Saturday, February 28, 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                                 16675-19447
Intermediate Term Uptrend                      16730-21881
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                                     1941-2922

                                    Intermediate Term Uptrend                       1762-2476
                                    Long Term Uptrend                                    797-2112
                        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---weekly purchase applications, January durable goods orders and February consumer sentiment; negatives---weekly mortgage applications, January existing home sales, January pending  home sales; February consumer confidence, January durable goods orders ex transportation, the January Chicago national activity index, February Chicago PMI, revised fourth quarter GDP and the February Richmond and Kansas City Fed manufacturing indices; neutral: January new home sales.  

The key numbers were January durable goods orders and ex transportation stats, existing home sales, new home sales, fourth quarter GDP, Chicago PMI and the Chicago national activity index.  Not a lot of joy in this data; and even where the news sounded good, there were problems: (1) the durable goods ex transportation is a much more informative measure than the headline figure and (2) existing home sales [down] are roughly ten times larger than new home sales [up].  

This puts the recent data flow ever closer to redefining a trend.  However, as I continually note, 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.

Real GDP per capita:

Yellen dazzled our congress this week and in the process managed to bolster the case for the doves on monetary policy.

Greece captured the early headlines this week with its complete capitulation to the demands of the EU/ECB/IMF.  It submitted a bailout plan that acceded to the guidelines laid out by that group.  The plan was approved; and will be voted on this weekend by several of the constituent sovereign parliaments that require it (Germany approved it on Friday).  That in turn buys the Greek government a four month extension to implement policies it swore that it would not do.  On the other hand, it removes the risk of a Greek default for four months.  That said, current EU fiscal/monetary policies make it virtually impossible for Greece, or any of the PIIGS for that matter, to achieve the objectives of the EU/ECB/IMF bailout dictates.  Clearly, economic conditions within the PIIGS have not reached the point where they realize the futility of trying to meet those dictates.  However, I believe that absent any change in policy, one or more of the PIIGS will ultimately reach that point.  When that time comes, the EU economy (and perhaps the rest of the world) may be in for a very rough ride.

The consequences of Greece (medium):

The second anti-government protest (short):

And the accompanying angst (short):

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.  Oil supplies remain abundant and that is a significant geopolitical plus.  Furthermore, lower prices should be constructive when viewed as either a cost of production or cost of living.  However, none of pricing positives have yet shown up in the macroeconomic stats.  Indeed, as I have been pointing out, that data has gotten worse over the last month.  So while one’s intuition may be favorably disposed to the ‘unmitigated positive’ notion, it simply hasn’t shown up in the numbers.

Where Americans are spending their savings on energy (short):

The one exception to that statement is the negative impact lower oil prices are having within the oil patch [employment, rig count].  In that regard what has me worried is the magnitude of the subprime debt from the oil industry on bank balance sheets and the likelihood of a default.  However, even in this case, there is little to substantiate a problem; just speculation about the potential danger.  

       The negatives:

(1)   a vulnerable global banking system.  This week Morgan Stanley agreed to a $2.8 billion settlement related to fraud in the mortgage securities market.  In addition, US officials are investigating 10 banks for possible rigging of precious metals market.                 

‘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.  This week, our ruling class did little to improve our lot though Obama did veto the Keystone pipeline bill showing His concern about employment and energy independence.  Far more important, He challenged the Constitution’s separation of powers in an executive order on immigration, demonstrating His qualifications for His previous job of teaching Constitutional law.  And the entire worthless ruling class spent the week burning the air waves debating the nomenclature of ‘terrorists’ while the Middle East burns. 

Meanwhile the FCC has decided that what the Internet needs most is……..drumroll…….more regulation.

As long as these morons remain aloof to the problems that too much spending, too high taxes and too much regulation cause, this economy doesn’t have a snowball’s chance in hell of returning to its long term secular growth rate.

(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. 

Yellen mewed her way through her Humphrey Hawkins testimony, leaving us all assured that the Fed would do nothing to upset the economy by raising interest rates.  Which is something of a mystery to me, since [with the exception of QEI] lower interest rates haven’t done diddily to stimulate growth [see revised fourth quarter GDP].  Furthermore, nothing juxtaposes the futility of the other Fed policy objective, i.e. drive up inflation to 2%, and reality like this week’s January CPI report [-0.7%].

Counterpoint (medium):

Of course, what she really means is that the Fed won’t do anything to upset the Markets.  Which is also a mystery to me since the misallocation and mispricing of assets has never been greater.  Need I repeat, this story will not end well?

Unfortunately, our Fed isn’t the only central bank in the game of easing money, doing its fair share to perpetuate the misallocation and mispricing of assets and aggravating the current trend in competitive currency devaluation (medium):

                                   Last night, China lowered interest rates for the second time (medium):

Welcome to bizarro world, where banks charge to hold your money and pay                  you to take out a loan (must read):

                                   This is decent attempt to explain why Fed policy hasn’t worked (medium):

Absolute must read interview with Lacy Hunt of the Fed’s bankrupt monetary     policy:

(4)   geopolitical risks.  Putin appears to have the military conflict in Ukraine under control. Meanwhile, NATO is threatening to ramp up the sanctions game.  The problem is they have no more will to win this battle than the shooting one.  Indeed, Putin holds the ultimate ace in the hole---gas.  Ukraine and half of western Europe can be shivering in the dark with the turn of a switch.   Given the leadership, the best thing our side can do at this point is to grab dates and run because pressing Russia will only end in more pain. 

China sides with Russia on Ukraine (medium):

The Middle East is nothing but murderous chaos.  Although I am much less worried about who is killing who over there and more worried about the lack of appreciation by our leadership of radical Islam’s intent to bring the war to our home.  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. There were again very few international economic stats this week; and again, what there was, was mixed.  This paucity of data provides no additional insight as to the overall direction of the global economy.  So we are stuck another week with a weak trend of ‘less bad’ numbers but no real indication that a real improvement is forthcoming. So for the moment, I am keeping a global slowdown as the biggest risks to our forecast.

One thing that did improve was the lessening of the risk of a Greek default---at least in the short term.   With the acceptance of Greece’s new policy objectives, there is a four month window for the new Greek government to prove its ‘stuff’ which would in turn put it in a position of getting additional bailout funds.  I am convinced that a plan to pay off current debt by enacting fiscal policies that inhibit economic growth in order to receive yet more new debt is not a viable long term strategy for economic improvement.  Something has to give in the way the eurocrats run the eurozone; and until new fiscal, monetary policies are authorized, we are going to face the probability of a default every time the rollover of bailout debt occurs.  ‘Muddling through’ will continue until it no longer can.  Then, we got problems.

Bottom line:  the US economic news was lousy for a fifth straight week which means that in the absence of any progress, I am going to have to alter our forecast at some point.  I have been reluctant to date to make those changes because we have seen this pattern in the current recovery before only to have it followed by a jump in activity.  In addition, the ever so slight improvement in the international economic stats raises the hope (operative word) that the rest of the world is becoming less of a drag on the US.  On the other hand, the longshoremen’s strike and nasty weather are certain to weaken the numbers that will be forthcoming in the next month.  So navigating the data and trying to separate the cyclical components from the strike/weather related effects over the next six weeks is going to be difficult.   The yellow light is flashing brighter. 

When will the next recession occur (medium)?

The easy money crowd got a hallelujah this week from Yellen as she demurred about raising interest rates anytime soon.  This keeps the asset pumping, competitive devaluation forces going full blast.  As you know, I believe that the ultimate price for the largest expansion in global monetary supply in history will be paid by those assets whose prices have been grossly distorted, not the least of which are US equity prices.

A Greek default appears to have been taken off the table for at least four months.  That doesn’t mean one won’t occur eventually.  Indeed, I think that without some dramatic reforms to EU fiscal policy, a default whether by Greece or any of the other PIIGS in inevitable.  The math simply doesn’t work otherwise.  But that is a problem down the road and how far I haven’t a clue.  So for the moment, the risk of financial turmoil within the EU has been lessened.

On the other hand, the Ukraine/Russia standoff has shifted from being purely military to include the chance of economic consequences, including but not limited to Russia shutting off gas to western Europe---a development that would play merry hell with the EU economy and by extension those of its major trading partners.

This week’s data:

(1)                                  housing: weekly mortgage fell but purchase applications were up; January existing home sales fell sharply; new home sales were down but not as much as anticipated; January pending home sales were up less than consensus; the December Case Shiller home price index rose twice as much as estimates,

(2)                                  consumer:  month to date retail chain store sales slowed;  weekly jobless claims dropped more than expected; February consumer confidence was below forecast while consumer sentiment was above,

(3)                                  industry: January durable goods were up more than consensus, ex transportation up less than anticipated; the January Chicago national activity index was weaker than estimates; February Chicago PMI was a disaster; the Richmond and Kansas City Fed manufacturing indices were well below expectations,

(4)                                  macroeconomic: January CPI fell more than forecast; fourth quarter GDP was revised down from 2.6% to 2.2% but that was slightly above forecasts of 2.1%.

The Market-Disciplined Investing

            The indices (DJIA 18132, S&P 2104) surged mid-week on the Yellen Humphrey Hawkins testimony then gave most of it back by Friday.  They remained well within their uptrends across all timeframes: short term (16675-19447, 1941-2922), intermediate term (16730-21881, 1762-2476 and long term (5369-18860, 797-2112).  Both ended above their 50 day moving averages and their mid-December all-time highs.  The S&P finished back below the upper boundary of its former long term uptrend.  As I noted yesterday, it has pretty much hugged that upper boundary line since breaking above it.  If it can’t pull away from it, then (1) I will likely reinstate it as such and (2) of course, it will clearly act as governor on any further price advance.  The Dow is still 700 point away from the upper boundary of its long term uptrend.

Volume was up on Friday; breadth was mixed. The VIX was down---a bit unusual for a down day in the Market.  It remains below its 50 day moving average and within its short term trading range and intermediate term downtrend.  I continue to think that, at these prices, it represents cheap insurance for the trader.

Update on margin debt:

The long Treasury seems (hopefully) to have found support this week, ending within uptrends across all timeframes and above its 50 day moving average.  Long bonds continue to represent the largest commitment in our ETF Portfolio.

Ten things to know about negative bond yields (medium):

GLD managed to act less sick this week, holding its short term uptrend and remaining within an intermediate term trading range and below its 50 day moving average. 

Bottom line: despite the flattish week, momentum still appears to be to the upside.  On the other hand, the S&P seems unable to break the gravitational pull of the upper boundary of its former long term uptrend.  To state the obvious, unless it can do that, the upside from here is limited.  Supporting that notion is (1) the fact that the Dow is still some distance from the upper boundary of its own long term uptrend and (2) the really poor breadth seen in our internal indicator.  That said, if stocks do trade higher, our Portfolios will continue to use that as an 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 have found some support.  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 (18132) finished this week about 51.5% above Fair Value (11966) while the S&P (2104) closed 41.5% 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 continue to paint a dismal investment picture.  We now have five consecutive weeks of subpar US dataflow.  And it is apt to get worse as a result of the west coast longshoremen’s strike and the disruptive January/February weather pattern.  While any downgrade in economic activity will have very little impact our Valuation Model since I use moving averages for many of our inputs, a slippage in profit growth will almost certainly affect the Market via psychology (i.e. lower P/E’s) and a decline in forward earnings estimates investors love so much.

The QE crowd received more good news this week in the form of a dovish performance by Yellen in her Humphrey Hawkins testimony. I continue to believe that the Fed’s current policy is not only not working but is compounding the damage it has wrought.  I suggest that the January CPI (-0.7%) and the latest revised GNP as well as the recent negative dataflow is evidence enough to illustrates the Fed’s failure to even get close to its goals (2% inflation and over 3% GDP growth).  Some will argue that it has attained its employment objective but the validity of that proposition is diminished considerably when one adds back in those that have completely dropped out of the labor force.

What low inflation means for stocks (medium):

The point here is not that the Fed is not trying to do the right thing nor that its lack of success, in and of itself, is a reason to cease and desist with monetary easing.  The point is the reverse; that is, the harm it is doing via (1) pricing and allocation irregularities in the financial system that sooner or later will have to be rectified and (2) the fact that it is morphing into a global currency war which has never been good for economies or markets.   It is the mispricing of assets that most impacts our investment outlook.

At this moment, the Greek/EU/ECB/IMF standoff has been pushed out for at least four months.  That clearly removes, for at least that four month period, the potential for a European financial crisis that could ultimately impact all markets.  For the moment, that fact along with a slightly better dataflow keeps the ‘Europe muddle through’ assumption in our Models on track.

The two biggest geopolitical risks to the Market continue at a slow simmer.  The military action in Ukraine seems to be subsiding but economic saber rattling has taken its place---which can be just as destructive to the financial markets as the potential spread of a shooting war.

The Middle East is slipping into chaos and no one seems to have an answer.  Frankly, I think that we ought to wall the place off and let them go on killing each other.  Unfortunately, that is not going to happen and even more unfortunate, radical Islam seems to want to bring the fighting to us.  And even more unfortunate than that, our government’s strategy is to treat these guys like a bunch of street punks, instead of a well-armed, highly motivated fanatics that want to wreak havoc with our country.  The risk here is that it takes another 9/11 or worse for those in charge to comprehend the error of their way.

Bottom line: the assumptions in our Economic Model haven’t changed though the yellow light is flashing ever brighter as the string of disappointing US stats moves through its fifth week and the central bankers refuse to acknowledge the damage that they are inflicting on the global economy.  There are some bright spots: a slight improvement the flow of global economic indicators and the removal of a Greek default as a catalyst for an EU financial crisis; but those are hardly sufficient to offset the negatives.

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.
DJIA                                                   S&P

Current 2015 Year End Fair Value*              12300                                                  1525
Fair Value as of 2/28/15                                  11966                                                  1487
Close this week                                               18132                                                  2104   

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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