Jeff Saut Presents: "As Long as the Roots Are Not Severed..."
It's spring again and last week many Wall Street wags pontificated about the resumption of strong economic growth.
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.
For the past few years, as spring has sprung and market pundits expressed conviction about a return to robust economic growth, I have referenced the book "Being There" by author Jerzy Kozinsky. The story line centers on a slow-witted gardener named Chance "the gardener," who knows only gardening and what he sees on television. Indeed, for his whole adult life Chance has not ventured outside the grounds of his employer's Washington, D.C. manor. Eventually, however, the employer dies and Chance is cast out onto the streets where through a mishap he encounters the wife of a D.C. powerbroker. Thinking that her car was the reason for the mishap, she insists that Chance "the gardener," who she interprets to be Chauncey Gardiner, come with her to her husband's estate. Benjamin Rand (the husband) is completely taken with Chauncey's simple, direct approach and mistakenly attaches profundities to Chauncey's ramblings about gardening. Viewing him somewhat as a savant, Rand introduces Chauncey to Washington's elite, including the President. In one exchange regarding current economic conditions Chauncey remarks, "As long as the roots are not severed...there will be growth in the spring."
Well, here we are. It's spring again and last week many Wall Street wags pontificated about the resumption of strong economic growth. Last Friday their "growth mantra" was reinforced by the economic figures. While my firm has also been hoping for renewed economic growth, we have lamented for months that we have been unable to discern if the economy was going to slow into recession, slow to a muddle, or actually reaccelerate. Recently, however, the figures have had a decided slowing tilt to them. More specifically, the report that nondefense capital goods (ex-aircraft) has fallen from near double-digit growth in mid-2006 to zero is concerning because it is now tracking into recessionary territory. In fact, the last time its six-month rate of change and its year-over-year rate of change were poised like this we were but a mere few months in front of a recession (see the chart).
Now for those pundits that insist that real estate is not spilling over into the real economy, I ask the question, "Why has the Association of Home Appliance Manufacturers' Index posted a roughly 10% decline in shipments?" Or, "Why is Circuit City (CC) laying off 3,400 of its best sales personnel and attempting to hire maladroit sales people at a much reduced compensation package?" Similarly, "Why is Citigroup (C) cutting 15,000 financial-related jobs?" And, "Why is GMAC stating that its Residential Capital subsidiary is going to hurt profits?" Inquiring minds want to know such things. Moreover, if the problems in sub-prime mortgages are NOT spreading, why are sub-prime mortgage companies dropping like flies, why are companies like ACC Capital closing their "call centers," and why are delinquencies rising not only in the Alt-A complex, but in prime portfolios as well? I think the answer resides in the fact that housing prices are falling while Mortgage Equity Withdrawals (MEW) are contracting. Indeed, MEW has declined from $844 billion to $386 billion over the past nine quarters as housing prices have softened and trillions of dollars of adjustable mortgages have reset at higher interest rates. And with the continuing decline in housing prices, combined with mushrooming adjustable rate mortgage resets, it is difficult to envision that this situation will not continue.
Meanwhile, "stuff" prices continue to surge, the Fed tells us that inflation is too high, the dollar decline extends, nominal retail sales stink, Washington is rattling its protectionist and regulatory "swords," the "wars" are getting worse, Iran is strutting its stuff, the major market indices remain optimistically priced despite what most pundits suggest, and the Bush administration is under attack, causing one Wall Street wag to exclaim, "When the President is in trouble the stock market is in trouble!" Whether this is true, the stock market will eventually "tell" us by breaking out of its recent trading range between roughly 1450 and 1400 basis on the S&P 500. Until this struggle between "light" and "dark" is resolved, I remain cautious.
The only thing my firm knows to do in such an environment is to stick to our knitting by embracing the themes that have made us money over the past seven years. To wit, and most importantly, adhere to Warren Buffet's two rules of investing: (1) Don't lose money; and (2) Don't forget rule number one. Verily, doing no harm is the prime directive in managing other people's money! My firm has has embraced Warren's wisdom for more than 30 years, but has been particularly cognizant of it since the September 1999 Dow Theory "sell signal." That insight saved investors a lot of money since our mantra has been to not let ANYTHING go more than 15% against you. Following our bearish tilt from 4Q '99 until 4Q '01, we have been steadfastly bullish on "stuff" given our sense that with 5 billion new entrants in the world's economy the demand for "stuff" (energy, timber, base/precious metals, grains, uranium, fertilizer, cement, water, etc.) was going to be a theme for the next 20 years.
Consistent with my firm's "stuff" theme, we positioned portfolios to take advantage of that theme and it has been profitable. Yet while over-weighted in "stuff stocks," preferably ones with a dividend, we have also recommended many more mainstream investments. The defense stocks and REITs have been two of our major sector "bets" since 2000, as have been the community banks. For participants not wishing to own individual stocks my firm has recommended select Exchange Traded Funds (ETFs), mutual funds and investment professionals whose strategy is consistent with our risk-adjusted style. Most recently I met with the good folks at PIMCO, as well as Churchill Management Group, on a recent trip to Los Angeles. Other risk-adjusted advisors often mentioned in these missives have been: Charlie Knott of Knott Capital; Jim Barksdale at EIC (Equity Investment Corporation); Mason Hawkins of Longleaf Partners fame; Manu Daftry at the Quaker Funds; various long/short funds like ICON and Diamond Hills; and last week I spoke with Michael Mara, portfolio manager of MFS' Sector Rotational Fund. We like sector rotation funds and were particularly impressed with Mr. Mara and his quantitative models.
Turning to my firm's verbal strategy comments of last Friday, we were covered-up with requests for a text version of said comments and while we are chagrined to repeat them, here you go (as paraphrased):
"Iran's sailor seizure surfaces memories of America's 444-day hostage situation back in 1979. This time, however, tensions are heightened by the ongoing wars, a claim by Iran that it owns the Greater and Lesser Tunb Islands that control the shipping lanes in the Persian Gulf, Iran's nuclear stand-off, and last Thursday's shocking statement by Saudi Arabia that the U.S. is illegally occupying Iraq. No wonder crude oil is up 32% from its January 2007 lows, begging the question, "Should we be selling partial positions (read: rebalance) of our energy stocks since any resolution to the hostage situation would likely cause a decline in crude oil prices?" Manifestly, we are ardent believers in rebalancing any investment position as through price appreciation it grows into too big a "bet" in the portfolio. However, as long as you believe an asset class is in a secular bull market you NEVER sell your entire position. So while my firm has rebalanced some of our energy position, we remain adamant in our long-term bullish energy leanings. Just listen to what the astute folks at the Bank Credit Analyst (BCA) had to say about energy last week (as paraphrased by me):
'Energy stocks have followed through on their (upside]) breakout. Each of the four major sub-components has climbed above their 200-day moving averages, the first time all have done so in tandem since 2005...Railcar shipments of petroleum products are growing at a much faster clip than overall railcar shipments. This strength is consistent with very depressed inventories of finished oil products, and points to a continued high level of refinery activity. Importantly, this measure of refinery activity has a good track record in heralding the momentum in relative stock performance for the integrated oil and gas group, and the current message is bullish.'
While my firm is a bit more cautious in the short-run than BCA, we are resolute in our positive views on energy over the longer-term. In recent missives we have recommended names like Helix, Williams Partners, and Petrohawk. While we still like all three, we would prefer to buy HLX and WPZ on pullbacks given their rallies since our recommendation. Petrohawk, however, can be bought right here. We also think 6.7%- yielding NGP Resources can be bought. As for our long-held bullish view on the Canadian Oil Sands, last week our Canadian-based energy team had some interesting comments on 4.2%-yielding Canadian Oil Sands Trust that we have recommended for the last four years:
The Trust is not expected to become cash taxable until 2012 - 2013 timeframe. The trust stated that it currently holds approximately $2 billion in tax pools available for use. These pools will be used to reduce taxes payable after the 2011 trust tax deadline, for a total of five to six years of continued tax free distributions to unit holders. Distributions are expected to increase. The trust reiterated its intent to move to a full payout of free cash flow in the near-term. My firm expects that this will occur shortly since the trust is very close to its target debt level of $1.6 billion. By our estimates this means that 2007 distributions will increase to $1.67/unit (a 39% increase) and 2008 distributions will increase to $2.32/unit (a 93% increase) - this corresponds to a 2007 and 2008 yield of 5.8% and 8.0%, respectively.'"
The call for this week: Last week crude oil was up 7%, heating oil rallied 10%, natural gas improved 5.6%, and gasoline lifted 4.6%. While all of this is good for my firm's investment positions in energy, it was not so good for my firm's trading position in the SPDR Financial Index. Nevertheless, we have a marginal profit in the XLF, the XLF is still on a "buy signal" according to our work, and we are using a 34.12 stop-loss point to minimize losses. Meanwhile, the D-J Industrial Average, the D-J Transportation Average, and the S&P 500 have negatively configured chart patterns, and the D-J Utility Average, basic materials, and the technology complexes are positively configured. We continue to invest accordingly.
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