Jeff Saut Presents: Lowry's Lament Redux
The question now is how low the correction will carry before the stuff-stock rally resumes.
"Preliminary data is inconclusive as to whether today was a 90% downside day. We will report the final figures in tomorrow's comment. Typically, 90% downside days are followed by rebound rallies lasting 2 – 7 days, after which prices turn lower in a renewed downtrend. It is important that investors not regard a 90% downside day at this point as indicating exhausted Supply [stock selling]. In fact, since 1980, a 90% downside day has occurred anywhere from 5 – 15 days after 4 of the 6 bull market tops."
. . . Lowry's 5-17-06
"Final figures confirm that yesterday was a 90% downside day. With today's decline, all short term indicators have reached oversold levels. In addition, the S&P 500 has reached the bottom of its 10% [trading] envelope. Similar indicator readings in the past have typically resulted in a market rally. Given the speed and strength, in terms of Selling Pressure, of the recent market decline, however, any rebound rally is likely to be short lived and best used as a chance to adopt defensive positions."
. . . Lowry's 5-18-06
So said the astute Lowry's organization last Wednesday and Thursday, and clearly their defensive stance makes sense to us since we have been defensively postured for months. Indeed, we have repeatedly stated that despite the upward onslaught by the DJIA, which we have termed the "solitary dance of the Dow" (historically a signal for caution), the stock market's "internals" have been deteriorating since January. That is why we have been furiously rebalancing ALL of our investment positions (read: selling partial positions) and holding the funds from those sales in cash. This rebalancing strategy was particularly emphasized over the past few weeks since our proprietary indicators finally gave their long awaited sell-signal. Recall that the last time our proprietary indicators gave a signal was back in mid-October 2005 when they "told" us to BUY stocks. Fortunately, our sell-signal preceded the Lowry's 90% down-day "sell signal" giving clients a leg-up on insulating their portfolios from the recent decline.
Currently the media ascribes the decline to "uncertainty." Uncertainty as to the Fed's direction . . . uncertainty as to the dollar's direction . . . uncertainty as to the parabolic rise in the commodity complex . . . uncertainty due to geopolitical concerns . . . and, uncertainty due to the economy's direction. Ladies and gentleman, uncertainty breeds opportunity as we suggested in last Tuesday's verbal strategy comments. To reprise those comments:
"I heard it again yesterday, on numerous TV/radio stations, that the recent decline in the equity markets is because, 'the markets hate uncertainty.' While at the margin this comment might hold a modicum of truth, it is blatantly untrue at major inflection points in the markets. Consider this, at the Dow's absolute low of 41.22 recorded in 1932, the uncertainty was so thick you could cut it with a knife. Again, at the February 1933 low of 50.16, when President Roosevelt declared a national bank holiday, uncertainty reigned, yet stocks rallied. Once again, when industrial production collapsed in February 1937, the Dow Jones Industrial Average stood at 113.64 and stocks dutifully bottomed and rallied. Clearly, in May of 1942, when it looked like the U.S. would lose World War II, the war uncertainty was ubiquitous; still the Dow bottomed at 92.92 and rallied. Following that, the Dow bottomed again amid uncertainty in June of 1949 at 161.60 and began an 'uncertainty-based rally' that would carry the senior index into its bull market peak of roughly 1,000 in 1966."
"From there, the Dow bobbed and weaved its way into the 1974 bottom at 577.60, where once more the uncertainty was so thick you could cut it with a knife. Once again, however, stocks bottomed and rallied into what is likely to be the greatest bull market of my lifetime. During that 11,145-point rally into the DJIA's 2000 peak (11,722), uncertainty accompanied the 1982 bottom and the 1987 'crash lows,' so telling me that the markets don't like 'uncertainty' just does not foot with history. Indeed, uncertainty presents opportunity, and the difference between perception and reality is where investors' opportunities lie!"
Another misnomer relates to the current question of, "When will the Fed be done raising interest rates, because that will lead to a stock market upside explosion?" Again, that just does not foot with historic precedence, since most successions of Fed tightening have seen exactly the opposite stock market effect (read: lower stock prices).
Another "media mantra," replete on the airwaves, has been that the "late comers," who bought the stuffstocks, commodities, and the emerging market complexes, have been exiting those "wrong bets" over the past few sessions. Late comers? We think NOT since, in our opinion, these asset classes are in the early stages of a secular bull market. "Hot money" (read: hedge funds) exiting…well maybe, because the "carry trade" is likely being unwound.
Consider this, for the past few years "hot money" has been borrowing money in Japan at effectively zero percent interest rates. Then that hot money has leveraged that borrowed money and bought anything that has been rising in value, namely stuff stocks, commodities, and emerging markets. Given the Bank of Japan's recent statement that it is "moving quickly" to take away its zero interest rate policy, is it any wonder emerging markets, commodities, and, consequently, stuff stocks have taken a pounding recently as those hedge fund "carry trades" have been unwound?
Also worth consideration is the fact that most Asian Central Banks are now raising interest rates, an event almost totally unreported by this country's media. Ladies and gentlemen, the raising of interest rates by the Asian Central Banks is likely the observation/question du jour and not "when will the Federal Reserve quit raising rates?!" Indeed, as one savvy seer laments, "It's not the snake you see that bites you."
We think the recent downside "heart attack" in "stuff," as well as stuff-stocks, represents a buying opportunity, although we are not sure if said opportunity is here or a few months from here. Yet we are convinced that over the longer term, the worldwide demand for "stuff" should put the wind at the back of this asset class for years to come. The question now is how low the correction will carry before the stuff-stock rally resumes. And that is why we use a "scale-in" buying approach to these complexes. It is also why for folks like us, who have held stuff-stocks for the last five years and had them grow into a huge "bet" in the portfolio, we have recommended re-balancing (read: selling partial positions) all of our stuff stock positions for the past few months. That technique re-balances such positions to keep their weighting more in-line with the portfolio's objectives. It also allows long-term gains to accrue in the portfolio giving us the "cushion" to withstand the inevitable downside price heart-attacks.
As for the equity markets, we think the markets have entered one of these 17–25 session selling stampedes. In past missives we have discussed both Buying Stampedes and Selling Stampedes in that they tend to last 17–25 sessions, with only 1–3 day counter-trend moves, before they exhaust themselves. By our count today would be day 8 off of the Dow's May 10th peak. That said, given the current oversold nature of the equity markets, it would be surprising if we didn't get some kind of "throwback" rally this week. It is also worth noting that the S&P 500 tested, and held (so far), its 200-DMA (1258) on Friday, which is a logical place to attempt a throwback rally. Whether it is sustainable is unknowable, but we think it is not and therefore remain cautious. Yet, if we don't get some kind of throwback rally soon, this decline would take on the characteristics of a mini-crash. Consequently, we are still predominantly defensive on the equity markets, as well as on stuff-stocks, thinking that just like a heart-attack patient doesn't get right out of bed and run the 100-yard dash, the equity markets should not do that either.
The call for this week: The media is replete with comments that the commodity "bubble" has been broken. Inquiring minds want to know WHY positions in commodities are currently "speculative," when positions in the tech/telecom complex were not "speculative" back in the mid-1990s. When you quit hearing the media using the words "commodity bubble," then you should get worried, very worried, about your stuff stocks. In the interim, "the difference between perception and reality is where investors' opportunities lie!" Accompanying the "heart attacks" we have seen in our markets has been equally disturbing declines in many of the world's equity markets. Therefore, this morning we are including some comments from Raymond James' Indian affiliate, a country on which we have been bullish for four years, at the end of these comments. We continue to like emerging markets like India and advise participants to invest accordingly.
In view of the sharp fall in the markets during the last few days (10% from the peak of 12671 and 6.3% during the day for BSE-Sensex at 11391 - a fall of 772 points during the day), we thought it prudent to give a brief overview of the situation. While, a normal reaction of 10% is healthy after any sustained rise in markets, what is discomforting is the volatility during the last few days. We believe that the there is no change in the fundamentals of the Indian economy in general and businesses in particular.
We would attribute the recent fall to three major reasons, while the first factor is certainly concerning; the remaining two factors are not a major concern according to us.
1. Proposed changes in tax treatment - A circular by Central Board of Direct Taxes (proposal - not yet implemented) suggests the application of fifteen criteria, which can change the taxation structure from capital gains to business income from shares/investment into mutual funds. Given the nature of criteria, there is scope of interpreting it either as capital gains or business income. This can potentially lead to much larger tax liabilities (if treated as business income), for both domestic entities and foreign institutional investors (FIIs) not domiciled in tax-efficient jurisdictions. While there is a lack of clarity on the above issue, if made applicable it is clearly a source of concern for both domestic and offshore investors. The post tax return on equities as an asset class would reduce if the circular were implemented. The FII's and offshore funds domiciled in tax efficient jurisdictions such as Mauritius, Singapore will continue to characterize their income as capital gains not taxable in India under the applicable Double Tax Avoidance Agreements (DTAA), provided they do not have Permanent Establishment in India. As we write this, there has been clarifications from the Finance Minister, that no FII has been assessed as a trader and there is no plan to change the taxation structure for FII's.
2. Fall in metal prices - The melt down in metal prices globally was triggered due the possible hardening of interest rates by US Federal Reserve Chairman, and it has implications on all asset classes. The reaction in Indian equities was in synchronization with the reaction in equities globally and more so within emerging markets. Some correlation to emerging markets is evident and will continue in future, what will prevail in the long term will be fundamentals of businesses, which continue to be promising.
3. Accentuating the fall - The pace of fall got accentuated due to speculative unwinding, compulsory squaring off the future and options positions due to margin calls, and panic selling by retail investors – all of them being temporary aberrations.
To summarize, we continue to be positive on Indian equities over the long-term. We believe that inherent fundamentals of the economy and businesses are strong and these will get reflected in equity returns over a longer-term horizon.
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