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Investment Strategy
by Jeffrey Saut
“Bear Stearns?!”
“The recent pickup in equities is likely temporary, rather than a sign that the economy is about to rebound... It is not surprising that the large decline in oil prices would lift the equity market and, for a short time, real economic activity... However, barring another significant decline in oil in the coming months, the focus of the markets will likely shift back to the slowing economy.
We are raising our 2007 S&P 500 target to 1550 from 1450, but remain unenthusiastic about near-term prospects... When equities begin to see through the economic slowdown, S&P 500 forward multiples could then expand by as much as two points next year and possibly more if the Fed cuts official rates... Still, in the near term, the market has yet to fully digest the economy's lackluster prospects.
There are a number of useful indicators that can give a heads-up as to what to expect from the Fed... At this juncture, some of these indicators are very clearly arguing that the Fed should already be easing policy or that a rate cut is very likely on the horizon... Others, however, suggest that the Fed is merely on hold and will likely remain there.”
. . . Francois Trahan, strategist at Bear Stearns
Gosh, I thought as I read Francois Trahan’s comments, that’s pretty much the way I feel except I am not so sanguine about the prospects for 2007. Like Mr. Trahan, Ed Hyman seems worried about the slowing economy, as his ISI organization opined last week:
“. . . a cooling housing market put downward pressure on the Philly Fed survey. In addition to the Philly Fed our house price survey weakened, the LEI (Leading Economic Indicators) declined, and MZM (money supply) declined. The weakness in housing will be the biggest theme for the markets over the next several quarters. Will the weakness in housing prove to be a homebuilder only story or does it leach into other areas of consumer spending?”
Plainly, Ed Hyman has asked the proper question, but while we have written extensively about the burgeoning housing debacle, historically real estate has been an “effect” and not a “cause.” For example, back in the early 1970s energy prices soared with a concurrent rise in interest rates. Those events were the “cause,” the “effect” was a collapse in housing prices. Consequently, to think that the current problems in housing will be sufficient to spill the economy into recession one must believe that real estate has become so entwined into the economic fabric of the economy that it has now become a “cause” and is not just an “effect.” While we are not quite there yet, I have to admit the odds of a recession have risen enough for us to abandoned the mantra embraced since October 2001 of “no recession.”
Our concerns center on an economy that “feels” much stronger than the economic figures suggest. Indeed, while the headline numbers continue to point to a slowing economic environment, tax receipts do not! Having lived inside the D.C. beltway we have a healthy distrust for most governmental figures. It is not that we believe in conspiracy theory, it’s just that in our opinion the government has a HUGE measurement problem. One data point we have come to trust, however, is tax receipts, because people only pay taxes on “real” income. Surprisingly, tax receipts are tracking north of 11%, which certainly does not “foot” with a slowing economy. And maybe, just maybe, that is what caused last week’s cognitive dissonance at the Federal Reserve, where one member spoke of “substantial (inflationary) risks,” as another suggested, “(inflationary pressures) have receded in the last 8 – 10 weeks.” While only time will tell who is right, the bond market certainly “spoke” by lifting the yield on the benchmark bond from 4.57% to 4.82%. In the process the 10-year T’Note’s yield broke out above its downtrend line, as can be seen in the nearby chart.
So far, however, stocks have been able to handle last week’s “yield yelp” as the carrot in front of the horse remains this week’s option expiration and potentially the November elections. Still, the rally, at over 900 days, is pretty long-of-tooth.
Further, valuations are not particularly cheap. Indeed, despite the media’s hype about the Dow’s continuing new highs, the senior index is changing hands at about 23x trailing earnings, possesses a paltry yield of 2.2%, an earnings yield below that of the benchmark bond, and is trading at roughly 3.5x book value. Moreover, as Paul Montgomery recently noted:
“The possibility of a top here has some cyclic support according to the work of our late colleague, George Lindsay. While the 4-year ‘bottom-to-top’ cycle is much better known, Lindsay demonstrated that markets often display a ‘bottom-to-bottom-to-top’ pattern (bbt). As Peter Eliades recently pointed out, the last two major bottoms in stocks occurred on October 8, 1998 and October 10, 2002. Using Lindsay’s ‘bbt’ pattern, one adds the 1463 days between these two lows to the second low, to get a projected top – which in this case calculates to October 12, 2006. There also was a major low on October 11, 1990. Adding the 2919 days between that low and the October 1998 low to the latter date projects a top for October 5, 2006. Also, adding the time between the major low of October 4, 1974 to the October 1990 low, yields October 18, 2006 as a target top date.”
Reinforcing our cautionary leanings is Jason Goepferts’ work as reprised by Bill Fleckenstein. To wit:
“Along those lines, it turns out that a proprietary stock-to-bond indicator from Jason Goepfert at SentimenTrader is stretched to a level that is three standard deviations away from the norm -- i.e., an event that should only happen about 1% of the time. In any case, what's remarkable about the indicator is its accuracy in catching major turning points.”
Nevertheless, our sense remains that the current rally will carry into this Friday’s “witch twitch,” or maybe even the November elections. That said, we have clearly under-played the recent rally, but are not inclined to compound the error by paying-up for the darling du jour right here. Rather, we favor buying names that are currently out-of-favor like the energy sector since winter is just around the corner. Manifestly, many of the energy stocks are three standard deviations oversold and consequently possess decent risk/reward ratios. For those ETF (Exchange Traded Fund) players, the Spyder Energy Trust (XLE/53.98) broke out to the upside last Friday, and for the more conservative types, the 5.8%-yielding Blackrock Energy Trust (BGR/$25.82) looks about as good as anything to “get long” energy given its 8% discount to net asset value (NAV). We continue to invest accordingly.
The call for today: This morning the Empire State Manufacturing report came in at a much stronger than expected 22.9, suggesting that the country’s housing woes have not been able to “kill” the economy’s ebullience. Verily, the “crash” in gasoline prices has rekindled the consumers’ sprits and that, combined with persistently rising core inflation, may change the sentiment that the Fed is done. Still, the carrot in front of the proverbial horse should be this Friday’s option expiration and maybe the November elections.
