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Jeff Saut Presents: Sisyphus Succeeds!


There is no doubt many investors have felt the same frustration with the S&P 500 1527 that Sisyphus must have experienced as that index tried to better its all-time closing high.


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.

"Sisyphus is the son of Aeolus (the king of Thessaly) and Enarete, and founder of Corinth. He instituted, among others, the Isthmian Games. According to tradition he was sly and evil and used to way-lay travelers and murder them. He betrayed the secrets of the gods and chained the god of death (Thanatos) so the deceased could not reach the underworld. Hades himself intervened and Sisyphus was severely punished. In the realm of the dead, he is forced to roll a block of stone against a steep hill, which tumbles back down when he reaches the top. Then the whole process starts again, lasting all eternity."
...Micha F. Lindemans, "Encyclopedia Mythica"

Indeed, in mythology, Sisyphus is required for eternity to roll a huge stone to the top of a hill only to have it plunge back down just as it nears the crest. There is no doubt many investors have felt the same frustration with the S&P 500 (SPX) 1527 that Sisyphus must have experienced as that index tried to better its all-time closing high. The first attempt was back in February, the second in April, for most of May it was the same story, but last Wednesday "Sisyphus" succeeded when the SPX (1536.34) reversed its early morning loss on another Chinese crashette (- 6.9%) and vaulted 12 points higher to close at 1530.23. That morning my firm had commented to participants that the déjà vu morning-downer was a "gift" on a trading basis (read: buy it) because the markets never discount the same thing twice and February 27, 2007 (- 416 DJIA points) was the discounting mechanism for a Chinese crash.

The "driver" for Sisyphus' success seems to be the building sense that what we have experienced is the fabled mid-cycle economic slowdown with the economy now set to reaccelerate. That sense was bolstered by recent reports on consumer spending (+4.4% annualized), the ISM Manufacturing Index (+55.0 in May), Industrial Production (+0.7%), Consumer Confidence (108.0 in May vs. 106.3 in April), Consumer Sentiment (88.3 in May vs. 87.1 in April), Construction Spending (+0.1), and then there was Friday's employment report. Said figures were stronger than expected with nonfarm payrolls expanding by 157,000 (130,000E). Yet, all is not as it seems, for part of the jobs strength is attributable to the government's "birth/death" model used by the Bureau of Labor Statistics to estimate the gains/losses in jobs from the launching, or demise, of businesses. In April, the birth/death model "guessed" that 317,000 jobs were added, including 49,000 construction jobs. In May, it assumed 203,000 jobs were added with a concurrent addition of 40,000 construction jobs. While I don't understand the entrails of this voodoo model, I do find it sketchy that a phantom 89,000 construction jobs have miraculously been added to the payrolls over the past two months given the reports out of the housing industry.

As my firm's real estate team notes, "that data took markets by surprise because it contrasts sharply with recent anecdotes from public builders regarding trends subsequent to March as most have made comments that April [and May] was/were largely worse than March." Moreover, the fallout from the housing debacle appears to be spreading with CBS news reporting a 110% increase in home foreclosures for 2006 at the New Jersey shore. For comparison, the invaluable Minyanville notes, "nationwide foreclosures jumped 65% from April 2006 to April 2007 on problems that have plagued the nationwide housing market – oversupply, lack of demand and ARM loan resetting."

Loan resetting indeed because the most popular mortgages two-to-three years ago were the adjustable rate kind with "teaser" interest rates that are just now starting to reset. This becomes increasingly important in a rising interest rate environment. And, almost on cue, the 10-year benchmark Treasury Bond's yield (TNX) broke out to the upside last week as can be seen in the chart below. I have repeatedly commented on this potential event ever since the TNX broke above its downtrend line on May 17, 2007, which had been intact since July of 2006. Consequently, not only has the yield broken above that downtrend line, but also above the "yield yelp" high of last January (4.91%).

I have deemed the TNX chart as probably THE most important chart around since higher interest rates have far-reaching ramifications. First, higher rates offer more competition for stocks. Second, history suggests that PE ratios tend to contract as interest rates rise. Third, various quantitative models used for equities have to reset for lower equity valuations as rates rise. Fourth, low interest rates have been the underpinning of the weaker dollar, and as rates have firmed, so has the U.S. dollar. This is not an unimportant point for it has been the weaker dollar that has largely provided the "bounce" to aggregate earnings and the economy. Clearly, there are more implications, but that is a discussion for another time.

Nonetheless, so far the equity markets have ignored the "rate ratchet" causing one frustrated Wall Street wag to lament, "Hey Jeff, I am afraid of this market because it is overvalued, over-extended and overdue for a correction, yet I have to play the long side since my performance has to keep up with 'the Jones,' the Dow Jones that is, so what am I to do?!" As stated in last week's verbal strategy comments, our friend Barry Ritholtz, eponymous captain of Ritholtz Research & Analytics, asked, and answered, this same question in a report titled, "How to Play the Long Side Safely." In the report he cited a few parameters: "1) Identify strong sectors with good money flow; 2) Look for stocks within those sectors with desirable risk/reward characteristics; 3) Screen for stocks with the best technical, fundamental and earnings potential; 4) Find stocks that are near good entry points; 5) Avoid 'runaway momentum' names; and 6) Look for stop loss protection that is a reasonable downside away."

To these points, we have been using Johnson & Johnson (JNJ) since $60/share. We have also used Quadra Reality (QRR), which is rated Outperform by my firm's research correspondent Credit Suisse. Since I have elaborated on these stories in past missives, I won't reiterate them this morning. What I have for you today are a couple of new risk-adjusted ideas. First is MeadWestvaco (MWV) that Credit Suisse issued a trading alert on last week stating, "We are establishing a long position in MWV shares. The catalyst for this trade is expected updates on the timberland sales and the $200 million annual cost savings initiatives over the next month." However, as noted by Glenview Capital's founder Larry Robbins at the recent Ira W. Sohn conference, there is more to the MWV story than that. To wit, while the land business is only 4% of EBITDA, Glenview thinks it is 21% of the company's value and should be monetized. It calculates that the 1.1 million acres is worth at least $2.4 billion. Further, it thinks the specialty chemical business should be sold and the office business merged. If done, Glenview believes valuations could reach $47. Given its view that the downside is roughly $30/share renders an upside risk/reward ratio of 2.4 to 1. With a 2.6% dividend yield, we find MeadWestvaco intriguing.

Another investment idea from our universe is 3% yielding, Outperform rated, Flagstar Bancorp (FBC). With $15.4 billion in assets, Flagstar is the largest savings and loan institution in Michigan. It is also one of the nation's top-30 mortgage originators. As such, the consternations in Michigan have left these shares down some 54% from their March 2004 high and selling near book value. Yet, Flagstar does not have much sub-prime exposure, and while the mortgage business is still a focus, Flagstar is using the cash flow from the mortgage operations to expand its retail branch banking network. Indeed, FBC has opened numerous new branches in excellent locations, which is consistent with the history of this savvy management team.

The call for this week: Hedge funds are about as fully invested as they ever get. Meanwhile, net shorts in the S&P 500 e-mini fell to their lowest level since March and as interest rates rise margin debt is substantially above its 20-year average. Moreover, history shows that "booms" tend to last a little over a year from when the yield curve inverts before things become dicey; May is month 15. Still, few of the telltale signs of a market top are in place... and don't look now, but last week Lowry's Buying Power Index crossed above Lowry's Selling Pressure Index for the first time in 21 months (read: bullish). While I don't understand it due to my firm's valuation concerns, we continue to be pretty "long" in the investment account and are moving our stop-loss points up on our long trading positions like the SPDR Financial (XLF), the PS Aerospace & Defense (PPA), the PS Water Resources (PHO), and the Japanese Yen Currency Shares (FXY). This week, Sisyphus goes long.

P.S. – As a follow-up to last week's missive regarding "corn fields for as far as the eye can see," it is reported that Mexican farmers are burning their fields of blue agave, the cactus-like plant used to make tequila, and planting corn as soaring ethanol demand pushes corn prices higher.

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