Oil That Is, Black Gold, Texas Tea....

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“You might think that institutions, with their large staffs of highly paid and experienced investment professionals, would be a force of stability and reason in the financial markets. They are not. Stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued.

Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do. An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. ‘You’re qualified for residence,’ said St. Peter, ‘but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.’ After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, ‘Oil discovered in hell.’ Immediately the gate to the compound opened and all the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. ‘No,’ he said, ‘I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all’.”

... Berkshire Hathaway annual report – 1984

“Oil that is, black gold, Texas tea,” as the song about poor, but wise, Jed Clampett (Buddy Ebsen) goes, who got rich in the hit series The Beverly Hillbillies by discovering oil on his property. Similarly, investors have become enriched recently by owning oil stocks. Verily, crude oil has surged from ~$84 per barrel in mid-February into last week’s parabolic peak of $103.41 with an attendant ascent for most oil stocks. Obviously, the driver for Texas Tea’s triumph has been the recent unrest in the Middle East. As stated in Friday’s verbal strategy comments, “Libya is particularly troubling because I think there is a fifty-fifty chance that Gaddafi, rather than cede power, will begin blowing up Libyan oil pipelines to send a message to protestors – it’s either me or chaos.” No wonder oil soared pondering what would happen if 1.6 million barrels a day were suspended from world supplies, not to mention what happens if Algeria is next (Algeria produces 1.25 million barrels per day). To that point, while it is unknowable how high oil prices will travel if the unrest spreads, it is worth noting that oil prices tagged what many technical analysts term a major upside price objective last week. Indeed, a Fibonacci 61.8% retracement of oil’s price decline from $147.27 (July 2008) to $33.20 (January 2009) yields a price target of $103.69. Accordingly, while last week’s intra-day price high of $103.41 was not exact, it was close enough to qualify as “price objective achieved.” While I am not a big believer in “Ouija Board” analysis, in a past life I have studied Fibonacci, Gann, Elliott Wave, etc. and found them somewhat useful at tipping points.

Speaking of “tipping points,” the prescient folks at GaveKal recently scribed the following, as paraphrased by me:

“In recent years, investors have become used to an environment whereby a weak US$ usually meant an easy monetary policy from the Fed, which in turn meant greater risk taking and growth in emerging markets, rising commodity prices and higher equity prices. ... But in the past week or so, this usual balance between the US$ and risk assets seems to have broken down, most likely because the rise in commodity prices is no longer a sign of global growth but instead a source of growing concerns. ... Whether the US$100/bbl price tag now attached to oil represents some kind of psychological barrier or a real economic hurdle, the positive dynamic of the past few months has now rolled over and we clearly seem to be at an important tipping point for a number of prices. ... Now if the US$ bounces from here, it is likely that oil will follow food prices into their recent consolidation, allowing for equities to once again bounce back. However, if the US$ melts down, or if oil shoots up on further Middle East unrest, then it is hard to see how equities will maintain the past few months' uptrend. So it does seem that we are at an important tipping point not just for the US$, but for most asset prices as well, which should not come as such a surprise since most assets in the world are priced off of the US$. (That) reality brings us back to a point Charles has been very vocal about over the past couple of months: we are rapidly reaching the stage in the cycle where the Fed needs to start tackling the weakness of the US$, and the surge in commodities, or risk undermining the very (economic) recovery it managed to jump-start. With that in mind, we would not be surprised if, in the coming days and weeks, various Fed directors come out to sound somewhat more hawkish in a bid to prevent commodities from further undermining the current recovery. ... Anyway, with so many unanswered questions, it is not surprising that equity markets are taking a breather.”

And take a “breather” indeed with the S&P 500 (SPX/1319.88) surrendering 3.7% from the previous Friday’s intra-day high (1344.07) into last Thursday’s intra-day low (1294.26) before firming on Friday emboldened by news Saudi Arabia would step up production to plug any crude oil shortfall. Now call me cynical, but I doubt the Saudis have the capacity to accomplish their pledge and therefore am also skeptical of Friday’s rally. Inasmuch, I think what we have seen is just the opening salvo in a correction that will likely be in the 5% to 10% range before ending. Reinforcing that sense, the recent stock “high” was accompanied by the most bullish stock sentiment since the DJIA’s peak in October 2007 (69% “Bulls” according to Market Vane); as well, the Volatility Index (VIX/19.22) recorded its lowest reading since the summer of 2007 (read: too much complacency). Ladies and gentlemen, it is rare to see those kind of extreme readings worked off in a mere three sessions. So yeah, I believe the correction has more to run, yet I continue to think it is a mistake to become too bearish.

Consistent with that strategy, I am going to begin committing some of the cash raised over the past eight weeks back into stocks, preferably during bouts of weakness. Moreover, one of the good things about a market decline is that it gives you a chance to see which stocks hold up better than others. Since the beginning of the year I have suggested 19 stocks and closed-end funds from Raymond James’ coverage universe for your “watch list.” Of those, these are the ones that have held up the best: Altera Corp. (ALTR); CA Inc. (CA); Celestica Inc. (CLS); Skyworks Solutions (SWKS); Stanley Furniture Company (STLY); Stanley Black & Decker (SWK); Tempur Pedic International (TPX); The Williams Companies (WMB); and closed-end fund Royce Value Trust (RVT).

The call for this week: Last Tuesday was a 90% Downside Day whereby 90% of the total points, and total volume, was on the downside. It was the second 90% Downside Day of the year; and, we almost had a third as January 28th came within 0.05% of qualifying. History shows that such Downside Days are quickly followed by a rally attempt before the short-term correction resumes. Thus it should not be assumed Friday’s Fling ended the correction. In fact, under the surface Friday’s action didn’t look all that strong. This does not mean you should “dump” stocks here. The time to raise cash was over the past eight weeks, not now. That said, by my pencil the intermediate trend of the stock market is “up,” and therefore it is an opportune time to consider purchase of select stocks on your “watch list,” preferably during pullbacks. As the keen-sighted folks at Bespoke observe (as paraphrased by me): 1) the big stocks in the S&P 500 have held up better than the smaller names; 2) stocks with the best valuations have held up better than ones with high P/E multiples; 3) stocks with high dividends have outperformed; 4) stocks with high short interest have done worse than low shorted stocks; 5) stocks with low institutional ownership have outperformed; and 6) stocks with high international revenues have underperformed domestic names.

“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.

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