Saturday, May 9, 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                                 17130-19927
Intermediate Term Uptrend                      17270-22385
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                                     2010-2991

                                    Intermediate Term Uptrend                       1814-2585
                                    Long Term Uptrend                                    797-2132
                        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.   This week’s data was negative, again: positives---weekly purchase applications, weekly retail chain store sales, weekly jobless claims, the April ISM nonmanufacturing index; negatives---weekly mortgage applications, the April/March nonfarm payrolls report, the April ADP private payrolls report, the April PMI services index, March wholesale inventories and sales, the April US trade balance, first quarter unit labor costs; neutral---March factory orders, first quarter productivity.

The April trade deficit and April nonfarm payrolls were the important numbers; neither very encouraging.  Once again on both a quantity and quality basis, the trend in economic growth is solidly negative---meaning fourteen out of the last fifteen weeks have witnessed disappointing data.

Additional comments:

(1) note that most of the positives are weekly numbers while the negatives are monthly.  I would argue that the latter carries more weight,

(2) the reason the trade deficit is important is because it is a component of GDP.  Following that negative [trade] report, general consensus among economists was that it pretty much guarantees a negative first quarter GDP number. 

       Counterpoint (medium):

(3) pundits are terming the April nonfarm payrolls report as ‘goldilocks’, i.e. good enough to indicate that the economy is doing just fine but not too good to push the Fed to accelerate raising rates.  Absent the dramatic downward revision of the March reading, I would agree; however, if you average the two, you get a jobs growth rate of 150,000 for each of those months.  That is hardly a ‘goldilocks’ number. 
More like an ‘ostrich’ number.  Whether you agree or not, the Market’s reaction to the nonfarm payrolls report, answered a big question about investor sentiment, to wit, good QE news is still good stock news,

A look at wage growth (short and a must read):

(4) Yellen made an unusual comment this week in which she characterized stock valuations a ‘quite high’.  This from the head of an agency whose sole purpose the last seven years has been to crank up asset prices.  The question is, was it a slip of the lip or did she really mean it; because if she meant it, the jobs report notwithstanding, the odds of a rate hike sooner than later just went up.

To be sure given the string of poor economic stats, it would hardly make sense for the Fed to start tightening near term.  On the other hand, the bond market is taking rates up and don’t think the Yellen is not paying attention.  And don’t think that she doesn’t realize that today like so many times before, the Fed, having totally f**ked up the timing of a transition to normal monetary policy, will sooner or later be forced to follow [if it keeps rates low, then foreign capital will flood to the US to borrow cheap, driving the dollar still higher].

            The international economic data was also mostly negative although the EU continues to report improving numbers---which keeps alive the hope that it has turned the corner.  Unfortunately, the euros can’t resolve the Greek bailout situation and that has the potential of banging whatever progress is being made over the head with a giant monkey wrench.  In addition, UK voters just gave a resounding victory to the conservative party whose campaign platform included major revisions in its relationship with the EU---another thread in the potential unraveling of the EU.

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 production in this country continues to grow which is a significant geopolitical plus.  However, [a] lower oil prices failed to bring the consumer spending bonus so many pundits expected and [b] prices now appear to have bottomed and are moving up. 

If energy prices have stabilized, absent any delayed consumer response, then the lower prices part of this positive factor no longer applies.  On the other hand, my concern about fracking related junk debt on bank balance sheets may also not apply.  It is  not clear to me at this point that we have seen the low in oil prices; but certainly, the longer they exhibit positive momentum, the more likely that the bottom has been made.

       The negatives:

(1)   a vulnerable global banking system.  No events this week.  I did link to a scathing editorial by an SEC commissioner faulting the SEC for being far too easy on the too big to fail banks AND their management.  Until the Fed stops funding those banks’ prop trading, their management is held accountable both financially and legally and their stockholders are forced to take the financial hit for incurring inappropriate risks, our banking system will remain on the precipice of another Lehman Brothers like occurrence.

‘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 still 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.

(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 central bank of Australia lowered its key rate for the fourth time,

 [b] a number of major Chinese brokerages raise margin requirements,

 [c] perhaps the most important development this week was severe whackage experienced in the global bond markets.  I have discussed a number of explanations for this in our Morning Calls.  But the one that is starting to make the most sense to me is that the bond guys have finally recognized that it makes no economic sense to hold a zero interest rate {or a zero real interest rate} fixed income instrument.  And as I also pointed out, it is not without precedent for the Markets to lead the central banks in raising rates; indeed, it has happened more often than not. 

If this proves to be the case {at the moment I am just hypothesizing on the cause (s) for the rate run up}, then the $64,000 question (s) is, how far will rates have to rise before the Fed acts? And if it does, what will the impact be on the economy?  In other words, will it lift rates as the economy slowing?  Quite the conundrum as they say.  Unfortunately, I think the Fed has painted itself into a lose/lose position; and that probably is not good for either the economy or the Markets.

QE and the Japanese economy (medium and a must read):

(4)   geopolitical risks: tensions remain in the Middle East as well as in and around Ukraine.  

There were no major incidents this week, though the US and Saudi Arabia have apparently agreed on a major arms sale to the Saudis---justified or not, that is only going to add fuel to the fire. 

In addition, I am concerned about radical Islam’s intent to bring the war to our home.  If you believe ISIS propaganda [and I can understand why you might not] this week’s failed massacre attempt in Texas is just the start of a more intense campaign of mayhem in this country.  I have no doubt that the FBI and other agencies are working hard to prevent such attacks; but you seldom win them all.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  It was a light week for international data which was largely negative.  Bad news out of Australia, China and Japan.  However, Europe again delivered more upbeat stats; enough so to keep the hope of economic improvement there alive.

However, the major news centered around:

[a] the Greek/Troika bailout discussions which didn’t go all that well---at least if you are a Greek.  True, Greece did make an IMF payment for E200 million this week; but it has a very full schedule of payments over the next couple of months.  Not the least of which is one for E750 million next Tuesday.  Part of the news this week was a statement by the EU that there was no chance of reaching a bailout agreement on Monday.  Oooops.

Not helping matters, the EC Commission slashed its forecast for Greek economic growth, disagreement broke out within the Troika over the proper conditions for a bailout, the ECB reduced the collateral value of Greeks bank assets and foreign banks lowered their credit lines to Greek banks.

The latest (medium):

[b] the UK elections which gave a major victory to the conservatives whose platform included substantial revisions in its relationship with the EU.  This can only raise more concerns about the sustainability of the EU.

    ‘Muddling through’ remains the assumption for the global economy in our Economic Model with the proviso that if a Greek default/exit occurs, all bets are off. This remains the biggest risk to forecast.
Bottom line:  the US economic news maintained its downward path; though there is a promise of improvement in the eurozone.

Meanwhile, spiking interest rates and a confusing comment from Yellen has muddied the global QE theme.  While I never believed that QE had much impact on any economy and what impact it did have was more negative than positive, those rising rates threaten to potentially turn a plus for asset prices into a negative, Friday’s pin action notwithstanding.

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 are still facing off in several geographic areas 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: weekly mortgage fell while purchase applications rose,

(2)                                  consumer: month to date retail chain store sales improved slightly; April nonfarm payrolls were slightly above consensus, but the March reading was revised down substantially; the ADP private payrolls survey was very disappointing; weekly jobless claims rose less that forecast,

(3)                                  industry: March factory orders were in line; April PMI services index was a little below expectations while the April ISM nonmanufacturing index was better than estimates; March wholesale inventories were up less than consensus, while sales fell [again],

(4)                                  macroeconomic: the April US trade deficit was much larger than forecast; first quarter nonfarm productivity was in line while unit labor costs were higher than anticipated.

The Market-Disciplined Investing

The indices (DJIA 18190, S&P 2116) finished the week on a high note as investors got jiggy with Friday’s nonfarm payroll number.  Both closed above their 100 day moving average and the trend of lower highs---for the third time. If they end there on Monday, those trends will be negated. 

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, 797-2132).  

Volume rose slightly, though not nearly as much as I would have expected, given Friday’s Titan III shot.  Breadth improved.  The VIX fell back below its 100 day moving average and is in a very short term downtrend---both positives for stocks.  That said, it is creeping closer to the lower boundaries of its short and long term trading ranges.  The closer it gets, the more attractive it becomes as portfolio insurance.

The following big declines early in the week, long Treasury moved modestly up on Friday. Still it remained below its 100 day moving average, within a short term downtrend and below the lower boundary of its former intermediate term uptrend.  In short, the bond community was not nearly as impressed with Friday’s nonfarm payroll number as the stock boys.  I am not sure what that means, since I was never sure why bonds plummeted in the first place.  What I feel reasonably sure of, is that if bonds continue to decline, stock investors won’t be able to ignore it forever.

GLD continues to do nothing---suggesting that whatever the cause of the bond market decline, it wasn’t concerns about inflation.  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: after a rough couple of days early in the week, the bulls were in charge on Friday, tip toeing through the tulips following an employment report suggesting that the Fed can continue to procrastinate raising rates.  If there is follow through next week, the trend of lower highs will be broken and the Averages will be set up to challenge 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’s recent pin action is causing me a great deal of uncertainty primarily because I see no clear reason for the substantial price decline.  In addition, bonds prices lifted only modestly amid Friday’s surge in stock prices, suggesting a lack of conviction that the Fed will continue to delay increases in interest rates.  My concern focuses on what might be the fundamental reasons for this contrary performance.  I still have nothing to offer by way of an explanation; but our ETF Portfolio did lighten its muni bond positions.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18190) finished this week about 50.6% above Fair Value (12073) while the S&P (2116) closed 41.1% overvalued (1499).  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.  However, as I said above, there is the hope that the European economy has started to improve.  I have not revised our forecast because we need some good news just to hold the current flat to slightly up outlook.

Questions (spiking interest rates and Yellen’s comment) arose this week about the sustainability of QE’s continued capacity to push asset prices higher; although the Market’s response to Friday’s nonfarm payroll report clearly addressed that issue, suggesting that stock investor’s love QE as much as ever. 

However, given the very limited response of the bond market to the nonfarm payroll number, I am not sure that it makes sense to assume that whatever was driving rates up is no longer valid.  So if the bond vigilantes keep pushing rates higher, it is going to make the Fed’s (transition timing) problem worse and sooner or later, equity investors will no longer be able to ignore the changes being wrought in the equity discount factor.  I am not saying that bond yields will continue to rise.  I am saying that if it is unclear what is propelling rates higher, then we can’t be sure it is not going to continue.

Geopolitical risks have not declined. There was no progress in the Greek bailout talks as differences broke out within the Troika as to the terms of the agreement and the Greek banks incurred additional pressure on their capital structure from the ECB and foreign banks. These can only have raised the odds of a default/exit and its consequences---about which I believe no one has a clue.  Clearly, that also ups the probability of market disruptions.

The NATO/US/Russia and Middle East standoffs haven’t been resolved though there was no further deterioration in either this week.

‘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 still 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 have to take 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.

Earnings growth without sales growth (medium and today’s must read):

Our Portfolios maintain their above average cash position.  This week, a number of the stocks on our Buy List fell below the lower boundaries of their respective Buy Value Ranges---not a plus for future price movement.  In addition, our ETF Portfolio lightened up on its muni bond 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 5/31/15                                  12073                                                  1499
Close this week                                               18190                                                  2116   

Over Valuation vs. 5/31 Close
              5% overvalued                                12676                                                    1573
            10% overvalued                                13280                                                   1648 
            15% overvalued                                13883                                                    1723
            20% overvalued                                14487                                                    1798   
            25% overvalued                                  15091                                                  1873   
            30% overvalued                                  15694                                                  1948
            35% overvalued                                  16298                                                  2023
            40% overvalued                                  16902                                                  2098
            45%overvalued                                   17505                                                  2173
            50%overvalued                                   18109                                                  2248
            55% overvalued                                  18713                                                  2323

Under Valuation vs. 5/31 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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