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Investment Strategy
by Jeffrey Saut

It's learning!

April 17, 2017

Back in 1983 I was enthralled with the movie “War Games.” According to Wikipedia:

WarGames is a 1983 American Cold War science fiction film. The film stars Matthew Broderick, Dabney Coleman, John Woods, and Ally Sheedy. The film follows David Lightman (Broderick), a young computer hacker who unwittingly accesses WOPR (War Operation Plan Response), a United States military supercomputer originally programmed to predict possible outcomes of nuclear war. Lightman gets WOPR to run a nuclear war simulation, originally believing it to be a computer game. The computer, now tied into the nuclear weapons control system and unable to tell the difference between simulation and reality, attempts to start World War III.

The sequence from the movie that “stuck” with me was near the end where it was suggested that the WOPR computer was actually learning from the game simulations that any nuclear attack by the U.S. was a losing proposition (War Games). Similarly, it appears to us that President Trump is “learning” on the job, just like WOPR did in the movie. I mean just last week our president embraced many of the “things” he had campaigned against. Now it appears Janet Yellen may stay as Fed head, NATO is no longer obsolete, China doesn’t manipulate its currency, the U.S. dollar is “too high,” and the list goes on. Add to that a decidedly stiffer foreign policy strategy with the Syrian missile strike and the “Mother of All Bombs” (MOAB: the GBU-43/B) that was dropped on an ISIS bunker complex in the Achin district of eastern Afghanistan. Up until now the stock market has turned a deaf ear to such events, but that seemed to change late last week.

Indeed, to Andrew and me it has seemed quite eerie to see the stock market hanging in there given the geopolitical environment, the Atlanta Fed cutting its GDP growth estimate for 1Q17 in half (to +0.6% from +1.2%), the Federal Reserve raising interest rates, in-fighting in D.C., a potential Whitehouse staff shakeup, the potential for a confrontation with North Korea over the long weekend, China threatening to bomb North Korea’s nuclear facilities if it crosses Beijing’s “bottom line” (Bomb), and hereto the list goes on. As we suggested on TV last Thursday, “Who wants to be long trading positions going into the Easter weekend given the skein of events last week?!” Of course we have been pretty much of that mindset since the first week of February following our models’ negative “flip” at the end of January. Meanwhile, many “seers” continue to come out with four or five new investment/trading ideas every day, but most of them are losing opportunities. As Warren Buffett says, “One or two good ideas a year are all you need!”

As for us, since going dormant at the beginning of February we too have listed a number of ideas for your potential “buy lists” if the equity markets ever managed to drop into our models’ target zone of 2270 – 2280 so often mentioned in these missives. But to repeat, these are for your potential “buy lists” because as Warren Buffett points out:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle – an undervalued investment opportunity.

Last week, however, after ignoring most of the geopolitical threats, the S&P 500 (SPX/2328.95) took a decided step toward our models’ target level when the SPX broke below last Wednesday’s intraday low (2341.18), as well as last Tuesday’s intraday low (2337.25), to close at 2328.95 bringing into view the March 27 intraday low of 2322.25. If that level “falls” the odds of a test of our 2270 – 2280 target zone increase noticeably. So, the “polarity flip” we thought would occur last week arrived and as anticipate it was to the downside. It should also be noted that our measurement of the stock market’s “internal energy” levels are almost back to a full charge implying if the downside gets going there is enough energy for a decent move. If that is the case, the strongest “energy flows” should come early this week suggesting the potential for a trading bottom late week. Also suggestive of a trading bottom are the Volatility Index (VIX/15.96), the CBOE Put/Call Ratio, and the sentiment readings.

Consistent with these thoughts, we were intrigued by a list of companies compiled by Goldman Sach’s David Kostin that he thinks can expand their profit margins by at least 50 basis points, and increase sales by more than 4%, in both 2017 and 2018. The names from said list that are rated positively by our fundamental analysts, and that screen positively on our models, include: Netflix (NFLX/$142.92/Outperform), Expedia (EXPE/$128.13/Outperform), Abbvie (ABBV/$64.13/Outperform), Masco (MAS/$33.09/Outperform), Qorvo (QRVO/$68.48/Outperform), and Nvidia (NVDA/$95.49/Strong Buy). Yet to reiterate, these names are for your potential “shopping list” because as Warren Buffett states, “One or two good ideas a year are all you need.”

The call for this week: Last week Mark Hulbert published an excellent article about Dow Theory (Hulbert). He only made one mistake when he wrote that Dow Theory was created by William Peter Hamilton when in reality it was created by Charles Dow. Granted refinements were made to Dow Theory by Hamilton in the 1920s, Robert Rhea in the 1930s, George Schaefer, and my friend Richard Russell, but the theory originated with Charles Dow. There are not many of us left that IMO know how to correctly interpret Dow Theory, and by our pencil Dow Theory remains solidly bullish with the primary trend “up.” So over the weekend nothing happened with North Korea and this morning the equity markets are giving a sigh of relieve with the preopening futures relatively flat. Yet, retail sales have fallen for the second month, Japan is readying for a North Korea emergency, Vice President Pence warns North Korea on U.S. resolve shown in Syria and Afghanistan, the Pentagon is protecting the U.S. electric grid, bank loan growth has stalled, bank stocks that have led the rally are now in full retreat, President Trump says, “North Korean problem will be taken care of,” and the preopening S&P 500 futures are only off 3 points as we write at 5:00 a.m. In our view prudence demands caution here with the SPX only six points away from the March 27 reaction low of 2322.25.

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Shad Rowe

April 10, 2017

I spoke with uber investor Frederick “Shad” Rowe, captain of Dallas-based Greenbrier Partners, last Thursday. Shad always has great investment insights, and his March letter to investors was no exception. I like Shad’s letter:

Traditionally, there have been two proven, well-worn paths available to investors seeking financial security or riches. The first has been compounding money through the ownership of publicly traded securities. The second has been through being a technology entrepreneur or knowing the right venture capitalists. For most investors the first path was too slow and too unsteady, while the second path produced too little boom and too much bust. Obsessed with its own short-term profitability, Wall Street lost interest in the first path and has been intellectually and financially unequipped to be of any real use with the second path. It was assumed that these two paths were separate and mutually exclusive, making it impossible to travel both paths at the same time. One saw oneself as either a patient investor or as a venture capitalist. I chose the path of patient stock market investing. It was the more conservative approach, but it was the more assured.

Amazingly, however, it would seem as though the two paths have re-converged. The four dominant technology companies we own are Facebook, Apple, Google, and Amazon. These companies, which represent about 45% of our equity at market, have the potential to both compound their earnings predictably and have dramatic step-ups in value – if their venture investments pan out. What is proven and recognized is that these companies have been winners. Everybody gets that. What we believe is proven but not yet recognized is that these companies can be far more than long-term compounders. The companies that we have invested in appear to grow more powerful by the day. They have wonderful business models, massive scale and have (and can attract) the best, most creative people, the best ideas, the best science, the best resources, the most extensive market knowledge, and nearly unlimited venture capital arms funded by their enormous cash flows, so they can buy or build any great technology they want. These companies also have locks on ways of doing things, rather than just locks on individual things, which allows them to evolve.

It has become a winner-take-all world, with only a few winners and many, many losers. Together, FB, AMZN, AAPL and GOOG spent $82 billion on capital expenditures, research and development and acquisitions in 2016. They currently have $289 billion in net cash. This compares to $42 billion raised by 253 venture capital firms in 2016. Further, these companies provide true value to society, sometimes by disrupting the seemingly entrenched monopolies of the past that do things to, rather than for, their customers, and by revolutionizing the ways we do almost everything else, which is really the point. Rather than selling a product or service, what these companies are really selling are new, better and more fun ways of doing things. As we have said before, we want to own the agents of change and avoid the targets of change.

Boy, do I agree with Shad on those points and would note that these companies resemble what Warren Buffett refers to as “companies with an economic moats around them.” According to Investopedia:

The term economic moat, coined and popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.  Remember that a competitive advantage is essentially any factor that allows a company to provide a good or service that is similar to those offered by its competitors and, at the same time, outperform those competitors.

Shad’s investment model is very much reminiscent of this quip from Brown Brothers Harriman: “Our aim is to identify great businesses, buy them [the stock] at a discount and patiently wait for the market to recognize their value. We believe this is the best recipe for consistent long-term investment results. In our book, patience is more than a virtue: it’s a necessity.”

There’s that word “patience” again, and as often opined in these letters, “Patience is the rarest commodity on Wall Street!” So, in mid-February the S&P 500 (SPX/2355.54) was changing hands around 2355 and as of last Friday it closed at 2355.54. Over that timeframe, we have seen mixed economic reports, a Fed rate ratchet, numerous terror tactics, a failed healthcare bill, a stronger and then weaker than estimated employment report, a filibuster, hints that tax reform may take longer than expected, a Tomahawk missile strike on Syria, and the list goes on. Given that skein of events, we find it somewhat bullish that stocks have hung in there. Speaking to last week’s missile strike, it has long been our belief that such events tend to not have any long lasting effect on the various markets, especially if it is a “discrete action” and not the beginning of a broader campaign. Our friends on Capitol Hill suggest that is exactly what last Thursday’s air strike was, a discrete action, which is likely why the market’s response was muted. Still, the SPX was unable to breakout above its downtrend line that has been in effect since the March 1, 2017 high (chart 1). Also worth mentioning is that the SPX once again held above its 50-day moving average (DMA). However, the Russell 2000 (RUT/1364.56) and the D-J Transpiration Average (TRAN/9104.81) have not stayed above their respective 50-DMAs (chart 2 and chart 3). Adding to the mixed signals is the fact that the average stock in the S&P 500 is down 18.4% from its 52-week high. Maybe these conflicting signals will be resolved this week since the stock market’s internal energy has been rebuilt and our models are looking for a “polarity flip.”

Meanwhile, 1Q17 earnings reports are slated to begin this week with expectations for a 9.1% increase in y/y earnings for the S&P 500. If correct, this would further reinforce our belief that the secular bull market has transitioned from interest rate driven to earnings driven.

The call for this week: The SPX has basically been trapped in a trading range between 2335 and 2400 since mid-February of this year as the forces of “light and dark” battle. Meanwhile, as we drill down into the economic numbers, Andrew and I think the economy is just fine. However, last week Jamie Dimon (JP Morgan) and Larry Fink (Blackrock) warned about weakening U.S. economic stats, and on Friday the Atlanta Fed cut its 1Q17 GDP to +0.6% from +1.2%. That comes as 1Q17 earnings are expected to post their strongest gains in years. Indeed, confusing! To reiterate, “Maybe these conflicting signals will be resolved this week since the stock market’s internal energy has been rebuilt and our models are looking for a ‘polarity flip’”. This morning, the preopening futures are again flat as China’s nuclear envoy is in South Korea amid talk of President Trump’s potential action against North Korea. As stated on Friday, “Do not play unless absolutely necessary because the environment is extremely unpredictable.” 

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Investment Strategy: Peter Pan?!

April 3, 2017

Washington D.C. is not considered a city noted for theatrical productions. Most of the central city empties out after work heading for the suburbs, and much of the downtown area is virtually deserted after dark. There are good bars, restaurants and hotels, but that seems to be the extent of nighttime activities. There was one play that did have a lengthy run in Washington. J.M. Barrie’s “Peter Pan” starring Sandy Duncan as “The Boy Who Never Grew Up” had the longest run at the time of any play produced in the nation’s capital. In an interview, Ms. Duncan was asked why the play had lasted as long as it did. Her answer was, “I think it’s because people in this town relate easily to fantasy.” I saw the play with Mary Martin in the title role. At each performance the actress (or actor) playing Peter Pan turns to the audience and says, “Do you believe in fairies? If you believe, clap your hands!” The last line is repeated until the house is clapping wildly.

. . . Ray Devoe, The DeVoe Report (2003)

I lived in and around the D.C. Beltway for years, and still have a good network on Capitol Hill. I have been thinking a lot about Ms. Duncan’s comments concerning people in D.C. easily being able to relate to fantasy given the current “fantasies” swirling around the “Beltway” since the presidential election. As the Trump administration entered the scene, the song “I Believe I Can Fly” was playing (I Believe), but alas such “beliefs” always seem to get dashed for the naïve newcomers, and 2017 is no exception. To be sure, the defeat of the AHCA bill (aka: Ryancare [H.R. 1628]) was a big blow to the Trump administration despite the fact it was a bad bill if you took the time to read it. BTW, very few people took the time to read the Obamacare bill (ACA) that just about any doctor will tell you is a complete disaster. So President Trump has decided to let the Affordable Care Act implode and then they will attempt to repair it. I think that will prove to be a very difficult task, but opinions vary.

Clearly, opinions varied last week on the Street of Dreams as the S&P 500 (SPX/2362.72) meandered through the week vacillating in a narrow range between 2341.59 and 2368.06 as buyers and sellers were evenly matched. In fact Friday’s trading range was between 2370.35 and 2362.60 making Friday yet another “inside day” because that range was inside Thursday’s trading range (2370.42 – 2358.58). According to Investopedia:

An inside day is often used to signal indecision because neither the bulls nor the bears are able to send the price beyond the range of the previous day. If an inside day is found at the end of a prolonged downtrend, and is located near a level of support, it can be used to signal a bullish shift in trend. Conversely, an inside day found near the end of a prolonged uptrend may suggest that the rally is getting exhausted and is likely to reverse.

Clearly the recent string of “inside days” has not come at the end of a prolonged downtrend since all we have experienced is a 3.3% decline. However, a support level was indeed found slightly above the upside chart gap created on February 13 of this year often referenced in these missives. The quid pro quo is that these “inside days” have not really occurred after a prolonged uptrend either, so if using Investopedia’s definition, these “inside days” are confused. Plainly that concurs with our short-term and intermediate-term proprietary models, which are back in sync in cautionary mode. Recall, both of those models target late-January/early-February as a potential window of downside vulnerability. Yet the short-term model flipped positive around the beginning of March while the intermediate model stayed negatively configured (read: confused). The recent stock market action, however, has caused our short-term model to again flip negative. We will note that the market’s “internal energy,” which suggested a pullback was coming, has been used up in the 3.3% decline and is in the process of rebuilding. While this could be the set-up for an energy release on the upside, our hunch is that it will come on the downside implying the long targeted 2278 level on the S&P 500 (SPX/2362.72) remains in play. Bear in mind that these “trading finesses” are just that, short/intermediate tactical trading “calls” because as my friend – oracle Leon Tuey – writes:

As mentioned, an internal correction has already commenced and is starting to broaden as since December several sectors have been correcting. In December, because of the grossly overbought condition and deteriorating sentiment backdrop, I felt that from an intermediate standpoint, the market was vulnerable to a correction. But given the widespread wariness, the huge cash pile on the sideline and improving fundamentals, the correction will prove to be more of a rotational/time correction rather than magnitude. Accordingly, emphasis should be on stock selection.

That’s very well said, so let’s reflect on the stocks featured in these missives since the beginning of February. All of the following stocks continue to have positive ratings by our fundamental analysts. Netflix (NFLX/$147.81/Outperform), Alibaba (BABA/$107.83/Strong Buy), American Financial AFG/$95.42/Outperform), Applied Optoelectronics (AAOI/$56.15/Strong Buy), DexCom (DXCM/$84.73/Outperform) and Trimble Inc. (TRMB/$32.01/Outperform) have all registered upside breakouts in the charts. Cavium (CAVM/$71.66/Strong Buy), Premier, Inc. (PINC/$31.83/Outperform) Hilton (HLT/$58.46/Outperform), Iridium (IRDM/$9.65/Strong Buy), Texas Bancshares (TCBI/$83.45/Outperform), ServiceNow (NOW/$87.47/Strong Buy), and Marinemax (HZO/$21.65/Strong Buy) have all gone nowhere, which is consistent with our observation that not much money has been made since the first week of February.

The call for this week: The week is chock-full of news and events. Economically speaking we get world market PMIs, ISM Manufacturing, Construction Spending, auto sales, and the jobs report to names but a few. As for events, we have the Michael Flynn scandal, the President Trump and China’s President Xi meeting, the continuing Russian brouhaha, the “leaks” about Kushner, Ivanka, and Gary Cohn, the Gorsuch vote, numerous Fed speakers, the resignation of Reince Priebus’ deputy, well you get the idea. The sad fact is that President Trump has not really had a good day since his address to Congress. Hopefully that changes this week. And then there was this from Leon Tuey:

Keep in mind that the market’s secular trend remains powerfully bullish and no end is in sight. The market does not rise in a straight line. Corrections are normal and healthy; they should be bought and not feared. The media always have a habit of spreading fear because fear sells. No doubt, as the correction widens, the headlines will get blacker. It is important for investors to ignore the headlines as they tell you what happened yesterday, not what lies ahead. Focus on the “primary trend.”

As our readers know, we have been steadfast in the belief that the “primary trend” was, and is, bullish since the October 2008 – March 2009 bottoming process despite some of our short/intermediate-term “pullback calls.” This morning the preopening futures are marginally higher as Commerce Secretary Ross criticizes China as a protectionist country ahead of this week’s meeting with President Trump. But, it is later in the week when our internal energy measurement is slated to be released.

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