Saturday, January 24, 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                                 16450-19222
Intermediate Term Uptrend                      16479-21634
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                                     1909-2290

                                    Intermediate Term Uptrend                       1734-2448
                                    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                          49%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        51%

The economy is a modest positive for Your Money.   The US economic data this week was sparse but weighed to the plus side: positives---weekly mortgage applications, December housing starts and existing home sales, December leading economic indicators, weekly retail sales and weekly jobless claims; negatives---weekly (home) purchase applications, December building permits and the January flash manufacturing PMI; neutral---none.  

The overall volume of positive indicators supports our forecast; although I don’t see anything earthshaking in these numbers.  To be sure, the housing data is significant but, in total, it contained both good and bad news. The only standout stat was the leading economic indicators which is a big plus.  On the other hand, the disappointing earnings or guidance announcements continued though they did moderate a tad.  Of course, it is early in the earnings season, so this trend could be easily reversed. But it is still a phenomena that hasn’t occurred in seven years.  Could it be a microeconomic precursor to negative macroeconomic data?  It could but, as I said, it is too early to know.  Nonetheless, it is enough to keep the flashing yellow light going after last week’s discouraging retail sales and industrial production numbers.

The other big news came from overseas, to wit, Draghi finally delivering on the promise of an EU QE.  He was joined in his QE quest by the central banks of Canada, Denmark, Turkey and China.  Not that these efforts will accomplish any more, economically speaking, than the US or Japanese versions. Regrettably, now that QE is all encompassing, it may set up a mad dash of competitive devaluations, which is not likely to end well.  Nevertheless, the hope (which always springs eternal) among investors is that it will keep asset bubble party going.

While there was other discouraging developments oversea (see below), nothing has yet impacted US macroeconomic data.    Hence for the moment, our outlook remains the same but with a bit less conviction (flashing yellow light) 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.  To date, there is no solid evidence about whether lower oil prices are good or bad for the overall economy.  All we really have is the narrative from both sides of the argument.  True, some microeconomic problems are quite visible---declining revenues, lower employment, declining capex---within the oil and oil service industries.  But there is nothing indicating an impact that will alter the direction or growth rate of the economy.

As you know, my concern is the magnitude of subprime debt from the oil industry on bank balance sheets and the likelihood of a default.  Here too there is nothing substantial; just speculation about the potential danger.

Speaking of which, this from Goldman (medium):

So until we can definitely say that lower oil prices are bad for the economy overall, 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 only potentially negative occurrence this week was the default of a major Chinese real estate developer.  There is no direct evidence that this could be disruptive to the Chinese banking system; although, the Bank of China did make a large infusion into the financial system on Wednesday.

Another conceivable headache could be awaiting us as the Greek elections take place tomorrow.  The party currently leading in the polls has made a whole host of unsettling campaign promises not the least of which is to withdraw from the EU and refuse to honor Greek debts.  Of course, the operative words are ‘campaign promises’; and we know that there is an enormous gap between what politicians promise and what they do. Nonetheless, if the new group plays hardball, it could have a troublesome effect on those entities holding Greek debt/liabilities [like the banks].

‘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 big [?] news here was Obama’s state of the union address and all the new policy initiatives that He announced.  Of course, the whole thing was DOA and hence lacks any significance except that it once again shows Obama as an ideologue and not a politician willing to compromise.

(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. 

Well, we got a snoot full of QE this week, as the ECB along with Denmark, Turkey and Canada joined the stampede to easier money and China injected funds into its banking system. 

On the surface, my eight year old grandson knows that QE has done nothing to stimulate either inflation or growth in any country that has tried it.  However, the theory is, at least for the growth part, that more money will stimulate increased bank lending and depreciate [more supply = lower prices] of the country’s currency making its products cheaper versus the competition.  The problem, of course, is that when everyone does it, it doesn’t work.  And right now it appears that everybody’s doin’ it, doin’ it, doin’ it. 

But back to the ECB QE for the moment, I am on record that Draghi really couldn’t match the size of US or Japanese efforts [though the results, i.e. nothing, were a given].  Clearly, he is trying or, at least, says that he is trying to equal their programs; although we are still a little short of details.  Nonetheless, we should know more in the coming days; and if Draghi is not fading us and Germany goes along, then I am going to be wrong on this call.  I will, however, stand by my statement that it is likely to be no more effective than the US or Japanese versions.

                              David Stockman on ECB QE (medium):

(3)   geopolitical risks.  Violence in Ukraine erupted again this week with all parties pointing fingers while the shooting continued.  In addition, ISIS rebels have overthrown the government of Yemen---the importance being that the US has a huge drone program resident in Yemen.  The point here being that both situations contain potentially explosive elements that could suddenly have negative global geopolitical implications.

Update from Ukraine (medium):

Putin’s position (medium):

(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe. There was little economic data from the rest of the world this week though the IMF did downgrade its outlook for global growth in 2015 and 2016. 

More important, (1) the continuing decline in oil prices keeps alive worries regarding their ultimate impact on the global economy; though I reiterate nothing has happened to date to give flesh to any of those concerns and (2) the Greek election on Sunday brings the potential for a Greek withdrawal from the EU and defaulting on their debts to the center of the table.  However, I don’t have a clue regarding the potential ripple effects.  That said, it is a risk that can’t be ignored.

My point in all this is that the aggregate risks incorporated in a faltering global economy I believe is the biggest threat to our own economic health. 

Bottom line:  there was too little US economic news this week to have much bearing on our forecast.  However, I think that the continuing trend of disappointing corporate earnings reports should be viewed as a potential threat to our outlook---potential being the operative word. The good news is that there is still nothing to suggest that any negative fallout from a slowing world economy is at our door. 

The QE dreamweavers received more good news this week from the ECB, Canada, Denmark and Turkey.  Ignoring for the moment the fact that there is little evidence to substantiate QE as a workable policy, with virtually all the global central banks, large and small, now pursuing the same easy money/currency devaluation initiatives, the question is how are they going to accomplish anything positive relative to other nations?  They are not, I think.  What they will do though is keep the speculators, hedge funds and carry traders well supplied with cash to keep the current asset bubble expanding. 

The key event to which to pay attention is now the Greek elections and the economic/political fallout that could occur as a result.  I have no idea what that will be but it almost certainly contains the risk of disrupting the EU banking system.

This week’s data:

(1)                                  housing: the National Association of Homebuilders’ January index was flat; weekly mortgage applications rose but purchase applications fell; December housing starts increased, but permits were down; December existing home sales were up, in line.

(2)                                  consumer:  weekly retail sales were up; weekly jobless claims fell,

(3)                                  industry: the January flash manufacturing PMI was slightly below expectations,

(4)                                  macroeconomic: the December leading economic indicators were ahead of estimates.

The Market-Disciplined Investing

            The indices (DJIA 17672, S&P 2051) had another highly volatile week, destroying that pennant formation that I had been watching but still closing within uptrends across all timeframes: short term (16450-19222, 1909-2290), intermediate term (16479-21634, 1734-2448) and long term (5369-18860, 783-2083).  For the moment, the only resistance/support levels that I am watching other than the boundaries of the aforementioned uptrends is the former all time highs (17986/2080) (resistance) and the mid December low (17288/1970) (support).

Volume was down on Friday; breadth deteriorated. The VIX advanced slightly, but confirmed the break of its very short term uptrend.  It also bounced off its 50 day moving average and remained within its short term trading range and intermediate term downtrend. 

The long Treasury bounced back above the lower boundary of its very short term uptrend, negating Thursday’s break.  It finished within the remaining uptrends across all timeframes and well over its 50 day moving average.  If last Thursday was the best that we are going to get by way of consolidation, then TLT clearly retains a very strong underlying bid.

In a stab at much needed consolidation, GLD was off slightly but remained within its very short term uptrend, above the upper boundary of its short term uptrend, within the intermediate term trading range and above its 50 day moving average.  If this decline remains above the lower boundary of its short term uptrend, then any bounce will likely prompt buying by our Portfolios.

Bottom line: the Market’s new found volatility continued this week.  It has been wild and woolly enough that it makes sense of widen our perspective particularly the distance element of our discipline.  So my focus is on the boundaries of the indices’ uptrends as well as the former high and mid-December low.

GLD is behaving very much like a bottom has been made.  I want to wait for the first downturn to see how that consolidation plays out.  If it holds trend boundaries, then it will be time to Buy.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17672) finished this week about 48.1% above Fair Value (11933) while the S&P (2051) closed 38.3% 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 cloudy.  While the reported economic data provided little guidance, we have to assume that the US economy continues its sluggishly improvement.  The lousy earnings reports from last week got a respite mid-week then continued with a vengeance on Friday with disappointments from UPS and Kimberly Clark.  I remain hesitant to extrapolate this trend.  Clearly, we are still in the beginning stage of this earnings season; so anything can happen.  But I am worried that the inauspicious beginning of this season may portend headwinds arising from (1) global economic weakness and (2) the near universal acceptance of currency devaluation [QE] and the negative impact that will likely have on the foreign profits of US companies.

Overseas, there was little economic information, though the IMF did lower its global economic growth expectations for 2015 and 2016.  However, there was no shortage of international developments.  QE led the list.  Not just the long anticipated ECB QE; but a land rush of other central banks climbing on the QE bandwagon: Canada, Denmark, Turkey and to a lesser extent China. 

My problem is that I have yet to hear one of the dreamweavers point to one example of QE success in creating jobs and economic growth as a rationale for their action.  Rather, these steps seem aimed at competitive devaluations which unfortunately only work when you are the only one doing it.  Now that virtually everyone is doing it, it looks the mirror image of the 1920’s Smoot Hawley tariffs which were enacted to accomplish the same objective---beggar thy neighbor.  I have no clue how this plays out; but when everyone is trying to punch their neighbor in the mouth, I can’t imagine the outcome being all that good.

As if that weren’t enough, (1) oil prices continue to fall---another trade related result of a weapon [overproduction] being wielded by Saudi Arabia, (2) the US backed government in Yemen [a major US drone base] has been overthrown by an Iranian sponsored rebel group, (3) the Greeks vote on Sunday for a new government.   Ahead in the polls is a party that has threatened to exit the EU and default on its debt.  While some of that may be political rhetoric, it still poses potential problems to the EU financial system and (4) the Russians and Ukrainians are at it again.  Like so much of the above, no one can project how this situation ultimately gets resolved.  But we do know that the cutting off of oil to Europe is among the possible outcomes.  Of course as I observe every week, so far none of these negatives have showed up in the numbers---and may never.  But the risks are still there.

However, even if none of these prospective negatives materialize, valuations are still stretched to extremes and the risk/reward equation at current prices levels makes no sense.

Bottom line: the assumptions in our Economic Model haven’t changed though the yellow light is flashing.  In addition, the risk to our global ‘muddle through’ scenario is  greater than ever as a result of the continuing decline in oil prices, disruptions in the global monetary system and a potential Greek exit from the EU.

The assumptions in our Valuation Model have not changed either.  I remain confident in the Fair Values calculated---meaning that stocks are overvalued.  As a result, 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                                               17672                                                  2051

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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