Saturday, February 21, 2015

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                                 16630-19402
Intermediate Term Uptrend                      16677-21832
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                                     1932-2913

                                    Intermediate Term Uptrend                       1757-2471
                                    Long Term Uptrend                                    797-2095
                        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                        53%

The economy is a modest positive for Your Money.   The US economic data this week again weighed to the negative side: positives---month to date retail chain store sales, weekly jobless claims, the minutes from the last FOMC meeting; negatives---weekly mortgage and purchase applications, January housing starts and building permits, February homebuilder confidence, the February NY and Philadelphia Fed manufacturing indices, January leading economic indicators, January industrial production and capacity utilization, January PPI; neutral---none.  

The key numbers were housing starts, industrial production and the leading economic indicators---all demonstrating weakness and making this the fourth consecutive week of subpar reports among primary indicators.  This puts the recent data flow on the cusp of redefining a trend.  However, we have been through so many instances in the current recovery in which a period of lousy data was suddenly followed by improvement, I am more hesitant to dub the current situation as the likely beginning of a slowdown than I might otherwise be.  Making this more complicated is that February stats are bound to reflect the negative impact of the west coast longshoremen’s strike as well as the terrible weather the eastern portion of the country has suffered.  So interpreting the economic tea leaves over the next six weeks is going to be very tricky.  This makes me very cautious about changing our forecast: but the yellow light is flashing brighter.

Greece dominated this week’s headlines---deal, no deal, deal, no deal--- culminating with a deal (I think).  The short version is that the Greek’s folded like cheap umbrella; and the bottom line is (1) that the euros did what they do best [kick the can down the road], (2) but that means our EU ‘muddle through’ scenario is intact, (3) it removes a potential Greek default as a major risk to our economic forecast---at least for the moment and (4) serves to re-focus our analysis to the key element of that outlook---the current string of key US economic indicators signaling of an impending economic slowdown in the US. 

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 hesitant 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.  I want to be clear about something.  Greater domestic supply of energy is and always will be a major long term positive, in that it gives the US greater control [less dependence on foreign oil] of a major component of production. 

The debate of late has been about energy prices---which is a shorter term issue.  And the problem has been that no one is winning the debate; that is, it is not clear if lower oil prices have been a plus for the overall economy as the consensus would have us believe.  In fact the opposite is true---economic stats have been worsening as oil prices have fallen.  I am not trying to draw a causal relationship here; but clearly a weakening in economic numbers at the same time that oil prices are falling is causing the ‘unmitigated positive’ crowd fits.  I leave open the question as to whether lower oil prices are a plus for the economy until we have either more evidence or better analysis or both. 

However, what we do have solid data for, is the negative impact lower oil prices are having within the oil patch.  And it is along those lines that I have concerns, specifically the magnitude of the subprime debt from the oil industry on bank balance sheets and the likelihood of a default.  Although here too, there is little to substantiate a problem; just speculation about the potential danger.  

       The negatives:

(1)   a vulnerable global banking system.  No new accusations, investigations or subpoenas this week; but the WSJ reported late Friday that Deutschebank and Banco Santander will likely fail a US bank stress test largely based on inadequate supervision of massive derivatives positions.

‘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.  Our ruling class is on another much deserved vacation this week.

(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. 

This only gets worse. Japan announced this week that it was so proud of its quadruple in, swing for the fence,  balls to the wall, give me liberty or give me death ‘beggar thy neighbor’ monetary policy, that it wanted to reassure the world that it was not about the quit.  And our own beloved Fed mewed demurely about how it couldn’t possibly raise rates by a whopping 0.25% because it simply doesn’t have enough information to suggest such a move wouldn’t cause an economic crash.  Of course, [a] an economy can’t crash when it cruising at an altitude of one foot and [b] it isn’t the economy these guys are worried about in the first place---it is the extraordinarily mispriced asset markets.  And they should be worried.  But let’s not confuse the issue: it isn’t the economy that will cause us problems; it has benefitted very little from QE’s and so I doubt it will be hurt by their absence. 

Draghi likely to have problems implementing his own version of QE         (medium):

(4)   geopolitical risks.  Putin appears to have the Ukrainian conflict under control after a little help from Merkel.  That is not to say that all is quiet on the western front, but Ukraine does seem to be diminishing as potentially major negative event. 

The Middle East, however, so f**ked up, I don’t think anyone has a clue as to how it will play out.  God only knows that US foreign policy would be better off if we didn’t even have a president or a secretary of state right now.  My fear is that it will take a major catastrophe [like burning people alive and mass beheadings aren’t enough] to make these morons realize how irresponsible, unsound, dangerous and intellectually vacuous our current ‘local law enforcement’,’ jobs for jihadists’ strategy [?] is. 

(5)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe. This week was another of mixed data from overseas---though this time the encouraging data came from both Japan and Europe.  While only the second week of ‘less bad’ data, it does raise the potential hope that the heretofore steady stream of negative global economic indicators might be ameliorating.  However, puking all over that notion, Goldman released a study on Thursday evening covering global economic activity [clearly far more comprehensive than my efforts] in which it reports that the international leading economic indicators are pointing at a decline in growth.  That carries more weight than one or even a couple pieces of upbeat data.  On the other hand, I can’t completely ignore those better reports.  So for the moment, I am keeping a global slowdown as the biggest risks to our forecast but with a little less certainty on my part.

Every time I report something new on the Greek/EU bailout negotiations, the opposite happens before the ink is dry.  But I am sure this time is different--- the Greeks and the EU reached a tentative agreement Friday afternoon.  The terms provide for a four month extension of the bailout funding for the Greek government, PROVIDED the Greeks submit a detailed plan on reform measures by Monday AND it is approved by EU/ECB officials. 

On the surface, it appears to be capitulation by the Greeks.  However, a lot of water is going to run under bridge back home between now and Monday and most of it will be focused on those two conditions above [a detailed plan that basically follows the old agreement that the Greeks have already rejected and its approval by the officials that have so rankled the Greeks to date].

If you assume that the Greeks comply, it will keep the EU ‘muddling through’ scenario intact---more or less in line with our forecast.  Hence, I view this less as a big positive and more as lowering the near term risks of a big negative. 

Of course, we will know more Monday as to whether the Greeks really and truly did surrender.  Unfortunately, even if they did, it will only make the arithmetic of more austerity and more debt ultimately more unworkable than it is now.  We may be only in the second rather than the fourth act of this tragedy; but there will still be a final curtain.  And unless something truly revolutionary takes place in EU fiscal and monetary policy, the economically unsustainable position of Greece and many of the other PIIGS will have to be reconciled---and that process is apt to be painful, more so the longer it takes to resolve. 

The text of the agreement (medium):

Analysis (medium):


Bottom line:  the US economic news was lousy for a fourth straight week which keeps moving our forecast further into ‘at peril’ territory.  I am not making changes at this time because (1) we have seen this pattern in the current recovery before only to have it followed by a jump in activity, (2) international economic stats were mixed for a second week in a row---though the new report out of Goldman may be a stake through the heart of any chance of global economic improvement and (3) earnings season is turning out less bad than first appeared.  Nonetheless, the yellow light is flashing brighter. 

Easy money received a boost this week from Japan and our Fed---even though there remains scant confirmation that QE anywhere, anytime [except QEI] has done a lick of good.  Because of that, I am not all that worried about an unwind of QE.  Rather I am more concerned about the consequences of a continuation of the policy especially as it relates to currency policy [‘beggar thy neighbor’] and its ultimate impact on global economic activity.

The negotiations between the Greeks and the EU/ECB seems to have yielded fruit at least for the short term (‘seems’ being the operative word at this moment).  If so, then Greece and the horrible state of its economy and finances get downgraded on our risk scale---again, at least in the short term. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were off markedly; January housing starts and building permits were much lower than estimates; February homebuilder confidence was lower than anticipated,

(2)                                  consumer:  month to date retail chain store sales improved; weekly jobless claims dropped more than consensus,

(3)                                  industry: the February NY and Philadelphia Fed manufacturing indices were below expectations; January industrial production and capacity utilization fell short of forecasts,

(4)                                  macroeconomic: the January leading economic indicators were below expectations; January PPI was worse than estimates; the minutes from the last FOMC meeting had a slightly more dovish tone than the statement issued after the same meeting.

The Market-Disciplined Investing

            The indices (DJIA 18140, S&P 2110) traded relatively quietly for most to the week then had a blow off Friday.  They remained well within (or above) their uptrends across all timeframes: short term (16630-19402, 1932-2913), intermediate term (16677-21832, 1757-2471 and long term (5369-18860, 783-2083).  Both ended above their 50 day moving averages and their mid-December all-time highs.  The S&P finished above the upper boundary of its long term uptrend for the fourth day.  If it closes above that level on Monday, the break will be confirmed.  However, under our trading discipline, the Averages have to be in sync to signal a change in trend; and the Dow still has 700 point to reach the upper boundary of its long term uptrend.

Volume was up on Friday (option expiration); breadth was strong but not as much so as I would have thought, given the pin action. The VIX was down, below its 50 day moving average and within its short term trading range and intermediate term downtrend.  I am not a trader; but if I were, at these prices I could buy portfolio protection pretty cheap. 

With both Averages above their December highs and the S&P above the upper boundary of its long term uptrend, I ran two studies on our internal indicator.  (1) looking at stocks at or above their long term highs: in a 141 stock Universe, 46 stocks were above their all-time highs, 10 were right on those highs and 85 weren’t close, (2) looking at stocks at or near the upper boundaries of their long term uptrends: in a 141 stock Universe, 26 were at or near their upper boundaries, 29 were above their all-time highs but not close to their upper boundaries and 85 weren’t close. 

Note: the seeming discrepancy in the math is that some stocks are in what at first glance appears to be two inconsistent categories; for example, a stock might have traded above the upper boundary of its long term uptrend, made a new high then backed off sufficiently to be materially below that all-time high but still above its long term uptrend.  Hence it would be counted as a stock that is above its long trend but is nowhere near its all-time high.)

The long Treasury suffered some more whackage this week but, at least, appeared to be attempting to stabilize.  The bad news is that it finished below its 50 day moving average and the lower boundary of its short term uptrend (for the second day) and within a developing very short term downtrend.  If it closes below the lower boundary of its short term uptrend on Monday, the trend will re-set to a trading range. The good news is that TLT remains well within intermediate and long term uptrends.  Any move down toward these levels will likely prompt our ETF Portfolio to Add back those share Sold last week.

GLD ended right on the lower boundary of its short term uptrend and below its 50 day moving average.  If it trades lower, then the remainder of our Portfolios’ positions well be Sold.  However, a solid bounce off the short term lower boundary could be cause for buying back those shares Sold week before last. 

Bottom line: the pin action this week shifted the momentum to the upside with the S&P very near breaking above the upper boundary of its long term uptrend.  That would almost assuredly set the stage for a further advance; though the lack of confirmation by the Dow as well as the abysmal reading from our internal indicator pose negatives.  While I don’t believe that the fundamentals justify higher prices---that is just my opinion.  On the other hand, if stocks do trade higher, our Portfolios will continue to use that opportunity to Sell stocks that no longer fit our investment criteria or those which trade into their Sell Half Range.

TLT and GLD seem to be trying to stabilize.  At the moment, our Portfolios are simply holding their positions.  That could change depending on the pin action.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18140) finished this week about 51.2% above Fair Value (11966) while the S&P (2110) closed 41.9% overvalued (1487).  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.

This week’s economic stats darkened the overall investment picture.  We now have four consecutive weeks of subpar US dataflow.  Because there has been a recurring pattern in this recovery of a period of weak economic numbers followed by improvement, I am prepared to let this go on a bit longer before altering our forecast.  Indeed, the numbers are almost certain to remain subpar as the effects of the west coast longshoremen’s strike and the disruptive January/February weather pattern work their way through the economy. 

That said, as I have explained before, any downgrade in economic activity will have very little impact our Valuation Model since I use moving averages for many of our inputs.  On the other hand, a slippage in profit growth will almost certainly effect Street psychology and the forward earnings estimates investors love so much.

If you are a QE devotee, the skies brightened this week with Japan quadrupling down on QE and our Fed sounding more dovish than anticipated in the minutes of its latest FOMC meeting.  As you know, while I acknowledge the very positive impact of QE on asset prices to date, I am far less sanguine going forward because (1) QE has caused excesses in the financial system that sooner or later will have to be rectified; and the greater the excess, the more painful the correction (2) QE is morphing into a global currency war which has never been good for economies or markets.   

At this moment, consensus is that the Greeks have folded their tent and gone to the house.  That may be a bit too pat; but I am tired of arguing over the risk of no resolution.  I would rather bottom line what this would mean for our Models---and that is: nothing. A settlement would clearly remove a potentially large negative from my list of worries.  But our basic assumption always has been and remains that Europe would ‘muddle through’ as it has for the past decade.

 Then why did I spend a lot of time and ink developing this subject?  Because (1) I don’t think the Greek (PIIGS) model is sustainable long term in a fiscally unreformed EU, (2) I thought the new Greek regime had bigger balls than is now apparent and (3) that was a combo that had a decent probability of leading to the painful but inevitable rationalization of the current unworkable EU monetary/fiscal regime.  Clearly I was wrong.  On the other hand, I don’t want to minimize my belief that barring a rewriting of the EU constitution, there will ultimately be pain incurred as result of correcting the economic problems being created by a monetary but no fiscal union---a lot of pain.

But that is for another day.  Today, we rejoice that the ruling class is doing what it does best which is to totally f**k things up and then kick the problem down the road.  Today, we worry not about a Greek default which never happened and wasn’t in our forecast anyway; we worry about the lousy numbers from our economy and from the global economy.

I guess that we can rate the resolution of the Ukrainian violence as a plus.  While clearly a victory for Putin, it at least takes a military confrontation between the US and Russia off the table. 

It seems daily that ISIS becomes stronger, spreads geographically and pushes the envelope on atrocious behavior.  Given that it almost assuredly views these developments a major positives, I don’t see how this stops until somebody or somebodies kick the living shit out of these guys----as opposed to, you know, finding them jobs.  I don’t claim to have a strategy; but I do fear that their violence will only get worse and get closer to home in its absence. 

Bottom line: the assumptions in our Economic Model haven’t changed though the yellow light is flashing as a result of (1) a four week string of disappointing US stats, (2) only marginal improvement the flow of global economic indicators and (3) the relentless pursuit of QE which is creating the conditions for a currency war.

The assumptions in our Valuation Model have not changed either.  I remain confident that the Fair Values calculated are so far below current valuation that it would take the second coming of Jesus for stocks to have even a remote chance of not reverting to Fair Value.  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.

            The problem with using forward earnings in valuing stocks (medium):
            Deutschebank: 0% upside (short):

DJIA                                                   S&P

Current 2015 Year End Fair Value*              12300                                                  1525
Fair Value as of 2/28/15                                  11966                                                  1487
Close this week                                               18150                                                  2110   

Over Valuation vs. 2/28 Close
              5% overvalued                                12564                                                    1561
            10% overvalued                                13162                                                   1635 
            15% overvalued                                13760                                                    1710
            20% overvalued                                14359                                                    1784   
            25% overvalued                                  14957                                                  1858   
            30% overvalued                                  15555                                                  1933
            35% overvalued                                  16154                                                  2007
            40% overvalued                                  16752                                                  2081
            45%overvalued                                   17350                                                  2156
            50%overvalued                                   17949                                                  2230
            55% overvalued                                  18547                                                  2305

Under Valuation vs. 2/28 Close
            5% undervalued                             11367                                                      1412
10%undervalued                            10769                                                       1338   
15%undervalued                            10171                                                  1263

* 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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