Saturday, May 16, 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                                 17174-19971
Intermediate Term Uptrend                      17322-22439
Long Term Uptrend                                  5369-19175
                        2014    Year End Fair Value                             11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2016-2995

                                    Intermediate Term Uptrend                       1820-2591
                                    Long Term Uptrend                                    797-2135
                        2014   Year End Fair Value                                     1470-1490

                        2015   Year End Fair Value                                      1515-1535        

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          51%
            High Yield Portfolio                                     52%
            Aggressive Growth Portfolio                        53%

The economy is a neutral for Your Money.   It is now 15 out of 16 weeks of poor economic data: positives---month to date retail sales, weekly jobless claims, the April small business optimism index, March business inventories/sales, the April US budget surplus; negatives---weekly mortgage and purchase applications, the April retail sales, May consumer sentiment, April industrial production, the NY Fed May manufacturing index, April export/import prices, April PPI; neutral---none.

April retail sales and industrial production were the key numbers this week---both negative.   In addition, the fall in April PPI and export/import prices give further weight to the notion of a very weak (deflationary) economy.  So it looks like all the pundits that blamed lousy February and March stats on weather and the west coast longshoremen’s strike are probably going to have to re-boot their models.

On the other hand, bond and gold prices are suggesting a pickup in economic activity/inflation.  Clearly, these inconsistencies add confusion to the mix.  But in the end, my bias is to opt for longevity, i.e. the economic data has been subpar for almost 16 weeks while the bond and gold markets indication of improvement is much shorter.  Plus, bond and gold are one off signals of economic activity versus the real deal; so there could be noneconomic explanations for their behavior. 

            The international economic data was mixed, with Europe continuing to show better results.  That is the only bright spot in an otherwise dismal global economic outlook and is the major reason that I am clinging to the ‘muddle through’ scenario by my fingernails.  Unfortunately, the Greek bailout situation seems to be nearing an end game where the possible outcomes include default or a Grexit---either of which could throw a giant monkey wrench in any EU recovery.

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.’

                Update on big four economic indicators (medium):

        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. 

I noted last week that ‘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.’  Unfortunately, I may have jumped the gun on the latter part of that statement as there still appears to be more trouble coming (medium):

       The negatives:

(1)   a vulnerable global banking system.  Multiple incidents this week.  Some actually demonstrating that the regulators as well as the TBTF institutions are working on reducing the magnitude of this risk:

[a] Fed regulators raised oversight of MetLife as a threat to the financial system,

[b] Morgan Stanley sold its oil trading operation,

[c] the DOJ is contemplating ripping up an agreement not to prosecute UBS for rigging interest rates.

But that doesn’t mean that all problems have been solved:

[a] five banks {including JP Morgan and Citi} plead guilty to foreign exchange fraud---but no one goes to jail,

[b] nor is anyone else accused of 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, congress failed to approve fast track authority for Obama in negotiating the Trans Pacific partnership talks.  I linked to an article that voiced objections to this agreement some of which were reasonable.  Later in the week, it looked like an amended version would be submitted for a vote; so it seems that our political system is simply in the process of refining this agreement in order to achieve a better end result.  I would add that just negotiating an issue is a welcome reprise from the last six years of a hamstrung, do nothing senate.

Greg Mankiw on trade (3 minute video):

(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, China cut interest rates for the third time and introduced its own version of QE which looks quite similar to the EU variety.  Whatever its form, it is still QE and helps keep the party going.

And the Chinese bail out has started (short):

On the other hand, global bond markets continued to get hammered this week in spite of plenty of weak economic news [suggesting more QE and lower inflation expectations].  The reasons for this phenomena seem to be coming into focus.  It appears to be a combination of [a] the central banks have bought so much debt paper, that there is not much left to buy, [b] hence, the fear that if the central banks ever start to sell, prices will drop precipitously, [c] because government regulation of bank trading desks {i.e. the market makers and hence the source of liquidity} has become so onerous that they are getting out of the business.  That and the fact that buying a zero to negative coupon bond can only be a ‘greater fool’ trade, i.e. if you are deriving no income from a trade, the only way to make money is selling it at a higher price.  That might work with growth stocks, but a bond is no growth stock.  In short, the bond guys may be starting to question the rationale for QEInfinity.

When as and if that occurs, as I have noted repeatedly, the economic impact will likely be limited since QE has done nothing to spawn economic growth but the effect on the stock market which has benefitted greatly from QE will probably be quite negative.

(4)   geopolitical risks: this week Arab leaders shunned Obama’s Middle East summit, sending a clear message [in my opinion] that His Iran appeasement policy sucks.  That is not likely to sway the Ideologue in Chief and it will probably only make matters more difficult in resolving the problems in that area of the world.

Iran sends naval escort for ship carrying ‘humanitarian’ aid to Yemen (short):

In addition, Kerry went to Russia this week to try to make nicey nice with Putin in the hopes of calming the confrontation in Europe and elsewhere.  I applaud the effort.  But given the administration’s inept execution of foreign policy to date, I have no reason to assume that Putin won’t get out the Vaseline and do whatever you do with Vaseline.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  It was another light week for international data.  Europe continued to show economic improvement---the bright spot in an otherwise dismal global outlook.  Speaking of which, the numbers out of China were pretty bad.

Slowing global trade (medium):

However, the Greek/Troika bailout discussions continued to hold center stage.  There was one piece of faux positive news: Greece made a E750 million IMF debt payment; but did so by drawing on its reserves at the IMF which have to be repaid within 30 days.  In short, Greece used E750 million of precious cash in order to keep its liabilities flat.

Other than that, the odds of a bail out continued to decline: [a] the IMF told the Troika it was no longer interested in participating in the bailout talks and began preparing for an exit, [b] internal pressure rose on Merkel to cut Greece loose, [c] and surprise, surprise, it turns out that the EU does have a Plan B {read: Grexit} for dealing with this situation.

                      Why the Greeks will blink (medium):

My bottom line here hasn’t changed: I don’t know how this ends, I don’t know what that means for the markets but I do believe that there will be unintended consequences; and since those are by definition unknowable, this situation demands some caution.    

    ‘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 continues to be improvement in the eurozone.  That is the sole bright spot and, frankly, I need it just to keep ‘muddling through’ as a plausible scenario.

Meanwhile, the somewhat mystifying rise in interest rates continued.  I think that I am getting a handle on the ‘why’ of what has been a confusing development.  Unfortunately, if (operative word) I am right, it will be of little help to either the US/global economy or the US/global markets.

One geopolitical hotspot maybe getting unresolved while the other remain just so (1) the Greeks and the Troika made no progress this week, and it appears that the endgame is rapidly approaching, (2) US/Russia face is hopefully [operative word] de-escalating with Kerry’s visit to Russia this week and (3) the geopolitics of the Middle East got more muddled as Arab leader shun Obama’s Middle East ‘summit’.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications declined,

(2)                                  consumer: month to date retail chain store sales improved, while April retail sales were below expectations; weekly jobless claims rose less than forecast; May consumer sentiment was well below consensus,

(3)                                  industry: April industrial production fell; the NY Fed manufacturing index was less than anticipated; April small business optimism index was better than estimates; March business inventories were up less than consensus but sales were strong,

(4)                                  macroeconomic: the April US budget surplus was higher than expected; April export and import prices dropped more than forecast; both the headline and ex food and energy April PPI were terrible.

The Market-Disciplined Investing

The indices (DJIA 18272, S&P 2122) finished the week on a high note after a volatile week.  Both closed above their 100 day moving average, negated their trends of lower highs but ended out of sync with respect to their former all-time highs.  The S&P above while the Dow hasn’t made it yet. 

Longer term, the indices remained well within their uptrends across all timeframes: short term (17174-19971, 2016-2995), intermediate term (17322-22430, 1820-2591 and long term (5369-19175, 797-2135).  

Volume rose on Friday; but it was option expiration day, so that is not surprising.   Breadth was mixed.  The VIX fell all week, finishing below its 100 day moving average and the upper boundary of a very short term downtrend---both positives for stocks.  However, it is again nearing the lower boundaries of its short and long term trading ranges.  The closer it gets, the more attractive it becomes as portfolio insurance.

Following big declines early in the week, long Treasury moved modestly up on Friday. Still it remained below its 100 day moving average and the upper boundary of a short term downtrend. 

For two weeks, I have been harping on the divergence of the bond and stock markets, primarily because they potentially imply totally different economic scenarios: the stock market rising on weak economic numbers/easy Fed while the bond market is falling presumably on better growth and higher inflation. 

Confusing matters even more (1) our internal indicator does not support higher stock prices, (2) gold is supporting the higher inflation scenario and (3) a progressively more vocal discussion has developed on whether or not QE has reached in logical conclusion [i.e. the central banks will have a very difficult time expanding their already huge positions in sovereign debt] and the degree of liquidity available in the securities markets due to the exit of large amounts of bank trading capital from the market making function. 

I have no idea how all these factors resolve themselves.  But till they do, I think patience is needed.

As I noted above, GLD has been acting a bit better, ending the week slightly above the neck line of the head and shoulders pattern.  If it remains above that level through the close on Tuesday, that formation will be negated and the short term trend will re-set to up.  However, given the head fakes GLD had thrown at us in the last year as well as the fundamental uncertainty surrounding the reason for its better performance, I am going to be very cautious before re-entering this trade.

Finally, adding just a bit more to the overall confusion in and among the markets, (1) oil was flat this week, finishing right around the upper boundary of a short term trading range---despite the Saudi’s giving themselves a high five for torching the US fracking market and (2) the dollar broke a short term uptrend, supporting the notion that the Fed could remain easier, longer than previously thought.

Bottom line: the bulls are pressing, with the Averages finishing above the trend line of lower highs---which was also the upper boundary of a narrowing very short term trading range.  The only fly in their ointment right now is that the S&P has managed to close above its former all-time high, while the Dow remains below its comparable level. Nevertheless, it appears that the momentum has changed to the upside; so we start looking at the upper boundaries of the indices long term uptrends as the next resistance point.  I am standing firm that these will prove insurmountable on any time frame save the very short term.

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 continues to suggest either inflation or a re-evaluation by investors of the sustainability and/or efficacy of QE.  Both clearly run counter to the message to the stock market.  Plus the volatility in gold, oil and the dollar only add their own version of a confused message.  I have no clue what long rates are going to do; but I worry that about the ‘why’ of what they will do.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18272) finished this week about 51.3% above Fair Value (12073) while the S&P (2122) closed 41.5% 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.  It does appear that recovery has taken hold in Europe which helps keep our outlook for the US economy as growing slowly rather than recession.  However, even that scenario points to lower corporate profits.  As I have explained numerous times that won’t impact the numbers in our Valuation Model, but it will almost certainly force changes in Street Models which will likely cause heartburn for equity prices.

Stock investors continued to love QE and all manner of evidence suggesting that it will endure.  Market reaction to this week’s crappy data being a perfect example.  However, the bond guys did not react with the same enthusiasm which begs the question, have they finally had enough of QE?  I still don’t have an answer for that.  The period of divergence has been short enough that it could be nothing but a severe market reaction to the earlier plunge of EU rates into negative territory. 

On the other hand, I am concerned about the growing number of voices pointing to the lack of liquidity in the bond markets caused primarily by the central banks physical inability to continuing to buy huge chunks of sovereign debt simply because supply is now limited due to ginormous past purchases plus the downsizing of bank trading desks which have traditionally been the market makers that brought a semblance to order to price movement.  The bottom line is that this is a confusing issue that has big potential implications for future price movements in the securities’ markets.

Geopolitical risks potentially declined a tad, as it looks like the US has blinked over Ukraine.  That probably assures that the status of the original alignment of Ukraine within the Russian sphere returns after some very stupid maneuvers by the US to replace the government.  Hopefully this removes the potential of a US/Russian showdown in which I have no doubt that US would be humiliated.

However, there was no progress in the Greek bailout talks as the Greeks have been getting ever more strident in the negotiations (if that is what you want to call them) with the Troika.  The odds of default or Grexit seem to have risen.  While I can’t predict that this will impact markets, there will be unintended consequences which certainly could.  Meanwhile, Arab leaders snubbed Obama at His Middle East summit which suggests that the risks of conflict (oil shortages) have grown.

‘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.

Our Portfolios maintain their above average cash position.  The Dividend Growth Portfolio and High Yield Portfolio Sold their positions in COP this week.

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                                               18272                                                  2122

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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