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Jeff Saut Presents: The Low-Priced Spread


When the going gets tough, the tough go on the road...and clearly the going has gotten pretty tough...


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.

When the going gets tough, the tough go on the road...and clearly the going has gotten pretty tough since the Dow Jones World Index (DJWORLD) peaked at 289.27 on February 26th, which is why I, and my firm have been on the road ever since then. First, we were off to see some institutional accounts and speak at various public seminars for our retail Financial Advisors in the Midwest. The next week we attended Raymond James' 28th Annual Institutional Investors Conference in Orlando, and last week we spoke at the Raymond James Financial Services Conference in San Diego.

Consequently, over the past few weeks, the only glimpse of the markets I have had has been via the media. Interestingly, in every one of those media venues, I was inundated with advertisements to execute this trade for $15 per ticket. Or make that trade for a flat $9.95 per ticket. One such commercial concluded with the tag-line, "Are you ready to declare your independence?" Obviously that "line" is a suggestion for investors to take financial affairs into their own hands and implement said affairs at the cheapest possible cost.

Now I am not a genius here in the strategy department, but I have to ask the question, "What was it worth hearing my firm say in 4Q '99, "the best has been seen and discounted by the various equity markets and therefore investors should not let ANYTHING go more than 15%-20% against them."

I venture to say that most investors would have to make $10 per ticket trades for the next 100 years to get back just a fraction of the money they lost when the bubble burst. Or, how about our notion in October 2001 that with 5 billion new people entering the world's economy (China/India), the demand for "stuff" (oil, gas, coal, timber, cement, water, base/precious-metals, uranium, grains, fertilizer, etc.) was going to be an investable theme for years. That theme has been a "home run" both on an individual stock basis and a mutual fund basis for those who heeded the advice. Verily, forward-looking investment advice, combined with the ability to go against the "crowd," has been the mantra of well-prepared investors for eons because it tends to produce consistent, risk-adjusted returns. Indeed, while it is easy to get caught up in the momentum stocks du jour, most investors need a lot of help with LAW... a.k.a., "leaning against the wind."

That inference was reflected in last Thursday's Wall Street Journal in an articled titled, "Few Firms Earn Loyalty of the Wealthy." The article went on to note,

"Well-heeled investors search for consistency...[but] it's difficult for fund companies to produce consistent returns that investors can be pleased with... [however] some do."

The article went on to list a number of mutual fund families that I have recommended in these letters over the years, as well as funds recommended/followed by Raymond James' Open-End Mutual Fund Research Department. To wit, American Funds, Davis Funds, Dodge & Cox, and T. Rowe Price to name but a few.

Coincidentally, I have often referred to investors' long-term investment desires by quoting Benjamin Graham who wrote, "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." Note that Mr. Graham uses the term "adequate return," not spectacular return. Unsurprisingly, my discussions with investors suggest they are looking for consistent, "adequate," risk-adjusted returns, not spectacular returns, because they know that spectacular returns require undue risk. Consequently, investors are seeking trustworthy investment professionals who can adequately grow their capital with an eye to safety of principal. Verily, the 1970s was the decade of the product. We "boomers" got out of school and bought the first car/house. The 1980s was the decade of the image. We bought the bigger house and the Mercedes Benz. The 1990s were experiential. We went to Europe and brought back experiences, not "things."

The new millennium is the decade of the relationship. We are ALL looking for professionals we can trust, whether it's a lawyer, a doctor, a mechanic, or especially, a financial advisor. More importantly, my generation doesn't mind paying more for such trustworthy folks, or as the chef in my cooking school says, "Sure can make a lot of things with the cheap priced spread (like oleo margarine), but the more expensive spreads (like butter) tend to give you better results!"

Along these lines, for months my firm has been counseling clients to "lean against the wind" (LAW) by reducing risk in portfolios as stocks rallied and building outsized cash positions. Our concerns centered on the fact that we couldn't figure out if the economy was going to slow dramatically into a recession, continue to muddle forward, or reaccelerate. Additionally, my firm was worried by the straight-up/unnatural rally that had taken place since August 2006, increasingly optimistic valuations, waning earnings momentum, rising gasoline prices (again), spreading mortgage problems, and the list went on. Still, stocks traveled higher. However, by my pencil the upside stock momentum began to wane when Japan raised interest rates, the Japanese yen firmed, the ubiquitous Japanese carry-trade began unwinding, and the rest, as they say, has been history. The result was a "global gotcha" on February 27th, which also saw the DJIA shed 416 points that day, and the name of the game ever since has been "defense."

Nevertheless, the short-term trading pattern my firm proposed following that downside break has played pretty well with stocks sliding into the prescribed March 5/6th trading lows where the perfunctory three to five session trading rally began. That trading rally peaked out within the typical skein, leading to the envisioned downside retest of those March 5th reaction lows (DJIA 12040). Unfortunately, those lows were violated last week. However, I have seen many tradable lows made by such an "undercut" low pattern whereby the previous, well-advertised low is marginally undercut just enough to shake participants out before a rally begins. Whether that plays here is a coin-toss, for while many of my firm's short-term indicators are oversold, our longer term indicators are a long way from being as oversold as they were last June when we were aggressively bullish.

Further, I believe the equity markets are involved in a worldwide selling-stampede that began on February 27th. Since history shows such stampedes tend to have a rhythm to them that encompasses 17–25 sessions before they end, participants should consider that today is session 15 from the DJWORLD Index's peak.

Despite the recent carnage, I find it interesting that many of my firm's investment positions have not really declined by all that much. This is particularly true of the energy complex, where a recommended name like Williams Partners (WPZ) has actually rallied as the equity markets have declined. In fact, the entire energy sector has held up better than most, implying it may lead any market rebound. Whatever the short/intermediate-term machinations for energy, the long-term direction is quite certain in my opinion. Energy conservation, oil substitution, alternative energy, and environmental issues will be BIG investment themes for the foreseeable future.

The call for this week: Despite all of the hand wringing, the DJIA (INDU), the S&P 500 (SPX) and the NASDAQ 100 (NDX) have not yet even tested their 200-day moving averages at 11832, 1351 and 1675, respectively. My sense is that eventually they will, as economic slowdown worries intensify into the spring, leaving equities on the defensive with participants pondering more negative corporate earnings' guidance. Moreover, I think "risk appetites" have peaked, providing another headwind for stocks. Nevertheless, this morning the futures are sharply higher as participants embrace the belief that last week's downside retest was successful.

While my firm has added some of the names mentioned in these reports to the investment portfolio recently [Covanta (CVA); Helix (HLX); Petrohawk (HK)], we continue to be pretty selective. Indeed, despite the inevitable throwback rallies that should occur, my firm continues to avoid risk, emphasize fundamentally high quality stocks and is not too proud to be holding outsized positions of cash. Or, as one of the better risk-adjusted money managers I met with in Los Angeles notes (a.k.a., Churchill Management), "Only time will tell us how this plays out but we are currently sitting in a comfortable position. Our cash equivalent position and our focus on large cap and large cap value stocks are currently paying off. We will continue to monitor this closely and will act accordingly."

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