How to play the health-care reform

The following is an investment strategy column by Jeffrey D. Saut, managing director at Raymond James & Associates Inc.

“There was a Chemistry professor in a large college that had some exchange students in the class. One day while the class was in the lab the professor noticed that one young man (an exchange student) kept rubbing his back, and stretching, as if his back hurt. The professor asked the young man what was the matter. The student told him he had a bullet lodged in his back. He had been shot while fighting communists in his native country who were trying to overthrow his country's government and install a new communist government. In the midst of his story he looked at the professor and asked a strange question. He asked, ‘Do you know how to catch wild pigs?' The professor thought it was a joke and asked for a punch line. The young man said this was no joke. ‘You catch wild pigs by finding a suitable place in the woods and putting corn on the ground. The pigs find it and begin to come every day to eat the free corn'.”

“When they are used to coming every day, you put a fence down one side of the place. When they get used to the fence, they begin to eat the corn again and you put up another side of the fence. They get used to that and start to eat again. You continue until you have all four sides of the fence up with a gate in the last side. The pigs, which are now used to the free corn, start to come through the gate to eat, you slam the gate on them and catch the whole herd. Suddenly the wild pigs have lost their freedom. They run around and around inside the fence, but they are caught. Soon they go back to eating the free corn. They are so used to it that they have forgotten how to forage in the woods for themselves.” …Anonymous

Another part of the “fence” got erected yesterday with the passage of the healthcare bill. Not that I don't think healthcare needs reforming, it does. Indeed, about a year ago my healthcare insurance provider refused to continue paying for Nexium, forcing my physician to prescribe a generic drug. It is half the strength of Nexium and therefore does not work nearly as well. The solution is to take two of the generic pills, which makes the cost more than that of Nexium – go figure. I also don't understand how you reform healthcare without addressing tort reform, but that's a discussion for another time. Anyhow, with the passage of said bill the government becomes even a larger component of the economy as it offers us more “free corn.” Yet Milton Friedman once stated, “There are no free lunches,” and there will most certainly be a price to pay for the policies of the past year. As the must read folks at the GaveKal organization write (as somewhat paraphrased by me):

“The best example of the long-term damage to an economy done by overtly interventionist policies can probably be found looking at the United Kingdom (UK). This for a very simple reason: the UK economic policy was Keynesian from 1966 to 1979, supply-side driven from 1979 to 1998, and Keynesian again under the wise guidance of Mr. Brown. And the results speak for themselves. In the (nearby) chart, the top red line represents the ratio between central government expenditures and GDP, on an inverted scale. In other words, the lower the red line is, the higher government spending as a percentage of the economy. The black line in the top panel is the seven-year moving average of the annual UK GDP growth rate. Finally, the grey line on the bottom panel represents the ratio between the value of the UK stock market and the operating surplus for UK companies as reported by the national accounts – a PE ratio of sorts.”

“Looking at the chart, something emerges quite clearly: a rise in government spending leads, over time, to a decline in the structural growth rate of the economy and to lower PEs. So it seems that the price that the system is paying for policymakers' attempts at stabilizing the economy in a recession, or for allowing an unchecked growth in government spending, is a much lower structural growth rate.”

“Currently, however, the U.S. equity markets don't “see” the potential for a lower structural growth rate, and lower P/E ratio, as the Dow Theory “buy signal” of last year was reconfirmed last Wednesday. Indeed, the DJIA finally confirmed the DJTA by registering a new reaction high. That upside action also left the DJIA above the “50% level,” meaning the Dow has recaptured more than 50% of the points lost in the October 2007 to March 2009 decline, which is likewise a bullish occurrence. At the same time, last Wednesday there were 601 new 52-week highs on the NYSE, a new high total, and well above the 523 new highs of January 11, 2010. All of this caused one Wall Street wag to exclaim, “Is this a breakout, or a fake out?!” Clearly it is a breakout, but it comes pretty late in the rally that commenced from the “hammer lows” of February 4/5th, and, has a lot of “hair” on it. For example, ~89% of the S&P 500 (SPX/1159.90) stocks are above their respective 200-day moving averages (DMAs) and consequently overbought. Likewise, ~86% of the SPX's stocks are above their 50-DMAs, leaving the SPX, in the aggregate, roughly two standard deviations above its 50-DMA. Maybe that's why the NYSE Overbought Indicator tagged a rare 90+ reading about a week ago, or why the S&P 500 relative strength index is above 90, both signaling that stocks are overbought. Now maybe this week's end of quarter “window dressing” will keep institutional types engaged on the buy side, but with mutual fund cash positions at a paltry 3.6%, much of their firepower has already been used. Perhaps that realization, or Friday's quadruple witch-twitch, is what finally rendered a “red candlestick” downside-day in the charts after the somewhat historic 14-day upside skein without any such “red candlesticks.” Still the overbought condition, as of yet, has been outweighed by the upside momentum. When the “momentum mash” wanes is anyone's guess, but as stated – I am not a very good momentum investor. Accordingly, in the short-term I remain cautious thinking the best strategy is to continue to pare some positions and/or raise stop-loss points. Longer-term, I maintain this is not the “new normal,” but rather the typical economic cycle. That is, corporate profits surge, which drives an inventory rebuild. Currently, profits have indeed surged with the largest ramp in corporate cash (y/y) since 1983. Combined with the increased activity at seaports, and the rise in shipping prices, it suggests inventory restocking has begun. Following an inventory rebuild comes a capital expenditure cycle and then companies begin to hire people. Then, and only then, comes a noticeable increase in consumption. It is important to note that hiring and consumption come on the back end of the cycle, not the front end. To be sure, the stock market believes this is the way it is going to evolve given that the Consumer Discretionary sector is the third best performing sector year-to-date (+8.34%), behind Industrials (+10.97%) and Financials (+8.98%). All considered, while cautious in the short-term, we are moored in the belief that the current backdrop will allow the SPX to fill the downside vacuum created in the charts by the Lehman bankruptcy over the next few months. That yields an upside target between 1200 and 1250, as can be seen in the following chart from our friends at Bespoke Investment Group. Inasmuch, we continue to like the strategy of accumulating favorably rated names, preferably with dividends, in the investment account. Some names for your consideration include: CenturyTel (CTL/$34.86/Outperform), Leggett & Platt (LEG/$21.47/Outperform), and Brinker (EAT/$19.74/ Outperform). The call for this week: The recondite healthcare bill passed last night and yet another “fence” has been built around the “wild pigs,” causing them to lose a little more of their freedom as they increasingly feast on the “free corn.” Meanwhile, the equity markets are pretty overbought, the SPX is at the top of its Bollinger Band, India joined China in monetary tightening, the yield curve is compressing because short-term interest rates are rising, and the number of analysts revising companies' earnings estimates upward is thinning. Hence the question this week becomes, “Does quarter's end institutional window dressing turn into an undressing?” Thus we are cautious, but not bearish, in the near-term. However, we remain bullish over the longer-term due to the fact that in nine of the ten bear market troughs since 1926 the SPX has gained an average of 9% in year two following said trough. For more investment strategies by Mr. Saut, go to raymondjames.com/inv_strat.htm.