Saturday, September 20, 2014

The Closing Bell

The Closing Bell

9/20//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%

            2015 estimates

Real Growth in Gross Domestic Product                   +2.0-+3.0
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      16331-17158
Intermediate Trading Range                    15132-17158
Long Term Uptrend                                 5148-18484
                                               
                        2013    Year End Fair Value                                   11590-11610

                  2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1944-2145
                                    Intermediate Term Uptrend                        1917-2717
                                    Long Term Uptrend                                    771-2020
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          45%
            High Yield Portfolio                                     53%
            Aggressive Growth Portfolio                        47%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s data releases by volume were positive but two primary indicators were negative: positives---weekly mortgage and purchase applications, weekly jobless claims, the NY Fed manufacturing index, August CPI and the second quarter US trade deficit; negatives---August housing starts, August industrial production and August leading economic indicators; neutral---weekly retail sales, the Philly Fed manufacturing index and August PPI.

August housing starts and industrial production are this week’s stand out numbers.  Both are primary indicators and both suggest a potential slowing in the US economy---as does the latest reading of the leading economic indicators.  Certainly, it is much too early to tell.  But the big question is, is the slowdown in the global economy beginning to impact our own?  Clearly it reinforces my recent reordering of risks to the economy---with global recession now numero uno.  Stay tuned.

Of course, all the above was overshadowed by the FOMC meeting, the release of an updated Fed policy statement and the subsequent Yellen news conference.  I covered this all in Wednesday’s and Thursday’s Morning Calls; but the bottom line is that the stock boys interpreted the statement/news conference as dovish while the bond guys saw them as hawkish---which leaves me confused.  It also emphasizes that the Fed policy remains a significant risk not just to the economy in that it may botch the transition to normalized policy but also to the Market in that the uncertainty created by the obtuseness of its communication could by itself spawn a huge risk-off move.

Quantitative futility (short):

What QEIII bought us (medium)?

Our forecast:

 ‘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, the weakening in the global economic outlook, 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.   Surprise, surprise.  We actually made it a week without learning of another bankster misdeed. 

That doesn’t mean that there are no problems (medium):

‘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.  ‘With election season in full swing, nothing is likely to happen to alleviate the problems of an inefficient tax code, too much irresponsible spending and too much government regulations.  The one bright spot is that the growing economy is generating sufficient tax revenue to drive down the budget deficit.’

Congress has already come and gone, staying just long enough to pass a continuing budget resolution and approve Obama’s new war (oh, wait a minute, we aren’t supposed to use that word) policy---which if you are like me, you now feel ever so much more confident in the likelihood of our success.

The operative word above is ‘gone’ meaning that when the ruling class is out of town, they can’t fuck with us.

(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. 

Cognitive dissonance reigned supreme this week.  (1) the Japanese reported that August exports continued to decline making a further mockery of Abenomics’ QE to infinity---as if it needed something else to make the point.  (2) the ECB tried the first installment of its new liquidity injection funding  facility and it was a total bust---the banks simply didn’t want the money irrespective of its give-away price, (3) China injected funds into its financial system---which initially had investors getting jiggy with it.  But then it stated this action was limited and should not be interpreted as the start of any loosening in monetary policy, and (4) last but certainly not least, our own Fed issued a new policy statement, which to date has had the bond and stock markets going in opposite directions.  Ultimately, this whole dovish versus hawkish dichotomy will be resolved.  Based on historical performance, I think that the bond guys will prevail.  But that doesn’t mean that they will.

The point of this discussion is that monetary policy among the major economic powers is tuned to expansion but it is not having the impacted expected by the bureaucrats implementing it.  As you know, this is hardly a surprise to me; and frankly, it shouldn’t be a surprise to anyone with a reading proficiency above the third grade.  The question is, have we reached the point where the global markets have had enough of central bank pumping and dumping and as a result, they will go from responding to policy moves to forcing them?

Whether or not that happens, the above does suggest that at least some of the markets are no longer buying QEInfinity.

(3)   rising oil prices.  Unless the West does something really stupid, it looks to me like it is all over but the shouting in Ukraine.  Putin has Crimea and a land bridge there to.  To be sure, Ukraine is making noises of joining NATO; but that is more than a year away---giving Putin plenty of time to thwart that move. 

On the other hand, the action is picking up in Syria/Iraq/ISIS.  Gosh only knows how this mess will work out; but given the lack of success of our foreign policy to date, I am not holding my breath for a positive ending.

That said, the price of oil has only gone down for the last month.  Indeed, because of the favorable supply/demand picture, oil prices are almost assuredly higher than they would be in the absence of all these conflicts.  So barring a dramatic development, I would judge this risk as ever diminishing in magnitude.

(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  The incoming economic data from Europe and Japan remain weak; and the central banks are working feverously to inject additional liquidity into their financial systems.  Unfortunately, as I noted above, those efforts to date have come to naught; and I see no reason why that should change.

The questions are, are these central banks at the end of their policy rope? And if they are, how long can the European and Japanese economies hold on before an accelerated slide into recession begins? And if that occurs, what happens to all those massively indebted sovereigns and overleveraged banks?

The Japanification of central banks (a bit long and a bit in the weeds, but a very good read):

Bottom line, I have no reason to assume that the results from the latest BOJ/ECB QE will be any different from prior failed attempts.  Certainly, the recent poor export data out of Japan bears witness to the lack of success of implementing competitive devaluation (devaluing the yen via excessing money printing).  Which begs the question, what the fuck are these guys thinking about? 

Hence, I see continued deterioration rather than improvement in global economic activity; and that belief is what drives me to the conclusion that global recession is the number one risk to our economy.


To be sure so far, the EU/Japan and the rest of the world have ‘muddled through’ with little impact on our economic progress.  Indeed, that is our forecast; but as I noted, it is now the biggest risk in that outlook.  And unfortunately, we may be seeing the first signs of that weakness effecting our own economy.

Bottom line:  the US economy continues to progress though this week’s housing and industrial production numbers are concerning.  Of course, it is too early to tell, but the worry is that they presage the impact of a slowing global economy on the US.

The economic news from Japan, China and Europe, three of our major trading partners, keeps getting worse. True, the central banks of all these entities have instituted easier monetary policies; but history is repeating itself and to date these policies are having little effect.  Although as in the US, speculators are loving the cheap money.

The fat lady appears about to sing in standoff between the EU and Russia over Ukraine.  Putin has Crimea and his land bridge to it.  On the other hand, Ukraine is pushing to join NATO to which Russia very much objects.  So this story is not quite over.  But barring something really stupid out of the EU and US ruling class, the danger of some geopolitical nightmare seems to be subsiding.

ISIS and Obama are poking each other in the eye.  By all rights, severely disabling this group ought to be a walk in the park.  But with a pacifist president who is being pushed by His party to look tough ahead of the elections and a lack of support from an imaginary ‘coalition of the willing’, the outcome of this conflict is anything but assured.  Truth be told, US policy has done nothing but make the Middle East more volatile and uncertain since we invaded Iraq.  Now with a weak and reluctant president, stability seems out of the question.  I have no idea how this morality play ends; but I fear it won’t be good for the US.

Stockman on Obama’s ISIS policy (long but a good read):

In sum, the US economy remains a plus, assuming this week’s housing and industrial production numbers are outliers. The rest of the world is not in such great shape and my main concern is that its growth rate slips further and starts to impact the US economy.   The geopolitical risk from Ukraine is declining while the Middle East is heating up. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were up; August housing starts were extremely disappointing,

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims fell more than forecast,

(3)                                  industry: August industrial production was less than anticipated; the September NY Fed manufacturing index was much stronger than expected while the Philly Fed index was in line,

(4)                                  macroeconomic: August leading economic indicators rose less than estimated; both the headline and ex food and energy components of August PPI were in line while those of August CPI were well below forecasts; the second quarter US trade deficit was lower than anticipated.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 17279, S&P 2010) had a mixed day on Friday (Dow up, S&P down) but a good overall week.  The Dow broke above the upper boundaries of its short (16331-17158) and intermediate (15132-17158) term trading ranges.  Under our time and distance discipline, if it remains above 17158 at the close Monday, the short term trend will re-set to up.  If it does so at the close on Tuesday, the intermediate term trend will re-set to up.  It finished within its long term uptrend (5148-18484) and above its 50 day moving average. 

The S&P closed within uptrends across all timeframes: short term (1944-2145, intermediate term (1917-2717) and long term (771-2020).  It is also above its 50 day moving average.

As you know, there were conflicting interpretations of the FOMC/Yellen statement; but clearly the Averages believed them to be dovish---which pushed prices higher and provided the strength for the Dow to break and hold above 17158.   True, there remains some time left in our trading discipline before DJIA re-sets its short and intermediate term trends.   But I assuming that those re-sets will occur.  That means that the upper boundaries of the indices long term trading range are the next upside target for them to aim at. 

If the stock market’s interpretation of a dovish Fed is correct, then the Averages will also surely challenge those levels; and the likelihood of confirming a break above them has become higher.  That said, the further stocks advance, the more questionable valuations become and the fewer true believers will be left to buy.  So even if those long term uptrends are challenged, I believe the pace of price increases will become more labored. 

Volume on Friday was through the roof---largely a function of quadruple witching (option and futures expiration); but breadth was abysmal.  The VIX was up fractionally, closing within short and intermediate term downtrends and below its 50 day moving average.

The long Treasury had a strong day on Friday, rebounding sufficiently to mark the 112.7 level as the lower boundary of a newly re-set trading range.  As you know, TLT along with bonds in general had a rough week primarily as a function of a more hawkish interpretation of the FOMC/Yellen statements.  I thought it curious that bonds staged a nice recovery on Friday while the S&P and small cap averages were down. 

That said, bonds, stocks and commodities all experienced volatility this week and not always in a consistent manner.  That has created some confusion for me in that I am not sure what kind of scenario they might individually be discounting.  Of course, it may be nothing more complicated than that investors across the board are as confused as I am and their trading reflects it. 

GLD was down on Friday, remaining stuck within short and intermediate term downtrends and below its 50 day moving average.  It continues to be one of the ugliest charts around.

Bottom line: on the surface, the Averages are telling us that it is clear sailing for as far as the eye can see.  But not only are the internal divergences continuing to widen, but now bonds, commodities and real estate (REIT’s) are behaving in a way inconsistent with a dovish Fed, Bank of Japan, ECB and Bank of China. 

I could propose all kinds of possible scenarios that might explain this behavior but it would be sheer speculation.  So I will stick with the easiest: I don’t know; I am not sure many investors out there have a clue; hence, I wait for clarity---happy in the knowledge that our Portfolios have lots of firepower if things go awry.

 Our strategy remains to do nothing.  Although it is not too late to Sell stocks that are near or at their Sell Half Range or whose underlying company’s fundamentals have deteriorated. 

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17279) finished this week about 46.0% above Fair Value (11829) while the S&P (2010) closed 36.9% overvalued (1468).  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, Japan and China.

The US economic dataflow continues to point to a sluggishly growing economy---although this week’s housing, industrial production and leading economic indicators reports were very disappointing and call that scenario into question.  As I always say, one week does not a trend make; but it can put you on alert.

Furthermore, the stats from overseas are not encouraging.  Japan just reduced its economic growth forecast.  The ECB’s first attempt at pumping money into the EU financial system was a bust and while the Bank of China added liquidity, it cautioned that it remained determined to wring speculation out of its real estate market.

As you know, I recently upgraded global recession/stagnation to the number one risk to our economy.  This week’s events only reinforces my conviction.  Indeed, I am concerned that the aforementioned poor US economic data could be the first sign that foreign economic problems are starting to impinge on US growth.  To be clear, this is a worry not a forecast.  But it clearly must be watched.

Meanwhile, the Fed managed to confuse everyone this week.  Certainly, equity investors weren’t confused.  They interpreted the FOMC and Yellen comments bullishly and pushed the Dow through the upper boundaries of its short and intermediate term trading ranges while at the same time making a new all-time high.  However, bond, commodities and real estate (REIT’s) investors were not nearly as sanguine as prices in all declined on the premise that the Fed had turned more hawkish.  Then on Friday, things only got even murkier when bonds rallied and the S&P and small caps declined

Check out the recent performance of the commodity index (short):

Now the charts of bonds, the Russell and the transports (short):

In short as of Friday, I am clueless as to what investors in any of the aforementioned markets are discounting.  Of course, I have been here before; and I do know that  all will be revealed in due course.  I am just glad that our Portfolios are not leveraged or overly exposed to any Market or market segment and have plenty of cash. 

Just to address the geopolitical risks for a second.  The crisis in Ukraine seems to be fading fast as Putin has gotten most of what he wanted.  There is still the matter of Ukraine being too cozy with the West; so the fat lady hasn’t sung yet.  But barring the West getting far more aggressive than it currently is, I suspect that won’t be an issue a year from now.

On the other hand, nothing good is likely to happen in the Middle East as the US lurches from one inane policy adjustment to another.  My hope is that the players are too busy killing each other to have the time to come after the US. Think 9/11 or worse.

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. 

Bottom line: the assumptions in our Economic Model haven’t changed (though our global ‘muddle through’ scenario seems more at risk every week).  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.

Bear in mind, this is not a recommendation to run for the hills.  Our Portfolios are still 55-60% invested and their cash position is a function of individual stocks either hitting their Sell Half Prices or their underlying company failing to meet the requisite minimum financial criteria needed for inclusion in our Universe.
        
            It is a cautionary note not to chase this rally.
            
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 9/30/14                                  11829                                                  1468
Close this week                                               17279                                                  2010

Over Valuation vs. 9/30 Close
              5% overvalued                                12420                                                    1541
            10% overvalued                                13011                                                   1614 
            15% overvalued                                13603                                                    1688
            20% overvalued                                14194                                                    1761   
            25% overvalued                                  14786                                                  1835   
            30% overvalued                                  15377                                                  1908
            35% overvalued                                  15969                                                  1981
            40% overvalued                                  16560                                                  2055
            45%overvalued                                   17152                                                  2128
            50% overvalued                                  17743                                                  2202

Under Valuation vs. 9/30 Close
            5% undervalued                             11237                                                      1394
10%undervalued                            10646                                                       1321   
15%undervalued                            10054                                                  1247

* 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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