Saturday, April 25, 2015

The Closing Bell

The Closing Bell

4/25/15

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                                 17047-19844
Intermediate Term Uptrend                      17168-22294
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                                     1993-2974

                                    Intermediate Term Uptrend                       1802-2575
                                    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%

Economics/Politics
           
The economy is a neutral for Your Money.   This week was another slow one for economic releases.  Unfortunately, most of what we got was downbeat: positives---March existing home sales, weekly mortgage and purchase applications; negatives---March new home sales, month to date chain store sales, weekly jobless claims, March durable goods orders, ex transportation; the March Chicago Fed National Activity Index and the April Markit flash PMI; neutral---none.

New and existing home sales, ex transportation durable goods orders and the Chicago Fed NAI were the big numbers this week.  Meaning that once again both on both a quantity and quality basis, the trend in economic growth is solidly negative.

            The international economic data was more plentiful but regrettably just as bad if not worse than our own.  Worth singling out is the EU composite PMI as well as its manufacturing and service components.  This ends the three week trend of positive data out of Europe.  The question is, which is the outlier: this week or the previous three? 

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.’
           
            Economists have discovered just how bad the economy is (medium):

        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.’  

In the last week, oil prices have been yo yoing above and below the upper boundary of their recent trading range.  It remains a work in progress; so without some follow through we can’t make be sure of a reversal.  However, it does seem that prices have found a level of support.

That doesn’t mean that all is well.  Unfortunately at current price levels much of the fracking production is unprofitable; and it is fracking that has accounted for the aforementioned abundance.  Which brings me to a problem---which is the impact lower oil prices [employment, rig count, cash flow] have had on the subprime debt from the oil industry that is on bank balance sheets and the likelihood of a default. 

Defaults coming in high yield energy bonds (medium):

Update on rig count (short):

       The negatives:

(1)   a vulnerable global banking system.  This week, the DOJ pushed JP Morgan and Citicorp to agree to a joint settlement on foreign exchange trading fraud that would cost each of them $1 billion.  And Deutschebank agreed to pay a $2.1 billion penalty for fraud in the Libor price fixing case.

That failed Austrian bank claims another (bigger) victim (medium):

Another potential problem is the consequences to the EU financial system of a Greek exit---which keeps getting more likely.  Many still believe that it will not occur.  I am not going to argue with that; but the odds are going up.

‘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, congress is trying to get a free trade agreement passed.   As you know, I believe that free trade is an important component in increasing future economic growth.  So while opposition exists, I am hopeful that it will be approved.

Here is a counterpoint; but note that most of the author’s objections are not that there are more losers than winners from the agreement, but how the US should be dealing with the losers (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. 

This week,

[a] the Bank of Japan said that it may not reach its 2% inflation goal until        2016.  And, a former BOJ official said that it would be impossible today for the central bank to exit QE because it would likely lead to higher interest rates which would crush the bank’s balance sheet

 [b] China lowered banking reserve requirements,

In other words, global QE continues with abandon even as its chickens are coming home to roost

Norway’s sovereign wealth fund slams central bank monetary policy (medium and a must read):

(4)   geopolitical risks: tensions in the Middle East remain.  Yemen was back in the spotlight as

[a] the Saudis continue to have a tough time battling the Houthis and

[b] Iran is sending a naval convoy to Yemen supposedly bearing Iranian special troops as well as supplies.  In response, the US sent another carrier group to the Red Sea {there are already two}.  Does that mean that two US carrier groups couldn’t handle eight Iranian ships? Even if it takes three carrier groups, is there a snowball’s chance in hell that Obama has the balls to engage those ships?  This is just another red line that will be crossed and another useless squandering of US prestige.

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, in response to Russia selling an air defense missile system to Iran, the US agreed to sell a missile defense system to Poland.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  While we were light on US economic news, the week was jam packed with overseas developments:

[a] China allowed its first state owned business to default.  It also reported its April Markit PMI which showed contraction,

[b] Japan recorded a positive trade balance due largely to declining imports which it trumpeted as a sign of QE {currency devaluation} success.  My guess is that the Japanese workingman was not that enthralled since is meant higher prices on imported goods and no rise in production {wages},

[c] Europe broke its string of improving economic data reporting April composite PMI came in below expectations as did both the manufacturing and service components,

[d] a wee bit closer to home, Puerto Rico appears on the verge of insolvency,

[e] and last but certainly not least, the Greek bailout talks have degenerated into a grade school pissing contest. First, the Greek government confiscated municipality cash reserves.  Second in another attempt to avoid complying with troika mandates, it began serious negotiations with Russia on a pipeline deal; to which the EU responded by filing anti-trust charges against Gazprom.  Finally, the Greek government stated that it would not present bail out fiscal reforms at the ECB finance ministers’ meeting on Friday.  The ECB then lowered the collateral value of Greek bank assets posted to secure loans; and judging by the headlines out of Europe on Friday, the Greeks made good on their promise to present no reform measures and were roundly chastised by all.

A great article from a Grexit nonbeliever (medium):

But the Greeks still face a formidable repayment schedule (medium):

In sum, ‘muddling through’ remains the assumption in our Economic Model; although that scenario took a blow this week as the EU economic stats turned poor again, the odds of a Grexit appeared to rise and the Chinese and Japanese economies continue to falter. This remains the biggest risk to forecast.

           

               


           
           


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

Overseas, the economic news was plentiful and all bad.

Meanwhile, QE remains the principal theme among the central bankers with evidence that it is not only not working but is a hindrance to economic progress.

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.

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) US/Russia standoff heated up and (3) the Middle East violence continues and with it 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 existing home sales were double expectations, while new home sales dropped well below estimates; weekly mortgage and purchase applications were up,

(2)                                  consumer: month to date retail chain store sales slowed again; weekly jobless claims rose versus an anticipated decline,

(3)                                  industry: March durable goods orders soared but were significantly impacted by transportation orders, ex transportation, the number was abysmal; the March Chicago Fed National Activity index was negative; the April Markit flash PMI was below consensus,

(4)                                  macroeconomic: none.

The Market-Disciplined Investing
           
  Technical

The indices (DJIA 18080, S&P 2117) finished the week on a high note.  The S&P closed above its 100 day moving average and its prior high---breaking the string of lower highs.  If it ends there on Monday, that trend will be negated.  However, the Dow could not get above its prior high though it too was above its 100 day moving average.

Longer term, the indices remained well within their uptrends across all timeframes: short term (17047-19844, 1993-2974), intermediate term (17168-22294, 1802-2575 and long term (5369-18873, 797-2129).  

Volume rose; breadth was mixed---the second day in a row in which the Averages were up but breadth was mixed---reflecting the fact that almost half of all S&P stocks are trading below their 50 day moving averages.  The VIX has negated the lower boundary of that pennant formation, suggesting more movement to the downside (up for stocks).  However, it is not that far from the lower boundary of its long term trading range---which should offer stiff if not impassable resistance.  I continue to think that the VIX remains a reasonably priced hedge. 

A Death Cross on the VIX (short):

NYSE margin debt hits all time high (medium):


The long Treasury moved up again on Friday, bouncing back above its 100 day moving average and the lower boundary of the very short term trading range that was negated on Thursday.  The issue now is, will it continue higher, making the two day break an outlier or head lower again and challenge the lower boundaries of its short term trading range and its intermediate term uptrend?  The latter will create heartburn issues for the ETF Portfolio’s muni bond holdings. 

GLD continues its rotten performance.  A head and shoulders pattern is still developing, a break of which would set it up for a challenge of its long term trading range.

Bottom line: the bulls were in charge this week, accepting a snoot full of bad economic and geopolitical news and trudging higher.  Nevertheless, the Averages are out of sync on their challenge of their very short term downtrends.  If those challenges prove successful, then they will likely make another run at the upper boundaries of their long term uptrends.  Although they must take out their all-time highs before doing so.  I continue to believe that the upper boundaries of their long term uptrends will strangle any meaningful attempt to move higher.

That said, longer term, the trends are solidly up and will be so until the short term uptrends, at the very least, are negated.
           
            The long Treasury chart still has some work to do to establish a stable low off the recent uptrend; and the GLD is fighting to just stay on the chart.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18080) finished this week about 50.2% above Fair Value (12036) while the S&P (2117) closed 41.6% 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 international economic stats confirm the economic assumptions in our Valuation Model.  In fact, the US numbers are going from disappointing to worrisome; and the poor EU PMI data brings into question whether the recent trend in more positive readings was an outlier.  I have not revised our forecast but we need some good news just to hold the current flat to slightly up outlook.

Central bank easy money remains the policy du jour though there continues to be little evidence that it is working; and what little evidence we got, is not what is wanted:

(1)   the Bank of Japan said that it may not reach its 2% inflation goal until        2016.  And, a former BOJ official said that it would be impossible today for the central bank to exit QE because it would likely lead to higher interest rates which would crush the bank’s balance sheet,

(2)   it did, however, record a positive trade balance due largely to declining imports which it trumpeted as a sign of QE [currency devaluation] success; although it also means higher prices on imported goods and no rise in production [wages],

(3)   China lowered banking reserve requirements; but allowed its first state owned business to default.  It also reported its April Markit PMI showed contraction,

Nevertheless, as long as investors ignore the data and focus on QEInfinity, stocks are likely to continue their winning ways---until they don’t.  I don’t see how stocks can make new valuation highs while the global economy deteriorates.  Sooner or later reality impinges.  Just ask Nero.

Geopolitical risks have not declined. The only progress in the Greek bailout talks this week was negative as the government pissed off the EU finance ministers by again delaying the presentation of any reforms while at the same time enacting debt forgiveness measures---the opposite of what the troika wants to hear. 

The NATO/US/Russia global standoff wasn’t helped by Russia discussing plans for a gas pipeline through Greece and the US agreeing to sell a missile defense system to Poland.  While in the Middle East, Iran is sending a naval resupply convoy to Yemen and the US moved another carrier group into the Red Sea---yeah, that’s going to end well.

‘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 are unchanged but in danger of being revised down again.  If they are anywhere near correct, they will almost assuredly result in changes in Street models that will 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                                               18080                                                  2117   

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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