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Jeff Saut: Certainty or Uncertainty, You Pick It


January's employment report tends to set the market's trend into the State of the Union address.


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.

As we enter the new year, the media is replete with pundits stating that "there is a lot of 'uncertainty' and markets don't like uncertainty."

While I too am uncertain if the overspent, under-saved U.S. consumer is sated with debt; uncertain as to the extent of the mortgage mess; uncertain how much worse the housing situation is going to get; uncertain as to how market-impactful the "raise taxes" political rhetoric is going to get; and consequently uncertain about the economy, don't give me that hogwash that the markets like "certainty" and don't like "uncertainty." While at the margin this "uncertainty" comment might hold a modicum of truth, it is blatantly untrue at inflection points like the major market "lows" that occurred in 1933, 1937, 1942, 1949, 1974, and the summer of 1982, when "uncertainly" was ubiquitous! Moreover, just seven short years ago things were "certain" and investors embraced the "new era" mentality, right before the S&P 500 lost nearly half its value and the Nasdaq fell some 80%.

Plainly, "uncertainty" was rampant at last August's "lows" when it looked like the sub-prime contagion was going to topple a number of financial institutions. Yet I was bullish at those "lows," cautious at the subsequent mid-September throwback-rally "highs" and, bullish again at the successful late-November downside retest of those August lows. My mantra has been that I remain positive on stocks into year end, but enter the new year "in cautious mode." Still, even I was surprised by this year's first day of trading "trashing" (-220 DJIA). The resulting sell-off left the senior index below its December low and me thinking about the December Low Indicator that states if the Dow Jones Industrial Average (DJIA) breaks below its December low at any time during the first quarter of the new year, watch out!

Interestingly, the S&P 500 and the Nasdaq did not break below their December lows in last Wednesday's Wilt, potentially setting up a downside non-confirmation. Consequently, I noted last Thursday that "I am watching the Dow's November closing low of 12743.44, as well as the Dow Jones Transportation Average's (DJTA) closing November low of 4366.78, as fail-safe or "uncle" points since a penetration of those lows should be viewed negatively, as well as a confirmation of the November 21, 2007 Dow Theory sell-signal."

I further opined, "It should also be noted that I view the 1435-1440 level for the S&P 500 as an "uncle" point. If any of these levels are decisively violated, I would consider it to be the stock market's message that tough times lie ahead."

The quid pro quo, I said, "is that failing those downside violations should be viewed as a sign that the stock market has seen, and discounted, the worst with no recession on tap for the foreseeable future." Additionally, I have learned the hard way that the first few sessions of the new year can often be "noisy" and hence ignored. Therefore, I am currently sitting on my hands, consistent with another of my mantras: "Sometimes me sits and thinks; and sometimes me just sits."

To this point, last Thursday night 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 weeks of the new year are often accompanied by initial straight-up, or straightdown, 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's 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 had hoped that last Wednesday's weak ISM report, and concurrent 221-point Dow Dive, might preempt Friday's employment report and stated in Friday's strategy comments:

"My guess is today's numbers will set the tone for the next three weeks. If the report is Street friendly, the market's trend into the State of the Union should be irregularly higher. If, however, the report is bad, I think stocks will have a tough time into the January 28th address."

Intuitively, this makes perfect sense because a lot of folks set their "policy statements" on the State of the Union rhetoric. So as one portfolio manager said to me late Thursday, "Hey Jeff, believe in God, but be sure to tie-up your horse!" Clearly, that has been my strategy as I entered the new year in cautious mode.

Regrettably, Friday's employment numbers were ugly, with December Nonfarm Payrolls rising by a mere 18,000 versus expectations of +70,000. Worrisome is that the recondite birth/death model added 66,000 to that 18,000 figure, or Nonfarm Payrolls would have actually been negative. Also of worry is that the Unemployment Rate rose to 5% (median forecast was 4.8%), its highest reading since November 2005 and 0.6% above the low water mark of 4.4%. Myles Zyblock, of RBC, had this to say about the employment report:

"We flagged all periods since 1948 when the unemployment rate increased by greater than or equal to 0.6 percentage points over a 12 month period. There have been 10 prior episodes where this has occurred. In all ten prior episodes we were in recession . . . all10! This is the eleventh such occurrence. It could be different this time but as we wait to find out, I think it is prudent to lower the risk in my equity portfolio."

While I am still not in the recession camp, and would note that employment figures are often revised, I still have to admit the odds of a recession have risen. And, when Friday's figures were taken in concert with last Wednesday's weak ISM report, it proved to be too much for stocks, leaving all of the indices I follow sharply lower into Friday's closing bell. The result also caused most of the indexes to break below their respective December lows, while some of them broke below their November, as well as their August, lows.

Surprisingly, the DJIA remains above its respective November low of 12743.44, potentially setting-up a short-term downside non-confirmation and a subsequent one- to three-session "throwback" rally since the markets are currently oversold (short-term, but not long-term, oversold). Nevertheless, history suggests that stocks should not regain their poise until after the State of the Union address, which is why I remain cautious.

That said, the recent economic data clearly shows the economy is slowing and that the mortgage/housing situation is worsening. In my opinion, this leaves the Federal Reserve with little choice other than to reduce short-term interest rates until the yield curve steepens.

A steepening yield curve should help financial institutions recapitalize and ameliorate some of the financial contagion. Recently, the markets seem to be telegraphing this outcome with the price of crude oil, gold, commodities, etc. all trading higher. The last time the Fed re-liquidified the system like this, equities were overvalued, while bonds, commodities, and real estate were undervalued.

Today the opposite is true. Indeed, using the Fed Model, which compares equities "earnings yield" (earnings divided by price) to the yield of the 10-year T'note, shows equities' "earnings yield" is more than 4% greater than the benchmark T'note's yield (according to a study of 29 various countries compiled by Lehman Brothers). The last time such a wide dispersion occurred was back in September 1974 right before the equity markets rallied strongly.

While other valuation metrics (price-to-book, price-to-dividends, price-to-sales, etc.) are nowhere near as "cheap" as they were in 1974, it is worth noting the Fed Model's current valuation in light of the probability of lower short-term interest rates. I mention the Fed Model this morning, for while I am cautious, I think it's a mistake to become too bearish.

As for my recommendation on Outperform-rated Verifone (PAY), I recommended buying a one-third tranche of PAY on its initial price collapse to under $20/share back in early December. I am considering buying a second tranche, and then still another one-third tranche somewhere in the future to complete this investment position. A similar strategy may be employed with Motorola (MOT) and Avnet (AVT). As always, I never buy, or sell, an entire position all at one time.

This strategy has served me well over the years, as can be seen with my tranche "in," and partially tranched-out, approach to Monsanto (MON), which was recommended in the mid-teens four years ago as part of my firm's agricultural theme.

Call For This Week: I think this is a critical week! The Transports (DJTA) are 106 points below their November low, while the Industrials (DJIA) are 57 points above their November low (a potential nonconfirmation).

Moreover, the DJIA has traced out a head-and-shoulders "top" formation in the charts (see chart below) and has fallen below both its 50-day moving average at 13340, as well as its 200-DMA (13366). Additionally, last week the Dow's 50-DMA crossed below its 200-DMA and thus, by my interpretation of moving averages, is negatively configured.

Click to enlarge

Click to enlarge

Further, for the past few weeks new daily lows have vastly exceed new highs. I have learned over the years that it is extremely difficult to make money in the equity markets when new lows are expanding over new highs. Consequently, my firm remains cautious. Recall, this is the same strategy with which I began 2007; and, it worked. The Analysts' Best Picks for 2007 returned 30.5% last year, while the Focus List gained 10.7%. Hopefully, this same risk-adjusted approach to the markets will treat me as well in 2008.


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