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Jeff Saut: A Time For Caution


Changing environment could involve major dislocations.


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.

"...After the workshop, another student took us out to Claibourne, the thoroughbred farm where Secretariat was buried. He was one of the great racehorses of all time. We went to his grave. He was buried in an eight-foot mahogany coffin with a gold satin lining. My student told me, 'They don't usually bury the whole horse, but he was special. Hundreds of people came to his funeral.'

'Well, what do they bury if they don't bury the whole horse?' I asked.

'Most horses they don't bury at all. With real winners, they bury the head, the hooves, and the heart,' she told me, nodding.

'The heart?' I asked, astonished.

'Yes, that's what a horse runs with, his heart. That's why they say, "That horse has heart." If they've got heart, it makes up for other things, they can win,' she explained."

- Long Quiet Highway (Natalie Goldberg)

Big Brown was the odds-on favorite to win last Saturday's Kentucky Derby, and he won. Despite starting from the far outside 20th position, he took the lead at the top of the "stretch" and roared to the finish line. The race, however, had a tragic ending as filly Eight Belles, who finished second, had to be euthanized on the track after collapsing while breaking both front ankles. The breakdown brought to the surface memories of the 2006 Baltimore Preakness, when Barbaro shattered his rear leg and had to be euthanized a few months later.

Clearly, both horses had "heart." Similarly, in the Wall Street Derby you've gotta have "heart." Indeed, in this business you've gotta have heart, as well as experience, to give you the confidence to make the correct "bets" necessary to win the performance derby; or as one Wall Street wag put it, "Experience tells you what to do, but heart gives you the confidence to do it!"

To be sure, I've had "heart" this year, having entered it in a cautious mode with a high cash position, worried about the potential of a "selling stampede." As noted, I thought the selling-stampede ended on January 22/23rd (at 1270 basis on the S&P 500), and said so, concurrent with recommending committing some of your cash to stocks. The ensuing rally took the S&P 500 up to 1395 in February, where I turned cautious, advising participants that bottoms tend to be a function of both "price and time."

Subsequently, I suggested the averages needed to come back down and retest the January "lows" before we could get a sustainable rally that would carry them above their February highs. Almost on cue, the averages peaked and slid into their respective March "lows," which proved to be a successful retest of the January "lows" and I again recommended committing some cash to stocks. At the time, "the Street" was rife with stories about the impending market disaster that awaited investors, and my sanity was questioned, except by our friend Herb Greenberg, who in a CNBC interview stated, "I don't want to go against Jeff Saut, since he is one of the smartest guys on Wall Street."

From Herb's mouth to God's ears, for again, almost on cue, stocks gathered themselves together and rerallied in a move that would carry them above their February highs toward my long-envisioned target zone of 1420-to-1440 basis the S&P 500 (SPX/1413.90). Interestingly, most of the folks that questioned my sanity at the March lows, and consequently would not "buy 'em" at the time, lit up our phones last week with the question, "What do we buy?"

Regrettably, I had to reply that on a trading basis I'm much less sanguine here than I was a mere month ago; and, that I would actually be a scale-up seller of trading positions on any blue-heat upside hour that took the SPX into the aforementioned zone. That move came Friday morning on the much better than expected employment numbers, with an opening salvo that left a "print high" for the SPX of 1422.72; I acted accordingly.

While I still believe the averages can extend higher into our cluster of timing-point "highs" between May 7th – May 14th, I also believe it's pretty late in the up-move and therefore I'm not recommending any new trading positions. Rather, I continue to recommend scale-up selling of trading positions into strength on the belief that come late May it'll become apparent that our economic problems are not behind us. That revelation should bring about a decline that will first be measured by "if" the U.S. economy spills into a recession (I still doubt it); and secondly, if that potential recession will be shallow/short or long/deep.

While that is my strategy for the trading side of portfolios, I have a different view for the investing side of portfolios. Indeed, there are many investment stocks that have not participated in the recent rally, yet afford investors attractive risk/reward ratios.

One such name was added to my Focus List last week, that name being 6%-yielding Embarq (EQ). I think Embarq's 30% share price decline from last September's high of $63 has more than discounted this telecommunication company's exposure to the housing debacle. Likewise, I favor 7%-yielding Alaska Communications (ALSK) for its exposure to the vast Alaskan natural resource reserves that should eventually be developed. My recommendation on Schering-Plough's (SGP) 8%-yielding convertible preferred "B" shares remains in force; even though I lost my fundamental analyst, along with his Strong Buy rating, last Friday (the shares are still positively rated by our correspondent research affiliates). And while I 've clearly been wrong on recommending scaling into 3.7%-yielding General Electric (GE), after eight years of avoiding it, I continue to think investment positions in GE will be rewarded over the next few years (GE remains positively rated by my research correspondents).

"But Jeff," one caller questioned me last week, "the economic news has suddenly turned for the better! So why now, after being bullish at the January/March 'lows,' are you now turning cautious?"

My answer was "While the headline numbers are indeed turning bullish, if you drill down into those numbers all is not as it seems." Case in point, the 1Q'08 GDP report, which at first blush showed a much stronger than expected positive 0.6% growth rate. However, if you exclude the increase in inventories of unsold goods, the "final sales" number was negative by 0.2%. In other words, the inventories of unsold goods added an artificial 0.8% to 1Q'08 growth. Moreover, residential investment collapsed to the tune of 26.7% annualized. Yet the GDP figures misstate this because they do not separate residential investment into true final sales of new homes, as well as into unsold inventories of new homes. Similar nuances massaged last week's ISM Manufacturing report; and, then there were Friday's employment numbers.

At first glance, the employment numbers looked impressive, with Nonfarm Payrolls falling by a much less than expected 20,000 (-80,000 estimated), while the Unemployment Rate edged down to 5.0% versus the median forecast of 5.2%. However, as stated in George Orwell's book 1984 – "numbers mean what we say they mean" – the U.S. government's recondite birth/death model, which adds jobs it thinks are being created but can't actually count (read: fallacious jobs), added 45,000 construction jobs and 8,000 financial jobs. Ladies and gentlemen, given the state of real estate and financial industries, such additions are clearly a stretch!

Accordingly, I think such numbers will begin to be questioned in the months ahead and I continue to invest and trade accordingly.

The call for this week: Last Friday I recommended scale-selling "trading positions" into strength in the S&P 1420-1440 target zone (basis the SPX); and especially into my cluster of timing points between May 7th and May 14th. This view is driven by the fact that we have had the envisioned rally, as well as that 77% of the S&P 500 stocks are above their 50-day moving averages (DMAs) for the highest reading since last October (read: overbought). Amazingly, 85% of the S&P's financial stocks are above their 50-DMAs, which is likely why the financials outperformed gold last week for the first time since last July. Meanwhile, volatility is falling, bonds have broken down (read: higher interest rates), bond spreads are narrowing, the U.S. dollar has "firmed," and commodities have "cracked," all of which suggests risk appetites are rising. Plainly this concerns me and begs the question, "Are we entering a new kind of investment environment?" History shows that if so, it will not be without some major dislocations, which is why I'm now turning cautious.

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