Sector Investing

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Raymond James Investment Strategy
by Jeffrey Saut

http://www.rjf.com/inv_strat.htm

7–11 is a winner on the “come out” roll of a crap table. Similarly, the date 7–11 was a winning “roll” last Friday as participants ignored Thursday's 120-point Dow Dump and took stocks straight up from the opening bell. The causa proximas for Friday's fling were ratings upgrades for Intel (INTC/$23.34) and Home Depot (HD/$33.17/Strong Buy), as well as GE's (GE/$28.82) ability to pull another earnings “rabbit” out of its hat. Unfortunately, we were not around to see the upside fireworks, having been tapped as a speaker for Raymond James' Summer Development Conference in Orlando. As usual, we found the depth of knowledge of the 200 Financial Advisors attending the conference to be stimulating and thought that we would spend the preponderance of this morning's comments reprising some of their questions, since we think said questions represent a microcosm of what inquiring minds currently want to know about the stock market.

Obviously, the foremost question was, “Is this a new bull market?” As we have often stated, “That depends on your definition of a bull market.” If you consider a 20%+ rally to be a bull market, then in retrospect we think you will see a plethora of mini-bull and bear markets over the next few years. Yet, our definition of a secular bull market does not “foot” with the 20% rally consensus view. Verily, secular bull markets begin with stocks selling at below “known” values (P/E multiples below 10x, price-to-book below 1x, S&P 500 yielding above 5%, etc.). Moreover, at the beginning new secular bull markets are ALWAYS greeted with universal disbelief, unlike this rally. Further, typically the leading sectors of a new bull market are NOT the leaders of the last bull cycle, which in this case suggests that technology stocks would not be the leaders if this were a new bull market.

As Susan Berge of the astute Berge Consulting Group notes:

“It is remarkable that this kind of [bullish] sentiment has so easily returned, after the devastating declines most people have suffered over the past three years. There are certain things that happen at major stock market bottoms that haven't happened yet. There are certain things that happen in recessions that haven't happened yet. Unless it's different this time, these things are going to unfold the way they have in previous cycles. At current price levels, the stock market is fundamentally overvalued and technically vulnerable.”

Given our trading range strategy, we clearly agree with Ms. Berge, sensing we are at, or near, the top of the range. Additionally, we would note that after every secular bull market peak in history the markets at best have gone sideways for a period of years. At the peak of the 1946 to 1966 secular bull market the ensuing range-bound market lasted 16 years. While we are hopeful that this trading range market doesn't last that long, we continue to believe it is not anywhere close to being over.

“But Jeff,” follows question number two, “What about the Dow Theory buy signal you discussed back at the beginning of June. Doesn't that constitute a new bull market?” While it's true that by our pencil Dow Theory registered the first buy signal since its sell signal that we wrote about in September of 1999, that doesn't necessarily constitute a new bull market. Indeed, as we were taught, Dow Theory needs to be taken within the context of valuations. At the 1982 Dow Theory buy signal, the S&P 500 had a P/E multiple of 8x, a dividend yield of 6.3%, and a price-to-book value of less than 1x. While we can accept that valuations probably won't get that cheap again given the current low interest rate environment, the current S&P metrics of a 33x P/E multiple, a dividend yield of 1.7%, and a 2.9x price-to-book are hardly bear killers. Even using what we consider to be the over-optimistic 2003 operating earnings estimate of $53 renders a lofty forward P/E multiple of 19x, while using the more accurate “reported earnings” estimate produces a P/E multiple of 23x. So no, we don't think this is the start of a new secular bull market. That said, we do believe there will be many opportunities to make money, just like there were in the 1966 to 1982 trading range environment, which by the way saw a number of Dow Theory buy and sell signals.

That brings us to question number three, “What about the current ubiquitous 'call' for a robust economic recovery?” Flatly, we don't believe it! Indeed, we remain in agreement with our economist Scott J. Brown, Ph.D., who thinks economic growth will likely approximate 2%-to-3% and that just isn't enough growth to “suck up” the excess capacity that exists in the system. What is required is 5%+ GDP growth and that is just not in the cards, in our opinion. Furthermore, we would note that there is absolutely NO correlation between GDP growth and stock market performance. For example, many countries have outperformed the U.S. on a GDP growth basis, but few have outperformed our equity markets. Manifestly, stock performance is linked to profits and corporate governance and unfortunately profits are only improving at crawl speed.

As for the often quoted “productivity miracle,” regrettably, productivity growth only means that hours worked have risen less than GDP. Consequently, we think productivity growth is not the panacea that most believe! If there is insufficient demand, like now, increased productivity only results in more unemployed workers, reduced capacity utilization, and subsequently lower growth! Consider this–for the past eight years productivity has been growing at a little over 2% per annum. Meanwhile, the labor force has grown by about 1% per year. That implies that real GDP must grow at better than 3% (2% + 1%) to create new jobs and as stated, we just don't see that happening. Ladies and gentlemen, without job growth consumer spending should begin to wane and the main engine for world growth should start to sputter, but not stall.

Alas, all of this leaves us little changed from our “muddle through” economic view and concurrent trading range stock market strategy. We do think there will be a modest economic pick-up in the second half of this year, spurred by the tax cuts that went into effect last week, the low interest rate environment, and a Fed that is pumping up the money supply at a very rapid rate. Which brings us the most asked question of the Summer Development Conference, “Given your scenario Jeff, how do we invest?”

Here we have not changed much. For investors we continue to like unlevered (little debt) real assets that throw off good cash flows and hopefully pay a dividend. The timber company Plum Creek Timber (PCL/$26.88) is a good example and has a 5% tax favored dividend. Certain REITs qualify as well and for ideas here we suggest consulting Raymond James' research universe. Sticking with the dividend theme, it is worth noting that we have now had five consecutive quarters of earnings growth and therefore should see some decent dividend increases driven by the government's new tax treatment of dividends. Last week we proffered that if participants could anticipate a sizable dividend increase, or the start of a dividend, by certain companies, it could prove to be a profitable strategy. To that point, we offered a few such ideas that hit our “screens” as potential candidates, those being: AOL (AOL/$16.44/Market Perform), Circuit City (CC/$9.04/Strong Buy), Cisco (CSCO/$18.57), Citigroup (C/$46.15), and Tyco (TYC/$18.87).

Moving up the risk curve a bit, we find the track record of the RJ&A Analysts' Best Picks list to be truly amazing. Its five-year (1998–2002) averaged annual return is 46.9% versus the S&P 500's return of 1.2%. That outperformance continues this year with the Analysts' Best Picks up 20.43% from its 12/6/02 start through 6/30/03. That return compares to the S&P 500's return of 6.83% over that same timeframe. While the Analysts' Best Picks list assumes that investors just buy and hold the names in said list until the next Analysts' Best Picks list is published this December, a number of Financial Advisors (FAs) use variations on this theme. For instance, one FA buys all of the Analysts' Best Picks stocks in December and then as a risk management technique sells any stock that declines by 20%. Another FA buys the list and uses their individual stock charts to determine when one of the holdings should be sold. Whatever technique one uses, the Analysts' Best Picks list performance has been amazing.

For those investors not wanting to be as proactive as necessary to operate in the trading range environment we foresee, we have suggested smaller, more nimble mutual funds that hopefully have some kind of “sell” discipline in order to avoid the big loss. Along this line our resident technical analyst, Art Huprich, shared some such mutual fund ideas with the FAs attending our presentation at the conference. We also think sector selection will prove tantamount going forward and therefore recommend Pimco's new “All Asset Fund” where the sector decisions will be made by the brilliant Bob Arnott. As for individual money managers, we recently shared the podium at a seminar with one Jim Barkdale, president of Equity Investment Corporation (EIC) based in Atlanta, Georgia. EIC's investment philosophy is centered on providing decent investment returns with below market risk. We like Jim's risk adverse investment style, as well as his very good track record. We would suggest contacting a Raymond James Financial Consultant for additional information on EIC.

The call for this week: The bears can't even get a couple of back to back down days to say I told you so. Consequently, the bulls are back. With all the good earnings due this week, look for a plethora of Wall Street upgrades, a cheerlead from Alan Greenspan on Tuesday and Wednesday, and an upside tilt to this week's option expiration. All enough to break the Dow and S&P 500 out above their June highs and finally confirm the NASDAQ's upside breakout. If that happens, we would sell 'em short.

July 14, 2003