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Jeff Saut: The GE Effect


Market bellwether sets tone for equities.

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.

We began last week thinking the S&P 500 was poised to finally break out above the often discussed 1370 pivot-point and scoot into the mid-1400s.

And that was the way it looked like it was going to play last Monday until the early session surge, which took the S&P up to 1386, failed to sustain, leaving the index back at that "sticky" 1370 level by the closing bell. "Oh well," we thought, "If at first you don't succeed try, try,

Here too, that was the way it looked to play as the indices backed and filled into last Thursday's session as they stored up "energy" for another assault on 1370, or at least so we thought. Indeed, Thursday seemed to be the set-up for the envisioned upside sequence, but early Friday morning we got GE'd!

Readers of these missives know that after shunning General Electric (GE) since 1998, for the past few quarters we have periodically recommended purchase of these shares. GE was rated Outperform by our various research correspondents, and our sense was, and remains, that the sector-spanning conglomerate plays to a number of themes we embrace, its shares are statistically cheap, it possesses a bond-like dividend yield of 3.9%, it's a proxy for international growth, and it appeared to be a consistent "grower" and despite that growth its share price was 40% below where it was in the spring of 2000.

On Friday, however, GE shocked the investment world by "missing" its earning's estimate as the cry erupted, "If you can't trust GE, who can you trust?!" And with that, the market mauling was "on," causing a Dow Dump that would leave the senior index 257 points lower for the session.

Speaking to GE's ill-fated earnings report, Q1 2008 earnings per share were reported at $0.44 versus expectations of $0.51. Most of the shortfall was attributed to its financial-services unit, GE Capital, which accounted for $0.05 of the $0.07 "miss." Also on the softer side were GE's Healthcare and Industrial divisions, all of which offset
double-digit growth at the Infrastructure division.

GE's shares now trade for a reasonable 14.2 times 2008 estimated profits ($2.25 EPS), and just 13 times 2009 estimates, making the risk/reward ratio look pretty attractive given the 3.9% dividend yield. Fortunately, our investing strategy is always, and everywhere, to not buy anything all at once, but rather to scale buy into a situation three or four times. We think this is just such a time, for as Barron's noted, "General Electric's First-Quarter profit shortfall Friday shocked Wall Street, embarrassed the company and hurt the credibility of CEO Jeff Immelt. But it doesn't kill the investment case for the company, whose shares now trade about where they stood a decade ago."

Speaking of "things" that trade where they stood a decade ago, there was an interesting article in The Wall Street Journal titled, "Stocks Tarnished By [the] Lost Decade." The article pointed out that atypically, the S&P 500 has made no progress over the last nine years. To wit, "When dividends and inflation are factored in, the S&P 500 has risen on average 1.3% a year over the past ten years, well below the historic norm."

The article further notes, "Over the past nine years, the S&P 500 is the worst-performing of nine different investment vehicles tracked by Morningstar, including commodities, real-estate investment trusts (REITs), gold and foreign stocks." Of course, this should come as no surprise to clients of Raymond James since we first wrote about the Dow Theory "sell signal" in Q4 of 1999 and advised participants to not let anything go more than 15% - 20% against them, reduce high beta stocks in portfolios, and overweight REITs, as well as
defense-related stocks.

We modified that strategy following the tragedies of 9-11-01 by suggesting the bear
market was ending, but we were likely entering a trading range environment and not a new secular bull market. And that, ladies and gentlemen, is why we've eschewed index investing since the late 1990s in favor of a more proactive approach using select money managers, mutual funds, exchange-traded funds (ETFs), closed-end funds, and yes, individual stocks.

Moreover, in Q4 2001 we adopted the strategy of overweighting "stuff stocks" (energy, metals, timber, cement, agriculture, etc.), which certainly "foots" with what the good folks at Morningstar are referencing. Interestingly, however, the trading range environment could be coming to an end over the next few quarters, for as the insightful "Bespoke Investment Group" wrote in an piece titled "Rolling 10-Year Market Return Hits 30-Year Low:"

"In early March [2008], we performed a similar analysis in our 'The Lost Decade" post that highlighted the weak performance in equities since the new millennium began. We took the 10-year total return performance of the S&P 500 back to 1900 (non-inflation adjusted) and charted the results below (see chart below). When the line is highlighted in red, 10- year returns were lower than they are now. As shown, periods where returns were lower occurred in 1914, 1921, 1932, 1938, 1974 and 1977. We also highlight years where returns peaked -- 1929, 1959, 1992 and 2000. While the returns could easily get worse, periods that have been this bad have not lasted longer than 4 years (1937-1941) before they've started to get better."

Click to enlarge image

As for the short-term direction of the equity markets, while GE's 13% session swoon contributed only 36 negative points of the Dow's 257-point Friday Flop (because the DJIA is a price-weight rather than market capitalization-weighted), GE's psychological impact was much more severe. As Barron's put it, "If GE got stung, how will lesser companies fare?"

With the parade of upcoming earnings reports that question will likely get stress-tested this week. Unfortunately, the stock market has the right to change its mind on a dime and GE's "hairball" could be the linchpin that swings sentiment back to the negative side of the equation.

While only time will tell, we're still hopeful that the late-January "lows," and the subsequent March retest of those "lows," will prove to be the intermediate-term lows. Reinforcing that view is the fact that despite all the consternations, last week's wilt merely pulled the major averages back into the middle of their respective three-month trading ranges.

Moreover, while the DJIA and S&P 500 ended below their 50-day moving averages (DMAs), the Dow Jones Transportation Average, the NASDAQ Composite, and the Semiconductor Index (SOX) remain above their 50-DMAs. Further, the DJIA is some 350 points above its January closing low, while the DJTA is a whopping 642 points above its January

This is pretty amazing given soaring crude oil prices and all the bad news that's been thrown at the equity markets over the past few months.

Nevertheless, last week's failure by the S&P 500 at the 1370 level leaves a glaring upside failure in the charts, suggesting the rectangle formation of the last three months continues with the potential, repeat potential, of a downside retest of the lower-end of said rectangle.

Click to enlarge image

Consequently, we are raising stop-loss points on all trading positions. As for our investment positions, we remain comfortable with those positions, thinking our averaged-in prices on names like Schering-Plough's (SGP) $17.21/Strong Buy 8%-yielding convertible preferred "B" shares, Covanta (CVA) $29.15/Outperform, Delta Petroleum (DPTR) $26.03/Strong
Buy, Johnson & Johnson (JNJ) $66.00/Strong Buy, et all, afford attractive risk/reward levels for investors.

We continue to invest, and trade, accordingly.

The call for this week:
Gee . . . no GE; we got GE'd last Friday, and the psychological damage has the potential to change the near-term investment sentiment. Combine that with this morning's negative Wachovia (WB) news, and what is likely a 90% "down day" last Friday (I just got back from the conference in Palm Springs and have not had a chance to run the numbers), and is it any wonder the pre-opening S&P 500 futures are off 8 points?!

Therefore, it's important for the S&P 500 to gather itself "up" quickly, and rally, to regain its former health. If that doesn't play, the averages should revisit the lower end of the rectangle formation in the charts.
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