Saturday, March 21, 2015

The Closing Bell

The Closing Bell

3/21/15

Statistical Summary

   Current Economic Forecast

           
            2013

Real Growth in Gross Domestic Product:                    +1.0-+2.0
                        Inflation (revised):                                                           1.5-2.5
Growth in Corporate Profits:                                            0-7%

            2014 estimates

                        Real Growth in Gross Domestic Product                   +1.5-+2.5
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

            2015 estimates

Real Growth in Gross Domestic Product (revised)      0-+2%
                        Inflation (revised)                                                          1.0-2.0
                        Corporate Profits (revised)                                            -5-+5%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                                 16814-19585
Intermediate Term Uptrend                      16859-22044
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                                     1962-2943

                                    Intermediate Term Uptrend                       1779-2533
                                    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%

Economics/Politics
           
The economy is a neutral 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, February building permits; negatives---the NAHB sentiment index, February housing starts, weekly mortgage and purchase applications, the March NY and Philly Fed manufacturing indices, February industrial production and capacity utilizations, February leading economic indicators and the fourth quarter trade deficit; neutral---none.

While it was a slow week for data points, there were three important numbers: housing starts/building permits, industrial production and the leading economic indicators---all negative, although building permits were something of an offset to housing starts.  

There was almost a dearth of international stats though here too the trend remains negative.  In addition, the Greek bailout is in total disarray.   True, the Greeks promised action on a fiscal plan yesterday.  But they have done that before and (1) their subsequent ‘plans’ missed the Troika’s guidelines by a mile, (2) while their rhetoric was defiant and inflammatory.   It may be different this time; but the onus of proof is on the optimists.  Of course, the optimists also believe that if a Grexit occurs it will have little impact on the EU economy.  That may be true.  But events have unintended consequences; and I would like to know those before dismissing this as a minor nuisance.

In short, nothing in the numbers to suggest that the US and global economies aren’t slipping backwards.  Unfortunately, this has been going on long enough that it warrants a change in our forecast.  Accordingly, I am revising 2015 outlook for (1) economic growth from 2-3% to 0-2%, (2) inflation from 1.5-2.5% to 1.0-2.0% and (3) corporate profit growth from 5-10% to -0.5-+0.5%.  Note that this is not a recession forecast; but it does incorporate the probability of a decline in earnings.  I assume you noticed the change in verbiage in the first paragraph.

Corporate cash and profitability may not be as good as you think (medium and a must read):


As you know, the FOMC met this week and pulled the biggest sleight of hand I can recall.  It removed the word ‘patient’ from its statement, implying that it would tighten soon, but then sounded more dovish than ever in the remainder of the text.  I think that this is in recognition of my theme for the last eight weeks, to wit, the economy is slowing down.  On the margin, this is a plus in my opinion, in that, a rise in rates would only increase the odds and/or magnitude of any slippage in economic growth.  That said, it also recognizes that the Fed once again has bungled the transition from easy to tight money.  It is now in the position of facing a declining rate of economic growth with no policy tools left in its bag save more of the same (QE) that got us into the current mess we are in in the first place. 

Our forecast:

 ‘a below average secular rate of recovery, exacerbated by a declining cyclical pattern of growth,  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 only gets worse the further oil prices fall. 

There is also a problem and that 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. 


       The negatives:

(1)   a vulnerable global banking system.  This week that Austrian bank mentioned in the last Closing Bell went into default and claimed a German bank as its first victim.  In addition, proving once again that our ruling class is either too stupid or too preoccupied with self-serving endeavors to learn a lesson, it now appears that there is a decent probability that Fannie and Freddie will require another round of bail out money.

On the criminal enterprise front, BNY Mellon agreed to pay a $714 million fine for foreign exchange fraud.

‘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, a tax reform measure is being worked on in the House. At first blush, it has a number of positive proposals [lower tax rates accompanied by fewer deductions].  However, before getting too jiggy, it needs to at least get to a vote in the House.  Let’s hope.

(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 week, Sweden lowered interest rates while the Bank of Japan reiterated their devotion to same.  In our own backyard, the Fed basically admitted that QE hasn’t worked but that it doesn’t know how to get out of the mess it is in.  So the solution is to do nothing.  Regrettably, nothing is something; and that something is weakening the dollar [higher interest rates strengthens a currency] which I fear contributes to the global race to see who can post the lowest interest rate and will only spawn more of the same results, i.e. declining economic activity and deflation.
                       
This is a great essay on the negative impact of QE (medium and today’s must   read):

Does the Fed mandate of price stability = 2% inflation (medium and another must read):
                       
(4)   geopolitical risks.  The saber rattling continues in Ukraine but has now managed to spread across the NATO/Russian border.  Implied threats are rising and coming with more frequency, the most belligerent of which was this week’s statement by Putin that he would have used nukes to defend Russian’s annexation of Crimea.  I don’t really believe that this standoff will turn into a shooting war though the economic sanctions part of this faceoff could have an impact on an already slowing global economy.

The Middle East is nothing but murderous chaos; and the administration is attempting to cut a deal with Iran on its nuclear program.  As I am sure you are aware, many in the government are worried that Obama and His minions don’t have the chops to negotiate an agreement that will effectively halt the Iranian drive to hoop.  In addition, Netanyahu was re-elected and if he doesn’t like the deal that introduces another wild card into the picture.  I have no idea how this could play out; but clearly there are some potential negative outcomes. 

In addition, …I am…concerned 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 Our Glorious Leader 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. While we received some positive economic stats from the rest of the world, the dataflow in totality is negative, in particular, the report that Chinese GDP grew at the lowest rate in 20 years. 

In addition, the Greeks have not been particularly cooperative in terms of meeting the fiscal demands of the Troika.  That has served to move both parties closer to a Grexit.  However, as I noted above, Greece announced on Friday that it would provide a plan that meets the requirements.  That said, the Greeks and the Troika have been at this exact place before in what appears to be a game of ‘chicken’---to which someone is going to have to blink and it has to be soon because Greece is running out of money.  Who knows where either parties ‘uncle’ point is.  But I think it safe to say that there is some probability of a Greek exit from the EU; and while numerous pundits have pronounced it of little import, I am always worried about unintended consequences.  I am not saying that there is a huge price to pay.  I am saying I don’t know and I don’t think anyone else does either.

Finally, there is the economic battle going on between NATO and Russia.  I am no foreign policy expert; so I am not predicting any outcome.  But I am concerned about what happens to EU economic growth if Russia turns off the gas spigot.

In short, ‘muddling through’ may continue but I believe that time is running out, particularly on the economic policies of the EU.  This remains the biggest risk to our downwardly revised forecast.


Bottom line:  the US economic news was lousy for an eighth straight week. Even the Fed has awakened to that fact.  I think it time to scale back our outlook for economic and corporate profit growth as well as inflation. Those new numbers are above.

The easy money crowd continues to get more good news this week as Sweden lowered its key rates while the Fed and Bank of Japan renewed their vows to QE.  My immediate concern is that these actions add fuel to the currency devaluation race---the history of trade wars generally suggest that they don’t end well. Further, 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.

Overseas, (1) the stats don’t seem to be improving, (2) Greece is on the verge of default and (3) the shouting war between NATO and Russia goes on unabated.  The faltering economic data are the easiest to deal with, in that there are historic relationships between economic growth of our trading partners and ourselves that can at least give a hint of potential problems---and that hint is recession if the trend continues unabated.  The EU/Greek standoff is like trying to predict the outcome of the gun fight at the OK corral; and the NATO/Russia cat fight is even more difficult.  The best case is that they all ‘muddle through’; the worst case is that EU QE doesn’t work any better than it has for others, so Europe continues to slide into recession, Greece defaults and Russia turns off the gas.

This week’s data:

(1)                                  housing: the NAHB sentiment index was below estimates; February housing starts were atrocious; weekly mortgage and purchase applications fell,

(2)                                  consumer:  month to date retail chain store sales picked up slightly; weekly jobless claims were very slightly better than forecast,

(3)                                  industry: the March NY and Philadelphia Fed manufacturing indices were below expectations; February industrial production and capacity utilization were less than anticipated,

(4)                                  macroeconomic: February leading economic indicators came in below estimates; the US fourth quarter trade deficit was larger than consensus.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 18127, S&P 2108) ended the week with a bang on a quad witching Friday, though they continue their up day/down day pattern.  They remained well within their uptrends across all timeframes: short term (16814-19585, 1962-2943), intermediate term (16859-22044, 1779-2533 and long term (5369-18860, 797-2116).  Both stayed above their 50 day moving averages.  Friday’s moonshot puts them within striking range of the upper boundaries of their long term uptrends; so I assume that they will mount another challenge.  However, I continue to believe that they will be unable to break the gravitational pull of those boundaries.

Volume was up on Friday---it was a quadruple witching day, so no surprise.  Breadth was positive; also not unusual. The VIX was down, closing within its short term trading range, its intermediate term downtrend, its long term trading range, below its 50 day moving average and within a developing pennant formation.  I continue to think that, at these prices, it represents cheap insurance for the trader.

The long Treasury rose, finishing within its short term trading range, intermediate and long term uptrends and above its 50 day moving average.  Every day we get this kind of positive pin action, it appears more and more like its chart has stabilized.

GLD’s price picked up on Friday.  However, it still closed within its short and intermediate term trading ranges, its long term downtrend, below its 50 day moving average and within a very short term downtrend.  This is not a pretty chart.

Bottom line: a good Friday capped off a good week for stocks.  While they have been in a fairly consistent pattern of one day up then one day down, the price moves on the up days this week were greater than those on the down days.  I guess that means that momentum has returned to the upside though (1) the huge Friday move was driven at least partially by options expiration which could easily reverse itself on Monday and (2) the up day/down day pattern doesn’t exactly inspire great confidence in a sustained directional move.  Nonetheless, given the Averages’ proximity to the upper boundaries of their long term uptrends, I would expect a challenge of those levels although I don’t believed that they will be sustained.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18127) finished this week about 51.4% above Fair Value (11966) while the S&P (2108) closed 41.7% 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 US economic numbers were abysmal---again.  Plus the global economy continues to slowdown.  The good news is that the Fed seems to recognize all this; hence, the dovish tone coming from this week’s FOMC statement.  The bad news is that (1) the Fed once again has stayed too loose for too long and now it has no policy arrows to combat a decline in activity and (2) its move reinforces the continuing trend of other major central banks towards competitive devaluations.  Neither have any socially redeeming features and both will likely only exacerbate the current slowdown.  In sum, they point to a necessary change in our outlook---slower economic growth, lower corporate profit growth, if any at all and lower inflation.  

How accurate is Fed forecasting?  Not very (medium):

Richard Fisher on stock valuation (medium):

However, as I have pointed out previously, this will have little to no impact on our Valuation Model since it uses long term moving averages for these inputs.  Of course, since our Model already has Fair Value for the Averages as well as many of the stocks in our Portfolios at considerably lower levels, it will not likely prompt any actions.  Indeed, so many of our stocks have already traded into their Sell Half Ranges, much of my work on the sell side has already been done.  Admittedly, sooner than I might otherwise have wanted.  But that is yesterday’s story. 

On the other hand, if I am correct and economic and corporate growth estimates start coming down on the Street, that will almost assuredly generate heartburn for many whose valuation models are tied to forward looking data---and that will undoubtedly have an impact of security prices.

To be sure, there are risk scenarios out there than could impact our Models: a global recession of some magnitude brought on by the current competitive devaluation race, a default in the financial system brought on by too much leverage (derivatives) or an unanticipated consequence of a Greek bankruptcy (even though the Market got very jiggy with Friday’s statement from Greece that it would submit a plan pronto), a major flare up in the Middle East that severely impacts energy supplies/prices, a misstep in the NATO/US/Russia face off or another 9/11 like tragedy.

Bottom line: the assumptions in our Economic Model have changed.  While they will have no effect on our Valuation Model, if I am correct they will almost assuredly result in changes in Street models which will have to bring their consensus Fair Value down. 

The assumptions in our Valuation Model have not changed either; though there are scenarios listed above that could lower Fair Value.  That said, the current calculated Fair Values are so far below current valuation that any downward revisions by the Street will only bring their estimates more in line with our own. 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.
           
            Are we in a bull or bear market (short):


DJIA                                                   S&P

Current 2015 Year End Fair Value*              12300                                                  1525
Fair Value as of 3/31/15                                  12003                                                  1491
Close this week                                               18127                                                  2108   

Over Valuation vs. 2/28 Close
              5% overvalued                                12603                                                    1565
            10% overvalued                                13203                                                   1640 
            15% overvalued                                13803                                                    1714
            20% overvalued                                14403                                                    1789   
            25% overvalued                                  15003                                                  1863   
            30% overvalued                                  15603                                                  1938
            35% overvalued                                  16204                                                  2012
            40% overvalued                                  16804                                                  2087
            45%overvalued                                   17404                                                  2161
            50%overvalued                                   18004                                                  2236
            55% overvalued                                  18604                                                  2311

Under Valuation vs. 2/28 Close
            5% undervalued                             11402                                                      1416
10%undervalued                            10802                                                       1341   
15%undervalued                            10202                                                  1267



* 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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