None of Us Connected the Dots?!

Investment Strategy: “None of Us Connected the Dots?!” [¹]

By Jeffrey Saut | 8 October 2007

As most of you know, I have been traveling rather extensively over the past five weeks and this week will be no exception. Interestingly, I spoke at a conference last Friday where one of Wall Street’s marquee strategists also spoke. Having often heard him speak, I sat dumbfounded as he waxed bearishly about the stock market’s prospects for 2008. This, I thought, is coming from a gentleman that typically would be bullish if they nuked New York because the infrastructure would have to be rebuilt! Indeed, during the entire technology "bust" he stayed outspokenly bullish all the way down. Therefore, I was truly stunned by his negative forecast and surprisingly, I agreed with many of his talking points.

His cautionary comments centered mainly on the U.S. stock markets and the rhetoric that is likely going to surface into the presidential election. That envisioned rhetoric should involve eliminating the favorable tax treatment on capital gains, dividends, and raising taxes pretty much across the board. He correctly noted that when "Hillarycare" was first proposed in 1993, even though none of its 11 tenets were ever passed, certain sectors of the financial markets lost billions of dollars in value just on the mere hint of change. Manifestly, one of the things that continues to worry us is the increasing movement inside the "beltway" toward protectionism, intervention, and over-regulation. And since financial markets are driven by fear, hope, and greed, only loosely connected to the business cycle, investors should take heed.

While he thinks the U.S. equity markets will stay perky into year-end, given the aforementioned forecast, municipal bonds are his investment du jour for 2008 because their tax-free yields should attract the money exiting dividend-paying stocks on the tax-hike campaign rhetoric. He is also bullish on the international markets, as well as commodities (stuff), opining that a synchronous emerging market "boom" began when China joined the World Trade Organization (December 2001) and that "none of us (referring to all Wall Street strategists) connected the dots" and tilted their recommendations accordingly. And with that statement, we take GREAT exception since we have been unwaveringly bullish on stuff-stocks, and international markets, since 4Q01.

We also take exception with his strategy of being heavily over-weighted in Chinese equities. While we have made a lot of money during the past six years investing in stocks that play to things China and India need (cement, timber, copper, iron ore, etc.), we have eschewed direct investments in China. Our so far wrongfully based fears have been due to China’s expensive valuations (P/E, P/Book, P/Cash Flow, etc.), its communist party’s ability to manage the prodigious economy, and our sense that eventually the country’s banking complex is in for a dramatic shakeout.

[ Normxxx Here:  Whereupon, the Communist party will "do its thing—" whatever they think that is— and to hell with the "hairless barbarians" (foreign investors)  ]

Verily, none other than Alan Greenspan has stated, "the Shanghai stock market looks like a bubble." Of course, this comes from a man who claimed not to be able to spot "bubbles."

Another way to invest in the Chinese growth story is via Taiwan. Taiwanese companies have many of the same opportunities as Chinese companies without the nosebleed valuations. You could, however, wake up one morning and find that China has decided to invade Taiwan, but then we would have a lot more than just investment problems on our hands. [[Moreover, I doubt your Chinese investments will do much better than your Taiwanese investments!: normxxx]] The Taiwan ETF (EWT/$17.60) is one of the easiest ways to invest in Taiwan, but there are also two closed-end funds: Taiwan Fund (TWN/$23.32) and Taiwan Greater China Fund (TFC/$8.14).

As for our overall international investment style, we have tended to keep it pretty simple. For years we have owned international mutual funds as our "core" foreign investments. One of the best has been the MFS International Diversification Fund (MDIDX/$17.76). We then overlay those core international mutual funds with ETFs, and/or closed-end funds, in countries that we want to overweight. Such countries have historically been: Brazil, Canada, Malaysia, Thailand, Indonesia, India, Australia, Mexico, etc. We continue to favor this strategy since we believe the international/emerging markets offer better value, and growth, profiles than our domestic markets.

Speaking to our markets, [the Friday before last] stronger than expected jobs report pushed the major stock averages to new highs. Of particular interest were the groups that have been lagging the senior indices this year that led last week’s rally. Indeed, the small capitalization stocks and the financials were the stars of the week, suggesting that investors think the credit-contagion issues are behind us. Other former laggards that came to life last week were the REITs, retailers, transports, and pharmaceuticals, causing one savvy seer to exclaim, "When they run the laggards, it’s time to get even more defensive!"

That said, while we were fairly aggressive on the long side at the mid-August lows, we have been defensively postured for the last few weeks and Friday’s or last week's Fling has not changed our view. It has, however, changed the view for many investors in that the sentiment numbers for both the AAII, and the Investors Intelligence, surveys have reached their highest levels in nearly a year. Meanwhile, as the DJIA has risen, the D-J Transportation Average (DJTA) has steadfastly refused to confirm the Dow’s upside breakout. Similarly, the D-J Utility Average (DJUA) remains well below its respective price-high of five months ago. Another important "tell" for the equity markets has historically been the Security Brokers Index (XBD/243.50), whose internal strength indicators have dropped to multi-year lows. Moreover, the selectivity of the current rally is concerning, for as the Lowry’s organization points out: "When the DJIA rose to a new all-time high on October 1st, only five of the thirty stocks (17%) rose to new all-times on that same day. [And] only ten components (33%) rose to new 52-week highs on October 1st. . . . The transitional stage from an old uptrend to an emerging downtrend is always the most difficult period in stock market analysis because of the cross-currents. The media keeps the spotlight on the stocks still making new highs, while an increasing number of issues are not participating in the rallies or are quietly slipping to new lows. However, as long as this rally continues, careful stock selection and narrowly structured portfolios will be critical to success."

Clearly, that strategy has been our focus as we have stuck with the mantra that, "Good things tend to happen to cheap stocks!" To this point, it’s worth noting that Pfizer (PFE/$25.58/strong Buy) is up 10.5% from its August low, Johnson & Johnson (JNJ/$66.25/Strong Buy) is better by 9.1%, and General Electric (GE/$41.77) has lifted 15.4%. Further, all of these names possess outsized yields. It’s also worth considering that these companies have a large exposure to international markets. And in GE’s case, its emerging operations are growing at twice the pace of its developed markets potential making this year the first year where GE’s sales outside the U.S. will exceed those of inside the U.S.!

In conclusion, unlike most of our counterparts, we can’t determine if the collateral crunch is going to morph into an honest-to-gosh credit crunch, which then has the potential to spill over into a recession [[Likewise, I have moved to the fence for the 'mild' recession I was expecting in late 2007 or early 2008, but I am still calling for the "Big One" by the end of 2009: normxxx]]. That’s why we are sticking with themes that should do well irrespective of economic circumstances. In addition to our international/ emerging markets and stuff-stock themes, we remain over weighted in pharma, defense, homeland defense, security, water, agriculture, energy, cement, base/precious metals, towers, RFID, electricity, etc.

The call for this week: Well, we are on the road again, making these the only strategy comments for this week. Today we are in Traverse City, Michigan overlooking East Bay, which is just off of Lake Michigan. Regrettably, the real estate situation here is no better than anywhere else even though this is a relatively protected resort location. And there, ladies and gentlemen, is the $64,000 question. Is the housing, financing, and collateral contagion situation behind us? As stated, "We don’t know and are unlikely to know for at least 60 – 90 days." In the interim, we continue to invest in cheap stocks on the premise that good things tend to happen to cheap stocks. We’ll speak to you next Monday.

Normxxx    
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