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Jeff Saut Presents: Changes in Latitudes, Changes in Attitudes


The only thing constant is change.


Many years ago, we used to call on a major East Coast mutual fund where each portfolio manager had a placard on their desk that read, "The only thing constant is change." Change, indeed, for in this business if one does not change their indicators for the changing causal relationships they are doomed. And last week we changed a major tenet of the investment strategy we have employed for the past four years. Recall that we were bearish from the September 1999 "Dow Theory sell-signal" until the twin Trade Tower tragedies. Since then (October of 2001) we have averred that the equity markets were transitioning from a bear market, not to a new secular bull market, but to a trading range market for the major market indices like the S&P 500. Concurrent with that range-bound "call," we have steadfastly maintained that the place to be invested was in the mid/small-capitalization universe of stocks. Last week we changed that strategy.

To wit, since March 1999 the mid/small-cap universes of stocks have outperformed their large-cap brethren, as seen in the nearby charts. That outperformance has left the mid/small-cap indices trading at forward P/E multiples greater than that of the S&P 500. Moreover, that outperformance has lasted for 77 months. Historically, such outperformance has averaged 66 months. Consequently, the mid/small-cap "move" is very long-of-tooth. We are therefore changing our strategy from overweighting the mid/small-capitalization stocks to underweighting them. The quid pro quo is that we now recommend tilting portfolios toward large-caps, but not the mega-caps, because historically mega-caps have underperformed large-caps by some 21% per year (6.25% vs. 7.56%). This strategy change has broad implication for the strategic (read: investing) side of the portfolio, as well as for the mutual fund investor. Over the coming weeks we will be rebalancing our mutual fund investments in keeping with these "Changes in latitudes, changes in attitudes."

Speaking to mutual funds, as readers of these reports know, for some time we have been recommending that an oversized portion of your portfolio be positioned in international investments. That strategy has been driven by our sense that most foreign markets had cheaper valuations and that their economies were likely to grow faster than the muddling economic environment we envision for the U.S. So far that view has borne fruit given the capital gains it has produced in places like Japan, Korea, India, Asia, Latin America, etc. The problem has been that we needed to purchase a number of different mutual funds to check all of the "style boxes" we wanted. However, at one of our recent speaking engagements we were introduced to a relatively new fund from MFS called "The MFS International Diversification Fund" (MDIDX). Simply stated, MFS has combined five of its existing international funds, as well as their respective portfolio managers, into one fund. That fund allocates internationally, diversifies across market capitalizations, styles, sectors, and countries, while automatically rebalancing the overall portfolio periodically. In the process it checks all of the Morningstar Style Boxes that we consider necessary.

Turning to the tactical (read: trading) side of the portfolio, in last Monday's missive we suggested that the equity markets were potentially setting up for a tradable low. The only question in our mind was whether the low was going to be made by a selling-climax or a selling dry-up. As always, our preference was for a selling-climax because those kinds of lows are more easily identifiable. And that was the way it appeared things were heading, as telegraphed by the Hindenburg Omen signal of September 19th followed by the 90% down-day reading of October 5th. And then, last Monday, Lowry's Selling Pressure Index crossed above Lowry's Buying Power Index for the first time in 17 months. As stated by the astute Lowry's service, "Not all Selling Pressure crossing points are followed by major market declines, but such crossing points have occurred prior to, or during the early stages, of every major market decline during the past 72 years."

Consequently, the stage was set for a selling-climax low and we were telling folks last week that if we could "script it" the ideal pattern would be for stocks to slide into Friday's inflation figures and then accelerate into one of those "I think I'm going to be sick" type of downside hours triggered by a worse than expected CPI report. If that pattern played we would have been buyers. But a funny thing happened on the way to that capitulation-climax "buying point," for while the headline CPI figure soared to its biggest monthly increase since March of 1980 (+1.2%), the so-called "core" inflation rate was up a mere 0.1% . . . and the folks at the Labor Department didn't even wink as they reported it! And that, ladies and gentlemen, screwed-up the perfect selling-climax pattern. Yet, we have still not given up on that pattern. Indeed, we have followed the Lowry's Selling Pressure/Buying Power Indexes for 35 years. Our notes show that while such "crossings" tend to produce a three- to five-session "throwback" rally (sometimes shorter), the indexes subsequently retest their recent lows more than 90% of the time. Additionally, in half of those downside retests the averages actually made lower lows. So we have NOT given up on a selling-climax finale to this decline.

In conclusion, we met with "Deep Throat" during our travels of the past few weeks. Long-time readers will remember him as the portfolio manager of a multi-billion dollar large-cap value fund that has graced us with so many spectacular investment ideas over the past seven years. Currently, he is rebalancing his energy stocks (read: selling partial positions like we did nine weeks ago). Moreover, he is actually beginning to sell short certain refining stocks since the current cracking-spreads are unsustainable. As for what he has been buying, one of his recent purchases has been Time Warner (TWX). As the story was related to us, Time Warner has a huge amount of "content" and when buying the shares at $18.00, down from $95.00 per share, gives you AOL for FREE . . .'nuff said!

The call for this week: Based on the S&P 500's decline (-6.3%) the DJIA should be at 10000 and using the NASDAQ's decline (-8.7%) would put the Senior Index at 9768. Yet, our proprietary indicators are as oversold as they were at the March/April lows. Meanwhile, the percentage of NYSE stocks above their 10- day moving averages (DMAs) has dipped below 10%, while the percentage of stocks above their 30-DMAs slipped below 20%, leaving both of those indicators also well oversold. Still, the 10-year T'bond broke down technically last week, causing its yield (now at 4.49%) to rise above its August yield-yelp high of 4.44% as the inflationary scare we have been warning of gained more traction. Indeed, worries of inflationary impacted earnings have clipped the S&P and NASDAQ for between 5% and 10% as we suggested they would weeks ago. Clearly, the bond market didn't believe Friday's "core" CPI of 0.1% given last week's rate-rape.
Also worth noting is that for the first time in more than two decades the 4.7% year-over-year increase in the CPI is above the T'bond yield. And, on a three-month basis the CPI is rising at a 9.4% annualized rate. No wonder the Federal Reserve is hoisting interest rates and will likely continue to do so until there is a financial accident in true historical precedent . . . hello Refco (RFX).

No positions in stocks mentioned.

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