Saturday, April 18, 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 (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                                 16990-19767
Intermediate Term Uptrend                      17104-22230
Long Term Uptrend                                  5369-18973
                        2014    Year End Fair Value                             11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1989-2970

                                    Intermediate Term Uptrend                       1796-2567
                                    Long Term Uptrend                                    797-2129
                        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 neutral for Your Money.   The economic data this week was mostly negative: positives---March builders’ confidence, April Philly Fed manufacturing index, March PPI and April consumer sentiment; negatives---March housing starts and building permits, weekly mortgage and purchase applications, March industrial production and capacity utilization, March leading economic indicators, March small business optimism, April NY Fed manufacturing index, the March budget deficit and March CPI ex food and energy; neutral---March retail sales and sales ex food and energy combo, March CPI and the Fed Beige Book.

Housing starts, industrial production, leading economic indicators and retail sales were the big numbers this week---the score: negatives 3 and neutral 1.  So both on both a quantity and quality basis, the trend following last week’s nonevent is back to solidly negative.

An optimist on industrial production (short):

            The international economic data was also downbeat.  While we did get another positive datapoint from the EU (auto sales), China reported several, not just negative, but very negative stats.  On the former point, this is the fifth week of good numbers from the EU; though it is still too soon to state with confidence that the EU is coming out of its slump.  As I noted last week, one of the things that holds me back is the unresolved problems of Greece and Ukraine.  Both of which experienced adverse developments this week and either of which could stop any potential recovery in its tracks.

Our forecast:

 ‘a much 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.’  

Unfortunately for the ‘unmitigated positive’ crowd, oil prices appeared to have broken out of their recent trading range to the upside. My question now is, will that same group of folks start yakking about how negative this development will be were it to continue?

Of course, the problem that I am really worried about is the impact lower oil prices [employment, rig count, cash flow] have had on the subprime debt from the oil industry on bank balance sheets and the likelihood of a default. 

The latest numbers on rig count (short):

       The negatives:

(1)   a vulnerable global banking system.  This week, there was more fallout from the bankrupt Austrian bank as it claimed another victim.

Another potential problem that I have mentioned before is the consequences to the EU financial system of a Greek exit---which seems to be gathering some momentum.  I am not predicting that it will happen; gosh only knows that the EU ruling class has turned pulling back from the brink of disaster a major art form.  Still it is a risk about which I believe that the pundits are bit too smug.

Even the banksters’ bankers are having problems (short):

‘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 only news this week was the now growing federal deficit---which has been part of major long term negative---too much spending, too high taxes, too much regulation

In the interest of being fair and balanced, several GOP presidential candidates offered plans this week to address the spending/tax problems: tax reform [Rubio] and entitlements reform [Christie].  We might take some hope from this; but it is a long way until the elections and an even longer way from the actual execution of any reform.

Rubio’s plan (medium):

Christie’s plan (medium):

(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets. 

Moody puts student loan bonds on watch for downgrade (medium):

This week,

[a] ECB kept interest rates unchanged {ZZZZZZZZZZ}.  While that maybe a snoozer, its bond buying program {QE} is causing all kinds of problems, to wit, negative interest rates and an acute the scarcity of government bonds---which has the ECB now looking at buying corporate debt; and nothing says mispricing of assets like buying non-risk free bonds when you are supposed to be buying risk free bonds,  

 [b] a Japanese government official suggested that the current exchange rate          for the yen was too high, i.e. it needs to be devalued more,

[c] our own Fed gave us a snoot full of dovish comments on Thursday after it dawned on them that the US economy wasn’t doing too well. 

At the risk of being repetitious, I have suggested that the Fed would once again mishandle the transition to normal monetary policy.  The evidence gathers daily that this economy has seen its highs in growth; and after twelve weeks of nonstop bombardment, the Fed is getting a clue that whatever transition it might have thought it could execute, whenever it thought that the economy might be strong enough for higher rates, has all been a giant wet dream.  In short, the Fed is still batting 0.000. 

The important point here is that if I am correct on the direction of the economy, the world is going to have to alter its current ‘goldilocks’ scenario; and whatever the new improved version is, it may not be quite as palatable as the one they dream about at the moment.

(4)   geopolitical risks: tensions in the Middle East remain.  Iraq regained the spotlight this week as ISIS and Iraqi army units are in a pitched battle. Unfortunately, ISIS appears to be winning.  Equally regrettable, US friendlies appear to be losing everywhere in the Middle East while the administration pursues a self-destructive ‘legacy’ policy with Iran which will in effect make it the hegemon of the area---which got a boost this week when Putin agreed to sell it a state of the art missile defense system.

James Baker on the Iran deal (medium):

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. 

Meanwhile, violence in Ukraine is on the rise as Putin turns up the heat while Ukraine tries to get funding from the IMF.

And the US now officially has boots on the ground in Ukraine (medium):

(5)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  We got a single upbeat datapoint out of the EU this week, keeping alive the prospect that the European economy may be starting to turn. 

However, the rest of the news was pretty bleak: [a] China reported multiple negative stats, [b] the Japanese reinforced their commitment to QE, [c] the latest WTO 2015 and 2016 world trade estimates were downgraded, [d] while the problems in Ukraine and Greece just got worse.

With respect to Greece, it continues to inch toward an exit from the EU.  Perhaps not deliberately; more likely it is either naiveté or recklessness.    Specifically, the Greek government [a] once again failed to deliver enough details on troika mandated reform measures to earn it the financial assistance it so desperately needs [b] began discussions with a well-known sovereign debt restructuring/bankruptcy attorney and [c] last but certainly not least, began discussion with Paul Krugman---the same genius that has been advising the Japanese government.  What could possibly go wrong?

In the meantime, those optimistic pundits pronouncing that Greece offers no risk to the EU or its financial system are getting a lesson in humility.  Adding insult to injury, S&P lowered Greece’s credit rating to CCC+.

More (medium):

And the latest on the subject from the ECB (medium):

‘Muddling through’ remains the assumption in our Economic Model.  Hopefully, the recent EU data will continue to improve; which should improve the odds of this scenario.  On the other hand, [a] a Grexit remains a decent probability and no one knows the unintended consequences of such an event and [b] the Chinese and Japanese economies continue to falter and they collectively are bigger than the combined EU economies. This remains the biggest risk to forecast.

Bottom line:  the US economic news resumed its downward path.

Overseas, the EU economy is still showing improvement, though we got some very rough data out of China.

Meanwhile, QE remains the principal theme among the central bankers as (1) the Japanese central bank reiterated its devotion to currency devaluation, and (2) the Fed officials offered up more crawfishing comments on rate hikes. 

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.

Hoisington’s first quarter review (a bit long but worth the read):

The geopolitical hotspots remain unresolved (1) the Greeks and the Troika appeared to make no progress this week, as the Greeks continued to look for ways to weasel out of repaying their debts, (2) the Ukraine/NATO/Russia standoff heated up and (3) the Middle East violence has escalated raising the odds of a Sunni/Shi’a civil war---which almost certainly won’t leave oil supplies unscathed.

This week’s data:

(1)                                  housing: March housing starts and building permits were well below consensus; weekly mortgage and purchase applications were down; the March NAHB builders’ index was better than estimates,

(2)                                  consumer:  March retail sales rose less than expected though ex food and gas they were slightly better than anticipated; month to date retail chain store sales slowed markedly; March consumer credit declined; weekly jobless claims were well ahead of forecasts; April consumer sentiment rose fractionally,

(3)                                  industry: March industrial production fell twice the consensus, while capacity utilization dropped; the March small business optimism index was well below estimates; the April NY Fed manufacturing index was negative while the Philadelphia Fed index was up from February,

(4)                                  macroeconomic: the March US budget deficit was larger than anticipated; March PPI was up but less than in February; March CPI came in on target, though ex food and energy, it was a hotter than expected; March leading economic indicators were short of forecast and the February reading was revised down; the latest Fed Beige Book was useless, except to blame any shortfall on the weather.
The Market-Disciplined Investing

The indices (DJIA 17826, S&P 2081) finished the week on a major down note.  The S&P has now made a second lower high and kept that very short term downtrend intact.  As you know, on Thursday the Dow negated the existing upper boundary of its very short term downtrend; however, it still didn’t get even with or above the prior high, meaning that it too has marked a second lower high. 

On the other hand, the Dow closed right on its 100 day moving average, while the S&P remains slightly above its comparable trend.  Remember that the 100 day moving average has proven a very resilient support level for the past two years.  So the next couple of days pin action around this boundary could give us a hint on future short term price movement.

Longer term, the indices remained well within their uptrends across all timeframes: short term (16990-19767, 1989-2970), intermediate term (17104-22230, 1796-2567 and long term (5369-18873, 797-2129).  

Volume rose; but it was options expiration, so that was to be expected.  Breadth was terrible.  The VIX bounced 10%, finishing back above the lower boundary of a pennant formation---which was negated by Thursday’s pin action.  I am reversing/putting on hold that call until we see how the Markets trade next week.  Meanwhile, it remained within its short term trading range, its intermediate term downtrend, its long term trading range and below its 100 day moving average.  I continue to think that the VIX remains a reasonably priced hedge. 

The long Treasury was up strong on Friday; not surprising given the equity market performance.  It finished within its very short term and short term trading ranges, its intermediate and long term uptrends and above its 100 day moving average. 

GLD’s price rose, closing within its short and intermediate term trading ranges, its long term downtrend and below its 100 day moving average.  In addition to the really crappy overall performance of GLD, it is starting to develop a head and shoulders pattern which, if completed, has negative implications.

Bottom line: Friday’s pin action (1) created a second lower high for both of the indices, (2) but left them right on their 100 day moving averages which has offered considerable strength recently.  So short term, the technical picture is a bit cloudy.  How the Averages handle their 100 day moving averages next week should provide some insights on direction. 

That said, longer term, the trends are solidly up and will be so until the short term uptrends, at the very least, are negated.
Fundamental-A Dividend Growth Investment Strategy

The DJIA (17826) finished this week about 48.1% above Fair Value (12036) while the S&P (2081) closed 39.2% overvalued (1495).  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 poor US and Chinese economic news only confirms the assumptions in our Valuation Model. 

The Japanese enthusiastic embrace of QE notwithstanding, problems with this ineffective, overused tactic continue to appear (1) in the EU, zero interest rates and the scarcity of available bonds for purchase under their version of QE are severely impacting the pricing of risk and the misallocation of assets, (2) in China, rampant speculation in the securities markets have forced it to institute measures [raising margin requirements] to reduce it, (3)  while in the US, the Fed appears to have overstayed its commitment to money forever and is now stuck with a decline in economic activity and no policy levers to combat it save the same ones that helped cause the problem in the first place.  All these signs of the problems (misallocation of investment, asset mispricing, encouraging speculation, beggar thy neighbor currency devaluations, negligible economic improvement) of a failed QE; and all signs that the correction process in the securities markets may be more painful when it occurs.

Geopolitical risks have not declined. The Greek bailout talks have progressed very little, the outcome of the current Ukraine/NATO/Russia standoff is heating up again and the military developments (ISIS progress in Yemen and Iraq; sale of a Russian missile defense system to Iran) in the Middle East are increasing the explosive potential there.

‘As I noted last week, I have no clue how to quantify the aforementioned geopolitical risks’ impact on our Models even if I could place decent odds of their outcome because: (1) the outcomes are mostly binary, i.e. Greece either exists the EU or doesn’t and (2) they all most likely incorporate potential unintended consequences, which by definition are unknowable.  Better to just say these are potential risks with conceivably significant costs and then wait to see if we ‘muddle through’ or have to deal with those costs.  The important investment takeaway, I believe, is to be sure that your portfolio had at least some protection in the downside.’

Bottom line: the assumptions in our Economic Model have recently 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, our Model’s 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.
DJIA                                                   S&P

Current 2015 Year End Fair Value*              12300                                                  1525
Fair Value as of 4/30/15                                  12036                                                  1495
Close this week                                               17828                                                  2081   

Over Valuation vs. 4/30 Close
              5% overvalued                                12637                                                    1569
            10% overvalued                                13239                                                   1644 
            15% overvalued                                13841                                                    1719
            20% overvalued                                14443                                                    1794   
            25% overvalued                                  15045                                                  1868   
            30% overvalued                                  15647                                                  1943
            35% overvalued                                  16248                                                  2018
            40% overvalued                                  16850                                                  2093
            45%overvalued                                   17452                                                  2167
            50%overvalued                                   18054                                                  2242
            55% overvalued                                  18655                                                  2317

Under Valuation vs. 4/30 Close
            5% undervalued                             11434                                                      1420
10%undervalued                            10832                                                       1345   
15%undervalued                            10230                                                  1270

* 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. 

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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