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Jeff Saut Presents: Risk vs. Reward


A lot of people have missed the rally over the past nine months. Those investors view missing the rally as opportunity lost.


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.

"Psychologists have uncovered a surprising number of idiosyncrasies from making the soundest choices in many situations. These lapses explain some of the mysterious up and downdrafts that can lift and lower stock prices. Understanding them can make successful investing easier. The most important findings arise from answers to a pair of questions.

The First: If faced with the prospect of two possible gains, which would you choose?

-A 100% chance to win $3,000.
-An 80% chance to win $4,000.

Asked this question, most people choose the guaranteed $3,000, even though the second choice has a higher value according to probability theory. The value is determined by multiplying the chance of winning, or 80%, by the $4,000 the winner stands to gain (80% of $4,000 is $3,200). So in the long run you come out ahead by making the second choice consistently. Most people are bothered by the 20% chance of getting nothing in the second choice, which tells psychologists what stock market theorists knew all along: That investors in general prize certainty and abhor risk.

It's not that simple, however. When people are confronted with prospective losses, quirky psychology turns them into riverboat gamblers. That fresh discovery became clear from another question: Which would you choose?

-A certain loss of $3,000.
-An 80% chance of losing $4,000 and a 20% chance of losing nothing.

Most people will gamble on the second choice, which offers a 20% chance of going unscathed, even though it is riskier (again, 80% of $4,000 is $3,200). Because people's horror of losses exceeds even their aversion to risks, they are willing to take risks – even bad risks. Contrary to what's been believed, risk aversion is not always the guiding light of decision-making.

To measure just how deep the fear of loss runs, psychologists follow up this pair of questions with another. Students were invited to wager on a hypothetical coin toss: Heads, you win $150; tails, you lose $100. Though the potential payoff is 1½ times the possible, most students refused to bet.

How can otherwise rational people act so unwisely in the face of promising moneymaking opportunities? Despite the outsize reward for taking this risk, the researchers say, most people are put off by the 50% chance of losing. Loss aversion is a surprisingly powerful emotion. So great, in fact, that it keeps people from accepting good bets, both in coin flipping and in selecting stocks."

--John J. Curran, 1987 INVESTORS' GUIDE

A lot of people have missed the rally over the past nine months. Those investors view missing the rally as opportunity lost.

Accordingly, I am getting the sense that investors, confronted with these "prospective" losses, are turning into catch-up "riverboat" speculators. A case in point was last Monday's "rush" into the shares of Dow Chemical (DOW) on takeover rumors. By the end of the week, however, Dow had fired the two top officials that had been posturing for a buyout, leaving Monday's speculators sitting with losses.

More confirmation of this bullish abandon can be found in the record margin debt at brokerage firms. And the little guy is not alone, for Wall Street strategists are collectively recommending the heaviest stocks mix in years. In fact, some strategists are actually forecasting a "melt up" for stocks. While I have learned that markets can do anything, I have also learned that there are times to be aggressively bullish and times to be cautious. Currently, I am obviously cautious on the major market indices even though it feels like they are going to trade higher. This caution stems from the fact that despite what many pundits suggest, stocks, in the aggregate, are not particularly cheap at 17.8x trailing earnings, 3.2x book value, and sporting a dividend yield of 1.9% (basis the S&P 500).

Moreover, I am concerned about the dearth of capital spending. More specifically, the report that nondefense capital goods (ex-aircraft) has fallen from near double-digit growth in mid-2006 to zero is concerning to us 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.

Meanwhile, the "productivity miracle" seems to be waning. As my firm's economist Scott Brown, Ph.D. notes: "Nonfarm business productivity has risen at a 1.5% annual rate since 2Q '04. The preliminary estimate of 1Q '07 productivity growth won't be reported until May 3. However, it seems clear that output per worker grew at a meager pace. A protracted slowing in productivity growth would have enormous consequences for the outlook for economic growth, inflation, corporate profits, the dollar, and the long-term federal budget picture." And, last week the U.S. dollar may have sensed such consequences because the Dollar Index (at DX.1/81.81) broke below its December 2006 reaction low, making its next target the December 2004 low of 80.60 (basis the June 2007 future). Failing that level would suggest another leg down for the greenback (see the chart).

U.S. Dollar Index

Source: Reuters BridgeStation

Maybe last week's dollar dive was driven by the government's report showing a 19% downward revision to the nonfarm payroll numbers through 3Q '06. If that trend holds for the 4Q '06, it could imply a downward benchmark revision of about 450,000 jobs according to Merrill Lynch's economist David Rosenberg. Or maybe the weakness is attributable to the recent GDP report that showed the growth in corporate profits has stopped. Indeed, after the capital consumption (CCA) and inventory valuation (IVA) adjustments, profits before taxes declined 0.3% in the 4Q '06. While it is likely that oil inventories played a roll in these figures, it is a developing profits trend that bears watching. Also worth watching is the government's increasing movement toward protectionism and regulation/intervention.

In such an environment, where we can't decide if the economy is slowing into recession, slowing to a muddle, or reaccelerating (although recent figures have a decided slowing tint), we have tried to focus on themes, and special situations, that make sense to us. Energy is one such theme, for while the U.S. seems to be slowing economically, the rest of the world is not, as demonstrated by China's roughly 13% increase in crude oil demand. To take advantage of that demand my firm has recommended most of the Canadian oil sands complex, which had a fairly big rally last week. This is particularly impressive in light of the Canadian Dollar's recent strength (we remain bullish on the Canadian Dollar).

My firm has also recommended a number of energy names that presented at the Raymond James Institutional Conference in March. Accordingly, ideas like Petrohawk (HK), Kodiak (KOG), 6.7%-yielding NGP Resources (NGPC), and Helix (HLX) have performed well over the last few months. Yet for non-stock-specific investors, the recommendation of the 5%-yielding Blackrock Global Energy (BGR) ETF has been a risk-adjusted way to participate in the energy theme, whose shares broke out to the upside in the charts last week. My firm has also embraced non-economic-sensitive themes like homeland security using L-1 Identity Solutions (ID), which recently received a large contact. Then too is the non-economic-sensitive "water theme." While the non-stock-specific investor may want to consider the Water PowerShares (PHO), my firm's Canadian-based analysts have been recommending Laperrier & Verreault (GLV.A) as a way to participate in the water theme. As always, Canadian securities should be checked for Blue Sky laws in this country.

The call for this week: Last week the DJIA rallied 0.4%, but the Dollar Index declined 1.0% begging the question, "Did stocks really rally, or did the measuring stick decline (aka; the U.S. dollar). Meanwhile gold, at $690.60/ounce (also an anti-dollar bet), is challenging its reaction high of $692.50/ounce and I remain bullish as I have been since gold's October 2001 lows of $280/ounce. While my firm has recommended MANY gold stocks since then, most investors will be best served buying the shares of a precious metals mutual fund. Currently, we are using the shares of OCM Gold Fund (OCMGX). As for my firm's trading position in the Financial SPDRs (XLF), while we are profitable in this position, and are using a stoploss point slightly below $34.00, we have been disappointed in the financials' performance over the past few weeks and subsequently have raised our stop-loss point. That said, even though we expect stocks to trade higher, there may be more risk than reward at this point.

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