Jeff Saut Presents: Reflections on a Year Winding Down
...our tactics going forward will likely remain the same.
Year-end letters are always difficult to write because there is a tendency to reflect on the year gone by, or worse, attempt to make predictions about the upcoming year. As Yogi Berra said, "It's tough to make predictions, especially about the future." Indeed, who would have predicted that after 13 interest rate increases by the Federal Reserve, the 10-year Treasury Bond's yield would be below where it was when said "rate ratchet" began?! Certainly not me, nor most other Wall Street pundits. Still, Wall Street's "best and brightest" are at it again as the media was replete last week with predictions for 2006. Just for the record, we urge participants to read the book "Bull: 144 Stupid Statements from the Market's Fallen Prophets" (by Eckler and MacDonald) to see just how wide of the mark most of these soothsayers have been over the years. Nevertheless, the "Wall Street Waltz" always seems to play this time of year. Yet while making predictions is fun, it should in no way be construed to be investment advice. As noted in the first paragraph of chapter one of Benjamin Graham's epic book "The Intelligent Investor:"
"What do we mean by 'investor'? Throughout this book the term will be used in contradiction to 'speculator.' As far back as 1934, in our textbook 'Security Analysis,' we attempted a precise formulation of the difference between the two, as follows: 'An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.'"
These cogent comments hang on the wall of our office to remind us of the difference between an "investment" and a "speculation." The book goes on to note, "You must never delude yourself into thinking that you're investing when you're speculating. Speculating becomes mortally dangerous the moment you begin to take it seriously. You must put strict limits on the amount you are willing to wager." Also of tantamount importance is the line, "promises safety of principal and an adequate return." Note that Graham speaks of an "adequate return," not spectacular returns. This is an investment philosophy not followed by most. To this point, in a Forbes article titled "Be Conservative Not Conventional" preeminent portfolio manager Ken Fisher points out, "Here's the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return - and sleep better en route." Plainly we agree.
Given the aforementioned Benjamin Graham quote ("Operations not meeting these requirements are speculative"), making predictions about the upcoming year are by default "speculative." That said, over the weekend we found ourselves reflecting on 2005 and thinking about 2006. The year winding down has been good to us. Our Focus List has gained roughly 16% year-to-date (YTD), while the Analysts' Best Picks List was up some 22%. That exceeds anything we expected since we began 2005 suggesting it was likely to be a relatively "flat" performance year for the major market averages. As often happens to us, we were generally correct and precisely wrong in that the DJIA is up less than 1%, yet the NASDAQ has gained 3.9%. Meanwhile, the S&P 500 has improved by 4.9%, driven to a large degree by its energy components.
Fortunately, we have been well overweight the energy stocks, and most "stuff stocks," for the past few years. However, the oil and gas stocks are not the number one performing group YTD; coal is (we were bullish)! "King Coal" is followed by Exploration & Production (2), Oil Equipment (3), Water (4), and Heavy Construction (5) . . . indeed, generally correct. As for precisely wrong, the next five top-performing sectors are: Mining (6); Internet (7); Healthcare Providers (8); Non-ferrous Metals (9); and Real Estate (10). While we have recommended four of this year's top five performing sectors, we only "got" two of the next five winners right (Mining and Non-Ferrous metals); and we have completely missed Real Estate (save the REITs) for the last three years. By far, however, our biggest mistake of the year was recommending hedging portfolios for the downside in February with the DJIA around 10800. Luckily, we only used the dividend/interest income from the portfolio to purchase those "hedges," so all we have forgone is the income and not the capital appreciation. (It is worth noting that those downside hedges are still active.)
On a trading basis, our best macro "call" of the year was telling participants to get their "buy lists" together at the beginning of October and then begin a "scale-in" buying approach for those lists in mid-October. We also were right, and wrong, on the dollar having entered this year looking for a counter-trend rally in the "buck" and hedging for it. We unwound those dollar-hedges in May/June when we thought the dollar-rally was over. And, that strategy looked correct for a while as the Dollar Index (currently 89.71) fell from 91 in July to around 86 in September before rallying to almost 93 in late November. Nonetheless, we remain dollar "bears," believing the dollar will lose many of its tailwinds in the New Year. The same can be said of gold in that the January-to-May timeframe has typically been a softer pricing environment for the yellow metal. Longer-term, we remain steadfastly bullish on gold, as well as most of the metals (precious/base-metals).
Turning to the New Year, as noted, we have rarely seen such a wide dispersion of opinion for 2006's market outlook. Certain seers are forecasting 20% gains for the S&P 500, while others are looking for a 20% decline. As previously stated, our guess is the correct forecast is somewhere in the middle as we believe the economy will regress to the mean (read: soften). Notionally, with central banks tightening and energy prices rising again, the economy should be set to weaken, led by an overspent/undersaved consumer. Like at this time last year, we think this implies a continuation of the trading range environment with hopefully a slight upward bias. 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.'"
In conclusion, our tactics going forward will likely remain the same. In the low return environment we envision participants should continue to focus on dividend-paying stocks. Strategically, for the first time in four years, we favor large capitalization stocks over mid/small-caps, although we continue to think select mid/small-cap situations will provide "outsized" earnings growth. Participants should also spread their "bets" while making certain their investment mix includes stocks, bonds, real estate, and money market funds. Additionally, you should set portfolio percentage-weightings for each sector and stick to them. For example, you might allocate 30% of your portfolio to large-cap U.S. stocks, 20% to mid/small-cap U.S. stocks, 15% to emerging markets, 10% to developed-foreign markets, 7% to commodity funds, 6% to REITs, 6% to bonds, and 6% to money-market funds. Through appreciation, or depreciation, these weightings will change over time and consequently should be periodically rebalanced. Rebalancing, when done correctly, is an art form and is one of the keys to a successful investment operation.
The call for this week: Yogi Berra additionally noted, "The future ain't what it used to be;" and, regretfully, we agree, believing 2006 is going to be a difficult investment environment. Eerily, just like 2004, this year's performance has been jammed into the last few months of the year. Fortunately, we anticipated the rally and have benefited from it. However, the time to be aggressively bullish was nine weeks ago . . .not here! While we continue to think the S&P 500 can trade into the 1280 - 1300 area, the risk/reward ratio has gone from LOW in mid-October to higher-risk currently. As the invaluable "Thechartstore.com" service said in its weekend blog, "The S&P 500 continued to consolidate and has basically moved sideways for four weeks. The setup for a run into the time cycle high, expected the week of January 13, 2006 (plus or minus a week), is about complete. Overhead resistance is at 1300 - 1315. Support is at 1225 - 1240." We continue to invest/trade accordingly. Happy Holidays to y'all . . .
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