Investment Strategy
by Jeffrey Saut

Street smarts

April 24, 2017

Some people can have a lot of experience and still not have good judgement. Others can pull a great deal of value out of much less experience. That’s why some people have street smarts and others don’t. A person with street smarts is someone able to take strong action based on good judgement drawn from hard experience. For example, a novice trader once asked an old Wall Street pro why he had good judgement. “Well,” said the pro, “Good judgement comes from experience.” “Then where does experience come from?” asked the novice. “Experience comes from bad judgement,” was the pro’s answer. So you can say that good judgement comes from experience comes from bad judgement.

. . . Adapted from “Confessions of a Street Smart Manager,” by David Mahoney

Years ago we read a book that a Wall Street pro told us would give us good judgement by benefitting from the experiences of others who had suffered hard hits. The name of the book was “One Way Pockets.” It was first published in 1917. The author used the nom de plume of Don Guyon because he was associated with a brokerage firm having a sizeable business with the public and he had conducted an analytical study of orders executed for active public traders.

The results were “illuminating enough to afford corroborative evidence of general trading faults which persist to this day.” The study detected “bad” buying and “bad” selling, especially among active and speculative participants. It documented that the public “sells too soon, repurchases at higher prices, buys more after the market has turned down and finally liquidates on breaks… a true response in all similar Wall Street periods.”

For instance, the book showed that when a bull market begins the accounts under analysis would buy for value reasons; buy well, though very small. The stocks were originally bought for the longer term rather than for day-to-day trading purposes. But as prices moved higher participants were so scared by memories of the previous bear market, and so worried they would lose their profits, they sold. At this stage “the accounts showed scores of complete transactions, yielding profits of less than two points, liberally interspersed with losses.”

Then in the second phase, when accounts were convinced that the bull was for real and a higher market level was established, stocks were repurchased, usually at higher prices than where they had previously been sold. “At this stage larger profits were the rule; three, five, seven and even ten points were taken… the advance had become so extensive that several attempts were made to find the ‘top’ with short sales… the experiments were almost always disastrous.”

Finally, in the latter stage of the bull market the recently active and speculative accounts would tend not to over-trade or try to pick “tops,” but resolved to buy and hold. So many times previously they had “sold” only to see their stock dance higher, leaving them frustrated and angry. “The customer who months ago had been eager to take a profit on 100 shares of stock would not take ten points of profit on 1000 shares of the same stock now that it had doubled in price.” In fact, when the market finally broke down, even below where accounts bought their original stock, they bought more. They would not sell. The tendency of the trading element at this mature stage of the bull market was to buy breaks. The author concludes that their trading “methods had undergone a pronounced and obvious unintentional change with the progress of the bull market from one stage to another . . . a psychological phenomenon that causes the great majority to do the direct opposite of what they ought to do!” Conclusion: “The collective operations of the active speculative accounts must be wrong in principal… so the method that would prove profitable in the long run must be the reverse of that followed by the consistently unsuccessful.”

Not much has changed from 1917 to 2017, just the players, not the emotions of greed versus fear or supply versus demand. Like in the book “One Way Pockets,” we too have studied the psychological mindset changes participants go through over the course of a secular bull market. As Ray DeVoe notes, they are: 1) Aftershock and Rebuilding; 2) Guarded Optimism; 3) Enthusiasm; 4) Exuberance; 5) Unreality; and finally 6) Cold Water and Disillusionment. Clearly we are nowhere near “Enthusiasm, Exuberance, or Unreality.” We think investors’ mindset is currently at “Guarded Optimism.” And that “Guarded Optimism” continued last week as the D-J Industrial Average (INDU/20547.76) broke a two-week losing streak by gaining 0.5%. In last Monday’s report Andrew and I hinted that might just be the case when we wrote:

It should also be noted that our measurement of the stock market’s “internal energy” levels are almost back to a full charge, implying if the downside gets going there is enough energy for a decent move. If that is the case, the strongest “energy flows” should come early this week, suggesting the potential for a trading bottom late week. Also suggestive of a trading bottom are the Volatility Index (VIX/15.96), the CBOE Put/Call Ratio, and the sentiment readings.

Well, we didn’t get the perfect pattern last week, which would have been an early week whoosh to the downside into the long-targeted 2270 – 2280 level by the S&P 500 (SPX/2348.69). However, late last week we advised participants to get their “buy lists” ready because a rally may be in the cards. We still feel that way. Indeed, since being in cautionary mode from the first week in February our models took a decided turn for the better last week despite the backdrop of nasty geopolitical events, mixed economic reports, and some earnings misses. Our sense is that over the next few weeks the lack of “selling pressure” is going to allow stocks to attempt to lift. While we don’t think it will be a vigorous “lift,” it should still be a lift. Accordingly, we would urge you to sift through the stocks featured in these missives over the past few months that Andrew and I have suggested you put on your “watch lists” for potential purchase when the time was right. We think the time is finally right after the past nearly three months of “going nowhere” consolidation.

The call for this week: This week Andrew and I are in Orlando at the Raymond James National Conference where we will be seeing portfolio managers, financial advisors, and giving a keynote address. Hopefully the equity markets will give an “upside address” of their own in our absence. To that point, it is worth mentioning that there has been an “internal correction” going on for the past few months, leaving only 25% of the S&P 500 stocks above their respective 10-day moving averages (DMAs). Meanwhile, 75% of the S&P 500 stocks reside above their 200-DMAs, which is evidence that the primary trend of the equity market is still “up.” Plainly, Dow Theory agrees with that! Amazingly, the equity markets have held up pretty well despite the talk of thermonuclear war and ICBMs, implying this has been a three-month bullish upside consolidation pattern. That is very much like the 18-month bullish consolidation chart pattern that occurred between November 2014 and July 2016, where the Bear Boos told us it was a major top, yet we remained steadfastly bullish. Ladies and gents, this is a secular bull market with years left to run. In addition to the stocks featured in our reports, the only sector that is “overbought” in the short-term is Consumer Discretionary (see chart 1 on page 3). And over the weekend Macron (the globalist) has a lead over Le Pen (the nationalist), leaving the preopening S&P 500 futures up some 26 points at 5:00 a.m. as we watch the sun rise in Orlando at the RJFS National Conference. As we said last week, “Ready your buy lists!”

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It's learning!

April 17, 2017

Back in 1983 I was enthralled with the movie “War Games.” According to Wikipedia:

WarGames is a 1983 American Cold War science fiction film. The film stars Matthew Broderick, Dabney Coleman, John Woods, and Ally Sheedy. The film follows David Lightman (Broderick), a young computer hacker who unwittingly accesses WOPR (War Operation Plan Response), a United States military supercomputer originally programmed to predict possible outcomes of nuclear war. Lightman gets WOPR to run a nuclear war simulation, originally believing it to be a computer game. The computer, now tied into the nuclear weapons control system and unable to tell the difference between simulation and reality, attempts to start World War III.

The sequence from the movie that “stuck” with me was near the end where it was suggested that the WOPR computer was actually learning from the game simulations that any nuclear attack by the U.S. was a losing proposition (War Games). Similarly, it appears to us that President Trump is “learning” on the job, just like WOPR did in the movie. I mean just last week our president embraced many of the “things” he had campaigned against. Now it appears Janet Yellen may stay as Fed head, NATO is no longer obsolete, China doesn’t manipulate its currency, the U.S. dollar is “too high,” and the list goes on. Add to that a decidedly stiffer foreign policy strategy with the Syrian missile strike and the “Mother of All Bombs” (MOAB: the GBU-43/B) that was dropped on an ISIS bunker complex in the Achin district of eastern Afghanistan. Up until now the stock market has turned a deaf ear to such events, but that seemed to change late last week.

Indeed, to Andrew and me it has seemed quite eerie to see the stock market hanging in there given the geopolitical environment, the Atlanta Fed cutting its GDP growth estimate for 1Q17 in half (to +0.6% from +1.2%), the Federal Reserve raising interest rates, in-fighting in D.C., a potential Whitehouse staff shakeup, the potential for a confrontation with North Korea over the long weekend, China threatening to bomb North Korea’s nuclear facilities if it crosses Beijing’s “bottom line” (Bomb), and hereto the list goes on. As we suggested on TV last Thursday, “Who wants to be long trading positions going into the Easter weekend given the skein of events last week?!” Of course we have been pretty much of that mindset since the first week of February following our models’ negative “flip” at the end of January. Meanwhile, many “seers” continue to come out with four or five new investment/trading ideas every day, but most of them are losing opportunities. As Warren Buffett says, “One or two good ideas a year are all you need!”

As for us, since going dormant at the beginning of February we too have listed a number of ideas for your potential “buy lists” if the equity markets ever managed to drop into our models’ target zone of 2270 – 2280 so often mentioned in these missives. But to repeat, these are for your potential “buy lists” because as Warren Buffett points out:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle – an undervalued investment opportunity.

Last week, however, after ignoring most of the geopolitical threats, the S&P 500 (SPX/2328.95) took a decided step toward our models’ target level when the SPX broke below last Wednesday’s intraday low (2341.18), as well as last Tuesday’s intraday low (2337.25), to close at 2328.95 bringing into view the March 27 intraday low of 2322.25. If that level “falls” the odds of a test of our 2270 – 2280 target zone increase noticeably. So, the “polarity flip” we thought would occur last week arrived and as anticipate it was to the downside. It should also be noted that our measurement of the stock market’s “internal energy” levels are almost back to a full charge implying if the downside gets going there is enough energy for a decent move. If that is the case, the strongest “energy flows” should come early this week suggesting the potential for a trading bottom late week. Also suggestive of a trading bottom are the Volatility Index (VIX/15.96), the CBOE Put/Call Ratio, and the sentiment readings.

Consistent with these thoughts, we were intrigued by a list of companies compiled by Goldman Sach’s David Kostin that he thinks can expand their profit margins by at least 50 basis points, and increase sales by more than 4%, in both 2017 and 2018. The names from said list that are rated positively by our fundamental analysts, and that screen positively on our models, include: Netflix (NFLX/$142.92/Outperform), Expedia (EXPE/$128.13/Outperform), Abbvie (ABBV/$64.13/Outperform), Masco (MAS/$33.09/Outperform), Qorvo (QRVO/$68.48/Outperform), and Nvidia (NVDA/$95.49/Strong Buy). Yet to reiterate, these names are for your potential “shopping list” because as Warren Buffett states, “One or two good ideas a year are all you need.”

The call for this week: Last week Mark Hulbert published an excellent article about Dow Theory (Hulbert). He only made one mistake when he wrote that Dow Theory was created by William Peter Hamilton when in reality it was created by Charles Dow. Granted refinements were made to Dow Theory by Hamilton in the 1920s, Robert Rhea in the 1930s, George Schaefer, and my friend Richard Russell, but the theory originated with Charles Dow. There are not many of us left that IMO know how to correctly interpret Dow Theory, and by our pencil Dow Theory remains solidly bullish with the primary trend “up.” So over the weekend nothing happened with North Korea and this morning the equity markets are giving a sigh of relieve with the preopening futures relatively flat. Yet, retail sales have fallen for the second month, Japan is readying for a North Korea emergency, Vice President Pence warns North Korea on U.S. resolve shown in Syria and Afghanistan, the Pentagon is protecting the U.S. electric grid, bank loan growth has stalled, bank stocks that have led the rally are now in full retreat, President Trump says, “North Korean problem will be taken care of,” and the preopening S&P 500 futures are only off 3 points as we write at 5:00 a.m. In our view prudence demands caution here with the SPX only six points away from the March 27 reaction low of 2322.25.

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Shad Rowe

April 10, 2017

I spoke with uber investor Frederick “Shad” Rowe, captain of Dallas-based Greenbrier Partners, last Thursday. Shad always has great investment insights, and his March letter to investors was no exception. I like Shad’s letter:

Traditionally, there have been two proven, well-worn paths available to investors seeking financial security or riches. The first has been compounding money through the ownership of publicly traded securities. The second has been through being a technology entrepreneur or knowing the right venture capitalists. For most investors the first path was too slow and too unsteady, while the second path produced too little boom and too much bust. Obsessed with its own short-term profitability, Wall Street lost interest in the first path and has been intellectually and financially unequipped to be of any real use with the second path. It was assumed that these two paths were separate and mutually exclusive, making it impossible to travel both paths at the same time. One saw oneself as either a patient investor or as a venture capitalist. I chose the path of patient stock market investing. It was the more conservative approach, but it was the more assured.

Amazingly, however, it would seem as though the two paths have re-converged. The four dominant technology companies we own are Facebook, Apple, Google, and Amazon. These companies, which represent about 45% of our equity at market, have the potential to both compound their earnings predictably and have dramatic step-ups in value – if their venture investments pan out. What is proven and recognized is that these companies have been winners. Everybody gets that. What we believe is proven but not yet recognized is that these companies can be far more than long-term compounders. The companies that we have invested in appear to grow more powerful by the day. They have wonderful business models, massive scale and have (and can attract) the best, most creative people, the best ideas, the best science, the best resources, the most extensive market knowledge, and nearly unlimited venture capital arms funded by their enormous cash flows, so they can buy or build any great technology they want. These companies also have locks on ways of doing things, rather than just locks on individual things, which allows them to evolve.

It has become a winner-take-all world, with only a few winners and many, many losers. Together, FB, AMZN, AAPL and GOOG spent $82 billion on capital expenditures, research and development and acquisitions in 2016. They currently have $289 billion in net cash. This compares to $42 billion raised by 253 venture capital firms in 2016. Further, these companies provide true value to society, sometimes by disrupting the seemingly entrenched monopolies of the past that do things to, rather than for, their customers, and by revolutionizing the ways we do almost everything else, which is really the point. Rather than selling a product or service, what these companies are really selling are new, better and more fun ways of doing things. As we have said before, we want to own the agents of change and avoid the targets of change.

Boy, do I agree with Shad on those points and would note that these companies resemble what Warren Buffett refers to as “companies with an economic moats around them.” According to Investopedia:

The term economic moat, coined and popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.  Remember that a competitive advantage is essentially any factor that allows a company to provide a good or service that is similar to those offered by its competitors and, at the same time, outperform those competitors.

Shad’s investment model is very much reminiscent of this quip from Brown Brothers Harriman: “Our aim is to identify great businesses, buy them [the stock] at a discount and patiently wait for the market to recognize their value. We believe this is the best recipe for consistent long-term investment results. In our book, patience is more than a virtue: it’s a necessity.”

There’s that word “patience” again, and as often opined in these letters, “Patience is the rarest commodity on Wall Street!” So, in mid-February the S&P 500 (SPX/2355.54) was changing hands around 2355 and as of last Friday it closed at 2355.54. Over that timeframe, we have seen mixed economic reports, a Fed rate ratchet, numerous terror tactics, a failed healthcare bill, a stronger and then weaker than estimated employment report, a filibuster, hints that tax reform may take longer than expected, a Tomahawk missile strike on Syria, and the list goes on. Given that skein of events, we find it somewhat bullish that stocks have hung in there. Speaking to last week’s missile strike, it has long been our belief that such events tend to not have any long lasting effect on the various markets, especially if it is a “discrete action” and not the beginning of a broader campaign. Our friends on Capitol Hill suggest that is exactly what last Thursday’s air strike was, a discrete action, which is likely why the market’s response was muted. Still, the SPX was unable to breakout above its downtrend line that has been in effect since the March 1, 2017 high (chart 1). Also worth mentioning is that the SPX once again held above its 50-day moving average (DMA). However, the Russell 2000 (RUT/1364.56) and the D-J Transpiration Average (TRAN/9104.81) have not stayed above their respective 50-DMAs (chart 2 and chart 3). Adding to the mixed signals is the fact that the average stock in the S&P 500 is down 18.4% from its 52-week high. Maybe these conflicting signals will be resolved this week since the stock market’s internal energy has been rebuilt and our models are looking for a “polarity flip.”

Meanwhile, 1Q17 earnings reports are slated to begin this week with expectations for a 9.1% increase in y/y earnings for the S&P 500. If correct, this would further reinforce our belief that the secular bull market has transitioned from interest rate driven to earnings driven.

The call for this week: The SPX has basically been trapped in a trading range between 2335 and 2400 since mid-February of this year as the forces of “light and dark” battle. Meanwhile, as we drill down into the economic numbers, Andrew and I think the economy is just fine. However, last week Jamie Dimon (JP Morgan) and Larry Fink (Blackrock) warned about weakening U.S. economic stats, and on Friday the Atlanta Fed cut its 1Q17 GDP to +0.6% from +1.2%. That comes as 1Q17 earnings are expected to post their strongest gains in years. Indeed, confusing! To reiterate, “Maybe these conflicting signals will be resolved this week since the stock market’s internal energy has been rebuilt and our models are looking for a ‘polarity flip’”. This morning, the preopening futures are again flat as China’s nuclear envoy is in South Korea amid talk of President Trump’s potential action against North Korea. As stated on Friday, “Do not play unless absolutely necessary because the environment is extremely unpredictable.” 

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