Saturday, March 22, 2014

The Closing Bell

The Closing Bell

3/22//14

Statistical Summary

   Current Economic Forecast

           
            2013

Real Growth in Gross Domestic Product:                    +1.0-+2.0
                        Inflation (revised):                                                           1.5-2.5
Growth in Corporate Profits:                                            0-7%

            2014 estimates

                        Real Growth in Gross Domestic Product                   +1.5-+2.5
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                     15330-16601
Intermediate Uptrend                              14696-16601
Long Term Uptrend                                 5050-17400
                                               
                        2013    Year End Fair Value                                   11590-11610

                    2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1781-1958
                                    Intermediate Term Uptrend                        1734-2434
                                    Long Term Uptrend                                    739-1910
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          43%
            High Yield Portfolio                                     46%
            Aggressive Growth Portfolio                        46%

Economics/Politics
           
The economy is a modest positive for Your Money.   It was a light week for data; what we got was mixed: positives---February building permits, weekly jobless claims, the March Philly Fed manufacturing index; February industrial production and capacity utilization, the 2013 fourth quarter current account deficit; negatives---weekly mortgage and purchase applications, February housing starts and the March NY Fed manufacturing index; neutral---weekly retail sales, February existing home sales, the February and revised January leading economic indicators and February CPI. 

What was notable this week was:

(1)   the general trend of the stats appears to have returned to mixed to positive:  while it is still probably a bit too soon to declare the economy back on course, it does appear to be coming through the weather induced period of lousy numbers in decent shape.  I am leaving the yellow light flashing but it is not quite as bright as before,

(2)   the FOMC meeting, policy statement and subsequent Yellen news conference caused quite a stir on Wednesday.  I covered the subject in Thursday’s Morning Call; but in summary, I believe [a] that Yellen’s more hawkish tone was an unforced error and likely inaccurately portrayed her true intent and [b] ‘qualitative guidance’ is a sign of weakness and uncertainty within the Fed as to how to extract itself from the untenable position {massive balance sheet} in which it has placed itself and increases the already substantial odds of it bungling the transition process.

As I noted above, I keep the warning light flashing though it appears that it will again prove a false warning and leave our forecast unchanged:

‘a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet, and a business community unwilling to hire and invest because the aforementioned along with...... the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.’
           
        The pluses:

(1)   our improving energy picture.  The US is awash in cheap, clean burning natural gas.... In addition to making home heating more affordable, low cost, abundant energy serves to draw those manufacturers back to the US who are facing rising foreign labor costs and relying on energy resources that carry negative political risks.

       The negatives:

(1)   a vulnerable global banking system.  This week JP Morgan agreed to sell its commodities trading unit---a positive step in de-risking its balance sheet.  Meanwhile, UBS is being investigated for manipulating the London gold price fix:

In addition, the Fed released the results of its latest bank ‘stress test’ this week.  I covered this in our Morning Call; but in summary (1) after all the free money the Fed has given the banks, it is no surprise that they are in better shape, (2) the Fed has no way of calculating the counterparty risk in the banks’ derivative trading and (3) the problem with insolvency is not the prevailing regulations or their monitoring, it is in the people administering the regulations and monitoring.  As a final note to this item, after the Market close Friday, the Fed released a ‘revised’ stress test:

‘My concern here.....that: [a] investors ultimately lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly a collapse of the EU financial system.’

(2)   fiscal policy.  Congress is on vacation; so the mischief level is now low, at least temporarily.  On the other hand, we did get some electioneering on the familiar cost cutting, tax reform rhetoric from the GOP---which they have made little attempt to implement beyond lip service.  Oh wait, they did manage to hornswoggle Obama into the sequester which Paul Ryan then negotiated it away.  The bad news is that this is probably a sign of what is to come from our ruling class for the rest of this year, i.e. a lot of positioning for the election with no real intent to do a bloody thing to actually help the economy or taxpayers.

(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets. 

As I noted above and in more detail in Thursday’s Morning Call, I think that ‘qualitative guidance’ is an admission that the Fed has no clue how to extract itself from its horrendously easy monetary policy and is trying to obfuscate the fact by attempting to dazzle us with a lot of technocratic bullshit.  This only increases the odds of future economic problems resulting from a botched transition to normalize monetary policy.

That said, I was surprised that FOMC member Bullard on Friday reinforced Yellen’s comments on the timing of an interest rate increase---which got me thinking [I know, that’s dangerous] that maybe Yellen meant everything she said, that the obfuscation from removing the unemployment rate as a visible quantitative guideline was done to confuse the Markets and that the Fed really is intent on ending QE and moving rates up on a more rapid timetable than most think.  I don’t think that the case is overwhelming; but I don’t think that we dismiss the possibility out of hand.  It is certainly something that I will be watching.

I would love to eat crow on my initial FOMC/Yellen conclusions.  To me, the quicker the Fed starts to unwind its ultra easy monetary policy, the less pain the economy and the Markets will have to endure---and to be clear, I think that there will be pain especially in the securities markets.  But every drunk has to sober up; better to start the hang over now than wait and feel even worse.

      And this from Citi (medium and a must read):


(4)   a blow up in the Middle East or someplace else.  The turmoil in Ukraine is subsiding as the rest of world recognizes the Russian annexation of Crimea as a fait accompli.  We should all be very proud of the US response---a lot of ‘sharply worded warnings’ and sanctions imposed on seven rich Russians [Friday afternoon it rose to 33].  I feel reasonably sure that Putin and his cronies are laughing their collective asses off at our political ineptness.  On the other hand, I am not sure the whole affair is over in that [a] once an aggressor realizes that he can invade and conquer adjacent lands with relative impunity, he tends not to stop and [b] Putin’s oft quoted statement that the greatest tragedy of the twentieth century was the dissolution of the Soviet Union.

(5)   finally, the sovereign and bank debt crisis in Europe and around the globe.  The potential for an international financial crisis has grown to include more than just Europe.  Indeed, the immediate focus in now on Japan and China.  Again, I have covered the developments in these two countries ad nauseum in our Morning Calls, so I don’t want to be repetitious.  The bottom line though is that problems are starting to arise from overly expansive monetary policies particularly as they relate to what has become a ginormous global ‘carry trade’ that appears to be starting to unwind---the result of which could be a major haircut to asset prices. 

And:

Bottom line:  the economic data continues to improve from a month ago.  It appears that the weather was merely a temporary setback.  But I would like a couple more weeks of upbeat numbers before declaring our forecast intact and switching the warning light off.

Fed tapering policy was affirmed by the FOMC this week though it managed to inject ‘qualitative guidance’ into monetary policy.  I interpret this as a sign that the Fed is getting very nervous about its ability to transition to tighter money and wants to give itself the ability to conceal that uncertainty---though there is an argument that it was intentional and the transition is moving forward at a faster pace than most expected.  Something we have to pay attention to. 

The Chinese central bank continues its policy of re-introducing ‘moral hazard’ into the investment equation.  This week, two more corporations were allowed to default and the yuan continues to depreciate.  Whether this marks the beginning a global unwind of the ‘carry trade’ remains to be seen; but it is clearly going forward in China.  The one mitigating circumstance is that the Bank of China has thus far managed to prevent an economic crisis.  Unfortunately, the same can’t be said for the securities markets as the Chinese equity market slipped into a bear market this week.  This whole process could potentially be pointing to our own future, in that, the crisis is occurring in the markets not in the economy.  That leaves me sticking to my ‘muddle through’ economic scenario but flashing the caution light for the markets.

This week’s data:

(1)                                  housing: weekly mortgage applications and purchase applications fell; February housing starts were much worse than estimates though building permits improved; February existing home sales were off 0.4%, in line,

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims rose less than estimates,

(3)                                  industry: the March NY Fed manufacturing index was below consensus while the Philly Fed index was well above its forecast; February industrial production and capacity utilization was better than expected,

(4)                                  macroeconomic: the February leading economic indicators were ahead of estimates but the January number was revised down; February CPI was up slightly, in line; the fourth quarter 2013 current account deficit was less than anticipated.



The Market-Disciplined Investing
           
  Technical

`           The indices (DJIA 16302, S&P 1872) had a volatile week, though they managed to finish in the plus column.  The S&P closed within uptrends across all timeframes: short (1781-1958), intermediate (1734-2534) and long (739-1910).  The Dow remains within short (15330-16601) and intermediate (14696-16601) term trading ranges and a long term uptrend (5050-17400).  They continue out of sync in their short and intermediate term trends---which leaves the Market trendless.

Volume on Friday was huge due mainly to options expiration; breadth was terrible.  The VIX rose but continues to meander within its short term trading range and intermediate term downtrend.

The long Treasury was strong after getting slapped around for much of the week. As you know, I thought it negative that it couldn’t break above the top of its short term trading range (now a triple top).  However, there wasn’t much of a follow through to the downside; plus it remains above its 50 day moving average.  So there remains a chance that the long bond could break to the upside.  Such a move would indicate coming economic weakness or the US as a safe haven if crises break out elsewhere in the world.

GLD sold off big this week but stopped right at the lower boundary of its very short term uptrend and then bounced on Friday.  While it remains within short and intermediate term downtrends, if Monday is another up day, our Portfolios will likely start to nibble.  A break above the upper boundary of its short term downtrend would then be a signal to add to the holding.  GLD also finished within an intermediate term downtrend. 

Bottom line:  the bulls are still in control.  They were challenged but overcame  Yellen’s ‘six month’ comment as well as continuing deterioration in the Chinese and Japanese markets brought on by the unwinding of the ‘carry trade’ in both currencies.   So despite having a trendless market as well as growing technical divergences, there appears to be enough residual strength to keep prices advancing toward the upper boundaries of their long term uptrends.  However, I still believe that those upper boundaries will prove too formidable to be successfully challenged.

Meanwhile, we have a trendless Market; so there is really not much to do save using any price strength that pushes one of our stocks into its Sell Half Range and to act accordingly.

                Market performance in mid-term election year (short):

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (16302) finished this week about 39.6% above Fair Value (11675) while the S&P (1866) closed 28.7% overvalued (1449).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, a botched Fed transition from easy to tight money, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe and China.

The economic stats are starting to once again reflect our forecast.  However, I am not quite convinced that all is well, so I am leaving the yellow light flashing.  If the past year is any guide, investors are likely to react positively to a more certain economic environment.  But since that is already in our Models, I am not going to discount it twice.  On the other hand, if the recovery is not intact, the Market is apt to react negatively.

Tapering for pussies continues apace; and given Yellen’s ‘slip’ at her news conference, I suppose that there is some probability that interest rate hikes will begin next year.  At the moment, I have a slightly more jaundice view of the latest Fed actions.  The ditching of the unemployment rate as a guidepost to transition and the adopting of ‘qualitative guidance’ in its stead suggests to me that the Fed has no idea how to execute a smooth transition process and so it is obfuscating that uncertainty by removing any quantitative standards against which its policy can be judged.  That raises the already substantial odds that it will again fail. 

Finally, China is growing as a potential sources of investor cognitive dissonance.  Their securities market are already reflecting the pain of re-introducing ‘moral hazard’ into the investment equation.  There is some risk that its effects will be transmitted to the international markets via a dramatic repricing of the ‘carry trade’.  That risk is likely heightened by similar problems in the Japanese markets.  So far US markets have escaped any fallout; the risk clearly being that it won’t last.

Ukraine seems to be receding as a potential threat to our markets as (1) Putin consolidates Crimea and (2) Obama continues His limp wristed attempt at sanctions.  The risks are that (1) Russian minorities in eastern Ukraine are suddenly ‘targeted’ for persecution and ask for Putin’s help or (2) Obama pushes His luck, pisses Putin off and gets bitch slapped for all to see. My guess is that neither will be well received by the Markets.

Or maybe there is a third risk (medium):

Overriding all of these considerations is the cold hard fact that stocks are considerably overvalued not just in our Model but with numerous other historical measures which I have documented at length.  This overvaluation is of such a magnitude that it almost doesn’t matter what occurs fundamentally, because there is virtually no improvement in the current scenario (improved economic growth, responsible fiscal policy, successful monetary policy transition) that gets valuations to Friday’s closing price levels.  Indeed, the problem is that any revision in the economic outlook from here is more likely to be negative than positive.

Bottom line: the assumptions in our Economic Model haven’t changed and the risks that they might are diminishing.

The assumptions in our Valuation Model have not changed either.  I remain confident in the Fair Values calculated---meaning that stocks are overvalued.  So our Portfolios maintain their above average cash position.  Any move to higher levels would encourage more trimming of their equity positions.

 I can’t emphasize strongly enough that I believe that the key investment strategy today is to take advantage of the current high prices to sell any stock that has been a disappointment or no longer fits your investment criteria and to trim the holding of any stock that has doubled or more in price.
            
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 3/31/14                                  11675                                                  1449
Close this week                                               16302                                                  1866

Over Valuation vs. 3/31 Close
              5% overvalued                                12258                                                    1521
            10% overvalued                                12842                                                   1593 
            15% overvalued                                13426                                                    1666
            20% overvalued                                14010                                                    1738   
            25% overvalued                                  14593                                                  1811   
            30% overvalued                                  15177                                                  1883
            35% overvalued                                  15761                                                  1956
            40% overvalued                                  16345                                                  2028
            45%overvalued                                   16928                                                  2101

Under Valuation vs. 3/31 Close
            5% undervalued                             11091                                                      1376
10%undervalued                            10507                                                       1304   
15%undervalued                             9923                                                    1231

* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term   cyclical influences.  The model is now accounting for somewhat below average secular growth for the next 3 to 5 years with somewhat higher inflation. 

The Portfolios and Buy Lists are up to date.


Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973.  His 40 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns, managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies.  Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.








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