Jeff Saut Presents: General Electric, a Proxy for the US Economy
Almost on cue, GE's shares lifted from their then $37 per share level and tagged almost $40 before last week's Dow Dump left them nestled near $38 by Friday's close.
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.
He said, "Gee." I said, "No, GE!" He said, "I thought you didn't like GE?" I said, "Well, from 4Q '99 until a few weeks ago, that was true"... and then I showed him my missive from June 11, 2007 that read:
"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."
Almost on cue, GE's shares lifted from their then $37 per share level and tagged almost $40 before last week's Dow Dump left them nestled near $38 by Friday's close. Nonetheless, GE has broken out to the upside of what a technical analyst terms a flag chart formation that was nearly three years in the making, as can be seen in the nearby chart. Said breakout suggests that something fundamentally has changed for the good at General Electric. The Barron's article elaborated on that "something good" when it stated:
"Far more important, the global economy is growing by a healthy 4% a year, and emerging economies by even more, creating new and inviting markets for GE's industrial and infrastructure products. The company's flagship infrastructure segment enjoys operating margins of nearly 20%, and is likely to see sales grow by 15% to 20% annually in the next few years. As a welcome consequence of these trends, GE has reached the so-called tipping point."
I think GE shares are like a mini-mutual fund given the company's disparate businesses. I also would argue that GE is a pretty good proxy for the U.S. economy, as well as the world's economy. Consequently, I remain friendly towards GE's shares, especially on weakness into the "flag formation" (between $32 and $37), which has now become a support level.
Speaking of mutual funds, I recently had the pleasure of dining with Michael Mara, captain of the MFS Sector Rotational Fund (SRFAX), which has gained almost 12% year-to-date sans sales charges. As I understand it, prior to his 22 years in the financial services industry, Michael was assigned to the U.S. Army's Intelligence & Security Command where he became skilled in the discipline of algorithms. For the record, an algorithm is a finite list of well-defined instructions for accomplishing some task that, given an initial state, will terminate in a defined end-state. Plainly, this skill-set has served him well as a portfolio manager since asset allocation, combined with sector rotation, is one of the keys to investment success. In this regard, we have often referred to legendary investor David Swensen, who has guided Yale University's endowment fund to outsized returns for over 17 years. In his book, Unconventional Success: A Fundamental Approach to Personal Investment, Mr. Swensen states that asset allocation is responsible for 90% of investment returns. While I think that percentage is somewhat high, I do believe that correct asset allocation accounts for more than 50% of a portfolio's return, and so does Michael Mara.
To wit, "Long-term performance comes from asset allocation," Mike said. He then went on to note, "That process includes allocating between stocks and bonds, as well as styles such as growth, value and various market caps." "As a portfolio manager," he continued, "you have to stave off the noise and focus on the process of investing." Mike uses a quantitative model that employs one-third value factors, one-third growth factors, and one-third momentum factors in an attempt to avoid making too large a "style bet." Of particular importance to my frim is Michael's disciple of avoiding the "big loss." Indeed, for the type of stock market environment I envision going forward, Mike Mara is the kind of portfolio manager I feel comfortable with to manage a portion of my firm's investment dollars.
As for the kind of environment I see going forward, despite all of the worries over the past few weeks and the increase in volatility (my firm is long volatility, expecting it to pick up), the market's recent machinations have still not caused the indices to break down technically. Clearly, we had what looked like a one-day downside reversal last Tuesday when the S&P 500 (SPX) opened higher than the previous day's high and then closed lower than the previous day's low, but while that's a "warning flag," it does not constitute a violation of the uptrend. Indeed, the SPX has been trapped in a trading range between roughly 1490 and 1540 for nearly seven weeks. And, until that range is decisively violated on the upside, or downside, it is merely a guess as to how the equity markets will resolve themselves. Sure, I hazarded a guess two weeks ago when I opined:
"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."
Obviously that was a wrong "guess" since the SPX subsequently gathered itself together and then re-rallied back to 1539 before failing again and, in the process, potentially tracing out a double-top in the charts. If the second time is the charm, we are once again only four sessions off of the potential double-top.
As for the burgeoning sub-prime debacle, my firm has repeatedly warned that with the incredible growth of Collateralized Debt Obligations (CDOs), derivatives, etc., the eventual outcome would not be pretty. While there have been some warning "tells" of this over the past few quarters, last week the Bear Stearns' (BSC) "bombshell" came home to roost with the implosion of a couple of highly leveraged hedge funds. As I understand it, the Bear Stearns High Grade Structured Credit Strategies Enhanced Fund raised some $600 million nearly a year ago and immediately purchased over $11 billion of securities (mainly sub-prime related) while selling short another $4.5 billion, causing one Wall Street wag to lament, "High grade, now there's an oxymoron!" With the recent interest rate rise and the concurrent 40% collapse in the BBB – 7/01 tranche of the ABX Index (credit-default swaps based on sub-prime mortgage bonds), said hedge fund was "underwater" and about to be seized and liquidated. Only a last minute, $3.2 billion rescue saved the fund, begging the question, "Why such a Herculean effort?" The answer, ladies and gentlemen, is very simple: a liquidation would give the financial community the one thing they REALLY wanted to avoid – a "real" current market price on the bonds, CDOs, derivatives, etc. that are in the portfolio – causing a potential ripple effect, and ensuing price mark-down on ALL such "bonds," with a subsequent reduction in the net asset value of all similar hedge/mutual funds. While some will argue this is the kind of negative news that tends to mark the end of such debacles, I believe caution is still warranted and continue to invest accordingly.
The call for this week: In this missive I stated that, "Despite all of the worries over the past few weeks, and the concurrent increase in volatility, the market's recent machinations have still not caused the indices to break down technically."
While this statement is true for most of the equity indexes, it is blatantly untrue for the bond market whose price breakdown (higher rates) has clearly caused problems. As the always insightful BCA organization notes:
"Treasury yields should pause in view of the further deterioration in housing and cracks in parts of the credit market. However, lower yields await a sizable setback in stock prices and/or weaker consumption and employment data. Investors should continue to underweight corporates within bond portfolios. The equity market is skating on thin ice from a short-term perspective, as additional technical divergences have developed. The rebound in earnings expectations means that there is room for disappointment this summer, as new-found economic optimism will fade shortly."
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