Jeff Saut: Foretold is Forewarned
Can the government services group outperform the broader markets this year?
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.
Ever since the successful downside retest of the August 2007 "lows" that occurred in late November, I have repeatedly stated that while I remained constructive on stocks into year-end 2007, I was entering 2008 in a cautious mode. I reiterated that caution the first week of January when I said:
"Last Thursday (1/3/08) I reviewed my notes of some 40 years and found that January's employment report tends to set the market's trend into the State of the Union address. My notes also confirmed that the first few days of the new year are often accompanied by initial straight-up, or straight-down, moves that suddenly reverse on the employment numbers. The year 1988 is a good example. The mood in early 1988 had turned positive. The Dow had "crashed," and bottomed, in October 1987, even though the stock market's breadth (advance/decline line) continued to deteriorate into year-end. As the new year began (1988), stocks traded sharply higher into the early-January employment numbers; and then b-a-n-g, in one session the Dow lost nearly 7%. From there, stocks never regained their poise until AFTER the State of the Union address."
"I had hoped that last Wednesday's (1/2/08) weak ISM report, and concurrent 221-point Dow Dive, might preempt Friday's employment report and stated in Friday's verbal strategy comments, 'My guess is today's numbers will set the tone for the next three weeks. If the report is Street friendly, the market's trend into the State of the Union should be irregularly higher. If, however, the report is bad, I think stocks will have a tough time into the January 28th address.' Intuitively, this makes perfect sense because a lot of folks set their 'policy statements' on the State of the Union rhetoric. So as one portfolio manager said to me late Thursday (1/3/08), 'Hey Jeff, believe in God, but be sure to tie-up your horse!' Clearly, that has been my strategy as I entered the new year in cautious mode."
Regrettably, those employment numbers were ugly and I went on to warn participants that the stock slide was taking on the characteristics of a "selling stampede." As often stated in these missives, "selling stampedes", and/or "buying stampedes," typically last 17 to 25 sessions with only one- to three-day counter trend "pauses" before they exhaust themselves. It just seems to be the rhythm of the thing in that it takes participants that long to either get bearish enough, or bullish enough, to capitulate; and, in the current case, "cough up" their stocks. While it is true a few stampedes have lasted 25 to 30 sessions, it is rare to have one extend for more than 30 sessions. Subsequently, I began my "day count" with today being day 17, and I am excited, because for the well prepared investor volatility breeds opportunity!
Meanwhile, the "selling stampede," combined with softening economic statistics, has caused the politicians to spring into action with what looks to me like another ill-fated scheme to ward off the normal business cycle.
Recall it was on December 6, 2007 that the President's last scheme debuted. Titled operation "Hope Now," it was designed to stop mortgage interest rates from resetting to higher levels and was supposed to help hundreds of thousands of mortgage holders. According to Barron's, however, it has helped less than a hundred mortgagees to date. Last week's proposed "scheme" was a $145 billion economic-stimulus package, which is expected to contain hundreds of dollars of tax-rebates per taxpayer, as well as tax breaks to encourage businesses to buy new equipment. It seems to me that this scheme is also flawed since the current problems stem from too much debt. If so, recipients of the tax rebates will probably use them to pay down existing debts rather than spend them and stimulate the economy.
As the President unveiled the plan, I found myself screaming at the TV screen, "Don't you realize that trying to prevent the inevitable conclusion of the business cycle (read: recession) a few years ago is exactly what got us into the present predicament?!" Clearly the Federal Reserve, like the politicos, is worried given Mr. Bernanke's comments last week. Yet if the overspent, undersaved American consumer is finally sated with debt, the Fed could be "pushing on a string" by lowering interest rates. Further, the Fed may just be in a "box," for as Milton Friedman noted, "a central bank can control its exchange rates; it can control its money supply growth rate; or it can control its interest rate; but, it cannot control all three at the same time!" However, ISI's Ed Hyman framed the problem differently when he recently wrote:
"Here's the problem. If we have a U.S. recession, even a mild one, developing economies are likely to slow. U.S. unemployment is likely to rise above 5.5%. Developing economies are likely to dump goods on world markets. [And] All of this could launch protectionist legislation that would lead to the end."
Indeed, for many months I have railed against the increasing traction of protectionism, intervention, and overregulation which are gaining inside the D.C. beltway. The question thus becomes "Does growth collapse from here because of the weight of the credit crunch, or not?" As the astute GaveKal organization opines, "if the answer is 'no' and growth holds up, then indeed the situation is just like 1998, and the liquidity that the central banks dumped into the system will turn out to be inflationary... [if] yes; growth does collapse, and the liquidity that the central banks push in ends up going down the proverbial 'black hole,' leaving central banks to do little more than pushing on a string."
To this point, it is worth considering that if Congress approves the recently proposed defense spending plan, which calls for tens of billions of increased spending, it should spread massive amounts of dollars to small/medium businesses whose multiplier effect could go a long way in avoiding a recession. This is another reason I have been unwaveringly bullish on U.S. government IT, defense, and the Homeland Security complex for the past number of years. Most recently, I have turned constructive on the shares of Strong Buy-rated Cogent (COGT). With more than 500,000 aliens entering the U.S. every year the authorities need a 99.9% accurate fingerprint reading in less than 30 seconds, which is one of the products Cogent manufactures. The company's $5.00 per share in cash implies that we are buying the rest of the company for $4.19 a share. If my analyst is correct, Cogent should earn $0.55 per share in 2009, meaning we are buying the shares at less than 10 times forward earnings (ex-cash per share). Since 2008 is a great product pipeline year, as well as a potentially favorable contract "win" year, I think the risk/reward ratio is right for investors.
To be sure, I continue to like the Government IT and Homeland Security themes. Still, the government service stocks have tumbled around 8% in January due to the broad market decline and in-line with the seasonal trading patterns seen in the group. Due to the sell-off, my sense is the group looks more attractive than it has in quite some time. Moreover, I think investors are beginning to look for investments that are acyclic to the broader market concerns surrounding the consumer, energy prices, subprime exposure, and housing problems. Given the current valuation, fundamentals, and lack of a fundamental correlation to the overall market, I believe the government services group can outperform the broader markets in 2008. In addition to Cogent, I see value in Stanley (SXE) and NCI (NCIT).
As for our Canadian jaunt last week, western Canada is "booming"! In Edmonton every other street was littered with signs proclaiming "Help wanted!" This labor demand has occurred even in light of the new increased royalty-regime legislated by Alberta's politicians. Clearly I overreacted to said regime, but while I have not invested any new capital in Alberta since that regime decision, I have held my remaining "long" stock positions in the Abathasca Tar Sands companies. I remain bullish on Canada, consistent with my "stuff stock" theme; and don't look now, but a headline in a British Columbia newspaper read, "B.C. Energy Shortfall Looming," which was a direct reference to the money that needs to be spent to upgrade B.C.'s electric infrastructure (see Raymond James Ltd.'s research for Canadian ideas).
The call for this week: Last week Treasury Secretary Paulson, when referring to the potential economic stimulus plan, averred, "This is not an emergency. There is an urgent need." To this I ask, "If this is NOT an emergency, then why is it urgent?!"
Clearly the politicos are worried about a recession and are pulling out all the "stops" to prevent the normal business cycle, which can be seen in the nearby charts from my friends at www.thechartstore.com. While I don't think the recession question will be answered for months, I do think the selling stampede is coming to an end and suggest getting your "buy list" together for at least a trade and maybe something more.
And lo and behold, in a surprise move the Fed has panicked this morning and cut the Fed Funds target interest rates by 75 bp to 3.5%. With that the pre-opening S&P 500 futures have firmed, but still indicate a 3.4% lower opening. It will be interesting to see if, like my firm, the Street interrupts the Fed move as "panic." Whatever the outcome, I think a change for the better is approaching and am busy readying accounts accordingly. And that's the way it is on day 17! So get ready, get set...
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