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Jeff Saut Presents: What Time Is It?!


Participants tend to not want to hold "long positions" over the weekend...


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.

"We are all 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 great 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 that everyone keeps asking, ``What time is it? What time is it?'' but none of the clocks have hands."

Adam Smith - Supermoney

"I should have 'sold' two weeks ago," was the lament from many stock market participants I encountered in my travels last week. Consequently, it will be interesting to see if that same sentiment is prevalent at the Raymond James 28th Annual Institutional Conference here in Orlando this week. Nevertheless, even though my firm has been too cautious over the past number of months due to optimistic valuations and waning earnings momentum, readers/listeners of these comments should have been well prepared for last Tuesday's Tumble. My thoughts on the subject were best expressed in our verbal strategy comments recorded last Wednesday morning. To wit:

"My firm thinks Tuesday's Tumble was set up a few weeks ago when Japan raised interest rates, thus signaling it was ending its zero interest rate policy of over a decade. While I got into a few heated discussions with various Panglossian pundits on CNBC that Japan's rate-ratchet would be gradual, I argued that while I agreed it will indeed be gradual that was NOT the point. The point was the direction of Japanese interest rates and that direction is now UP.

Given the massive amounts of hedge fund money feeding at the Japanese carry-trade trough, my firm warned that the environment calls for even increased caution. Recall that for years the hedge funds have been borrowing a million bucks in Japan at virtually zero percent interest rates, levering that money ten, twenty, or even thirty to one and taking that ten, twenty, or thirty million dollars and buying something that either yielded more than the cost of the borrowed funds, or was going "up" in price, be it New Zealand bonds, gold, Brazil stocks, or in this case Chinese stocks. As long as the purchased vehicle was going 'up' in price, and the Japanese yen held steady or better yet declined, it was nirvana and highly profitable. Yet when Japan raised interest rates, the Japanese yen went into a bottoming pattern, in our opinion. I spoke repeatedly about the yen's bottoming sequence and in fact, to take advantage of this, recommended purchase of the newly created Japanese yen currency shares (FXY) a few weeks ago.

Well on Monday night (last week), one of the hedgies levered-long positions of choice, namely Chinese stocks, got shellacked for 8.8% overnight and when you are levered 30:1 the margin calls mount quickly. Adding to the hedge funds' pain was a sharp rally in the Japanese yen and therefore it became the 'shot heard round the world.' Verily, the Chinese 'movie theaters' were packed to overflowing and somebody yelled 'FIRE!'

The result was a massive dash for the exits as the Japanese 'carry trade' started to be unwound. This unwinding is reflected in the CFTC data, which shows speculative 'short' positions in the yen starting to unwind. Interestingly, many markets like China, Vietnam, Thailand, etc. don't have much liquidity so when a hedge fund gets a margin call they sell what they can sell. In this case it was very liquid U.S. stocks. That selling begat more selling and when the closing bell rang on the NYSE last Tuesday the DJIA had shed 416 points to 12216.

So what do we do? Well, my firm would expect some kind of throwback rally attempt today (last Wednesday). Regrettably, I think that rally attempt will fail, leading to a series of bottoming attempts at best as the markets attempt convulses, or at worst they take-out Tuesday's lows and extend the correction. In any event, the market has had a heart attack and just like a heart attack patient does not get right out of bed and run the 100-yard dash, my firm doesn't think the stock market will do that either. Consequently, my firm remain cautious. If you want to try and buy something, my firm continues to suggest the long/short mutual funds of Icon Funds (IOLCX) or Diamond Hills (DHFCX). As for my firm, we are not inclined to bottom-pick individual situations because we know old traders, and we know bold traders, but we don't know any old and bold traders!

The Call for Today (last Wednesday): Well, this morning the talking heads are trying to explain away yesterday's Dow Dump on a computer glitch that occurred around 3:00 p.m. and took the Dow Jones Industrial Average down over 200 points in about four minutes. But the selling that caused the 3:00 p.m. glitch had already taken the Senior Index down some 300 points before the glitch ever occurred! And that, ladies and gentlemen, is the real story as things continue to get curiouser and curiouser...

So my firm said last Wednesday and from our mouth to the market's "ears" because the major market averages have traded pretty much in accord with last Wednesday's "call." Troublingly, the late week "fade" broke the DJIA below its December low (12194.13) and as long-time readers/listeners of our comments know, that raises another red warning flag (see my strategy comments of 2/5/07). So what is the "call" from here?

Well, all day Friday my firm told accounts, "Never on a Friday" meaning that markets typically don't bottom on a Friday once they get into one of these sorts of downside skeins. Indeed, participants tend to not want to hold "long positions" over the weekend, fearing that investors will brood about their weekly losses and therefore show-up the beginning of the following week in sell-mode. And that, dear readers, is what gives us the trading sequence whereby stocks bottom in the Monday/Tuesday timeframe leading to the perfunctory three to five-session throwback rally. From there another pullback should be in order and that is when it will become more apparent if this is something more than just a 5% - 8% correction.

As for my firm, we remain cautious and will be attending a number of presentations at this week's conference in an attempt to decide if we should be putting some of our outsized cash position back to work. Some companies my firm will be seeing include: Covanta (CVA); AT&T (T); HCC Insurance (HCC); L-1 Indentity Solutions (ID); and Sprint Nextel (S), most of which did not pull back all that much in last week's carnage. While my firm already owns many of these names, as well as numerous "stuff stocks" (oil, gas, coal, timber, base/precious metals, fertilizer, grains, water, cement, uranium, etc.), one energy name we are particularly excited about seeing is Petrohawk Energy (HAWK). Hawk's story is pretty simple.

Indeed, Petrohawk Energy is a premier E&P provider in the Permian Basin, Mid-Continent and Gulf Coast regions. It's a value-asset play with huge reserve/production growth, a low-risk profile, and developmental focus. The company boasts a 93% success rate over the past few years and has 10 years worth of inventory. It has 724 proved and 4,000+ unproved drilling locations that offer 2.6 Tcfe potential. Petrohawk Energy makes acquisitions and divest assets. The Street sometimes looks unfavorably upon this as if they "buy growth". Yet Petrohawk Energy buys assets, aggressively drills and ramps production, then looks to sell once the growth moderates. The recent acquisition of KCS should provide meaningful cost synergies with neighboring properties and KCS's technological expertise in the area will help decrease drilling time. KCS had an extremely low-cost profile and its COO is now the COO at Petrohawk Energy. Overall finding costs have decreased since the merger and there is room for them to move even lower. We expect Petrohawk Energy will realize 30%+ production growth coupled with decreasing finding costs that should maximize EPS and cash flow growth over the next few years. If that analysis is correct, Petrohawk Energy's 38% discount to our proved NAV should narrow, as should its 12% discount to the peer group.

The call for this week: Last week my firm's investment portfolio held up pretty well due to its cautionary composition and outsized cash position. Moreover, our long trading positions in the Volatility Index (VIX) recorded spectacular gains, while our Japanese yen shares registered decent gains. Such is the story for the well-prepared investor. We continue to invest and trade accordingly.

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