Jeff Saut Presents: Forget Paris
Earnings are in the process of regressing to the mean.
Obviously, we are referring to the 1995 hit movie Forget Paris about the torrid love affair between Mickey (Billy Crystal) and Ellen (Debra Winger) and not the sordid affairs of "Paris" Hilton (the woman). Indeed, in said movie the romantic life of NBA referee Mickey becomes intertwined with Ellen when he journeys to Paris with his estranged father's body to bury him with his World War II buddies. The casket is lost in transit and Mickey becomes romantically involved with the airline executive handling the problem (namely Ellen). A whirlwind love affair ensues between the two leading to marriage. The ups and downs of their marriage are recounted by their friends over dinner during the balance of the movie. Like the couple, we too have a love affair with the "City of Lights," knowing many good folks who live there and having been raised by French parents. Consequently, we always look forward to our recently concluded European speaking-tour for multiple reasons. This year, however, many of our stateside friends worried about us in our travels given the recent riots in Paris. Having lived through the 1960s riots in Detroit and Washington D.C., we found what is occurring in the suburbs of Paris to be somewhat analogous to the same economic-driven riots in this country a generation ago. As the astute research boutique GaveKal recently noted (paraphrased by me):
The challenge is demographic and sociological in nature: how to make an old and rich society co-exist with the young, poor (immigrant), and desperate societies, in the same geographic zones, with the knowledge that there can be no military solution? . . . As such, the immigrants (have not been) assimilated into the French society. . . . The children grow up feeling excluded, resentment builds, and by the time adolescence is reached, that resentment has blossomed into a full fledged hatred of France. . . . Beating the kids into loving France will not work either. . . . (Saut insert - with young immigrant unemployment running north of 35% in the Paris suburbs, the problem is more economic than racial/religious). For a number of young men, the army was the last hope. A last stop before a life of ill-discipline, petty crime, drug abuse, prison, etc. . . . Removing the military service did little to the upper and middle classes, but it destroyed an avenue of possible social advancements for the bottom social classes.
Unsurprisingly, during our multi-country European sojourn only the Americans asked us about the "fires" in Paris. From the European portfolio managers the questions du jour seemed to center on the dollar, interest rates, earnings, the economy (read: the consumer), and valuation levels. As for the dollar, we remain bearish, yet have successfully hedged that "bearish bet" twice over the past three years. Most recently, we entered 2005 looking for a counter-trend rally in the greenback and hedged our portfolios accordingly. We removed those hedges last summer, believing that the dollar's rally was over. That strategy looked correct until recently, when the dollar broke out to a new reaction high on November 4th (basis the Dollar Index). Our sense is that while the dollar may continue to have a "tailwind" into 1Q '06, that tailwind should fade in the New Year. On interest rates; quite frankly, we have been wrong, having thought that in our finance-based economy Fed Fund's rate-rape would stop around 3.5%. It appears now, however, that the new Fed chairman will continue to raise rates for a multiplicity of reasons. That would be consistent with the history of new Fed Heads who have entered their positions with a hawkish bias. This implies that the Fed likely will continue to raise interest rates until there is a financial accident.
As for earnings, we remain in "show me" mode, believing that earnings are in the process of regressing to the mean, implying single-digit earnings growth sometime next year. Likewise, we (that means me) believe the economy is also in mean-reverting mode and will produce a sub-3% year/year GDP growth rate in some quarter next year. And that brings us to VALUATIONS. Ladies and gentlemen, in the envisioned decelerating earnings environment, accompanied by rising interest rates, where P/E multiples should compress, it is difficult for us to envision much more than single-digit gains for major market indices. Meanwhile, there is an "even money" chance that 2006 could be pretty challenging if the "consensus call" is wrong and this is not the mid-cycle slowdown, followed by an economic reacceleration that everybody is expecting. This is why we are continuing to avoid "indexing" portfolios and have focused on thematic/sector specific investing and attempted to trade around those themes near the various markets' inflection points.
Such an investment strategy has led to pretty decent performance this year for as we traveled Europe. The Zack's Investment Research organization reported that Raymond James' Focus List had recorded the best returns of the year as compared to the various participating investment firms in Zack's stock-picking contest. To wit, as of 3Q '05, Raymond James' Focus List had placed FIRST in returns for the quarter, first year-to date, first in returns over the trailing 12 months, eighth over the past three years (I don't know what happened here even though I "sit" on the Focus List committee), first on a five-year return, and first on a seven-year return basis . . . enough said!
Speaking to inflection-points, while our long-term investment strategy remains pretty much unchanged, our trading stance has "moved" from where it was two-months ago. Recall that we entered October suggesting participants get their "Buy Lists" together. In mid-October we began a "scale in" buying-approach for trading and investment positions. On October 25th we penned a Special Strategy Alert flatly stating that "the lows are in!" Most of the index recommendations we made have rallied as well as most of the stock-specific names we used. And, that recent stock enthusiasm has caused the major-indices to break out to the upside amid the cry "the Santa rally is here!" Yet, we think there is now the potential for a "Hitchcock Twist." As such, at least on a short-term trading basis, we are focusing not on what to buy currently, but what percentage of our "long" trading-positions to sell. Verily, on a trading basis the time to be aggressively bullish was six weeks ago, not following a 13% gain for the Bank Index (BKX/105.84), a 10% rally for the NASDAQ 100 (NDX/1701.05), and a 7% rise for the Dow Diamonds (DIA/109.35), which were the three indices we were using for the anticipated rally.
In addition to the three indexes, we recommended buying all the stocks comprising the Analysts' Best Picks, which taken in the aggregate has rallied 9.4% since October 14th (when we began our scale-in buying program) and 6.2% since our October 25th "the lows are in" Special Strategy Alert. All in all, we have recommended 30 trading/investment positions since starting to compile our Buy List at the end of September. Only two of those recommendations are lower now than they were then. Yet, despite these "wins" this morning we want to talk about one of our losers, namely Synagro (SYGR/$3.79). We used SYGR as an investment position with an averaged "in" cost basis of around $4.60 based on our "water theme," and our fundamental analyst's Outperform rating. While we were in Europe SYGR imploded to $3.38 per share. Upon returning last week we checked with the company, and a number of portfolio managers who own these shares, but the story was best summed-up by our own analyst Bill Fisher. The Street seems to think that the 10% dividend is an all or nothing affair when in reality Synagro could reduce it to $0.35 per share (from $0.40) if cash flow gets too thin next year as the company ramps-up the new projects. That would still give SYGR a 9%+ yield. Once ramped-up (4Q '06), however, the company could raise the dividend back to $0.40 (see Bill's report dated 11/03/2005 for more details).
In conclusion, we continue to embrace all of the themes detailed in these reports over the past year [stuff stocks, homeland defense, post secondary education, water, towers-stocks, Public Utility Holding Company Act (PUHCA), Canadian Oil Sands, timber, emerging markets (particularly Brazil, Turkey and Malaysia currently), etc.]. As for the reoccurring question regarding "energy," that we got throughout Europe; back in August/September we noted that we thought oil was making a parabolic pig-peak and subsequently recommended reducing every energy stock in the portfolio by 20% - 30% (except for our coal stocks). While we remain long-term energy "bulls," currently we can't decide if oil's price decline is over. Technically, oil's correction should end somewhere between its current price, which is hovering around its 200-DMA ($57.80), and the $55/barrel trendline, as can be seen in the nearby chart. Failing that, oil's long-term trendline appears to be around $50/bbl. The reciprocal of oil is that we think gold is reaching for near-term parabolic price "pig-peak." Hereto, we remain long-term bulls on precious metals, as well as a "bull" on many basement stocks . . . save copper, which after three years of being a copper "bull" we have been selling. Nevertheless, we like gold a lot and would welcome a 20% price decline in the barbarous metal.
The call for this week: Enter December, and "The Stock Traders Almanac" states that - since 1950 "#1 S&P month average gain 1.7%, #2 Dow 1.8%, #2 NASDAQ 2.1% since 1971." Yet, the Hirsh organization also notes that, "most bear markets have started in earnest around year-end." While we are not expecting a bear market, we are worried about a near-term "Hitchcock Twist" to the downside.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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