Jeff Saut Presents: It's Not the Snake that Bites You?!
Indeed, "it's not the snake you see that bites you" for while participants have been focused on crude oil prices, gasoline, the dollar, etc., the yield on the 10-year benchmark T'note has risen nearly 20% since last December...
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.
I learned the apothegm in the title from a guide that used to lead canoe trips down the Au Sable River. The implication for campers is obvious, yet I think it applies to the various markets as well. While I have not reprised it for awhile, I have repeatedly reiterated that, "With everybody asking the same question, it is likely not the right question!" That reference was directed at this year's near ubiquitous question, "When is the Fed going to lower interest rates?" I, on the other hand, maintained the "fooler" for 2007 might be that instead of lowering interest rates, the Federal Reserve might just raise them. And, last week "the Street" seemed to awaken to that possibility.
Indeed, "it's not the snake you see that bites you" for while participants have been focused on crude oil prices, gasoline, the dollar, etc., the yield on the 10-year benchmark T'note has risen nearly 20% since last December (4.40% to 5.24%). I commented on "higher interest rate" feelings when the benchmark note's yield broke out above its downtrend line in the charts back on May 17th. I reiterated my rate concerns when it surpassed the mid-April high of 4.78%. And, last week it surmounted its January 2007 yield-yelp high of 4.91%.
Always in search for an approximate cause, the media attributed last week's rate-ratchet to Bill Gross' (Pimco) switch from bond bull to bond bear, stating the 10-year yield is on its way to 6.5%. While Mr. Gross' revelations are certainly a headline grabber, it is worth noting that the bond market has been wobbly for months as interest rates have steadily marched higher. Nevertheless, equity participants quickly cranked that anticipated 6.5% yield into their valuation models with an attendant 200-point Dow Dive last Thursday.
Despite Friday's Dow Delight (+157 points), the three-day "heart attack" left the senior index (DJIA) off 1.78% for the week. Meanwhile, the D-J Transportation Average (DJTA) shed 3.87%. Yet the real victim of the week was the D-J Utility Average (DJUA), which lost an eye-popping 5.39%. My firm warned of the utilities' demise a few weeks ago when that index broke down technically and in the process fell below its 10/30/50- day exponentially weighted moving averages (EMAs). Last week the DJTA did the same. Not so, however, the DJIA, which after knifing through its 10- and 30-day EMAs held at its 50-day EMA and rallied on Friday. This should not come as a surprise, for history shows that after such a stock swoon, stocks typically have what a technical analyst terms a "throwback" rally. If that throwback rally fails to generate a new high, then "things" become more tenuous, at least on a short-term basis.
Whether the equity markets shake off last week's heart attack, only time will tell, but it is worth noting that a lot of technical damage has been done. Indeed, a quick glance at the market's sectors reveals that ALL 10 macro sectors in the S&P 500 were negative for the week. Even more alarming is that only four of the 100 sub-sectors were positive. For the record those sub-sectors were: Defense; Internet; Computer Hardware; and Electronic Office Equipment. Also of note, despite what the "talking heads" espouse, is that stocks are not particularly cheap, with the average PE for the S&P 500 at 23.5 times trailing earnings and trading at 4.5 times book value. And, maybe that is why market guru Steven Leuthold appeared in the previous week's Barron's magazine in an article titled "Downshifting Into Neutral on Stocks."
In that article Barron's asked Mr. Leuthold, "You mentioned all the similarities to 1987. What's different today?" Steve responded with this:
"The valuation level in the S&P 500 is not as extended as it was back then. Then it was selling at 20 times earnings, now it's selling at 15½ – 16 times current earnings. But if you normalize theearnings, we may be looking at peak earnings for the S&P or very close. Also, the S&P is much cheaper than almost any other aspect of the market. By our estimation, were the S&P to go back to median valuation levels, it would decline about 13% from current levels. But mid-caps and small-caps would decline about 25% or 30% because the universe of 3,000 stocks we cover in those categories are in the 97th percentile of valuations historically and at about 21½ times normalized earnings. In terms of normalized earnings, the S&P 500 is in the 81st percentile, so it's modestly over-valued. We are starting to see a shift where large-caps are winning by a small margin over small- and mid-caps. That is also typical of what we saw in 1987."
Large-caps versus small/mid-caps... a debate that has taken place over the past five years. From October 2001 until year-end 2005, my firm has favored small/mid-capitalization stocks. And, while we still believe the small/mid-caps have superior earnings growth, and consequently capital gains potential, over their large-cap brethren, we tilted our asset allocations toward large-caps in 2006. More recently, my firm has become increasingly friendly to large-caps given our strategy of trying to play the long side of the market safely. Manifestly, large-caps tend to trade at lower PE ratios than small/mid-caps. They also tend to have a dividend yield, which we consider extremely important in the total return equation, as well as hopefully giving us some kind of margin of safety. This is especially true when a large-cap company plays to one or more of my firm's investment themes.
A case in point would be 3% yielding General Electric (GE). Followers of Raymond James' work know we have been negative on GE since 4Q '99, except for a brief trading foray when the shares dipped into the mid-twenties during late 2002 and early 2003, because of worries regarding GE's HUGE financial exposure. Disciples of my firm's work should also know that we have been unwaveringly bullish on water investments, as well as companies that sell into the utility complex. Those themes are driven by the fact that this nation is going to have to spend notionally $1 trillion over the next 20 years to bring our aged electric complex into the digital era. As well, $1 trillion needs to be spent to upgrade this country's water infrastructure. Unsurprisingly, GE plays to both of those themes. As General Electric's CEO recently stated in Barron's:
"For the first time in maybe 20 years, our set of industrial businesses can grow to or faster than our financial businesses... Rising demand for power generation in the U.S. and elsewhere will be another big driver of GE's earnings in coming years... The developing world's appetite for new power plants and equipment, as well as other infrastructure projects, will dwarf that of the U.S. and Western Europe in the next decade."
Accordingly, after eight years my firm is turning friendly toward GE's shares and would be buyers, especially on weakness. For further information, I suggest reading the Barron's article dated June 4, 2007, or perusing my firm's correspondent research from Credit Suisse and Lehman, which rate GE an Outperform and Overweight, respectively.
I conclude this morning's comments with a quip from the late 1980s when a newspaperman visiting the Raiders football training camp read a sample of Jack London's prose to the colorful Raiders' quarterback Ken "the Snake" Stabler:
"I would rather be ashes than dust! I would rather that my spark should burn out in a brilliant blaze than it should be stifled by rot! I would rather be a superb meteor, every atom of me in magnificent glow, than a sleepy and permanent planet. The proper function of a man is to live, not to exist. I shall not waste my days in trying to prolong them. I shall use my time.
The newspaperman then asked the quarterback, 'Snake, what does this mean to you?'
'Throw deep,' said Stabler!"
Ladies and gentlemen, there are times in the markets to "throw deep" and there are times to employ Woody Hayes' strategy of "three yards and a cloud of dust." Until things sort themselves out, we're playing Woody's game...
The call for this week: Whether this is the pause that refreshes or a selling stampede is unknowable at this point. If it is a selling stampede, we are just four sessions off of the top with a skein of 17–25 downside sessions due, only interrupted by 1½–3 day counter trend rallies, before said stampede is over. While I am not forecasting that, an S&P 500 close below 1490 would raise the odds of such a stampede. As for Friday's rally, it is worth noting that many of the momentum stock leaders lacked upside volume, suggesting more short-covering than "real" buying. Also of note is that in a financed-based economy, it is not the level of interest rates per se, but rather the rate of change. For example, the 70% rise in the benchmark bond's yield from 3.07% to 5.24% has more negative economic impact than the positive impact derived from the 7% rate decline from 14% to 12%. As the Bank Credit Analyst recently concluded, "From a long-term perspective, the era of 'free money' is unwinding. Global real interest rates are gradually returning to more normal levels, which will be bearish for bonds and, eventually, create a roadblock to the re-rating in equities. Keep an eye on exchange rates and central bank policies in Asia."
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