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Jeff Saut: Muddling Through the Big "W"


Employment numbers, crude prices not helping.


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.

It's a Mad, Mad, Mad, Mad World
is a 1963 comedy film that begins when the occupants of four vehicles stop on the side of the road to help another motorist who has careened off the highway in a spectacular crash. With his dying breath, Grogan (Jimmy Durante in his last screen appearance) tells the bystanders about $350,000 that is hidden in the nearby city of Santa Rosita "under the big W." With that, Grogan expires, and when the bystanders can't agree on how to split the money, a slapstick road race begins to the city of Santa Rosita in search of "the big W."

This morning I revisit the "big W," except in this case I'm referring to the potential for a "big W"-shaped economic pattern. To wit, while I've repeatedly stated the economy is slowing, I've also been steadfast in the belief there would be no recession in 2008 (two negative quarters of GDP). That sense was reinforced by the fact that every government-sponsored economic stimulus program since 1948 has worked!

And when taken in concert with the Herculean efforts of the Federal Reserve, as well as the politicians, I've been inclined to give this economic stimulus program the benefit of the doubt. That said, I've proffered the economic slowdown we've been experiencing might just be interrupted, in the short term, by improving economic statistics driven by said stimulus package, low interest rates (actually negative "real" interest rates), surging money supply, the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), et al. And, this short-lived economic rebound would give participants the impression that all of our economic troubles are behind us, fostering a rally in the stock market. To me, the envisioned economic rebound would represent the middle part of the "W" pattern.

Unfortunately, I think such a strengthening economic sequence will be accompanied by stronger than expected inflation readings, causing the Federal Reserve to raise interest rates and thus slowing the economy again; to wit, the back half of the "W," or an economic double-dip. To this inflation point, last week Ed Hyman's ISI organization noted, "The big news is in developing countries where ISI's 22 country Foreign CPI Composition Index broke above 7%. It has been below this level since early 2002. The central banks are getting the message. The Philippines, Indonesia, and Brazil Central Banks all raised rates yesterday (6-4-08)."

Interestingly, last week showed how quickly perceptions can change on the Street of Dreams. Indeed, on Thursday numerous events (economic, M&A, etc.) gave market participants the sense the worse was behind us with no recession on the horizon. The result was last Thursday's 214-point Dow Wow that made me feel like a "goat" since I'd been telling folks I was confused on the stock market's near-term direction and therefore recommended no trading positions.

The next day, however, I felt like a "hero" as the unemployment rate leaped to 5.5% (the highest level since October 2004). Shockingly, the recondite birth/death model, which adds jobs the government "thinks" are being created but can't actually count, added 217,000 jobs (before seasonal adjustments) to Friday's report or the numbers would have actually been worse. When the employment report was combined with crude oil's climb to new all-time highs ($138.54/bbl.), it set the stage for Friday's Flop that left the senior index down an eye-popping 395 points. The late week action caused one old Wall Street wag to exclaim, "Can you spell "schizophrenic"?"

Schizophrenic, as well as confusing, for the current investment landscape is like nothing I have seen in over 40 years of observing markets! The environment was, however, summed up about as well as I have seen by one particularly bright portfolio manager at the Muhlenkamp organization when Ken Dupre wrote (as paraphrased by me):

The two most important market trends I see today:

1) Banks and brokerages are being forced to de-lever as they bring their SPE (Special Purpose Entities) on to the B/S (balance sheet):

  • Increased margin requirements are forcing hedge funds to de-lever.
  • De-leveraging will lead to a decrease in consumer, corporate and commercial real estate credit.

This will cause decreased spending for consumers, poor credit businesses and commercial real estate.

2) Legislation:

  • CNBC talked about legislation adding margin requirements to CDSs (Credit Default Swaps, a $45 trillion world market). Many in the commodities market have been using some form of CDS instead of commodities futures because there currently are little to no margin requirements. If rules for CDSs are changed, it would force a lot of selling of commodity CDSs.
  • There are also possible legislative limitations on commodity trading, which would produce similar or add to CDS requirements.
  • It's clear to me that the increase in asset allocation (money flow) to commodities by pensions and the public has been a major contributor to the driving of higher oil and other commodity prices. And if commodity buying dries up (prices looking awfully high), there should be one strong down draft.

I'm still uncomfortable with a deep recession call.

  • The world is exhibiting strong economic growth; increased utilization of the vast amounts of under-utilized human capital in China/India (1/3 of world population) will continue to drive strong world productivity.
  • The U.S. consumer has decreased in influence. U.S. GDP has gone from 30% [of the world's GDP] 15 years ago to 27% in 2006 to probably >25%? (currency down 20% since 2006 and U.S. has under-grown world GDP) today. A 5% decrease on 30% = 17% less influence.
  • The Fed is currently goosing the economy with a 2% discount rate.
  • The U.S. dollar is cheap. US Steel is suggesting they are the low cost producer; U.S. coal exports are rising; Industrials export strength is growing. U.S. exported 11% of GDP in 2006.
  • Energy and mining companies' employment is booming.
  • Consumer income (CDI) has continued to grow in the face of our current turmoil.

However, I do see a slow economic growth/recovery while we digest:

  • More RMBS (Residential Mortgage Backed Securities) and related CDO (Collateral Debt Obligations) charges; coming CMBS (Commercial Mortgage Backed Securities) and CDS charges;
  • Deleveraging of bank/brokers/hedge funds;
  • More efficient ways of creating/using energy and raw materials. Current high prices are decreasing demand and fat profits are beginning to grow supply. The breaking of commodity prices will keep inflation in check.

The market is cheap at a 16x P/E multiple (vs. 19 P/E a year ago) on depressed financial earnings, and there is a lot of cash on the sidelines. To me, this suggests a slow, rising, more volatile market. I am also a seasonal man and believe there are always bargains to be found in September/October, so having some cash today, or raising some this summer in rallies, should be useful this fall.

I think Ken Dupre's comments are "spot on" and would emphasize that the deleveraging of corporate and consumer balance sheets, combined with increased regulation/legislation, suggests an economy that will, at best, "muddle." This is consistent with my continuing thoughts that the government's increasing movement toward intervention, and over-regulation, is my biggest concern! The only point I would contest in Ken's comments is whether stocks, in the aggregate, are really "cheap." To be sure, using most interest rate-based valuation methods (Fed Model, Dividend Discount Model, Earnings Yield Gap, etc.) stocks are "cheap." However, using Graham & Dodd type measuring sticks (Price to book, price to dividends, price to earnings, etc.) stocks are more of a neutral value.

Nevertheless, for whatever reason, last week's schizophrenia caused the S&P 500 (SPX) to break below its May reaction low rendering a near-term price target into the 1320 – 1330 support zone. If that occurs, I'd consider initiating "long" trading positions like I did at the January/March trading "lows."

It should also be noted that my firm's proprietary oversold oscillator is close to rendering its first oversold "buy signal" in years. If the SPX slides into the aforementioned support zone, it would likely tip my oscillator into "buy" mode. In the interim, as stated all last week, I "wait" in the trading side of the portfolio. For investors, however, I continue to be an opportunistic buyer, noting that many of my recent investment ideas acted pretty well last week. Indeed, Strong Buy-rated Delta Petroleum (DPTR) was up 18% for the week driven by expectations that drilling results from its Paradox Basin wells will make good reading when they are reported in July. Similarly, 10% yielding, Outperform-rated, LINN Energy (LINE) was up nearly 5% on the week, while 6.8% yielding Alaska Communications (ALSK) and 5.8% yielding Embarq (EQ) resisted last week's market machinations.

The call for this week: Friday's Dow Dive of 3.24% was the first 3% down day since February 2007 when the senior index was carving out a "bottom." It was also a 90% Downside Day (points and volume were 90% to the downside), following Thursday's 80% Upside Day, in true schizophrenic style. Also schizophrenically, oil and gasoline soared to new all-time highs, while the energy/economic sensitive D-J Transportation Average "tagged" a new all-time high.

Meanwhile, General Motors' (GM) shares fell to a multidecade low (so goes GM, so goes the economy), consumer net worth is down 1.0% year-over-year, the FDIC insurance deposit fund is close to its minimum statutory level, tax rebate checks appear to be driving the federal government's deficit to over $450 billion, Britain is running dangerously short of electricity, the Gangotri glacier (one of the Himalayan's largest glaciers) has shrunk by half a mile in the last 25 years (I continue to embrace the theme of companies playing to the rebuilding of the electric/water infrastructures), the Baltic Freight Rate Index registered new reaction highs (read: buy the dry bulk shippers), NYSE short interest is at record highs, Ed McMahon's house (Johnny Carson's sidekick) is in foreclosure, and I keep asking myself, "How can inflation moderate from such an allegedly low level (read: core levels)?"

Indeed, curiouser and curiouser, which is why I continue to chant, "Sometimes me sits and thinks and sometimes me just sits!" Manifestly, "It's a Mad, Mad, Mad, Mad World!"

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