% and consequently are singing the blues. Now martini moaning over that kind of performance may seem a bit much; still I played the groaning game with them, albeit with a grin, and sympathetically offered to pick up the check. They got the point, but earnestly explained, “We’ve just been too cautious. We’d have been up a couple hundred percent if we had been as aggressive as we were in the 1990s.”
I forgot to mention that these gentlemen are my age or older -- and have the gray hair to prove it. Though hardly geriatric, they have begun to suffer from what seems like incurable caution. They are also worried they will become victims of the current graybeard money manager go-for-gold syndrome – “Never trust anyone over 30 with your money!” I suspect such caution will be abandoned and they will succumb to the luring lyrics of all late stage bull moves – “Those who do not learn from stock market history are destined to prosper . . . until . . .”
Webster’s defines the word “until,” when used as a conjunction, as “up to the time that” or “up to such a time as.” In the aforementioned prose, my use of the word “until” implies – “Those who do not learn from stock market history are destined to prosper . . . until they don’t!” And let me tell you “until they don’t” is a really expensive proposition as investors learned following the “go for gold” tech syndrome of 1999. Indeed, I am reminded of the old stock market “saw” from Barron Rothschild, who when asked how he made so much money replied, “I never buy at the bottom and I always sell too soon." Importantly, while I am not advocating selling everything, I am currently advocating selling some partial positions, in select stocks that have surged, to rebalance those positions and to raise a little cash. Clayton Williams (CWEI/$102.33/Outperform) would be a good example. If you followed us into CWEI, you have made a lot of money; and while we still think the shares can trade higher, the strategy of selling 20% - 30% of that position makes good portfolio sense. Ditto our positions in Cenovus Energy (CVE/$36.99), which is rated favorably by our Canadian affiliate Raymond James Ltd.
“Selling” . . . the word alone makes most investors uneasy. They find the “B” word (Buying) much more pleasant. “Why” is perhaps best explained in a book first published in 1977, and written by Justin and Robert Mamis, titled “When To Sell” whose excerpts can be found on the third page of this report. Yet “selling” has been on my mind the past few weeks and last week I acted on that feeling by selling 20% to 30% of several investment positions. It was not because I think these stocks won’t trade higher over the longer term, because I do based on their fundamentals. But rather I sold partial positions to lock in some long-term capital gains, rebalance those positions back to the portfolio weightings that were first intended, raise some cash to take advantage of some new situations I have uncovered, and to be portfolio prudent. Moreover, the often referenced “buying stampede” that began on September 1, 2010 remains legend at now session 118 compared to the previous record of 52 sessions. As my friends at the “must have” Bespoke Investment Group write:
“We compared the market’s pattern since September 1st to all periods of the same length in the history of the S&P 500. We then calculated the correlation coefficient between each of the same periods and the current period and found five periods where there was a correlation coefficient greater than 0.97 (1.0 = perfect correlation). While the percentage changes in the prior periods vary, the similarities between their patterns and the current period are striking. In the charts, we highlight each of these periods along with the S&P 500’s performance over the following twelve months. As shown in the charts, in all five of the most closely correlated periods to the current one, the S&P 500 saw additional gains over the following 12 months with an average gain of 22.1%!”
To be sure, I agree with the good folks at Bespoke, which is why I have repeatedly stated “cautious but not bearish.” That said, if you study Bespoke’s five charts, you find that in each case the S&P 500 (SPX/1343.01), at this stage of the rally, was ready for a pause and/or a correction. Further, the S&P 500 bottomed 102 weeks ago and has since rallied 100%. There have been only two other instances when that has happened, 1934 and 1937. Following the peaks of February 1934, and March 1937, the stock market corrected. Hence, cautious but not bearish. Not bearish because individual investor exposure to equities, according to Barron’s, “Is at a generational low of 37% of all assets.” Barron’s continues by noting, “Another possible lift to the market? Rising S&P dividends, where the 26% payout ratio is less than half the 54% historic average.” Plainly I agree, but with risk appetites at their highest level since January 2006, combined with hedge funds “long” exposure at its highest level since July 2007, I can’t help but be cautious.
Despite my caution, I can still find attractive risk/reward investments. Last Monday I discussed why Royce Value Trust (RVT/$15.51) was an interesting situation. Also discussed was special situation company Stanley Furniture (STLY/$5.40/Strong Buy). This morning I offer up Williams Companies (WMB/$30.37/Outperform). For months Wall Street has been rife with rumors that the new CEO (Alan Armstrong) was going to split the company into two parts to increase shareholder value. Over those months I discussed these rumors with many of you. Last week those rumors were realized with an attendant rating raise from our energy analyst Darren Horowitz. To wit, “Admittedly, we are late to the party with Williams' shares up over 45% since the beginning of September. Up until this point, we had assumed the pending break up was going to take longer to materialize versus market expectations. That being said, based on the clear plan to break-up the company, and the underlying value of Williams' assets, we are upgrading Williams from a Market Perform to an Outperform and setting an initial target price of $36/share.” With the pending “split” acting as the carrot in front of the horse, I think the shares trade higher. For further information, please see our energy team’s comments.
The call for today: Recently, if you threw a brick out of a Wall Street window, it would go up! As seen in the charts, this skyscraper stampede has not given up much ground since it began on September 1, 2010. Indeed, the DJIA has not experienced anything more than the perfunctory 1 – 3 session pause/correction since this stampede began, not giving anyone an easy entry point. I was pretty constructive on stocks until the beginning of this year when I wrong footedly, like my gray-haired lunch friends, turned too cautious. Still, in this business you have to play the odds; and currently I just don’t think the odds are favorable enough to be aggressively bullish. As David Sklansky wrote in his book “The Theory of Poker,” “Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.” I continue to invest, and trade, accordingly.
I was on the West coast last week seeing institutional accounts and speaking at various seminars. The resounding question served up was, “Is this a rally in a bear market, or a new secular bull market?” The follow up question was, “How can you be sure that the pullback, you have wrongly been expecting, is for buying?” Speaking to the second question first, since 1940 there has never been more than one 10% or greater pullback in a bull move; we had a 17% pullback last year between April’s high into June’s low. Moreover, the retail investor is nowhere close to fully embracing this rally, which is typically what occurs around intermediate/long-term stock market “tops.” Consider this quip from Peter Lynch’s book “One Up On Wall Street:”
“If the professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own ‘cocktail party’ theory of market forecasting, developed over the years of standing in the middle of living rooms, near punch bowls, listing to what the nearest ten people said about stocks.
In the first stage of an upward market – one that has been down awhile and that nobody expects to rise again – people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, ‘I manage an equity mutual fund,’ they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque. When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely the market is about to turn up.
In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer – perhaps long enough to tell me how risky the stock market is – before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market is up 15 percent from stage one, but few are paying attention.
In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened.
In stage four, once again they’re crowded around me – but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbors tell me what to buy, and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.”
Manifestly, we are nowhere near stage 3 or 4; so yeah, I think any pullback is for buying. As for the first question, I have not wavered in the belief that since the first Dow Theory “sell signal” of September 1999 the major averages would do what they have done after every secular bull market peak – they would go sideways in a wide swinging trading range. My often mentioned example has been the trading range between 1966 and 1982 following the previous secular bull market that began on June 13, 1949 and ended on February 9, 1966. That wide swinging trading range market experienced no less than 13 swings of 20% or more (both up and down) during that 16-year range-bound environment. Interestingly, while the DJIA made its nominal price low in December 1974 at 577.60, the D-J Transportation Average refuse to confirm with a like new reaction price low (read: non-confirmation). That left the Dow’s nominal price low at 577.60, a level that would not be breached, or even retested, over the subsequent years. The Dow’s valuation “low” (the cheapest it would get in terms of price to earnings, price to book value, price to dividends, etc.), however, was not reached until the summer of 1982. Still, the senior index NEVER came anywhere close to its nominal price low of December 1974. Accordingly, for almost two years I have argued that the nominal price low for the current range-bound stock market came in March of 2009; I have also stated that I would be shocked if the major averages ever come close to those levels again. As for when the valuation “low” will occur is certainly a fair question, but my sense is it is still a few years away. Yet, that does not mean you can’t make money in the stock market, as has been demonstrated by our Analysts’ Best Picks list, which has outperformed the S&P 500 in nine of the past 10 years of a range-bound market.1
As for the shorter term, today is session 113 of the longest “buying stampede” I have ever seen. To be sure, a stampede typically last 17 -25 sessions, with only one- to three-day pauses/pullbacks, before resuming its upward onslaught. A few have lasted 25 – 30 sessions, but I can count on one hand those that have extended for more than 30 sessions. Previously, the longest such skein encompassed 52 sessions. The current stampede began on September 1, 2010, at the intra-day Dow low of 10016, and has continued higher into last Friday’s closing price of 12273.26 for an eye-popping 22.5% surge. Over that timeframe the senior index has not experienced anything more than a one- to three-day pause/pullback; truly an amazing run. Some internal dynamics have changed, however. To wit, the “winners” of late 2010 (gold, bonds, emerging markets, etc.) have been having difficulty this year. Meanwhile, the “step children” of late last year (developed markets, banks, technology stocks, etc.) are acting fairly spunky. The banks’ outperformance began in November 2010, as noted in these missives, and concurrent with the first buy recommendation I have made on them in some 10 years (please see our Investment Strategy commentary of November 8, 2010).2 There has also been a rotation out of small capitalization stocks into larger caps. All of this is generally consistent with my cautious (not bearish) stance coming into the new year; that is “consistent” up until February 1st, when the stock market seemed to take on a life of its own.
Yet even though I have been cautious, I still have been able to find special situations to buy. Take Stanley Furniture (STLY/$4.60/ Strong Buy) – our positive rating on Stanley Furniture stems primarily from its strong balance sheet ($25.5 million of cash and zero debt), the shares' inexpensive valuation, and our view that operating performance is likely to improve significantly in 2011 and beyond. Additionally, we believe the shares offer investors a "call option" on the potential receipt of $40 million (or more) of Continued Dumping and Subsidy Offset Act (CDSOA) monies – an amount well in excess of Stanley's current enterprise value. If Stanley receives the CDSOA money it will have in excess of $6 per share in cash, implying you would be getting the operating business for free.
Another potential special situation is Royce Value Trust (RVT/$15.06). A few weeks ago RVT announced it was reinstating the managed dividend distribution policy (MDP) beginning in March. RVT is currently trading at a ~16% discount to its net asset value (NAV). I think the recent news is not being reflected in RVT’s share price. I believe once the distribution becomes active the discount will narrow and the fund will trade closer to NAV. Our Closed End Fund analysts have RVT on their Idea List, as well as in their Total Return Model Portfolio. RVT previously had a 10% MDP, which was suspended when the fund had to start returning principal to comply with its MDP policy. I think a 5% MDP is a much more attainable yield and therefore recommend purchase at these levels.
The call for this week: “The last shall be first, and the first last,” so says the Bible (Matthew 20:16). And, that seems to be what’s happening on Wall Street this year as the favored trades of 2010 have become the least favored trades recently. Of course that has been part of the restless rotation that has sparked many of the upside non-confirmations on which I have been commenting. It is also responsible for my cautious investment stance since history suggests that upside non-confirmations are a reason for caution. And with interest rates backing up, the yield on the 10-year T’note is above its 200-week moving average for the first time since 2007; it will be interesting to see how the Financials act this week. Without the Financials rallying it should be difficult for stocks in the aggregate to extend higher.
“The Conversation,” except in this case I am not referring to the 1974 movie about a paranoid surveillance expert who has a crisis of conscience when he deduces that the couple he is spying on will be murdered, but rather an unbelievable 40-minute conversation I had with a portfolio manager (PM) last week. Unbelievable because it sounded like Jeff Saut talking to Jeff Saut; or as another Putnam person on the call opined, “It sounded like Nick talking to Nick.” The PM in question was Nick Thakore, who has captained Putnam’s Voyager Fund (PVOYX/$25.01) after associating with that organization in November 2008. Combining Nick’s current performance record, with that in a previous life, shows that he has outperformed in 11 of the past 13 years.* Voyager Fund was also the best performing fund over the trailing three-year basis in Lipper’s Large Capitalization Peer Group (+26.63% versus -1.42%). Obviously, such numbers indicate this is a pretty smart guy. Thus the conversation begins.
Nick commenced by stating that he was very constructive on equities because we are in a cyclic economic recovery despite a secularly changed world. Yet, everyone is aware of those secular changes like continuing above trend unemployment levels. However, over the long cycle it is all about earnings, and he (as do I) remains confident about earnings. Indeed, the investment equation is 90% about earnings, then comes valuations followed by earnings yields (earnings ÷ share price) compared to bond yields. After examining those metrics Nick looks at free cash-flow yields on individual stocks. He further opined that President Obama has moved to the middle (I think he’s actually run way past the middle, but have learned while living in D.C. to watch what they do not what they say). He concluded his opening remarks by noting that Washington’s mindset is not as anti-business as it was six months ago.
From there we began to discuss sectors. Eerily his favorite sector currently is the Financials. “That’s amazing,” I interrupted, “Because after 10 years of avoiding the banks I started using them when the Financials began to outperform the S&P 500 (SPX/1310.87) in November 2010.” Sheepishly I asked him, “I know why I like the banks, why do you like them?” Well, much of the government’s regulatory “push” is in the rearview mirror, loan growth is returning, net interest margins have expanded, the mortgage “put back” issue should look better next year, and the banks are WAY under-owned institutionally. Accordingly, if institutions decide to bring their portfolios up to a market weighting, the buying pressure would put the wind at the back of the Financials.
We spent the next few minutes talking about various banks. While Nick favors the big cap names like JPMorgan Chase (JPM), which he thinks has more than $6 per share in earnings power, I tend to favor the smaller regionals, such as IBERIABANK (IBKC), Huntington Bancshares (HBAN), and People’s Financial (PBCT). We also discussed insurance stocks as second derivative Financials plays. Both of us agree that cyclical names should be embraced over staples. Technology was also favored as it is attractively valued relative to the overall stock market. When I asked Nick for his favorite tech name, his response was Hewlett-Packard (HPQ) because it should earn more than $6 in 2012 and the shares should trade at least 10x earnings. From there the conversation focused on special situation stocks. Names I mentioned were companies like North American Energy Partners (NOA), Williams Companies (WMB), and Clayton Williams (CWEI), to name but a few. Nick offered First Solar (FSLR) because it has lowered its costs so much that it should be first to grid parity (Grid parity is the point at which alternative means of generating electricity is at least as cheap as the current electric grid power). And that was the only point of disagreement in our conversation. It is also why FSLR is such a controversial stock, as well as why it is so heavily shorted. I am neither bearish nor bullish, but the bear story goes like this.
FLSR is indeed the lowest-cost solar manufacturer, but its relative advantage is gradually shrinking as the cost of conventional (crystalline) panels is coming down more rapidly due to intense Chinese competition. Here's how the math works:
With that in mind, the issue becomes valuation. FSLR currently trades at 17x earnings if we use the high end of company guidance. By contrast, practically all of the crystalline companies – JA Solar (JASO) and TSL included – are in the single digits, typically in the 6x to 8x range. I look at FSLR's valuation premium as difficult to sustain over time, especially as competition in the thin film arena becomes more visible. As a side bar, the solar sector looks like it should be bought.
We concluded our conversation with Nick expressing his worries. Will the Egypt Eruptions become a broad middle-east event? Rising oil prices are clearly a worry with $120/bbl. price point potentially being the economic breaking point. His final worry was about rising inflation in the Emerging Markets if it doesn’t get contained. He also believes economic growth will slow in 2012, yet 2011 continues to look good. As for me, I couldn’t agree more; indeed, it was like hearing Jeffrey talking to Jeffrey.
Turning to the equity markets, January 2011 goes into the record books as registering some of the best monthly gains since 1997. Those outsized gains, however, were recorded by the DJIA and the SPX while other indices, like the Russell 2000 (RUT/800.11), generated a loss. I have been commenting on such divergences for nearly four weeks, often noting that the Buying Power Index was losing its momentum and that the Selling Pressure Index was gaining strength. As the good folks at the Lowry’s organization opine – while the weatherman can’t make it rain, he can tell his viewers that the dark clouds are increasing and the wind is picking up. Regrettably, the divergences continue to mount. Speaking to divergences, I have never seen such a divergence between the employment surveys (household vs. payroll) in my life with the unemployment rate plunging to 9.0% (from 9.4%) while payrolls increased a modest 36,000. As our economist, Dr. Scott Brown, writes:
“Bottom Line: Confusing; but, let’s try to sort it out. The payroll figure was weaker than expected, but there were likely weather effects and seasonal adjustment adds to the uncertainty. Manufacturing payrolls and hours rose, which is consistent with the story that fell out of the GDP report – that is, lean inventories should lead to production gains in early 2011. The unemployment rate fell sharply again and not all of that can be explained by a drop in labor force participation. The employment-to-population ratio improved only modestly. The two surveys paint somewhat different pictures, but the establishment survey data (which yields the payroll figure) is fuzzy in January and the household survey results are bizarre. Investors should take it all with a grain of salt. Information beyond this report suggests that the rate of job losses is trending very low and that new hiring is starting to pick up – that’s good. The bigger test of the labor market will come in March to June, when the unadjusted payroll numbers climb sharply. The drop in the payroll tax will boost disposable income in 1Q11, supporting consumer spending growth, and the inventory story is consistent with strengthening manufacturing activity. On balance, the economic outlook is brightening. Job growth should be above trend in the next several months. The bond market seems to have figured this out. The stock market still seems a bit confused.”
The call for this week: Well, I’m in California so these will be the only strategy comments of the week. Nevertheless, I believe that we have been in a “stealth correction” since the beginning of this year. While it’s true the DJIA and SPX have made new reaction highs many of the other indices have not (read: divergence). In addition, many emerging markets are declining, stock leadership continues to narrow, the MACD indicator has been negatively configured since January 18th, Lowry’s Buying Power Index is falling and Lowry’s Selling Pressure Index is rising, the 30-year Treasury Bond’s yield is about to break out above a spread triple top (read: higher rates) and the list goes on. Meanwhile, the top gaining sector since last November has been the Financials, but over the past few weeks the Financials have weakened noticeably. All of this continues to keep me cautious (but not bearish) as we enter February, which historically has been a down month.
*Versus the S&P 500 while at Fidelity and the Lipper Large Cap Peer Group while at RiverSource.
Notes: Prices are as of the most recent close on the indicated exchange and may not be in US$. See Disclosure section for rating definitions. Stocks that do not trade on a U.S. national exchange may not be approved for sale in all U.S. states. NC=not covered.
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