Jeff Saut Presents: Mr. Market
The call for this week...
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.
Benjamin Graham, the founder of margin of safety analysis, likened the market to a moody gentleman he called Mr. Market. As recounted by Warren Buffett:
"A remarkably accommodating fellow named Mr. Market . . . is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, 'If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.'"
I encountered the above witticism while reading some of Warren Buffet's prose back in the 1980s. Like other old stock market "saws," it has stuck with me over the years because the wisdom it imparts is invaluable, for as often stated in these missives, "Patience is the rarest thing on Wall Street!" Indeed, "Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you."
Clearly, "Mr. Market" was manic back in mid-June when my firm flatly stated on CNBC that we were "buying" stocks/indices on June 13, 2006. More recently, however, we have been ignoring "Mr. Market" for the most part, despite our repeated lament that, "It feels to us like the DJIA is going to track-out to a new all-time high (above 11722) totally unconfirmed by most of the other indices." My firm has further commented that the current environment reminds us of December 1972/January 1973, where the DJIA was trading higher while the fundamentals were deteriorating, although we are NOT forecasting a debacle like the 1973/1974 affair. To us, the present situation was best reprised by one particularly prescient market aficionado whose email read:
"We need a little help here. With [financial TV] going gaga over the Dow and S&P testing the May highs, and Mr. Cramer having everyone firing up their pickers to overdrive, lost in the fray seems to be a rather important fact that none of the other indexes are anywhere near recording new highs. Consider this, the Russell 2000, MDY (S&P Midcap ETF), the NASDAQ, the NDX (NASDAQ 100), the Dow Transports, and many of the global markets (in general), are as much as 7-8% from their respective May highs. It seems to me that this could be considered a major (upside) non-confirmation since the Dow, S&P and OEX are testing, or have bettered, their May highs. Your thoughts would be greatly appreciated."
Obviously, my firm agrees with those "non-confirmation" technical insights given our short-term timid trading posture. We have also averred that while we don't think a recession is in the offing (a view held since 2001), we do believe the economy is on a glide-path to "muddle," or a substantial reduction in GDP growth. That sense was recently reinforced by Merrill Lynch's David Rosenberg, who dissected the Fed's recent comments by scribing:
"The staff forecast prepared for this meeting indicated that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast. The marking down of the outlook was largely attributable to the annual revision of the national income and product accounts, which involved downward revisions to actual GDP growth in prior years and prompted reductions in the staff's estimate of potential output. The slowdown in the housing market, the effects of higher energy prices on household purchasing power, the waning impetus of household wealth effects on consumer spending and the effects of past policy tightening were expected to hold economic growth below potential over the next six quarters."
Ladies and gentlemen, six quarters of sub-par growth is a pretty long time for a stock market that is optimistically valued. Yes, optimistically valued (17.6x earnings and a dividend yield of 1.9% basis the S&P 500), for despite the media market pundits' rantings that stocks are "cheap," history shows that sub-10x earnings is indeed cheap! Verily, at EVERY stock market low in history the major markets have sported a P/E ratio of below 10x with a concurrent dividend yield of above 4.5%. That does not, by the way, mean that stocks cannot rally in the near-term, for we have learned the hard way the stock market can do anything! It does, however, mean that the historic odds favor caution . . . again a view shared by Warren Buffet.
For months my firm has opined that the question the markets were struggling with was, "Is this the fabled mideconomic slowdown, or something worse?" Over the past few weeks the markets have obviously embraced the view that this is merely a mid-cycle slowdown emboldened by the 31% silent-crash in gasoline prices, as seen in the below chart. While we certainly hope this is the case, we would still rather buy into those names that have already "crashed" rather than pay-up for the "darlings" du jour. To this point, two names mentioned over the past few weeks in these reports have been Chesapeake Corporation (CHK), where we are using the 4.9%-yielding convertible preferred, and the 8.6%-yielding shares of Trinidad Drilling Trust (TDGNF). Last week, I had dinner with Trinidad's CEO, which only served to reinforce my firm's conviction for this growth-oriented income trust.
"But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, 'If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.'"
The call for this week: "162 points and counting," was my firm's abbreviated "call" last Thursday morning, and again this morning, as the Dow is a mere 162 points from its all-time high of 11722. We think the DJIA will break out to a new all-time high totally unconfirmed by most of the other indices (read: upside nonconfirmation). To that sequence, it is worth noting that the S&P 500's 50-day moving average (DMA) crossed above its 200-DMA last week, which should be viewed as a confirmation of the positive momentum currently driving the equity markets. Also of note is the fact that value stocks have produced a trailing total return of at least twice the total return of growth stocks over the 1, 3, 5, and 10 years ending 8/31/06, leaving large-cap "growth stocks" cheaper than value stocks for the first time in 30 years (see the below chart). We continue to look for growth stock ideas in the large-cap universe, not mega-cap universe, many of which have been mentioned in these reports. We also like the idea of dividend-yielding stocks for the low return investment environment we envision for the foreseeable future as we continue to chant, "The difference between perceptions and reality is where investors' opportunities lie . . ."
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