Raymond James’ Jeffrey Saut: The Great White Hurricane

The following is an investment strategy column by Jeffrey D. Saut, managing director at Raymond James & Associates Inc.

“Unseasonably mild and clearing,” was the weather forecast going into the Ides of March back in the year of 1888. And it was true, as temperatures hovered in the 40s and 50s along the East Coast.

However, torrential rains began falling, and on March 12th the rain changed to heavy snow, temperatures plunged, and sustained winds of more than 50 miles per hour blew.

The “Great White Hurricane” had begun! In the next 36 hours some 50 inches of snow would blanket New York City and the winds would whip that snow into 40- to 50-foot snowdrifts. Telegraph and telephone lines were snapped, fire stations were immobilized, New Yorkers could not get out of their homes, 200 ships were blown aground, and before the storm was over 400 people would die.

The resulting transportation crisis led to the construction of New York’s subway system.

We revisit The Great Blizzard of 1888 this morning because of the weather that has crippled the Northeast corridor over the past few weeks. Fortunately, communities are more capable of dealing with such storms today than they were more than a century ago.

Still, the loss of productivity is likely going to be impactful in some of the upcoming economic reports. That said, over the long weekend we studied the D-J Industrial Average (DJIA) chart from 1888 and found that March 11 – March 14 marked a bottom for the stock market. Also of interest is that today is session 18 in the envisioned “selling stampede” so often discussed in these missives.

For new readers, “selling stampedes” tend to last 17 to 25 sessions, with only one- to three-day counter trend rally attempts before they exhaust themselves on the downside. While it is true that some stampedes have extended for 25 to 30 sessions, it is rare to have one last for more than 30 days. Accordingly, we are getting increasingly interested in stocks again, and have been adding names to our “watch list.”

As for Dow Theory, which we have often been asked to comment on over the last few weeks, so far there is no signal, at least as we were taught to interpret it. Indeed, for a “sell signal” to be generated it requires the following set up (as paraphrased by Mark Hulbert):

1. The Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a significant correction from joint new highs.
2. In their subsequent rally attempt following that correction, either one or both of the averages must fail to rise above their pre-correction highs.
3. Both averages must then drop below their respective correction lows.

Therefore, the stage is set because the DJIA recorded its closing high on January 19th at 10725.43, while the DJTA hit its closing high of 4262.86 on January 11th. Their subsequent lows came simultaneously on February 8th at 9908.39 (DJIA) and 3792.89 (DJTA), respectively.

Thus, if the two indices can rally back above their aforementioned “highs,” it would reinforce the Dow Theory “buy signal” generated last summer. If, however, they fail to better those highs, and then break below their February lows, a “sell signal” will be rendered. Regrettably, there is no way to anticipate such signals.

We tend to use Dow Theory for the strategic side of the portfolio (read: investing). To that point, the “buy signal” registered last summer remains in force until it is negated.

Optimistically, we continue to believe that negation is not in the cards. Indeed, with credit spreads back below pre-Lehman bankruptcy levels, we think there is no reason why the downside vacuum created in the S&P 500 (SPX/1075.51) chart by said bankruptcy cannot be filled to the upside, especially given the improving fundamental backdrop, suggesting targets of 1200 – 1250.

Driving that sort of pricing action has been explained in past missives where we have exhorted that the typical economic recovery cycle is for corporate profits to boom, driving an inventory rebuild cycle that fosters capital equipment expenditures. As companies spend money on the capex, people are hired, and then consumption “reboots.” Importantly, hiring and consumption come on the backend of the cycle, NOT the front end.

Currently, companies have the greatest profit leverage they have seen in a generation and consequently profits are booming. So far, this has allowed cash to build on corporate America’s balance sheets.

But with inventories plumbing historically low ratios, the nascent inventory rebuild should gain traction in the months ahead as sales improve. And, sales should indeed improve with stock brokerage accounts now up dramatically from their March 2009 lows accompanied by improving home prices.

Moreover, as James Paulsen notes, the fixed-cost portion of household ledgers, which includes debt service and energy costs, topped out at 25% of disposable income and is now down to 22%. Ergo, many consumers are now in a position to return to the shopping malls. And, that increased spending mindset should be reinforced by surging income tax refunds.

Speaking to stock market valuations, while on a trailing 12-month measurement the SPX is neutrally valued at ~18x reported earnings, looking forward shows stocks at ~13x 2010 estimates and ~11x the 2011 forecasts. Moreover, the recent 10% correction has brought the “negative nabobs” back out of the woodwork with a concurrent swoon in investors’ optimism (read that as bullish).

Meanwhile, there is more than $10 trillion on the sideline getting negative “real” returns (inflation-adjusted), some of which monies should eventually find their way back into stocks, particularly stocks with dividends. Inasmuch, we continue to add stocks to our “watch list,” and actually are accumulating some of those names in investment accounts. Additionally, we are getting pretty excited on a trading basis considering it is session 18 in our day-count sequence.

To review some the names that remain on the “watch list”: Walters Energy (WLT), O’Charley’s (CHUX), Select Comfort (SCSS), National Oilwell (NOV), CVS (CVS), Alpha Natural Resources (ANR), Cogent (COGT), Cenovus Energy (CVE), Radiant Systems (RADS), Dine Equity (DIN), North American Energy Partners (NOA), Allstate (ALL), Home Depot (HD), Inergy (NRGY), and last week we added Noble (NE). Noble operates one of the largest offshore rig fleets in the world with 63 mobile offshore drilling units. It has a ton of cash on its balance sheet and a low tax rate since it has moved its headquarters to Switzerland. Trading at attractive valuations, we find these shares compelling. And before I get a hundred emails, yes, we still like Celgene (CELG), which is followed by our research affiliate with an “Overweight” rating.

THE CALL FOR THIS WEEK

China is closed for the Chinese New Year this week (The year of the Tiger), so China is not going give us a hint as to if our markets are bottoming like it did last year. Still, we are pretty excited since today is session 18 in the envisioned 17- to 25-session “selling stampede” and we are looking for a bottom. Interestingly, so is the astute Lowry’s service. To wit:

“A well-known market analyst was said to have once remarked that every bull market has at least one pullback that fools investors into thinking a new bear market has begun. To create this deception, these pullbacks need to be severe enough to raise expectations a new bear trend is underway – such as might occur with a correction of 10% or more. But, to be deceptive, such declines should be relatively rare occurrences, which runs counter to the general perception. . . . So, rather than being commonplace, pullbacks of these magnitudes are relatively infrequent. . . . How then, are investors to differentiate between these corrections and the beginnings of a new bear market? One similarity in each of these cases of corrections reaching 10% or deeper is that they typically occurred well into the second stage (the Holding and Upgrading Zone) of the bull market. That is, profit-taking has already been well established, as reflected in a sustained uptrend in our Selling Pressure Index, thus setting the stage for deeper than normal corrections. In the present case, however, the Selling Pressure Index was recording an 18-month low in mid-January when the (stock) market correction began. Thus, based on the long history of the Lowry Analysis, the probabilities do not favor a 10% plus correction occurring at this relatively early stage of the uptrend.”

For more investment strategies by Mr. Saut, go to RaymondJames.com/inv_strat.htm.