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Jeff Saut: Poker Mentality


If there is another bubble to be blown it will likely be in emerging markets' equity prices...


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 how to play poker at a very young age. My father taught me the concept of playing the percentage hands. You don't just play every hand and stay through every card, because if you do, you will have a much higher probability of losing. You should play the good hands, and drop out of the poor hands, forfeiting the ante. When more of the cards are on the table and you have a very strong hand – in other words, when you feel the percentages are skewed in your favor – you raise and play that hand to the hilt."

"If you apply the same principles of poker strategy to trading, it increases your odds of winning significantly. I have always tried to keep the concept of patience in mind by waiting for the right trade, just like you wait for the percentage hand in poker. If a trade doesn't look right, you get out and take a small loss; it's precisely equivalent to forfeiting the ante by dropping out of a poor hand in poker. On the other hand, when the percentages seem to be strongly in your favor, you should be aggressive and really try to leverage the trade similar to the way you raise on the good hands in poker."
- Jack D. Schwager (Market Wizards), explaining Gary Bielfeldt's analogy between trading and poker

I have always found it ironic that a lot of folks think of me as a trader, when in fact I am much better at investing. While it's true that 20% of my portfolio is geared toward trading opportunities, the much more important 80% is for long-term investing.

Last year would be a good example of this strategy. I only made two trading forays in the 12 months of 2007. Granted, when I committed trading capital I bought a number of positions, but the fact of the matter is that I thought there were only two occasions in 2007 "when the percentages seemed to be strongly in my favor, and I was aggressive, and really tried to leverage the trade similar to the way you raise on the good hands in poker."

Those two occasions were between August 14 and 16, and again in late November, when the various averages were retesting those August lows. I subsequently sold all of those trading positions into year-end. I also rebalanced all of my "stuff stock" investment positions into year-end (read: sold partial positions) because they had grown into such a huge portfolio bet, which is how I entered 2008 with such a large cash position, consistent with my mantra of "I am entering 2008 in a very cautious mode." I got even more cautious when the January 4 employment figures accelerated the new year's stock slide into a selling stampede and commented at the time:

"Last night (1/3/08) I reviewed my notes of some 40 years and found that January's employment report tends to set the market's trend into the State of the Union address. My notes also confirmed that the first few days of the new year are often accompanied by initial straight-up, or straight-down, moves that suddenly reverse on the employment numbers. The year 1988 is a good example. The mood in early 1988 had turned positive. The Dow had 'crashed,' and bottomed, in October 1987 even though the stock market's breadth (advance/decline line) continued to deteriorate into year-end. As the new year began (1988), stocks traded sharply higher into the early-January employment numbers; and then b-a-n-g, in one session the Dow lost nearly 7%. From there, stocks never regained their poise until after the State of the Union Address."

I stuck with that defensive strategy, noting that "such stampedes typically run 17 to 25 sessions before exhausting themselves on the downside and are only interrupted by one- to three-day counter trend pauses/rallies." Consequently, on Wednesday, January 23, when the DJIA had its second largest daily point-swing in history (600 points) and closed "up" nearly 300 points after a 300-point early session slide, we concluded that the selling stampede was ending (on day 20 of the envisioned stampede). We therefore recommended buying some trading, as well as investment, positions on that Wednesday. The vehicles of choice were the Ultra S&P 500 ProShares (SSO) and the Ultra Real Estate ProShares (URE).

Subsequently, I recommended buying a second tranche of these positions last Monday as my confidence grew that the rally would extend.

I also recommended select investment positions, the most recent being Strong Buy-rated Schering Plough (SGP), except in this case I am using the 7.7%-yielding convertible preferred "B" shares. While this preferred is a relatively new one, I think the risk/reward metrics are similar to the last Schering Plough convertible preferred I owned, which provided me with a total return of nearly 30% per annum over my two-year holding period. Like before, the common shares of SGP have recently been devastated because of the fallible "Enhance" study on Vytorin. My doctor, as well as my analyst, suggests this study encompassed far too small a sample of participants and that Schering Plough's Vytorin is still a good drug. As always, the terms of the convertible preferred should be checked before purchase.

Other recent investment recommendations were 8%-yielding EV Energy Partners (EVEP), Delta Petroleum (DPTR), Interoil (IOC), and Cogent (COGT), all of which have some kind of upcoming news that I think might provide an upside catalyst.

Do these recommendations mean I think the difficult market environment is over? Not really, but I do believe the Fed, the banks and the politicians et al, have a vested interest in preventing a recession and are pulling out all of the tools at their discretion. Whether they will be successful remains to be seen, but in the near term it looks like the various markets believe they will.

As to how far the rally extends is anyone's guess, but it looks to me like there is scaled-up overhead resistance beginning at current levels for the DJIA and the S&P 500 .

Click to enlarge

Moreover, a lot of my shorter-term finger-to-wallet ratios are overbought, so it would not surprise me to see some kind of attempt to sell stocks off this week. Still, I think the near-term lows are "in" even if the economy spills over into a recession. To this recession point, as I sit here in Jackson Hole staring out at the Grand Tetons from my friend's house, we are discussing business.

Mark owns a specialty steel company. When I asked him how business was he responded, "What recession? Indeed," he continued, "Our business is smoking. I even asked our sales people to canvass our customers and their business is also smoking! It's the dollar," Mark opined. "Because of the dollar's decline we have become by default the low cost supplier of specialty steel products."

To aficionados of my strategy reports these comments should come as no surprise, yet it is not just such anecdotal gleanings that keep me of the opinion there will likely be no recession.

Plainly the manufacturing sector is improving. This trend was reflected in the recent stronger than expected durable goods report. Also, the manufacturing book-to-bill remains elevated, buoyed by strong foreign demand due to the dollar's drop. In fact, the astute GaveKal organization observes that "manufacturers' order books look better than at any other point in the last ten years – unfilled orders equal to nearly U.S. $2 for every U.S. $1 of current shipments." Indeed, if one deducts housing, inventories in the U.S. look exceedingly lean.

Clearly, the recent crash in interest rates is also going to help ameliorate the housing situation. But just for insurance, it looks like the politicos are going to raise the "mortgage cap" for conventional / conforming mortgages from $417,000 to $730,000. Previously, any mortgage over $417,000 was considered to be a jumbo mortgage with an attendant interest rate that was roughly 1% higher than conventional mortgages.

Manifestly, this is potentially a plus for housing. As for employment, despite Friday's downer numbers, employment is not a disaster. Even if the unemployment rate were to rise by 20% to the 6% level, 94% of the country would still be working! And, don't forget that everywhere we look there are negative "real" interest rates, which have always sown the seeds for economic growth. Consequently, I continue to feel the "recession call" is premature.

The call for this week: Since 1949 every government-sponsored stimulus package has worked. Consequently, my firm is inclined to think this one will as well. Whether the powers that be can create another "bubble" for the overspent/under-saved U.S. consumer is debatable.

My sense is that if there is another bubble to be blown it will likely be in emerging markets' equity prices following their recent correction. If you have not followed my lead for the past seven years of investing some of your assets internationally, I suggests using the recent weakness to position yourself accordingly.


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