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Jeff Saut: Moats, Goats and Market Calls

By markets, when risk appetites overshoot on the way up, they usually overshoot on the way down.


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.

"Everyone kept saying 'a top is not in place yet.' They persistently pointed to the 'normally reached' levels of this or that statistic that were not yet there to reinforce their desire to remain bullish... Apart from statistical measures of increasing blindness, this unwillingness to acknowledge what they themselves were already feeling revealed a comfortableness, a confidence, a conviction that whatever was happening – short-term survivable dips – would continue... until 'the top,' like a strip tease artiste of our youth would with decorum appear on stage, bow, and then, accompanied by applause from all the bulls eager to cash in on their excitement, would begin to twirl its statistical tassels in front of everyone.

I've gotten so old I can't remember the names of those ladies at the Old Howard, but I can remember that all you got was a flash of this or that, before they waltzed off. Stock market tops are like that. You know it's there somewhere if you squint hard enough, but you never quite see it, so you keep waiting for more. And then, in the end, as the curtain comes down on the bull market you realize that the one rule about tops is not that they provide this or that signal, but that they come before anyone is ready."

-Justin Mamis

I recalled this decades-old quote from historian, author, and stock market guru Justin Mamis as I stared at a long-term chart of the S&P 500 contemplating the probabilities of the "double top" that stared back at me.

Indeed, the S&P 500 peaked back in 2000 around the 1550 level and just returned there again last month.

Double-top? Well, maybe, and if it was, Justin's last sentence is clearly applicable, "They (read: tops) come before anyone is ready." Of course, nearly every pundit in the media last week termed the four-week "wilt" to be nothing more than a correction and now that the perfunctory 10% correction has come, combined with a discount rate cut, stocks are again poised to soar. One particularly cocky curmudgeon even took a potshot at Warren Buffett's cautionary comments, stating that he, "didn't pay much attention to what Warren Buffet has to say." Of course, this was the same guy that at Dow 14,000 was trumpeting how the equity markets were a discounting mechanism and therefore the future was so bright "I think I need shades."

What I would like to know is why the market is a discounting mechanism when it is going up, but not a discounting mechanism when it is going down?

Another question I would like answered centers on the S&P's financial sector. Given what appears to be a peak in the credit cycle, it seems reasonable to assume that the mortgage, junk bond, private equity, and M&A businesses are in for a slowdown. Yet, Wall Street has earnings' estimates for the "financials" increasing in 2008. Moreover, the financials comprise roughly 21% of the S&P 500, and if their earnings momentum is slowing, doesn't that put a pretty stiff headwind in the face of the S&P 500 Index? "Not to worry," cry the bulls, "The Federal Reserve has reduced the discount rates, so it's party on, Garth!" However, as John Plender points out in the Financial Times:

"The trouble with this cheery view is that the crisis is about much more than the subprime mortgage market. There has been a systemic deterioration in credit quality as a result of financial innovation...The best reason for thinking that the crisis remains unresolved is that an unprecedented de-leveraging process is under way in the financial system after an unprecedented credit bubble. When markets overshoot on the way up, they usually overshoot on the way down... The risk is that in a solvency crisis where real money has been lost in equities and property, overborrowed households draw in their horns and save more. Against such a background, interest rate cuts can be powerless to boost an economy."

Actually, there's another question I would like answered, "Is the Fed pushing on a string?" Put another way, is the overspent, undersaved American consumer at a point where the Fed could lower rates to zero and consumers won't borrow? While only time will tell, I do believe there has been a psychological change in the equity markets combined with investors' risk appetites that are now shrinking. As can be seen in the chart below, like markets, when risk appetites overshoot on the way up, they usually overshoot on the way down. And if risk appetites are truly in a declining mode, investors should heed Warren Buffett's words about managing your stock return expectations downward.

Source: Credit Suisse

Speaking to the stock market, in this business you are either a hero or a goat depending on how good your latest market "call" has been. While I have certainly had my share of "hero" market calls, for most of this year I have looked more like a "goat" given my cautious stance. Recently, however, my goat status has improved, having identified the selling-stampede that began on July 20. As stated, selling-stampedes tend to last 17 – 25 sessions with only one- to three-day counter-trend pauses/rallies before they exhaust themselves on the downside. Consequently, I said in last Monday's letter:

"I think that the averages will make a trading bottom over the next 10 sessions. As to whether the Fed cuts interest rates to facilitate said bottom depends on if the indices are involved in a mini-crash or not. Failing a crashette, I seriously doubt if the Fed will cut rates. Rather, I believe the markets will merely exhaust themselves on the downside. Of more importance, over the longer-term, is if the subsequent 'throwback rally' sustains itself above S&P 1500."

Well, last Thursday, on day 20 and after losing 722 Dow points for the week, we got an intraday mini-crash (-343) that sparked rumors of a Fed rate cut, lifting stocks to nearly even for the session. The next morning those rumors proved true as the Fed cut the discount rate. So while I remain unable to string together more than three upside days in a row, odds are that last Thursday was a trading low. Still, I have to measure the quality, and sustainability, of any subsequent "throwback" rally, which is why I remain cautious. If that was "the" low, I will have plenty of investment opportunities ahead. So much for goats: now on to moats.

For years Warren Buffett has talked about companies with "moats" around them, meaning competitive advantages or unique propositions that tend to protect them from competitors. Those moats could be a strong brand name, barriers to entry, geographical, etc. I like such companies, but the recent stock slide has democratically "sold" these kinds of stocks as well. Some to include on your radar screen would be the tower stocks like American Tower(AMT), SBA Communications (SBAC), and Crown Castle (CCI), all of which clearly have high barriers to entry. Like the tower companies, many of the homeland defense companies have barriers to entry due to security clearance, proprietary algorithms, technology innovations, etc. A few names playing to this theme would be: L-1 Identity Solutions (ID); Cogent (COGT); and Aerovironment (AVAV). And even though it is only rated Market Perform, Choicepoint (CPS) is an interesting company in this environment given its proprietary algorithms for risk-scoring.

The call for this week: Over the past six trading sessions the world's central banks have added more than $300 bln in liquidity and threw in a discount rate cut just for grins. The Fed's actions contradict everything it has been saying about the economy. Nonetheless, those actions finally produced a decent rally in equities last Friday, yet it will be vitally important to see its quality and sustainability. While I am cautiously optimistic, I find it difficult to believe that years of burgeoning credit addiction, enhanced by fancy financial structured products, can be corrected in just 20 days.

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