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Jeff Saut: No Regrets?


The selling stampede may have ended.


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.

"'Here's a quick economics quiz,' said Michael Shermer in the Los Angeles Times. As the 100,000th customer of a movie theatre, Mr. A wins a prize of $100. Meanwhile, down the block, Mr. B is standing just behind another theatre's one-millionth customer. That lucky patron wins $1,000, while Mr. B collects a consolation prize of $150. Would you rather be Mr. A or Mr. B? Amazingly, most people say they would rather be Mr. A. 'In other words, they would rather forgo $50 to alleviate the feeling of regret that comes with not winning the thousand bucks.' Such thought experiments go 'a long way toward debunking one of the biggest myths in all of psychology and economics, known as Homo economicus.' This mythical creature is unfailingly rational and always makes choices that maximize his advantage. In fact, human beings are all irrational and emotional in economic matters as they are in most other aspects of their lives. Like our primate cousins, we so dislike the feeling of regret that we'll pay to avoid it. 'That's weird and irrational, but it's the way it is' – whether economists like or not."
--"How money overcomes rationality," by Michael Shermer (Los Angeles Times), as recounted in The Week

"Regrets, I've had a few," is a phrase from Frank Sinatra's hit song "My Way." And, "Regrets" have been heard on The Street of Dreams recently as investors regret entering the new year in too bullish a mode with little thought of a recession. Yet as the Dow has declined, concurrent with certain weakening economic statistics, the word "recession" has sprung from the media's lips like raindrops on the roof of a Florida house in the summer. The result has left participants confused, pondering what to do, and yes regretful, as seen in the following email:

"Jeff, I am trying to cope with two points that you made recently in your weekly missives.

1) 'We flagged all periods since 1948 when the unemployment rate increased by greater than or equal to 0.6 percentage points over a 12 month period. There have been 10 prior episodes where this has occurred. In all ten prior episodes we were in recession... ALL 10! This is the eleventh such occurrence. It could be different this time but as we wait to find out, I think it is prudent to lower the risk in our equity portfolio.' (Myles Zyblock)

2) 'Since 1949 every government-sponsored stimulus package has worked.' Since this is not our father's recession, does point number 2 trump point number 1?

This point counter-point recession question is precisely what the various markets are struggling with currently, which is why they too have had a point counter point. Consider this – we wrote about the Dow Theory "Sell Signal" that was registered on November 21, 2007 indicating the DJIA has been in a bear market since July 19, 2007. That was one of the reasons we began the new year in a pretty cautious mode and with an oversized cash position. My firm's other reasons for caution that we thought would get more clarity later in the year were: the housing situation; the subprime contagion; the political environment; and whether the under saved/overspent U.S. consumer is finally sated with debt.

However, we wrote about the equity market's positive counter-point in our January 7, 2008 report, noting:

"The last time the Fed reliquidfied the system like this equities were over valued, while bonds, commodities, and real estate were under valued. Today the opposite is true. Indeed, using the Fed Model, which compares equities 'earnings yield' (earnings ÷ price) to the yield of the 10 year T'note, shows equities' 'earnings yield' is over 4% greater than the benchmark T'note's yield (according to a study of 29 various countries compiled by Lehman Brothers). The last time such a wide dispersion occurred was back in September 1974 right before the equity markets rallied strongly. While other valuation metrics (price to book, price to dividends, price to sales, etc.) are nowhere near as 'cheap' as they were in 1974, it is worth noting the Fed Model's current valuation in light of the probability of lower short-term interest rates. We mention the Fed Model this morning for while we are cautious, we think it's a mistake to become too bearish."

Surprisingly, last week I received another positive counter-point for equities from a savvy seer who stated:

"Jeff, I thought you may find the attached of interest. You may be familiar with Ford Equity Research, one of the oldest independent equity research firms utilizing a dividend discount model to value equities since 1970, as well as indices. When fear and anxiety overwhelm Wall Street, I like to take a more objective view and lean towards valuation and numbers that minimizes the emotions from the decision making process. That being said, barring a black swan event, based upon Ford Equity's model there have been few times (~3) in the past 30 years that the S&P 500 has been as cheap as it is today, and never in that time frame has a significant decline continued from these current valuation levels."

By studying the chart below from the good folks at Ford Equity Research( one can see for themselves the point my savvy friend is making.

So where does all this leave us? Well, it seems to me as though the equity markets put in a bottom of at least near-term significance on January 23rd when the DJIA recorded its second largest daily point swing in history from down more than 300 points in the morning to up nearly 300 points on the closing bell (the largest daily point swing since July of 2002). Indeed, I think the envisioned "selling stampede" ended on that date in session 18 of the typical 17- to 25-session "selling stampede" and are treating those late-January "lows" as the internal lows until proven wrong. Moreover, it is worth noting that a $10 per barrel drop in the price of crude oil is worth an additional one point of P/E multiple expansion for the S&P 500, or a 200-point rally. Further, the DJIA's closing low of January 22, 2008 (11971) remains un-violated on the downside, as does the D-J Transportation Average's low of 4140, and until those "internal lows" are breached, we are trading off of those lows bullishly.

Click to enlarge

As for the U.S. dollar, my firm has been bullish on the dollar since its November "lows" (basis the Dollar Index), often remarking that we don't know if we are going to be bullish on the U.S. dollar for three months, or three years, but we do know that after being bearish on the dollar for six years, we no longer want to be bearish of it! I would further note that the counter-intuitive strength of the dollar warns that the drivers of the foreign exchange market may be changing. On Treasury Bonds we are manifestly bearish (read: higher interest rates). Indeed, since the yield-yippy low of 3.28% on January 23rd, the 10-year benchmark T'note's yield has risen into last week's yield-yelp high of 3.81%. That yield spike was driven by the recent Treasury Bond auction, which at 1.82% was the worst bid-to-cover ratio in years. Even more worrisome was the lack of foreign buyers, reflected by the 10.7% ratio of indirect bidders. The resulting chart action leaves us thinking the yield on the benchmark 10-year note is on its way to 4.5%, while the yield on the "long guy" (30-year T'bond) should travel above 5%. And that, ladies and gentlemen, is likely why the U.S. dollar strengthened last week.

As for individual stocks, my firm was pleased to see that the astute BlackRock organization filed on our Delta Petroleum (DPTR), acknowledging that it owns a large amount of shares. For the more timid types, it should be noted that DPTR has a convertible bond yielding 3.5% (terms should be checked before purchase). We also like our investment position in Strong Buy-rated Schering Plough (SGP); except in this case we are using the 7.7%-yielding convertible preferred "B" shares. While this preferred is a relatively new one, I think the risk/reward metrics are similar to the last Schering Plough convertible preferred we owned, which provided us a total return of nearly 30% per annum over our two-year holding period. Like before, the common shares of SGP have recently been devastated because of the fallible "Enhance" study on Vytorin. Our doctor, as well as our analyst, suggests this study encompassed far too small a sample of participants and that Schering Plough's Vytorin is still a good drug. As always, the terms of the convertible preferred should be checked before purchase.

The call for this week: My firm thinks the equity markets are involved in a downside retest of last January's "lows." Our notes suggest that six of 10 such retests "see" a slightly lower "low" combined with a selling volume dry-up.

Consequently, my firm is treating the late-January "lows" as THE near-term "lows" until proven wrong...

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