Saturday, January 10, 2015

The Closing Bell

The Closing Bell


Statistical Summary

   Current Economic Forecast


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                                 16372-19142
Intermediate Term Uptrend                      16372-21542
Long Term Uptrend                                  5369-18960
                  2014    Year End Fair Value                                   11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1889-2281

                                    Intermediate Term Uptrend                       1729-2443
                                    Long Term Uptrend                                    783-2083
                        2014   Year End Fair Value                                     1470-1490

                        2015   Year End Fair Value                                      1515-1535        

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          47%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        49%

The economy is a modest positive for Your Money.   The US economic data this week was mixed: positives---the December ADP private payroll report, weekly jobless claims, December nonfarm payrolls, December retail chain store sales, the November US trade deficit; negatives---weekly mortgage and purchase applications, the December Markit services index, November factory orders, the December ISM nonmanufacturing index; neutral---weekly retail sales, November light vehicle sales, December consumer credit. 

As you can see, these stats are pretty well balanced not only by volume but also among the primary indicators.  Hence, they fit our forecast perfectly.  But as important, there continues to be no sign of a spillover of global economic weakness into the US.

Also deserving of comment was the limp wristed language in the latest FOMC minutes.  That is, it was another confused narrative, full of the usual ‘on the one hand/on the other hand’ noncommittal disclosure that conveyed the lack of conviction to do anything that would upset the Markets.   Humbug.  That was followed by a speech from a member of the FOMC that included a statement that a rise in interest rates would be catastrophic.  Score two for the QEInfinity crowd.  My bottom line on this factor hasn’t changed---QE does little for the economy but does help make the speculators, hedge funds and carry traders richer.

The numbers from overseas showed no sign of improvement---not good.  Plus we now have some new wrinkles in this otherwise dismal picture: the net effect of declining oil prices on the global economy as well as the potential fallout from the upcoming Greek elections (which is to say, a Greek default).  However, we have seen no economic signs of either, save the direct impact of lower oil prices on those countries in which oil production is a major component of GDP.

Hence, 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.

The pundits keep telling us that cheaper oil is a significant plus for the economy; but stocks keep cratering as oil prices decline.  Curiously, to date, nothing has showed up in the macro numbers that would support either case for the energy consuming countries; effects are being felt in the economies of energy producing countries

Until we get more substantive evidence on the impact of lower prices for the US, I am leaving this factor as a positive.  However, I am not going to stop worrying about the negative case, in particular, the extent of bank lending to the subprime sector of the oil industry.

       The negatives:

(1)   a vulnerable global banking system.   The gem of the week was Citicorp upping its exposure to the derivative trading/market.  This at a time that most other banks are lowering their activity.  I am assuming that this is somehow related to the recent [GOP sponsored] amendment of Dodd Frank that rolled back a provision forcing banks to divest a segment of their derivative trading operations.  Whatever the reason, it will almost surely keep your and my prospective liability from the gross mismanagement of the banking system higher than any of us want.

Here’s another gem from the grand old party (medium):

The Alice in Wonderland math of the banks’ derivative trading (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. Congress managed to do something constructive this week: it tasked the congressional budget office to dynamically score all future forecasts [meaning taking indirect as well as direct consequences of legislation/regulation into account; for instance, a tax cut may lower government revenue by the difference in the two rates; but it will also spur economic activity that will increase profits and hence tax revenues].  Score one for the good guys.

On the other hand, in Obama’s drive for a new spirit of cooperation, He announced that He would veto the current Keystone Pipeline bill.  No invitations to congressional leaders to meet with Him and try to hammer out a compromise.  No specifics on why He would veto it.  Just ‘if you pass it, I will veto it’. 

As you know, I have long maintained that Obama was an ideologue and incapable of compromise---the importance here being that if I am correct, we are looking at two more years of gridlock.  Of course, there are worse things than gridlock; so my comment shouldn’t be construed as a total negative.  On the other hand, it appears that tax and regulatory reform are more than two years away at a minimum.

But there is still plenty of time for Obama to give more of Your Money away (medium):

(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. 

The QE juices got pumped up this week by:

[a] the tone of the latest FOMC minutes---they being read as implying easy money {low rates} longer than many had thought.  Bolstering this interpretation were comments from a Board member the same day characterizing a rise in interest rates as potentially ‘catastrophic’.  The combination got the QE crowd really jacked up. But in the end, it is the same old shit: QE does nothing for the economy but the failure of the Fed to tighten in a timely manner is just another in a whole history of botched policy fiascos.

Stephen Roach on Fed policy (3 minute video and a must watch):

[b] the economic data out of Europe continue to be dismal, supporting Draghi’s case for an ECB QE.  From the analysis that I have seen, I don’t think that the ECB has the ability to do much; certainly nothing to compare with the Japanese or US QE.  But then it has done virtually nothing to date except gab and investor have still gotten tingly all over whenever Draghi gives his ‘whatever is necessary’ bullshit line.

(3)   geopolitical risks.  Except for the Paris massacre, the world was relatively quiet this week. Despite this calm, this is the source of a potential exogenous factor that could produce the loudest bang.

(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  The economic data from the rest of the world showed little improvement this week.  Most of it came out of Europe and included only one upbeat stat---German unemployment.  That keeps fears of increasing deflationary pressures alive and well. 

In addition, as oil prices fall, their impact on the economies of the oil producing nations should also act as a governor on global growth---but we have seen no evidence of that to date. 

And then there is the potential Greek exit from the Eurozone and the problems attendant to it, specifically a default on its sovereign debt and the impact that would have on the EU banking system.  German officials have been clear that they are ready for such an action and that the EU economy can handle it just fine.  That likely contains a healthy dose of propaganda; but we are not going to know for sure unless it really happens.

I have suggested, absent any improvement in worldwide economic growth that sooner or later the US is bound to be infected.  Perhaps even a larger worry is that while sovereign economies have been treading water or even declining, their debts both sovereign and corporate have been growing.  I don’t need to tell you that is a toxic combination that unless reversed will [a] impair the issuers ability to service that debt thereby increasing the risk of a sovereign default {see Greece} and/or [b] lead to bankruptcies within a global financial system that is not only overleveraged but holds excessive amounts of highly speculative, low quality assets. 

Europe’s largest bank needs capital (medium):

China is also facing some tough economic decisions (medium):

This is far too complicated a situation for me to assume that I can predict the point at which the US economy starts suffering from this global malaise or sovereigns and banks run out of cash flow to service their debts; but I do know that there is a clear risk of it happening; so this remains the biggest risk to our forecast.’

Bottom line:  the US economic news was mixed this week but there was nothing to suggest that our forecast is at risk or that any negative fallout from a slowing world economy is at our door. 

The QE advocates received a much welcome spike to the punch bowl as the Fed uselessly equivocates over raising interest rates and central banks everywhere promise more monetary ease with each release of even more disappointing economic indicators. Not that that has been shown to be a recipe for improving growth; but who needs that fact when stocks prices are roaring.

Falling oil prices, a strong dollar and the potential Greek exit from the EU were the principal headlines this week.  All hold the potential for disruptive consequences.

This week’s data:

(1)                                  housing: weekly mortgage applications and purchase applications were terrible,

(2)                                  consumer:  weekly retail sales were mixed; December retail chain store sales rose; December light vehicle sales were in line; the ADP private payrolls report was better than forecast while weekly jobless claims fell less than consensus; December nonfarm payrolls were better than anticipated; December consumer credit rose but credit card debt declined,

(3)                                  industry: the December Markit service index was slightly below estimates; November factory orders were down; the December ISM nonmanufacturing index was less than expected,

(4)                                  macroeconomic: the November US trade deficit was lower than forecast; the minutes from the last Fed meeting was more pabulum for the speculators, hedge funds and carry trade crowd.

The Market-Disciplined Investing

            The indices (DJIA 17737, S&P 2044) had a roller coaster week (down, up, down) but still closed within uptrends across all timeframes: short term (16372-19142, 1889-2281), intermediate term (16372-21541, 1729-2443) and long term (5369-18860, 783-2083). 

Both of the Averages closed right on their 50 day moving averages, having traded below that boundary, then back above it.  In addition, both are developing pennant patterns (higher lows and lower highs) which, in technical terms, ultimately get resolved by large directional moves.  Further, they are now within a narrowing spread between the lower boundaries of their short term uptrends and the upper boundaries of their long term uptrends---with the S&P in an especially tight range.  The only resolution to this is that one of the trends is successfully challenged.  And last but not least, the seasonal patterns are about as confusing as could be: the Santa Claus rally didn’t happen (negative), the trading in the first two days of January was down (negative) and a virtually assured negative first five trading days of January was thwarted by a fifth day moon shot to barely score a plus for this indicator which was then followed by a dive in prices.  Coupled with the dramatic volatility, this pin action suggests investor uncertainty/schizophrenia and leaves me directionally clueless. 

The levels to watch are (1) on the upside, the former (unsuccessfully challenged) highs (17998, 2080), the upper boundaries of the developing pennant formations and those existing long term uptrend upper boundaries and (2) on the downside, the last higher low, the lower boundaries of the developing pennant formations and the lower boundaries of their short term uptrends.

Volume fell on Friday; breadth deteriorated. The VIX jumped, closing within a two and a half year short term trading range, an intermediate term downtrend and above its 50 day moving average.  The VIX is also experiencing a narrowing gap between two boundaries, in this case the upper boundary of its short term trading range and the upper boundary of its intermediate term downtrend.  In fact, they are a short hair away from crossing.  Once that happens, then any move to the upside would violate one or both of these boundaries.

The long Treasury moved up strongly again.  To illustrate the strength of the current move, it finished above the upper boundary of its intermediate term uptrend, right on the upper boundary of its short term uptrend and well over its 50 day moving average.

Thoughts on the long term outlook for bonds (medium):

GLD was also up on Friday, closing within a very short term uptrend, a short term trading range, an intermediate term downtrend, a long term trading range and above its 50 day moving average.  It is fighting to make a bottom.

Bottom line: the Averages were all over the map this week.  While the uptrends across all timeframes remain solidly intact, there was a touch of schizophrenia in trading.  Not so much to be technically alarmed, but enough to notice, especially with bonds soaring and GLD attempting to score a turnaround.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17737) finished this week about 48.6% above Fair Value (11933) while the S&P (2044) closed 37.8% overvalued (1483).  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.

As a result of this week’s data/events, the overall investment picture remains basically the same: the US economy sluggishly improving (but we know that the US has been slowly growing); the rest of the world’s major economies either in a recession or struggling to stay out of one (but we know that and they have yet to impact the US); the largest central banks doubling down on QE (but we know that and that they have little to show for it); to which have been added a couple of wild cards: collapsing oil prices (which has yet to influence the US economy or those of the other major oil consuming nations) and the potential exit of Greece from the EU (which hasn’t happened yet).

In sum, that leaves our forecast in tact with a global slowdown, irresponsible monetary policy, higher oil prices and a Greek exit simply risks to that outlook.  Not that any or all of them won’t happen.  But even if they do, I have already factored several of them into our economic forecast and Valuation Model; and the spread between our Valuations and current prices is so large, making it larger would have little meaning.

In fact, in our calculations, to get prices where they are now, none of the aforementioned risks can materialize, indeed nothing negative can occur and US economic growth is the next five years has to match the strongest real growth rate in our modern history. 

So I remain in the unusual position of expecting a positive economic scenario but a lousy market.  What ties those two contrary notions together is monetary policy or to be more specific, QE.  The past six years have witnessed an unprecedented monetary explosion not just here but in many of the major central banks.  While doing little for their respective economies, QE has fed into the coffers of the big banks and other high powered institutional traders allowing them to borrow very cheaply and, in pursuit of a positive yield spread, use those funds to chase asset prices into their current nosebleed territory.  Hence a scenario the leaves the US economy slowly growing but witnesses a vicious mean reversion in securities prices seems a reasonable expectation.

I don’t know what is going to reverse this madness and I don’t know when it will happen.  But I do know that that valuations are stretched to such extremes that when it does happen, I am probably not smart enough or quick enough to be the first guy out the door.  And there is likely only going to be one.  Hence, I would rather forego any profit earned in an environment of excessively high valuations in order to avoid what will likely be far greater losses when this fairy tale comes to an end.

Bottom line: the assumptions in our Economic Model haven’t changed though our global ‘muddle through’ scenario is at risk with lower oil prices and economic disruptions from a potential Greek exit from the EU suddenly developing into a potentially dark underside.  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 2015 Year End Fair Value*              12300                                                  1525
Fair Value as of 1/31/15                                  11933                                                  1483
Close this week                                               17737                                                  2044

Over Valuation vs. 1/31 Close
              5% overvalued                                12529                                                    1557
            10% overvalued                                13126                                                   1631 
            15% overvalued                                13722                                                    1705
            20% overvalued                                14319                                                    1779   
            25% overvalued                                  14916                                                  1853   
            30% overvalued                                  15512                                                  1927
            35% overvalued                                  16109                                                  2002
            40% overvalued                                  16706                                                  2076
            45%overvalued                                   17302                                                  2150
            50%overvalued                                   17899                                                  2224

Under Valuation vs. 1/31 Close
            5% undervalued                             11336                                                      1408
10%undervalued                            10739                                                       1334   
15%undervalued                            10143                                                  1260

* 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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