Investment Strategy
by Jeffrey Saut
A Kid’s Market?!”
“’My solution to the current market,’ the Great Winfield said. ‘Kids. This is a kids’ market. This is Billy the Kid, Johnny the Kid, and Sheldon the Kid.’
‘Aren’t they cute?’ the Great Winfield asked. ‘Aren’t they fuzzy? Look at them, like teddy bears. It’s their market. I have taken them on for the duration.’
‘I give them a little stake, they find the stocks, and we split the profits,’ he said. ‘Billy the Kid here started with five thousand dollars and has run it up over half a million in the last six months.’ ‘Wow!’ I said. I asked Billy the Kid how he did it.
‘Computer leasing stocks, sir!’ he said, like a cadet being quizzed by an upper classman. ‘The need for computers is practically infinite,’ said Billy the Kid. ‘Leasing has proved the only way to sell them, and computer companies themselves do not have the capital. Therefore, earnings will be up a hundred percent this year, will double next year, and will double again the year after. The surface has barely been scratched. The rise has scarcely begun.’
‘Look at the skepticism on the face of this dirty old man,’ said the Great Winfield, pointing at me. ‘Look at him, framing questions about depreciation, about how fast these computers are written off. I know what he’s going to ask. He’s going to ask what makes a finance company worth fifty times earnings. Right?’ ‘Right,’ I admitted.
Billy the Kid smiled tolerantly, well aware that the older generation has trouble figuring out the New Math, the New Economics, and the New Market. ‘You can’t make any money with questions like that,’ said the Great Winfield. ‘They show you’re middle-age, they show your generation. Show me a portfolio, I’ll tell you the generation.’
‘See? See?’ said the Great Winfield. ‘The flow of the seasons! Life begins again! It’s marvelous! It’s like having a son! My boys! My kids!’”
. . . “The Money Game” by Adam Smith
The Great Winfield goes on to say, in Adam Smith’s classic 1967 book, “The strength of my kids is that they’re too young to remember anything bad, and they are making so much money they feel invincible.” He rented kids with the idea that one day the music will stop (it partially did in 1969-1970 and completely did in 1973-1974) and all of them will be broke but one. That one will be the Arthur Rock (legendary venture capitalist) of the new generation; Winfield will keep him.
Obviously, folks, we are back from our sojourn where it became abundantly clear that the “kids” are currently outperforming the stock market’s “greybeards” as the Warren Buffetts and John Templetons of the world worry about such silly things as optimistic valuations, waning earnings’ momentum, a slowing economy, a housing debacle, etc.
Speaking first to valuations, we have often stated that the best representative index for the average stock is not the S&P 500, but the ValueLine Index. At its peak the median P/E ratio of the ValueLine Index was 20.9x (see chart 1). Currently its P/E ratio is 18.3x, and while not as expensive as it was at its zenith, it is certainly not “cheap” by historic standards. Second, as for earnings momentum, if you deduct share repurchases, and seasonally adjust earnings, one finds that earnings momentum has been slowing since 4Q05 and is currently tracking toward mid-single digits. Third, recent reports leave little doubt that the economy is slowing. Indeed, GDP, capex shipments, ISM, private payrolls, Industrial Production, Existing Home sales, retail sales, et all, have been contracting. The lone stand-out arguing for economic strength remains governmental tax receipts, which continue to record low double-digit growth readings. Plainly that just does not “foot” with the recent 1.6% GDP report.
Other “non-footers” include: 1) a personal U.S. savings rate that appears to have bottomed, implying that Americans are saving more. This is not an unimportant observation, for it can be argued that for every 1% increase in the nation’s savings rate the business sector loses roughly $100 billion in profits; 2) reinforcing point one is a rare event that saw consumer credit actually get paid down in September with a concurrent reduction in bank lending to households during the month of October; 3) that begs the question, “following the Goldman Sachs-induced crash in gasoline prices, which have subsequently rebounded now that the gasoline weighting has been cut from 7.3% to 2.5% in Goldman’s much indexed commodity index, why have the retail stocks held up so well?!;” 4) evidently Amazon (AMZN/$42.55) and Wal-Mart (WMT/$47.50) don’t believe the retail rebound is sustainable since they are cutting their respective capex spending budgets; 5) and why, pray tell, does the U.S. Dollar Index remain amazingly resilient in light of low interest rates and given the fact that China, Russia, the United Arab Emirates, Saudi Arabia, Switzerland, New Zealand, etc. all telegraphed that they are reducing their weightings of U.S. Dollar reserves?; 6) why did the SEC, in mid-October, reduce margin requirements for select investments by hedge funds?; 7) how in the world can “guest workers” sue U.S. companies for under-paying them ( USA Today 11/15/06)?; 8) we could go on, but you get the idea . . .there are a lot of disconnects currently.
Meanwhile, participants have continued to increase their “risk profile,” as seen in the nearby chart from Merrill Lynch (chart 2), with an attendant parabolic rise in the D-J Industrial Average (DJIA). We have seen such parabolic rises before, most recently in gold’s upside blow-off between March and May of this year (we were sellers of gold back then), and historically such moves have tended to end badly. Verily, since the July “lows” the DJIA has truly gone parabolic. Interestingly, of the Dow’s 1500-point gain over those 87 sessions, roughly 1300 points have come during only 12 sessions where the often mentioned “mysterious buyers” showed up in the futures markets. This unnatural sequence has left the DJIA residing at nearly an unprecedented 1000 points above its 200-day moving average (@ 11341 DMA) and well over-bought relative to its MACD and Relative Strength Indicators (RSI).
What does this mean to us? Well, except for our token long trading positions in the Volatility Index (VIX/10.05), which has so far been a losing trade, we remain “flat” in the trading account. Not so, however, in our investment account, where we are 60% long stocks, 10% long fixed income, and 30% in cash. Fortunately, many of our investment positions “came to life” during our absence with positions like Strong Buy-rated Sprint Nextel (S/$20.26) traveling above $20.00 per share. Likewise, Chesapeake Energy’s (CHK/$32.51/Strong Buy) 5%-yielding convertible preferred has rallied from $91.00 to $100.00, Chicago Bridge & Iron ( CBI /$27.74/Rated Outperform by research correspondent Credit Suisse) lifted from the low $20s, Strong Buy-rated RFID player Intermec (IN/$25.01) rallied, homeland security participant L-1 Identity Solutions ( ID /$16.59/Strong Buy) “popped” . . . all of which have kept us outperforming the various indices. One name that has stalled, however, has been Convanta ( CVA /$20.45/Strong Buy), which we have recommended since the mid-teens. Given the fact that CVA plays to EVERYTHING needed in the environment we envision going forward, we suggest familiarizing yourselves with the CVA story. As well, we suggest you re-consider our long-standing recommendation on electric-grid participant ITC Holdings (ITC/$36.55), which also remains rated Outperform by our research correspondent Credit Suisse.
In conclusion, by far the preponderance of our recent emails have centered on the Canadian Royalty Trusts. Many of those questions were addressed while we were away by our Canadian analysts in a communiqué. For copies please contact the retail liaison desk (x72520) or Julie Lachman (x75559). While we have little value-add in this regard, we believe the proposed tax changes for said trusts will not go through in its present form.
The call for this week: We were aggressively bullish at the mid-June trading lows, and currently we are aggressively cautious. While that stance has cost us relative performance points recently, we continue to believe that you should not put in your “Rent-a-Kid” application right here because we think we are well past the hiring stage in this bull phase. Indeed, some of the “kids” are well on their way to going broke, like Armand Amaranth, Roger Real Estate, Larry Leverage, Jimmy Junk bond, and the over-leveraged dance continues. Our ideal trading pattern calls for a trading “top” during this holiday week, leading to a correction into the second week of December, which would set up the fabled year-end rally. Whether this plays or not only time will tell, but we have learned the hard way it is difficult to break the markets “down” during the latter half of December. However, when the markets do break down in December it can be significant . . . hello 2002, which saw the DJIA fall from its December high of 9000 into its March 2003 low of 7400. Consequently, we find ourselves left with a George Soros quote from the year 2000 – “Maybe I don’t understand the market, but I prefer not to have the same kind of continued exposure I’ve had up until now. In some ways I think the music has stopped only most people are still dancing.”
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