Saturday, November 15, 2014

The Closing Bell

The Closing Bell

11/15/14

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 Uptrend                                 16053-18819
Intermediate Term Uptrend                      16053-21053
Long Term Uptrend                                  5159-18521
                                               
                        2013    Year End Fair Value                                   11590-11610

                  2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1841-2207
                                    Intermediate Term Uptrend                       1692-2408
                                    Long Term Uptrend                                    783-2056
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          47%
            High Yield Portfolio                                     53%
            Aggressive Growth Portfolio                        49%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s economic data was weighed to the plus side: positives---weekly mortgage purchase applications, October retail sales, September small business optimism, November preliminary consumer sentiment, and the October budget deficit; negatives---weekly mortgage applications, weekly jobless claims and the September combos of wholesale inventories and sales as well as business inventories and sales; neutral---weekly retail sales.

The most important stat this week was the October retail sales number reinforced by consumer sentiment, indicating that the largest segment of the economy (the consumer) remains upbeat in both attitude and action.  In addition, the generally positive dataflow itself was important in that it emphasizes that what at first appeared to be a negative trend in data is in truth just another period of erratic stats---a pattern that has occurred repeatedly throughout this entire recovery.  How many times in the past five years have we seen a month or two of either negative or inconsistent overall stats, worried that it might indicate a rollover in the economy only to be followed by the resumption of economic improvement---slow, below average, but improvement nonetheless?  To be sure, this uneven trend doesn’t necessarily have to be followed a more steady advance.  But for the moment, my assumption is that it will.  The point here being that, at least for now, the US economy appears to be warding off the negative impact of a slowing global economy.

That said, the slowing global economy just keeps slowing. Numbers out of Europe and China this week indicate little improvement.  Granted France and Germany managed to turn in positive GDP growth for the third quarter, but the rest of Europe was not so lucky and Germany scored a plus figure (+0.1%) by a hair on its chinny, chin, chin.  So while the US is holding in there, a slowdown in the global economy still remains the number one threat to our forecast.

In short, our outlook remains the same, and the primary risk (the spillover of a global economic slowdown) remains just so.

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.

Unfortunately, this positive in our outlook may be getting to be ‘too much of a good thing’.  Whether because of new abundant supplies or falling demand, the price of oil has been getting hammered of late; and sooner or later this plus could become a minus.

‘I have no idea where the crossover point is, but there is one in which the positive created by lower prices to consumer and industry is offset by losses in employment and weakening corporate financial structures resulting from decreased drilling activity (remember the energy industry has been a major contributor to job growth and cap ex spending).’

       The negatives:

(1)   a vulnerable global banking system.   This week, global regulators fined five banks $3.4 billion for price fixing in the foreign exchange markets.  In a related action, the Bank of England fired an employee for ‘serious misconduct’.

This is an interesting and insightful article on the FX market and serves somewhat as a counterpoint to the above (medium and a must read):

‘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. The elections turned out as expected; and Obama, true to form, ignored the results.  Two issues appear likely to set the near term political agenda in DC: (1) Obamacare.  This week we all witnessed several videos of the architect of Obamacare smugly discussing the lack of transparency of the act which was intended to fool ‘stupid Americans’.  Committee hearings to follow.  (2) rumors are that Obama will change the US immigration policy by executive order as early as this coming week, confirming that He remains an ideologue and has no intention of working with Congress for the remainder of His term.  If it indeed occurs, it is likely to ignite a shit storm that will keep us all entertained for weeks.  Meanwhile, where is budget and tax reform?

More revelations on Obamacare (medium):

And (short):

(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. 

While the Fed has ostensively ended QE, Japan is just getting started and Draghi is threatening his own version, soon to be announced.  That leaves the globe awash in liquidity and provides the hedge funds and carry traders plenty of fuel to continue pumping up asset prices.  Ignored, of course, is the uncomfortable fact that QE hasn’t [except for QEI], isn’t and likely won’t do anything for economic growth. 

True the US economy continues to improve; but it has been and remains tough going.  The underlying theory [easy money and higher asset prices will drive spending and investment] for this disastrous experiment [QE] has clearly not worked.  One can only assume that the US economy is where it is in spite of QE and more likely the result of the ingenuity and hard work of industry and labor. 

That leaves us with the question, when all this money creation is over, will the global economy be negatively impacted?  You know my opinion---no.  Indeed, there is an argument that its termination would be a positive.

On the other hand, we know that all the QE’s have had a significant effect on asset prices.  One need look no further than investor reaction each and every time some iteration of QE was announced or confirmed.  Whether an end to QE, when, as and if it ever happens, will adversely impact asset prices remains to be seen.  As you know, I believe that it will.

(3)   geopolitical risks.  The main item this week is renewed hostilities in Ukraine---this less than two weeks after Ukraine made its first payment to Russia in accordance with an agreement on winter gas prices.  It would seem Putin believes that he has carte blanche to do whatever he pleases, whenever he pleases irrespective of prior agreements.  That doesn’t appear likely to change given the weak response to date from NATO/US to his maneuvers in Ukraine.  Emphasizing his lack of concern with NATO/US are increasingly aggressive bomber flights skirting NATO airspace.  Any bets on whether there is more to come?


(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  The news out of the rest of the world continued negative this week with UK and ECB lowering estimates of EU growth; and most of Europe, except France and Germany, reporting poor GDP numbers [and as noted above Germany’s report was hardly promising].  In addition, China reported downside misses in fixed asset investment, retail sales and industrial production.  In short, save for a brief respite a couple of weeks ago, the economies of a majority of our most important trading partners continue to deteriorate. 

There was one positive development, the Japanese are considering delaying the second retail sales tax increase---perhaps a sign that the ruling class is starting to wake up to the disaster they have created. The problem is that it maybe too little too late.  Time will tell.

A global slowdown/recession remains the number one risk to our forecast.

Bottom line:  the US economy showed signs of improvement this week.  On the other hand, economic news from our major trading partners continues to deteriorate.  The good news is that the US economy appears strong enough at present to withstand such widespread global weakness.  The bad news is that the operative words are ‘at present’ and that keeps this factor as number one on our risk hit parade.

Global QEInfinity marches on even without our Fed.  Japan has tripled down on its version while Draghi continues to insist that he will let go with his own.  That leaves the hedge funds, carry traders, yield chasers and prop trading desks free to push asset prices higher while the citizenry of Japan and Europe suffer the effects of economic stagnation and those countries’ problems (too much debt and overleveraged banks) remain unaddressed. 

On the geopolitical front, Russia continues to assert itself.  It is not out of the question that it will use its gas this winter to achieve further gains at the expense of NATO/US.  The Middle East remains a quagmire---ISIS, a potentially nuclear Iran, an increasingly isolated Israel.  If the US can escape this mess with some semblance of honor, it will be a miracle.

This week’s data:

(1)                                  housing: weekly mortgage applications were down but purchase applications were up,

(2)                                  consumer:  weekly retail sales were mixed while October retail sales were stronger than anticipated; weekly jobless claims were up and above forecasts; preliminary November consumer sentiment was better than estimates,

(3)                                  industry: September wholesale inventories were above expectations but sales rose less; September business inventories increased in line, but sales were flat; the NFIB small business optimism index came in slight ahead of anticipated results,

(4)                                  macroeconomic: the October federal deficit was less than forecast.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 17654, S&P 2039) spent the bulk of the week consolidating from an extremely overbought condition.  The good news is that the pin action was basically sideways---the optimal way of working off an overbought state.  The bad news was some deterioration in markers of internal strength.  As I noted in Friday’s Morning Call, that doesn’t necessarily have to be negative, since it is reasonable for that kind of action to occur in a period of consolidation.  On the other hand, the S&P finished near the upper boundary of its long term uptrend which typically represents a tough barrier to cross.  So the consolidation/weaker breadth measures could either be with us for a while as stocks continue to build strength for an assault on S&P 2056 or this action is a preamble to a roll over. 

All that said, both of the Averages closed within uptrends across all timeframes: short term (16053-18810, 1841-2207), intermediate term (16053-20153, 1692-2408) and long term (5159-18521, 783-2056).  They are also finished above their 50 day moving averages.

Volume fell on Friday; breadth was mixed. The VIX also declined, ending within a short term uptrend (but back near the lower boundary), an intermediate term downtrend and below its 50 day moving average.   

The long Treasury rose on Friday, closing within a very short term trading range, a short term uptrend, an intermediate term trading range and above its 50 day moving average.  

GLD had another strong rebound on Friday.  While it ended within short, intermediate and long term downtrends, it closed near the lower boundary of its former long term trading range.  The question is, will that level act as resistance or was the recent break of the long term trading range a false flag and a recovery above it mark a bottom in GLD?  Too soon to know and way too soon to bet any money on it.

And:

Bottom line: the sideways consolidation of last week is a very bullish indication of more upside to come; plus seasonal factors are a major plus.  On the other hand, the S&P is near a historically formidable barrier and some internal indicators could be signaling a breakdown in long term momentum.  We are not going to know which for a while.  So patience.  

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17654) finished this week about 48.6% above Fair Value (11876) while the S&P (2039) closed 38.1% overvalued (1476).  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.

Stumbling economic progress in the US, disappointments from all our trading partners, an Ideologue in Chief unwilling to compromise, the rise of a new more aggressive version of the Russian bear, chaos in the Middle East and historical valuation measures seem to have no effect on investors as long as some central bank is willing to carry the QE torch. 

To be sure, corporate per share earnings, which most certainly have an impact on equity valuations, continue to hit new highs.  But based either current or forward earnings, valuations are still high.  In addition a big part of the increase in earnings per share is a function of (1) layoffs which is ultimately not good for the economy and (2) easy money/low interest rates which allow companies to borrow cheaply and buy back their own stock.  In other words, aggregate profits are not progressing nearly as much as per share profits; and as soon as QE ends, the easy money source of this financial manipulation of earnings per share will also end.  That said, I have no doubt that asset prices, whether driven higher by direct purchases of carry traders and yield chasers (easy money) or by financially constructed higher profits per share (easy money) or both, will likely continue to levitate as long as QE goes on. 

With valuations (which I have thoroughly reviewed in the last two weeks) so out of whack, it makes no sense for a fundamental long term investor like me to do anything other than follow our established investment strategy---frustrating as it might be in the short term. 

Given the current momentum and the very positive seasonal bias for stocks, if I had any skill as a trader, I might try to ride this uptrend using very tight stops.  My choice of instruments would be an ETF (VYM---low risk; IWN—higher risk) so that I only had to worry about a single position from which to escape. 

However, my inclination is more towards setting myself up for the downturn whenever it might come---since that fits with my fundamental opinion of the Market.  As I noted earlier in the week, I am watching VXX (volatility), SH (the short of the S&P index) and GNT (a gold and income [current yield is about 12%] trust).  In addition, I am tightening the quality criteria for inclusion in our Universe with the thought of eliminating holdings that are on the cusp of qualification.

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 is at risk).  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.
       
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 11/30/14                                11876                                                  1476
Close this week                                               17654                                                  2039

Over Valuation vs. 11/30 Close
              5% overvalued                                12469                                                    1549
            10% overvalued                                13063                                                   1623 
            15% overvalued                                13657                                                    1697
            20% overvalued                                14251                                                    1771   
            25% overvalued                                  14845                                                  1845   
            30% overvalued                                  15438                                                  1918
            35% overvalued                                  16032                                                  1992
            40% overvalued                                  16626                                                  2066
            45%overvalued                                   17220                                                  2140
            50%overvalued                                   17814                                                  2217

Under Valuation vs. 11/30 Close
            5% undervalued                             11282                                                      1402
10%undervalued                            10688                                                       1328   
15%undervalued                            10094                                                  1254

* 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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