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Jeff Saut Presents: Poker Mentality?!


...the rarest trait on Wall Street is "patience."


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"I learned how to play poker at a very young age. My father taught me the concept of playing the percentage hands. You don't just play every hand and stay through every card, because if you do, you will have a much higher probability of losing. You should play the good hands, and drop out of the poor hands, forfeiting the ante. When more of the cards are on the table and you have a very strong hand - in other words, when you feel the percentages are skewed in your favor - you raise and play that hand to the hilt."

"If you apply the same principles of poker strategy to trading, it increases your odds of winning significantly. I have always tried to keep the concept of patience in mind by waiting for the right trade, just like you wait for the percentage hand in poker. If a trade doesn't look right, you get out and take a small loss; it's precisely equivalent to forfeiting the ante by dropping out of a poor hand in poker. On the other hand, when the percentages seem to be strongly in your favor, you should be aggressive and really try to leverage the trade similar to the way you raise on the good hands in poker."

"Market Wizards," by Jack D. Schwager, explaining Gary Bielfeldt's analogy between trading and poker.

I have often stated that the rarest trait on Wall Street is "patience." I have also often reprised Charles Dow's quote that, "The successful investor/speculator needs to ignore two out of every three potential money making opportunities." Sometimes these old stock market axioms have hurt my firm, but more often they have saved us a lot of money. Indeed, "Waiting for the right pitch," as Warren Buffet terms it, is the key to successful investing and trading. Plainly, my firm waited for the "right pitch," having not made a purchase recommendation for the trading account since the New Year until the stock market lows of June 13th. We also exhibited "discipline" as we rebalanced our "stuff stocks" (read: sold partial positions) during their parabolic upside blow-off between January and May. Where my firm "missed it," at least on a trading basis, was in not buying the subsequent downside retest of the mid-June lows in the July/August timeframe for the trading account, because as stated at the time, "our proprietary indicators were not nearly as oversold as they were in June." Silly us, for the DJIA has made a straight-up move from said lows in what we have termed an "unnatural manner."

Surprisingly, we are not the only ones that find the stock market's action somewhat odd, for as savvy market observer Laszlo Birinyi recently noted, "It is very odd not to have had a 1% down day in any of the U.S. large cap indexes for so many months." Obviously, my firm agrees, and in last Monday's missive we termed this an "eerie situation" and reprised Dr. Robert McHugh's ( observations, as paraphrased by me:

The rally since July has been almost entirely short-covering. We get one big move, about once a week, on buying panic, then no follow-up...Get this: All of the progress of this three month summer/autumn rally, all of it, occurred in only 9 days of trading, and all but one of the nine was a short-covering rally...Other than those 9 trading days out of 63 since July 14th, the other 54 days of trading produced only 4% of the upside progress, and zero since July 19th. ZERO...!

My firm went on to note that while we can't tell if those nine sessions were all "short covering," we did take the time to check Dr. McHugh's insights and found them to be right on point. Amazingly, those nine sessions - 7/19 (+212); 7/24 (+182); 7/28 (+119); 8/15 (+132); 8/16 (+97); 9/12 (+101); 9/26 (+93); 10/4 (+123); 10/12 (96) - accounted for 1155 of the Dow's 1200-point gain from the July lows. Even more amazing is that on ALL of those nine trading days, according to our notes, the aforementioned "mysterious" futures buyers were at work with the attendant arbs' action.

Almost on cue those "mysterious buyers" showed-up early last week, at 6:30 p.m., to be specific, and drove the S&P 500 emini-futures contract from 1375 to 1397 in only two minutes, as can be seen in the following chart.

While my firm has no idea who those mysterious buyers have been, the October 13th edition of The Wall Street Journal had an article titled "Paulson Pulls for U.S. Markets," which implies it just may be the Plunge Protection Team (PPT) a.k.a. the President's Working Group on Financial Markets that was created in 1988 by President Reagan under Executive Order 12631. Whoever those buyers are, there has been an unnatural "bid" to the equity markets ever since Goldman Sachs' (GS) unexpectedly re-weighted its much institutionally indexed commodity index in late July, dropping the gasoline weighting from 7.3% to 2.5% in staged increments right into November. We have repeatedly argued THAT has been the major reason for the DJIA's explosive rally, for obvious reasons, and the 87.8% correlation between the two (the decline in gasoline and concurrent rise in the DJIA) implies the same correlation.

Yet the weighting issue in Goldman's Commodity Index is not the only "weighting" issue. As the astute John Mauldin points out in his weekend letter:

"The Dow has always been price weighted, so the higher the price of a stock, the more important it is to the index. Most other indexes (like the S&P 500) are market cap weighted, so the higher the total value of the company, the more weighting it has in the index. If you use price as the factor for your index, the size of the company does not make a difference. As many have noted, only 10 of the 30 Dow stocks are above their January 2000 highs. Fifteen of the remaining 20 are down 25% or more. The biggest reason for the surging of the Dow has been just four of its stocks, which not coincidentally are its highest-priced components. And as Barry Ritholtz noted, not a one of the 30 Dow stocks was at an all-time high as the Dow was making its new index highs.

What would your returns look like if the Dow was capitalization weighted like the S&P 500? I asked my friends Rob Arnott and Jason Hsu at Research Affiliates to do the math for us. And since they also run indexes which are fundamentally weighted, I asked them to tell us what the returns would have been if you had weighted the stocks by valuation metrics rather than price or size. The Dow was at 11,453 on January 1, 2000. Today it closed at 12,134, up almost 700 points or around 6% over the almost 7 years. Including dividends (which is only fair) the total return on the Dow would have been 20.75%. What if the Dow had been capitalization weighted? Your total return (including dividends!) would have been only 1.13%! Taking away the dividends, the Dow 30 would still be under its high-water mark by about 13%!"

So what does this mean to us? Well, as stated, the whole affair feels unnatural, which is why my firm has remained cautious, although admittedly we have been too cautious. Still, our "call" over the last few months has been for higher equity prices into the late October fiscal year-end timeframe (many institutions end their fiscal year on October 31st) and potentially higher all the way into the November elections, where the Republicans look to be losing Congress (read: bad for big Pharma and managed healthcare). From there, political attentions should turn to the 2008 presidential election, where Hillary appears to be the leading Democrat (read: more bad news for drug companies). And, these are some of the reasons we have recommended selling the groups that have been working on the upside, like healthcare, and buying the groups that have not been working, like energy.

To that point, energy stocks rallied last week lifting names like Chesapeake Energy (CHK), with an attendant rise in our recommendation of Chesapeake's 4.5%-yielding convertible preferred "D" shares to the point that we are no longer buyers, despite last week's better than expected earnings report. No so, however, Blackrock Global Energy Resources' (BGR) 5.6%-yielding closed-end fund that still trades at a 9% discount to its net asset value (NAV). We also got lucky on our continuing recommendation of Sprint Nextel (S), which rallied 11.4% last week following its conference call.

Worth further consideration is that while energy, and gold's, demise is capturing the headlines, zinc, lead, tin, uranium, water, etc. are making new all-time price highs. This is being reflected in the Merrill Lynch World Mining Trust PLC (MLWMF), which has gained 46.9% over the last 12 months. My firm thinks such performance is likely to continue over the long-term as demand from 5 billion new people entering the world's economy, in their respective emerging markets, fuels demand for "stuff." We also think volatility is currently being under-priced, which is why we continue to recommend going "long" the Volatility Index (VIX). We continue to invest, and trade, accordingly.

The call for this week: Last week the "mysterious" events continued as Jeffrey Lacker again voted for higher interest rates despite the fact that his own Richmond Fed's manufacturing survey, which is the equivalent of the "Philly Fed's" manufacturing report, fell off a cliff (read: recessionary leanings and NO inflation). While the 30 structural revisions in the metrics of creating the CPI instituted during the Greenspan era are telegraphing little inflation, like Jeff Lacker, we don't believe IT, thinking the Fed may actually raise interest rates in the New Year (2007). And that, dear reader, is NOT being discounted by the various markets. We remain cautious and are picking our investing "spots" accordingly. Furthermore, it will be interesting to see if more mysterious buyers materialize this week and "spook" the markets higher into anyone?!

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