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Jeff Saut Presents: Las Vegas


...we remain in cautious mode and are picking our spots carefully.


"We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know, by the rules, that at some moment the Black Horsemen will come shattering through the terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so everyone keeps asking, what time is it? But none of the clocks have hands."

. . . "The Money Game," by Adam Smith

Greetings from Las Vegas, where not only do the clocks have no hands, but the casinos have no clocks! Nor do they have any windows, in order to leave the "players" unaware of whether it is day or night in an attempt to keep them at the "tables" gambling. Similarly, participants on the Street of Dreams often forget what time it is as they keep their "blinders on," oblivious to what time it is as measured by the valuation metrics used by such legendary investors as Benjamin Graham, Warren Buffet, John Templeton, Jeremy Grantham, etc. Indeed, despite what the conventional wisdom suggests, valuations are NOT currently cheap, with the best proxy for the average stock (aka the Value Line Index) trading at a median P/E ratio of 19.3x. Recall that at the peak of the bubble the Value Line median P/E ratio was only marginally higher at 20.7x earnings. Nor are the markets cheap on the basis of price-to-dividend, price-to-book, price-to-sales, or any other ratio you want to use. Moreover, we think earnings estimates for this year are too optimistic, a point reflected by Justin Lahart in his always informative "Ahead of the Tape" column (The Wall Street Journal), which noted that first quarter corporate earnings are coming in below forecasts. Of course, this does not mean that the averages cannot still rally, for as Lord Keynes stated, "The markets can stay irrational longer than you can stay solvent." Yet, we are odds players and unlike last October, when we were pretty bullish, we are currently pretty cautious.

Our cautious stance stems from the fact that we think equity valuations are optimistic, sentiment readings are complacent, real estate prices are declining, various yield curves are inverting, economic momentum is waning, the market's "internals" are weakening, and the list goes on. Further, the news backdrop seems rather poor, for as the astute GaveKal organization opines:

  • Bird-flu is spreading.
  • The Iran situation does not seem to be improving.
  • Neither does the Palestine situation following the election of Hamas.
  • The hysteria over the Danish cartoons continues unabated.
  • Nigeria.
  • In Venezuela, President Chavez continues to do his best to rattle our cages.
  • In the U.S., protectionism rhetoric is on the increase.
  • Bin Laden is once again making headlines.

GaveKal concludes by stating, "Putting it all together, the news has not been fabulous. But yet, financial markets do not seem to care. Is this a sign of complacency? Or that bull markets are all about 'climbing a wall of worry?' If pressed to choose, we would pick the former." Obviously we agree, and would love to invest some money with the GaveKal organization.

Unfortunately, it continues to feel to us like the DJIA is tracing out what a technical analyst would term a "Broadening Top" formation in the charts. A Broadening Top typically has three distinct upside peaks, at successively higher levels and, between them, two bottoms with the second bottom lower than the first. According to the book Technical Analysis of Stock Trends, "The assumption has been that it (the Broadening Top pattern) is completed and in effect has an important reversal indication just as soon as the reaction from its third peak carries below the level of its second bottom." As can be seen in the nearby chart, the DJIA has yet to break below the second bottom in the charts, but we think it will. And that would be consistent with the pattern we have laid out over the past few months.

Verily, January Jumps tend to "top-out" in the second to third week of January, followed by a sharp/quick correction and then attempt to re-rally. In that re-rally our notes show that the DJIA typically makes a higher high, which is a "bull trap." The only question from there is whether you lose money quickly, or slowly. And so far, ladies and gentlemen, that appears to be what is occurring as it has been pretty difficult to make much money recently. Unsurprisingly, many of the momentum stocks did not participate in the re-rally and have subsequently rolled-over and are substantially below their January highs . . . hello Google (GOOG), which is off more than 20% from its recent highs. A few weeks ago we commented that the causa proxima for a "momentum mashing" might just be that Japan was in the process of taking the zero interest rate "punchbowl" away. Last week that insight was confirmed by Bank of Japan. And, since many hedge funds have been feeding at the trough of Japan's zero interest rate policy by borrowing money in Japan, leveraging that money 10:1, and buying anything that was going up in price (read: carry trade), is it any wonder many of the momentum stocks have fallen as some of those carry-trades have been unwound?

Consistent with these thoughts, we remain in cautious mode and are picking our spots carefully. Since we are convinced there is a secular bull market in "stuff," we continue to buy the dips in select "stuff stocks" with the cash that was freed up months ago by reducing our energy stock positions by 20% - 30% when crude oil was around $70/bbl. Two recent recommendations have been 8.8%-yielding Precision Drilling Trust (PDS) and 10%-yielding Petrofund (PTF). PDS is rated Outperform by our Canadian energy analysts, while PTF garners a Strong Buy from them. With the recent terrorist activity aimed at the energy complexes, we think the more secure Canadian and U.S.-based energy assets are a good bet. The aforementioned investments ideas also adhere to Benjamin Graham's "margin of safety" requirements given their outsized dividend yields.

The call for this week: We don't believe the geometrically weighted, seasonally adjusted, hedonically priced, owner-equivalent rented, core-CPI numbers; instead, we use the non-core CPI numbers that do not exclude food and energy. And last week the non-core CPI was reported to have increased +0.7% for the month. That is an 8.4% annualized inflation rate, implying that despite all of the Fed's rate ratchets we may still be in a negative real interest rate environment. If true, the Federal Reserve might continue to raise rates higher than most expect. We don't think the equity markets are prepared for such a potential "rate rape" given their 19.3x P/E ratio combined with some of the highest profit margins in history. Since profit margins are probably mean-reverting, we think earnings estimates are overly optimistic. Consequently, we keep hearing the band Chicago Transit Authority echoing down the canyons of Wall Street and the tune is their 1970 hit "Does Anybody Really Know What Time It Is?" So far that question has been followed by the next line from that song, "does anyone really care?!" Clearly we do, which why we remain cautious and continue to invest/trade accordingly.


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