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Jeff Saut Presents: The Emerald City


...consider the fact that investing is not a "lap race" but a marathon!


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.

This week I venture to the Emerald City to speak at Minyans in Manhattan (NYC) and to raise money for children's education for Minyanville's sister organization The Ruby Peck Foundation. Obviously I'm in full holiday regalia, having watched The Wizard of Oz for the hundredth time, which always seems to kick-off the holiday jubilance. Consequently, my firm revisits our annual missive of the past 30 years to remind participants what "real" money is! Most people know The Wizard of Oz as one of the most popular films ever made. What is little known, however, is that the book was based on an economic and political commentary surrounding the debate over "sound money" that occurred in the late 1800s.

Indeed, L. Frank Baum's book was penned in 1900 following unrest in the agriculture arena (read: farmers) due to the debate between gold, silver, and the dollar standard. The book, therefore, is supposedly an allegory of these historical events making the information easier to understand. In said book, Dorothy represents traditional American values. The Scarecrow portrays the American farmer, while the Tin Man represents the workers, and the Cowardly Lion depicts William Jennings Bryan. Recall that at the time Mr. Bryan was the official standard bearer for the "silver movement," as well as the unsuccessful Democratic presidential candidate of 1896. Interestingly, in the original story Dorothy's slippers were made of silver, not ruby, implying that silver was the Populists' solution to the nation's economic woes. Meanwhile, the Yellow Brick Road was the gold standard, and Toto (Dorothy's faithful dog) represented the Prohibitionists, who were an important part of the silverite coalition. The Wicked Witch of the West symbolizes President William McKinley and the Wizard is Mark Hanna, who was the chairman of the Republican Party and made promises that he could not keep. Obviously "Oz" is an abbreviation for "ounce."

As we watched the movie we thought, "How appropriate an apologue for our current environment given the recent action of gold, silver, and the dollar." This time, however, the "man behind the curtain" is Ben Bernanke, to which we are paying little attention. What we are paying attention to are the charts, since in this business price is reality! Consequently, when we look at the "gold standard" of our era, namely the dollar, the picture is not a pretty one. As a sidebar, it should be noted that before 1873 the U.S. dollar was defined as consisting of either 22.5 grains of gold or 371 grains of silver. This set the legal price of silver in terms of gold at roughly 16:1 and put the country on a gold/silver bimetallic standard. Since both metals had other uses than just coinage, whenever the ratio got out of whack rational people would buy the cheaper metal and take it to the mint for coinage. That provided a natural stabilizing arbitrage. With the 1873 Coinage Act, however, the silver dollar was omitted, effectively shifting the country from a bimetallic to a gold standard. Other countries soon followed, and as tons of silver were unloaded, the market silver price of gold rose from 16:1 to 40:1. The result was that the dollar was now linked to a metal that was getting more scarce.

Particularly hurt by these events were the net debtors, among them the farmers because they had to face a rising real value of their debts combined with declining agricultural prices (in dollar terms). Now, while there was a bunch of "noise" in between (The Sherman Silver Purchase Act of 1890, the panic and depression of 1893, etc.), the situation hit its zenith in 1896 culminating with William Jennings Bryan's "Cross of Gold" speech at the Democratic National Convention.

While I have digressed, I find monetary history truly fascinating and would note that the value of the current dollar, in 1900 dollars, is worth roughly $0.07 (see Chart 1 below). Or, as one Wall Street wag lamented, "So much for the Federal Reserve System." Nevertheless, turning back to the chart of the U.S. Dollar Index (See Chart 2 below) shows that the "buck" broke below its recent reaction lows last week and is currently testing its May 2006 lows at 83.41. As well, it is below its 10-day moving average (DMA), its 50-DMA, and its 200-DMA. Moreover, these moving averages are all trending down (read that: negative). My firm has often spoken of the Dollar's Demise since the Dollar Index peaked at 121 in 2002 and is now down roughly 30% from that peak. This is not an unimportant point since the S&P 500 (SPX) would need to be trading at 1510 in equivalent dollar terms just to be even. And if one were to change the "measuring stick" from dollars to ounces of gold, the S&P 500 would need to be 60% higher than where it currently resides, again just to be even. Indeed, gold and silver concurrently broke out to the upside in the charts last week, which was clearly good news for my firm's long-standing recommendations of the precious metal stocks and attendant recommendations on precious metals mutual funds, as well as various metals ETFs.

Verily, my firm thinks the nation's embedded inflation rate is likely closer to the dollar's decline over the past five years (some 30%), implying a 6% inflation rate per year, rather than the re-jiggered CPI figure comprised by the government's gear-heads. Plainly, anyone living in the real world knows the current inflation rate is higher than the laughable 1.9% (estimated) core rate to which the government keeps referring.

As for the various market sectors, my firm's work "foots" with the astute Lowry's organization, which states:

"Based on increases in Power Ratings, the Energy, Industrial, Information Technology and Telecom sectors are currently the strongest performers among the 10 Lowry Industry Sectors. Of these, the performance of the Energy Sector is particularly impressive. Oil prices topped on August 7th at $76.98 and subsequently fell to a recent low at $55.81 on November 17th. Over the same time period, the Energy Spyder (XLE), which encompasses a broad range of energy stocks, was virtually unchanged. An ability to hold up under bad news is usually considered an important sign of underlying strength."

Hereto I agree, believing one of the true beneficiaries of the Democrats' "sweep" in the November elections will be the Canadian Oil Sands Properties. Also, to this energy point, I suggest considering today's upgrade of Horizon Offshore (HOFF) by my firm's Houston-based energy team. HOFF shares currently trade at a whopping 47% discount to its peer's 2007 P/E multiple. One obvious reason for HOFF's valuation disparity is the company's troubled history. However, Horizon's balance sheet is as strong as ever with a net debt to cap ratio of 10%. Likewise, the previous selling pressure due to institutional holders' lock-up agreement expirations has unwound, and none of HOFF's current institutional owners are Form 4 filers. In other words, the liquidity issues mentioned in my firm's comment dated 8/30/06 no longer present a major overhang.

Another Raymond James event you should consider is the upcoming "Data Capture and Supply Chain Conference" being held in the Emerald City (NYC) on December 12th. My firm has liked the fast growing, dynamic RFID space for some time since it is mandated to grow from a $100 million to a $5 billion business by 2009. In past missives I have used Intermec (IN) as a good way to participate in the burgeoning business. However, if the adaptation of RFID continues to accelerate at the current rate, Scansource (SCSC) could come into play faster than we expect. As a sidebar, and in keeping with our "Oz" vent, silver is the antenna of choice for the RFID devices and could require as much as 10% of the world's silver production when RFID becomes ubiquitous.

The call for this week: Benjamin Graham was fond of saying – the essence of investment management is the management of risks, not the management of returns. Well, managed portfolios start with this precept! I offer this "Grahamism" to those that are currently underperforming the various averages and suggest you consider the fact that investing is not a "lap race" but a marathon! Ben Graham also opined, "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." "Adequate return," ladies and gentlemen, is the operative phrase since my firm has produced outsized returns for the past seven years. Currently, our preferred trading pattern calls for a trading-top with a subsequent decline into the second week of December, setting the stage for the fabled "Santa Claus" rally into year-end. Whether that plays, only time will tell, but my firm remains defensively postured given the current lap-race mentality, and over-stretched valuation metrics, of the equity markets. I will follow the "yellow brick road" to the Emerald City (NYC) and hope to see you there.

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