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Investment Strategy
by Jeffrey Saut

7 come 11

May 22, 2017

On a craps table, if a 7 or 11 rolls on the first throw of the dice, you are an automatic winner if you are betting the “pass line.” But, if you roll a 2, 3, or 12 on the first roll, you lose. So “7 come 11” means that any time after the first roll, when a shooter has a point to make, you win with a bet on the “come line” with a roll of a natural 7 or 11 and lose on craps (2, 3, or 12).

So, last week I found myself in Reno Nevada, and then Las Vegas, speaking at events for our financial advisors and a couple of conferences. Now, anytime I am near a craps table, I like to throw dice. Unfortunately, my first attempt to do so saw me, as well as everyone else at the table, unable to make three passes in a row. The experience was costly, as the “pass line” bets were all losing bets. The second night, I decided to bet on the “don’t pass” line, meaning you are betting against the players trying to make the designated point. It is not much fun playing the “don’t pass” line, and the other players do not like people betting the “don’t,” but that night it proved to be the winning strategy. Having won back my previous losses, I decided to play the “pass line” the next night only to lose all the money I had won the previous night.

Similarly, participants should have bet the “don’t pass” line last Wednesday when the D-J Industrial Average (INDU/20804.84) lost an eye-popping 373 points for the biggest one-day loss of the year. Yet, this should have come as no surprise, because as Andrew and I wrote last Monday:

Our models suggest the “drop” in equity prices ended on April 19th with another breakout to new all-time highs slated to begin late this week. Early this week [however] has the potential for some further stock price weakness, but by late week that potential weakness should abate. The compression of the Bollinger Bands, like our models, are telegraphing the potential for a pickup in volatility, which we think will come on the upside beginning late this week or early the following week.

Last Monday, that strategy looked flawed when the senior index tacked on roughly 85 points. Tuesday, it looked a little better as the Industrials hugged the “flat line.” Comes Wednesday, and well, you all know how Wednesday turned out. To be sure, Wednesday’s Wilt caused the S&P 500 (SPX/2381.73) to close below its 50-day moving average (DMA) at 2369.53. As our friend Craig White wrote Wednesday afternoon:

To summarize Wednesday’s action, I sent a more balanced note to some contacts stating the following; “Art Cashin said it best this afternoon ‘a lot of damage done today on the charts, but not irreparable’. Indeed, a lot of uncertainty with respect to obstruction of justice etc. and those cracks/doubts finally emerged today. Far too early to determine if this is the start of a more serious decline, but I agree, I don’t like to see the banks lead on the downside. That said, yields gapped lower today so I’m not surprised to see this, which was also reflected in the insurers. Technology was off 2.8% today, with the mega caps contributing to a good percentage of the points lost. When the financial and tech sectors, which account for ~40 % of the index, lead on the downside, it’s bound to produce a more meaningful decline such as the 1.8% seen today. The divergence in transports is also concerning as it was broad based across the 20 constituents, but this trend has been in place since March. That said, the spread between the industrials and transports is widening which certainly needs to be respected. So where do we go from here? Well, the next few sessions should provide some guidance as to the seriousness of the recent Washington machinations with the market ultimately deciding on its relevance. It’s best to sit back and observe the ensuing trading action with patience and diligence. In the meantime, sharpen the pencils in anticipation of putting money to work if this blows over and another buying opportunity presents itself, which unless significantly violated on the downside, I believe will be the outcome. Stay tuned.”

Subsequently, Thursday and Friday did indeed “provide some guidance as to the seriousness of the recent Washington machinations with the market ultimately deciding on its relevance” with a two-day two step of some 200 points. That action allowed the SPX to recapture its 50-DMA, alleviating at least some of the technical damage that was done. Of interest is what the astute folks at Bespoke Investment Group wrote over the weekend (as paraphrased).

After hitting an all-time high Tuesday, the S&P 500 had its worst day since last September on Wednesday, falling by 1.82%. In the process of Wednesday's decline, the S&P 500 also dropped below its 50-DMA. What makes this combination unique is that in the history of the index, it has only hit a 52-week high on one day and dropped below its 50-DMA the following day just three other times. The prior three periods are highlighted in the chart and occurred on the two trading days ended 1/4/00, 11/15/91, and 9/26/55. (Chart 1 below)

What is amazing to Andrew and me is how fast investors’ bullish sentiment has declined. According to The American Association of Individual Investors (AAII), bullish sentiment stands at 23.85%, down a large 8.88 points from the previous week’s reading of 32.73% (Chart 2 on page 3). Ladies and gentlemen, that is the biggest weekly drop since July of 2015. It is also reflective of just how skittish investors are. Another sign of investors’ bearish sentiment is the flow of funds data that shows an $8.9 billion outflow of funds from U.S. equities recently. Hereto, we view that as a bullish event potentially setting the stage for the anticipated rally to new all-time highs. That would be in keeping with what our short/intermediate-term models continue to suggest. Verily, there is nearly a full charge of internal energy available, which implies last Wednesday’s action was a one-off event. While many will attempt to spin Wednesday’s Dow Dump into a precursor of nasty events yet to come, our models are just not reflecting that currently.

The call for this week: It will be interesting to see if the political brouhaha somewhat abates this week given the president’s speech in Saudi Arabia yesterday. Also arguing for less political infighting is that ex-FBI director Comey cannot readily accuse President Trump of obstruction without incriminating himself, because under the law, Comey was required to notify the DoJ of ANY attempt to obstruct justice. If the political environment softens, it would go a long way in helping this earnings-driven secular bull market. In any event, our work shows that the first part of this week has the potential to be strongly positive for equities. To that point, last week we noted, “The compression of the Bollinger Bands, like our models, are telegraphing the potential for a pickup in volatility, which we think will come on the upside beginning late this week or early the following week (Chart 3 on page 3). Plainly, the Bollinger Bands continued to compress dramatically last week, and in the process, the SPX tested the lower band.

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Inflation, El Niño, and fishmeal

May 15, 2017

“Washington – A gauge of U.S. business prices rose to the highest level in five years, another sign inflation pressure is picking up across industries.”

. . . The Wall Street Journal (5/12/17)

Some inflation numbers were reported last week. They read: April PPI jumped 0.5% month/month, +2.5% year/year; +2.2% year/year was expected. Meanwhile, core PPI increased by 0.4% month/month, +1.9% year/year; +0.2% month/month and +1.6% year/year were expected. The inflation report reminded us of something Pippa Malmgren (a policy consultant to numerous presidents) said to us at a recent national conference. She opined that when inflation goes from 1% to 2.5%, or maybe even 3.0%, it’s a really big deal; and we agree. Shortly after parsing those inflation figures I read something about the El Niño that is expected to “hit” in the back half of 2017. As paraphrased from the eagle-eyed David Lutz’s blog “What Traders Are Watching,” (Jones Trading):

The headline read, “Full-Fledged El Niño Increasingly Likely in Second Half 2017.” The U.S. government’s Climate Prediction Center (CPC) last month forecast El Niño conditions would prevail by the end of the northern hemisphere summer, but put the probability at only 50 percent. Most El Niño indicators have strengthened since then so the probability is likely to be revised higher when the CPC issues its next forecast later in May. Aussie’s wheat crop could see further drought damage. Sugar cane will also be impacted. Dryness in Southeast Asia could depress harvest levels of crops including rice and sugar in Thailand, Robusta coffee in Vietnam, and will add stress to rubber and palm oil trees in Indonesia and Malaysia. El Niño has also been linked to a weaker Indian monsoon and lower than average rainfall could affect crops including rice, wheat, cotton, and sugar. Indian farmers are large buyers of gold, and analysts at UBS last year raised concerns that a potential weak monsoon could hit purchases of the precious metal. El Niño has tended to impact cocoa production in West Africa. Meanwhile, Peru’s anchovy catch is almost always affected by the weather event, and is the main ingredient for fishmeal.

Interestingly, this “fishmeal” inference made me recall that a severe El Niño was responsible for the term "core inflation," which excludes food and energy prices in its inflation figures for those of you who don't eat or drive. We like this story:

It was in the early 1970s when an El Niño weather pattern caused torrential rains in Chile. Those rains caused Chile's Atacama Desert, the driest non-polar region in the world, to turn to mud. Since said desert lies between the Andes Mountains where copper is mined, and the Pacific coast, the copper could not be transported to Chile's ports, causing copper prices to surge. Further exacerbating the inflationary bias, the rain runoff spilled into the Humboldt Current. The Humboldt Current flows from the southern tip of Chile to northern Peru and extends about 1000 klicks off the coast into the Pacific Ocean. It is also responsible for about 25% of the world's "fish catch," mainly consisting of sardines and anchovies. For the uninitiated, those fish have many uses, like being dried and then crushed to be used in animal feed. The heavy rain runoff changed the saline content in the Humboldt Current causing the "fish catch" to collapse, which sent the price of feed stock for animals soaring with a concurrent rise in the price of beef, hogs, etc. At the same time OPEC was jamming “up” the price of crude oil with the OPEC oil embargo. A stumped Arthur Burns, then chief of the Federal Reserve, consequently asked his minions how to remove the price of food and energy from the inflation figures. P-r-e-s-t-o, "core inflation" was born, which excludes the costs of food and energy.

The impact of these La Niña/El Niño weather effects are not an unimportant point, for as Tony Heller notes:

“There are ominous signs that the earth’s weather patterns have begun to change dramatically and that these changes may portend a drastic decline in food production with serious political implication for just about every nation on earth. The [subsequent] drop in food output could begin quite soon, perhaps only ten years from now.”

Speaking of “drops,” the “drop” in the price of crude oil looks to be over to us and we are tilting portfolios appropriately. The individual stock of choice our models like, and our fundamental analysts have a positive rating on for this energy theme, is Genesis (GEL/$31.43/Outperform). In fact, looking at the sectors, the only two that are oversold are the Energy and Telecom sectors (see chart 1, below). Also of interest is that the emerging markets appear to have bottomed and in the process have formed a reverse head-and-shoulders bullish chart formation (see chart 2 on page 3).

The call for this week: I am in Nevada and California speaking at events for our financial advisors and their clients this week, so this is being written on Sunday night without the benefit of the preopening futures. Our models suggest the drop in equity prices ended on April 19th with another breakout to new all-time highs slated to begin late this week. Early this week has the potential for some further stock price weakness, but by late week that potential weakness should abate. The compression of the Bollinger Bands, like our models, are telegraphing the potential for a pickup in volatility (chart 3 on page 3), which we think will come on the upside beginning late this week or early the following week. While our models are not always right, they are right more times than they are wrong and hereto we are tilting portfolios accordingly. Meanwhile, the transition to an earnings-driven secular bull market is in full swing with 61.6% of companies reporting earnings beating the consensus estimates and 63.1% bettering revenue estimates.

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The Seinfeld market, redux

May 8, 2017

So Andrew and I received a plethora of emails wanting to know what we meant about “A Seinfeld Market,” which was the title of Friday’s “Morning Tack.” As disclosed in that report, the concept was not ours, but rather Dr. Ed Yardeni’s as scribed in his insightful blog. Dr. Ed begins said blog by writing:

"The Pitch” is the 43rd episode of the TV sitcom Seinfeld. It is the third episode of the fourth season. It aired on September 16, 1992. In it, NBC executives ask Jerry Seinfeld to pitch them an idea for a TV series. His friend George Costanza decides he can be a sitcom writer and comes up with the idea of “a show about nothing.” The bull market in stocks since March 2009 has had a fairly simple script too. As a result of the Trauma of 2008, investors have been prone to recurring panic attacks. They feared that something bad was about to happen again, so they sold stocks. When their fears weren’t realized, the selloffs were followed by relief rallies to new cyclical highs and to new record highs since March 28, 2013. Their jitters are understandable given that the S&P 500 plunged 56.8% from October 9, 2007 through March 9, 2009. From 2009 through 2016, there were four major corrections and several significant scares. I kept track of them and the main events that seemed to cause them. By my count, there were 57 panic attacks from 2009 through 2016, with 2012 being especially anxiety-prone with 12 attacks. (See our: S&P 500 Panic Attacks Since 2009.)

Indeed “The Seinfeld Market,” a concept that was espoused by Barron’s eagle-eyed Ben Levisohn in his “Trader” column over the weekend. To wit:

For most of the week it looked as if nothing was going to happen at all. Through last Thursday’s close, the S&P 500 had gone seven days without a move of 0.2% or more in either direction. That’s the fifth time that the popular benchmark has gone at least that many days without such a move, according to Bespoke Investment Group. The lack of action was putting many observers on edge, but Bespoke notes that stocks generally move higher when such streaks end: Following low-volatility streaks of seven days or more, the S&P was 2.1% higher a month later on average.

Clearly, that is what our models are suggesting following their “flip” to a positive reading on April 19, 2017 and we have recommended tilting portfolios accordingly. At the time our models went on a “buy signal” the S&P 500 (SPX/2399.29) was trading around 2335, while the NASDAQ 100 (NDX/5646.09) was changing hands at ~5397.18. So early last week a reporter asked me, “Your models are ‘saying’ the equity markets are going to trade out to new all-time highs, but how can that be given the weakening economic reports?” Well, firstly the models are forward looking, not driving down the road looking in the rearview mirror. Second, over the past few months we’ve had several things that have had a negative impact on the economic reports: 1) slow tax refunds; 2) the actual tax day; 3) rents have increased noticeably; 4) gasoline prices are up; 5) we experienced some bad weather; 6) Easter fell at a weird time; 7) auto sales have slowed; 8) healthcare costs have leaped; and the list goes on. We, however, believe the economy will strengthen in the months ahead with last week being a step in that direction.

Meanwhile, the transition to an earnings driven secular bull market continues. As our friend Sam Stovall (CFRA Research) writes:

With the S&P 500’s first-quarter earnings-report period largely over, the initial estimate is again on track to be exceeded by the actual growth in earnings per share, as has been the case of the past 20 quarters. Indeed, the final year-on-year quarterly growth in S&P 500 EPS exceeded the beginning-of-quarter estimate by an average 3.5 percentage points. It now appears as if first-quarter 2017 results will be no exception, as the March 31 estimate of +9.9% according to S&P Capital IQ, will now come in closer to +14%. Expectations for forward-quarter outcomes are probably contributing to equity optimism.

To be sure, with over 1800 companies reporting earnings, the record shows that 64.0% of them have beaten the consensus earnings estimates and 65.3% have bettered the consensus revenue estimates (Chart 1). This revenue “beat rate” is decidedly positive, since it has not happened since 2Q14. Importantly, more companies are raising forward earnings guidance than companies lowering guidance (Chart 2). Breaking out the earnings “beat rate” by sector, shows that technology and consumer discretionary have the highest “win ratios,” while telecom has the worst (Chart 3). Of interest is that the stocks with the most international revenues have performed the best (Chart 4). What do you think is going to happen when the stimulus from the new administration kicks in over the next few years?!

So, we have decent earnings growth and it is likely to continue. That means stocks are not all that expensive, based on future earnings. As we have argued in the past, there are more high growth/high margin companies populating the S&P 500 than ever before, which by definition implies valuations should be higher. Then there is the switch from tangible asset to intangible asset. For example, in 1985 companies had some 85% in tangible assets and 15% in intangible assets. Now that ratio is completely reversed. Hereto, by definition, that implies higher valuations. Finally, if you take out the aberrationally low P/Es of the 1970s and 1980s due to high inflation and high interest rates, and sum the beginning of the year P/Es for the S&P 500 starting in 1990, the average P/E is 23.85. Moreover, our work suggests “smart money” is accumulating equities. Professional money is buying on weakness and not selling on strength. Investor sentiment remains in a funk and you can read that as bullish. Finally, we are in a secular bull market “super cycle.” Studying Chart 5 show that such bull markets tend to last 15+ years, so even if you start the “count” in March of 2009 we should have another 7+ years left in this cycle. As we have noted in the past, however, it is likely this “bull market” began in either October 2011, or in April of 2013. As Zor Capital’s portfolio manager Joe Fahmy writes:

Think of everything that’s been thrown at this market over the past few years: geopolitical concerns, dramatic elections, viruses, Brexit, terrorist attacks, etc., and guess what? The market has been INCREDIBLY resilient and literally brushes off bad news. Now, imagine if the news over the next year or two actually turns positive.

The call for this week: Well, Macron won the French election. And, something is happening across Europe that many have missed: the mainstream left is getting crushed. The preopening futures initial reaction to that news was a leap higher, but since then they have come back to earth at -3.75 at 5:00 a.m. Of course that is in keeping with our models that forecast another week of timidity for the equity markets before a lift off to new all-time highs. Meanwhile, a 152,000 of the 211,000 Nonfarm Payrolls number was due to a change in seasonal adjustments (fake news), consequently a June interest rate ratchet is highly likely, the NY Fed cut its 2Q17 GDP estimate to 1.8% from 2.3%, Gary Cohn said the “Tax Plan Will Offer CEOs One Time Incentive to Bring Cash Back to U.S.A.,” U.K. retailers report weak sales in April, “Puerto Rico Declares ‘Bankruptcy’ Due to $123 Billion in Debts,” and the list goes on. As we write, the S&P futures are down 3.70. We will closely watch the first-hour indicator. If the S&P 500 Index jumps to a new high early, the first-hour low will be important support and the first-hour high will be resistance. The early Monday morning downside reversal should trouble bulls. And, that’s the way it is as we board a plane for Michigan . . .

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