Jeff Saut Presents: Dow Direction Dictates
"The absolute price of a stock is unimportant. It is the direction of price movement which counts."
"During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn't worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.
In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price -- by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance."
"Stock Profits Without Forecasting," by Edgar S. Genstein
We are leaving for our annual sojourn to Europe, where we will be speaking with institutional accounts. We'll be gone roughly two weeks and therefore wanted to leave you with the above paragraphs to ponder. They are two of the most important paragraphs we have encountered in more than 35 years of studying markets. Do not read them just once. Go off to a quiet spot that invites contemplation and read them several times. Then reflect on all of the mistakes you have made in trading and investing. Bells will ring, and curses will be uttered, if you are truly honest with yourself. Our advice is to keep this quote handy, read it over, and study it every time you get ready to make an important buy or sell decision; especially if your emotions reign.
Obviously, we agree with Mr. Genstein's advice, but over the years have added a "twist" to his sage strategy. That twist has been to be a scale-up seller, which tends to give us the "margin of safety" mentioned in Benjamin Graham's book The Intelligent Investor. This strategy allows us to hold some of our original scale-bought investment positions until we "wish we would have sold them sooner." For example, a few years ago we became enamored with Phelps Dodge (PD), a "stuff stock" (aka copper) that was rated outperform by one of our fundamental analysts. The vehicle we used to play this investment was Phelps Dodge's convertible preferred. Those shares were recommended in subsequent missives and at the time were "changing hands" below $90 per share with a 7% yield. Subsequently, we recommended selling one-third of that position in the $120s, while another one-third was sold in the $150s. And, before the company "forced" the conversion of those preferred shares into common shares, the convertible preferred shares were trading north of $200. Yet as of this writing, we still have not researched the point where we wished we would have sold "earlier" because we have the sales of the previous two-thirds of this position as a "profit cushion." We employ this "scaling" strategy on ALL of our investment positions, as well as our trading positions. Indeed, "The absolute price of a stock is unimportant. It is the direction of price movement which counts!"
"So Jeff," a Boston-based portfolio manager asked us last Friday, "You are getting ready to leave for Europe, what are you going to tell the folks abroad?" "Well," we replied, "The various markets should be at a crossroads over the next four to six months." To wit, the "shared belief" is that the current environment is merely a mid-cycle slowdown to be followed by the typical (post-World War II) economic reacceleration. While we certainly hope this is the case, our sense is that this remains the "fox trot" economy, where fast/fast economic figures will be followed by slow/slow figures as the "muddling" economic environment continues.
Indeed, we believe that real GDP peaked in 1Q04 at 4.7% and slowed to 3.6% in 2Q05. We also think GDP growth will slow to sub-3% as the economy regresses to its mean growth rate. That slowing sense is driven by continuing high oil prices, flattening yield curves, rising short-term interest rates, rising inflation rates, housing prices that appear to have peaked, and money supplies that are decelerating. Moreover, e-v-e-r-y-b-o-d-y is nervous! They are nervous about their jobs, their pensions, the wars, terrorism, healthcare legacy costs, continuing corporate scandals (read: Refco), and the list goes on. With these burgeoning problems, cooperation among our leaders is desperately needed, but that is just not happening.
For example, back on October 20th Senator Tom Coburn (R-OK) offered an amendment to the Senate's appropriation bill to redirect $223 million from Alaska to Louisiana for the repair of the hurricane-damaged Interstate 10 bridge, a major thoroughfare crossing Lake Pontchartrain and connecting New Orleans with the rest of the state. Those funds were to be transferred from a bridge project in Alaska dubbed, "The Bridge to Nowhere." That moniker seems appropriate because the proposed bridge was to connect the Alaskan town of Ketchikan (population 8,900) to its airport on the island of Gravina (population 50) at a cost to U.S. taxpayers of $320 million because (get this) some of the local residents complained that they had to wait 15-to-30 minutes for the ferry and then pay a $6 ferry fee. Ladies and gentlemen, think about that . . . $320 million amounts to $35,755 for every man, woman and child in the Ketchikan/Gravina area. What is even more incredulous is Senator Ted Stevens (R-AK) bombastic response that, "I don't kid people," he roared. "If the Senate decides to discriminate against our state . . . I will resign from this body!"
Regrettably, this is the kind of uncooperative attitude currently permeating Capitol Hill. Also worth noting is that such pork-barrel legislation is running wild inside the Beltway, and is being signed into law by a President who has yet to veto any spending bill that has come before him. And, that caused one Washington Wag to lament, "The smaller government era ushered in by Ronald Reagan is over!"
So yes, we think the next few months are critical. If our "call" is correct that the overspent/undersaved U.S. consumer has finally reached a tipping-point, and therefore the economy will slow, it should become evident in the first quarter of 2006. This would also be concurrent with a headline inflation figure (CPI) peaking between last month's 4.7% reading and 5%. Meanwhile, stocks (S&P 500) have gone nowhere for 3½ years despite 14 straight quarters of double-digit earnings growth, reinforcing our belief that we are in a P/E multiple "contracting" environment. And, that difficult environment has left investors less confident, more confused, and yes - nervous. Consequently, we continue to adhere to Charles Knott, eponymous captain of Knott Capital Management, who opines:
"With these concerns, our risk-adverse and conservative nature forces us to maintain a 'predominantly defensive' investment stance. Investors shouldn't have a highly optimistic or hardened pessimistic mindset. Proper sector-selection is the best tactic to achieve above average investment results. We favor those industry groups where valuations are reasonable, pricing power is formidable and earnings growth seems assured. We continue to sell-on-strength and buy-on weakness. This defensive tactic is flexible and adjusts to the market's volatility. It also allows gains to accrue as 'money is taken off the table.'"
The call for this week: Since turning more constructive on stocks following September 11, 2001, we have adopted a trading range strategy for the major indices (S&P 500). That said, over the past four years we have steadfastly maintained that the place to be was in the small/mid-capitalization complexes of stocks.
However, three weeks ago we changed that view to being overweight the large caps, but not the mega-caps (for more details see our report dated 10/17/05). As for the "here and now" (read: trading) we got our buylists together and began a scale-down buying program in mid-October on the premise that the equity market trading-lows were likely going to be made in "selling dry-up" fashion rather than by a "selling climax." That opinion was reiterated in our Special Strategy Alert (10/25/05) where we flatly stated the "lows are in!"
Taking that "stand" has made participants roughly 2.5% in the Dow Diamonds (DIA), 4%+ in the NASDAQ 100 (NDX), and nearly 5% in the Bank Index (BKX). Additionally, we suggested buying the entire Analysts' Best Picks List, which is up more than 6% since mid-October. For additional ideas you can peruse our Monday Missives of the past three weeks, as well as the October 25th Special 3 Strategy Alert. You can also access some of our international investing thoughts from our good friends at www.HeritageFunds.com.
In conclusion, we continue to favor the upside-seasonality into the holidays, taking our lead from the new all-time high in the D-J Transportation Average and the new rally high for the NASDAQ 100, but have noted that if we are going to get a pause/pullback it should come this week with an attendant yield-yelp on the three-step Treasury refunding. And with that, we are off to Europe . . . see you in a couple of weeks.
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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