Investment Strategy

June ,16 2008

“Sometimes me sits and thinks and sometimes me just sits!”

“A friend of mine, Eric Hanson, who runs Hanson Investment Management, publishes a regular investment letter. . . . (We) recently discussed soccer (known as football in most of the world). According to him, ‘football matches are low-scoring affairs and often decided by a penalty kick’ (and some matches, at the end of the game by a penalty shootout). ‘The goalkeeper is just 36 feet away from the player taking the shot and he has all of 0.2 to 0.3 seconds to respond. Not surprisingly, the kicker has the overwhelming advantage here. Eighty percent of penalty kicks score. But academics have asked an interesting question recently: even with the long odds, how best can a goalkeeper react to stop a penalty kick? By lunging left, by lunging right or by just sitting tight and staying right in the middle? Ofer Azar, a lecturer in the School of Management at Ben-Gurion University of Negev, in Israel, and two associates studied 311 penalty kicks from major leagues around the world. What they found was that lunging left or lunging right had about the same chance of stopping a penalty kick but simply doing nothing and staying right in the middle has twice the chance of making the stop. Goalkeepers, however, almost never do nothing. They remain in the centre only 6.3% of the time even though statistically this is the thing to do. Why the preference for action? Goalkeepers say that doing nothing opens themselves up to criticism – ‘you did nothing!’ Nobody criticizes you if you lunge left or lunge right.’” “I decided to quote Eric Hanson’s report because every day I get numerous emails from investors around the world who wish to receive ‘buy’ signals on everything from sugar and Chinese stocks to the dollar and gold. In other words, it seems that most investors are very short-term and trading oriented, which, as explained above, is likely to lead to disappointing results. In addition, all of the emails I receive, 99% concern buying opportunities, which shows that investors are far more concerned about missing further asset price increases – especially equities – than about incurring further losses.” . . . Dr. Marc Faber “Sometimes me sits and thinks and sometimes me just sits” is an axiom that has saved us a lot of money over the years because we have learned the hard way that when you attempt to “force” a trade, or an investment (lunge left or lunge right), it tends to be a prescription for losing money. Indeed, as Charles Dow wrote, “The successful investor must be willing to ignore two, out of every three, potential money making opportunities.” Accordingly, since recommending raising some cash at last May’s reaction price “highs,” we have been “sitting” awaiting another good trading buying-point like the ones we identified at the January and March “lows.” As stated, our preferred downside target has been the 1320 – 1330 level, basis the S&P 500 (SPX/1360.03), and late last week the SPX “tagged” the upper end of that envisioned zone. Conveniently, in last Thursday’s verbal strategy comments, we actually suggested a scale “in” buying approach for trading accounts given we were near our target zone, as well as the fact that our proprietary overbought/oversold Trading Index was more oversold than it has been in years. Almost on cue the SPX carved out a trading bottom and has subsequently lifted some 30 points. The question now becomes, “How long should any rally last and how far can it carry?” To this question the astute Lowry’s organization noted in Friday’s report. “The longevity of a rally is directly correlated to the strength of investor Demand during the rally. If Demand is broad and persistent, the gains could be significant. But if Demand is weak and selective, then the rally might best be used as an opportunity to sell.” Since we are only two days into the rally it is still too early to determine the extent of  investors’ “demand,” but we are constructive in the short/intermediate-term provided we are not in one of these 17- to 25-session “selling stampedes” (we doubt it). Our near-term constructive stance centers on the sense that what we are likely going to experience is a “W”- shaped economic pattern. To wit, while we have repeatedly stated the economy is slowing, we have also been steadfast in the belief there would be no recession in 2008 (two negative quarters of GDP). That sense was/is driven 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, we have been inclined to give this economic stimulus program the benefit of the doubt. That said, we have proffered the economic slowdown might be interrupted by improving economic statistics (like we saw last week) spurred by the stimulus package. Moreover, this short-lived economic rebound should give participants the impression that all of our economic troubles are behind us, fostering a rally in the stock market. To us, the envisioned economic rebound would represent the middle part of the “W” pattern. Unfortunately, we think such a strengthening economic sequence will be accompanied by stronger than expected inflation readings, causing the Federal Reserve to raise interest rates, thus slowing the economy again; aka the back half of the “W,” or an economic double-dip. Last week the Federal Reserve reinforced our sense that we are in the middle part of the “W” when Ben Bernanke declared “Mission Accomplished” and changed his focus from “downside risks to the economy” to “inflation concerns.” Clearly the Fed is worried the inflation “Genie” is climbing out of the bottle; and, if that happens, it is going to be very difficult to put said Genie back. Adding to the inflation worries were last week’s Import Prices, which rose at a 17.8% year-over-year ramp rate (the highest since 1983), with the exfuels Import Prices component increasing 6.1% year-over-year led by a 4.6% gain in import prices from China, causing one savvy seer to lament, “the days of importing deflation are over!” Also bolstering our near-term stock optimism is a sense the “political will” has reached a tipping-point, whereby there is going to be a concerted governmental effort to arrest the vertiginous rise in the price of crude oil. You can already see the movement toward this end from proposals to ban speculators from the crude oil trading “pits” to dramatically increasing margin requirements. Notably, history shows that a $10 per barrel drop in the price of oil tends to translate into an additional point of P/E multiple expansion for stocks. Consequently, when we combine the aforementioned gleanings with the fact that it is going to be VERY difficult to have a negative “real” GDP report in 2Q08 given the recent strengthening economic numbers (retail sales, trade numbers, unemployment claims, PMI, etc.), we have got to be optimistic that the equity markets are carving out a near/intermediate-term bottom. To us, last week marked a major change in the “body language” of the Federal Reserve. Our sense is that the Fed is now going to jawbone the U.S. dollar higher, and attempt to talk interest rates marginally higher, even though we don’t think the Fed will raise rates in the short run. Meanwhile, the politicos are trying to break the price of crude oil and other commodities. All of this is giving the “Street” the sense that the worst is in the rearview mirror; and, that even if Lehman Brothers (LEH/$25.81) defaults the Fed’s “checkbook” will bail them out in a Bear Stearns déjà vu dance. These perceptions are why I believe we have entered the middle part of the envisioned “W”-shaped economic environment, which should cause stocks to lift. And, at least the corporate insiders are listening, for insider selling has fallen more than 60% year-over-year, while insider buying is up by about the same amount. Despite this optimism, however, many portfolio managers (PMs) seem to have adopted a new investing mantra – invest not to make money, but rather not to lose money – as many of their favorite stocks have recently experienced “air pockets” on the downside. The PMs know that they have to stay pretty fully invested so there seems to be a scramble for “safe” stocks. However, even these alleged “safe” stocks are breaking down, as can be seen in the chart patterns of General Electric (GE/$29.15), Pfizer (PFE/$17.99), Home Depot (HD/$27.53/Strong Buy), Eastman Kodak (EK/$12.83), etc. as things continue to get curiouser and curiouser. The call for this week: In last Monday’s missive we wrote, “For whatever reason, last week’s schizophrenia caused the S&P 500 to break below its May reaction low, rendering a near-term price target into the 1320 –1330 support zone. If that occurs, we would consider initiating ‘long’ trading positions like we did at the January/March trading ‘lows.’ It should also be noted that our proprietary oversold oscillator is close to rendering its first oversold ‘buy signal’ in years.” Later that week, in Thursday’s verbal strategy comments, we told participants to begin a scale “in” buying approach in the indexes (ETFs) of their choice with close trailing stop-loss points. On Friday that “call” looked pretty good, but as Lowry’s notes, “The longevity of a rally is directly correlated to the strength of investor Demand during the rally.” While only time will tell if this “lift” can gain momentum, we are optimistic and would point out that unlike the Bear Stearns crisis, gold is ot rising and the U.S. dollar is not diving. These are NOT unimportant observations since last week’s news environment was certainly “dollar dour.” P.S. – I am in New York for the next few days so this may be the only strategy comment for the week.