Saturday, May 30, 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                                 17273-20078
Intermediate Term Uptrend                      17431-22559
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                                     2028-3007

                                    Intermediate Term Uptrend                       1830-2597
                                    Long Term Uptrend                                    797-2138
                        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.   The data this week was slightly weighed to the negative by quantity and the positive by quality: positives---April new home sales (note: last week  I mistakenly listed new home sales instead on housing starts), April pending home sales, weekly purchase  applications, March Case Shiller home price index, May consumer confidence and consumer sentiment and April durable goods orders; negatives---weekly mortgage applications, month to date retail sales, weekly jobless claims, the May Markit flash services index, the Dallas Fed manufacturing index, first quarter corporate profits and the May Chicago PMI; neutral---the Richmond Fed manufacturing index, first quarter GDP and price deflator.

The primary indicators this week were April new home sales (plus), April durable goods orders (plus) and first quarter GDP (neutral) and corporate profits (negative)---a positive showing.  Note though that I rated the poor GDP number a neutral just because it was not quite as bad as had been expected.  In sum, I rate this as a neutral week, meaning that the last eighteen weeks of economic data have been negative sixteen times and neutral twice.  That is a pretty abysmal showing.  Still the two neutral weeks were close enough together that it may be a sign that the economy is starting to flatten out---a circumstance that we desperately need to avoid having to lower our economic growth forecast even more.

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, we have yet to see the ‘unmitigated’ positive attributed to lower oil prices by the pundits.  Not surprisingly, with oil prices up, this same crowd is trumpeting the pluses that rising prices will have on capital spending.  If they keep trying, the law of averages says that they will eventually be right.  But who will listen?

       The negatives:

(1)   a vulnerable global banking system.  This week:

[a] Deutschebank pled guilty to falsifying prices of its derivatives holdings

Derivatives remain a blind spot in the TBTF banks (medium):

[b] our Masters of the Universe banks {Citi, JP Morgan and Bank of America} are under investigation of facilitating the bribe payments in the world soccer scandal.

‘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.  Nothing this week of consequence.

(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. 

Thankfully quiet after the s**t storm of confusion from the Fed last week.

(4)   geopolitical risks: the reportable items this week were [a] the buildup of Russian weapons on the Ukraine border.  That isn’t necessarily bad news in the sense that Kerry could very well have agreed to that {Russian hegemony over Ukraine} in his recent meeting with Putin and [b] the ISIS siege of Iraq’s largest oil refinery---not a happy occurrence if contemplating global oil supplies,

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  The key datapoints this week were:

[a] mixed Japanese data.  Early in the week I thought we might get a second week in a row of upbeat stats out of Japan; but that was deep sixed by poor numbers later.  I am not giving up yet that Japan could be improving; but clearly we need more than one positive week followed by a mixed week before even considering that a turn in the economy is possible,

[b] the turd in the global economic punchbowl is China where the data has not been good and keeps looking worse.  This week a third large Chinese company defaulted on its ‘in country’ bonds.  While the Bank of China seems to be pumping liquidity into its banking system in its own special version of QE, results to date have not shown promising results,

[c] the Greek/Troika bailout discussions continued---if that is what you want to call them.  For the last two weeks, they have mostly been comprised of the Greek government making upbeat statements about the progress being made in the bailout negotiations and the Troika slam dunking those comments as wishful thinking. 

There was a positive development on Friday in which the IMF said that it was considering allowing Greece to make all payments {there are four} due in June at the end of June, effectively postponing the June 6 maturity.  This is a clear reminder of the eurocrats excellence at kicking the can down the road. Certainly, it buys time for a bail out agreement.  Whether it works remains to be seen.

        Great analysis of the ongoing events (medium and a must read):

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 improved slightly, in the sense that a week of mixed stats is better than a sharp stick in the eye.  We need more of that to lower the risk that I may have to revise our forecast down again.

The international data didn’t improve the odds.  After an upbeat week of Japanese stats, they turned a bit more mixed this week.  There were two disappointing EU GDP reports (Switzerland and Greece). And the news out of China remains dismal.  Finally, the Greek/Troika negotiations managed a last minute delay to avoid a Greek default/exit next week.  But that technically could only be postponed until June 30---unless, of course, the IMF postpones repayment again.

The Fed thankfully was quiet this week---probably trying to figure out how to spin last week so there appears to be a semblance of logic in their words and actions.  I remain as confused as ever as to what these guys will do next; though I am more sure that whatever they do, it will have more impact on the Markets than it has on the economy.

This week’s data:

(1)                                  housing: April new home sales were much stronger than forecast, as were April pending home sales; weekly mortgage applications declined while purchase applications increased; the March Case Shiller home price index rose more than estimates,

(2)                                  consumer: month to date retail chain store sales slowed; weekly jobless rose versus expectations of a fall; May consumer confidence and consumer sentiment were better than anticipated,

(3)                                  industry: April durable goods orders fell less than consensus; the May Markit flash services index was below forecast; the May Chicago PMI was terrible; the Richmond Fed manufacturing index was in line while the Dallas Fed index was well below estimates,

(4)                                  macroeconomic: revised first quarter GDP came in slightly above negative expectations; the price deflator was in line; corporate profits were down almost 6%.

The Market-Disciplined Investing

The indices (DJIA 18010, S&P 2107) were down on the week.  Both closed above their 100 day moving average but below their former all-time highs.  The S&P is in a struggle passing above and below that level several times while the Dow managed a one day jaunt above its comparable level and is now well below it. 

Longer term, the indices remained well within their uptrends across all timeframes: short term (17273-20078, 2028-3007), intermediate term (17431-23559, 1830-2597 and long term (5369-19175, 797-2138).  

Volume rose markedly on Friday; while unsurprisingly breadth was poor.  The VIX was up modestly, but not as much as I would have expected on lousy day for pin action.  That along with a finish below its 100 day moving average and the upper boundary of a very short term downtrend keeps this indicator a plus for equities.

Margin debt hits all time high (short):

The long Treasury rose slightly on Friday, but still closed below its 100 day moving average and within its short term downtrend.  In Friday’s trading, it touched a minor resistance level, then backed off.  A push above that level will add some momentum to the upside. 

GLD continues to meander within a short term trading range.  Meanwhile, oil was up big on Friday, closing right on the upper boundary of its short term trading range; and the dollar was off slightly but remained above its 100 day moving average and the lower boundary of that former short term uptrend.

Bottom line: the Dow tried to make a new high last week, but failed and has declined ever since.  The S&P did manage to confirm a new high but just barely, on anemic volume and has been unable to return to that level.  On a more positive note, both of the Averages have established a series of higher lows and until that is broken, I have to assume that, at the moment, the buyers have the edge. 

‘I feel almost certain that, having come this far, the indices will at least make an old school try at challenging those upper boundaries.  That said, I also believe that challenges will be unsuccessful---which, from a strictly technical viewpoint, makes the short term risk/reward in the Market right now unattractive.’

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 (18010) finished this week about 49.1% above Fair Value (12073) while the S&P (2107) closed 40.5% 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 mixed US economic stats, while a welcome break from the steady drumbeat of poor reports, were still mixed.  And, as I mentioned several times, we need to have something a little better than mixed just to meet our current downwardly revised forecast.  So net, net, it did nothing to alter the assumptions in either our Economic or Valuation Models. 

Likewise, Japan’s economic numbers contained both good and bad news, which was a bit of disappointment given last week’s more upbeat data.  The key remains follow through. Europe and China both disappointed this week---Europe because it broke the recent trend in improving stats; China because things just keep getting worse.

 I noted last week that the economic progress being reflected in the EU and Japanese numbers were much welcomed in that if they were a sign that the trend in the international economy was stabilizing and perhaps even recuperating, our ‘muddling through’ scenario had an  increased probability of being correct.  This week didn’t help.

  All that said, as I have explained numerous times lousy economic data (at least at the current level of ‘lousy’) 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.

Thankfully, all was quiet on the central banking front, though that doesn’t remove the clear and present danger of the consequences of the unraveling of QE on the securities markets.

The Middle East just keeps getting more complex.  ISIS now has the largest refinery complex in Iraq under attack and Obama is doing His best ‘deer in the headlights’ impression.  If the ISIS action leads to problems in the level of global oil production, this could cause problems for the equity market---at least if history is any guide.

We are now at T-7 on the IMF repayment which Greece has already said it couldn’t make without a bailout.  This week was filled with claims of an impending deal and counter claims that someone was smoking dope.  This has all the drama and bluster of the final act; but these guys have such a rich history of kicking the can down the road, I feign to predict a conclusion. 

And speaking of kicking the can down the road, the IMF has apparently given the Greeks a reprieve on next Friday’s debt repayment, allowing them to repay all four June maturities on June 30.  My bottom line is that I have no idea how this resolves itself but if a default/Grexit occurs there are apt to be unintended consequences that are disruptive to the Market.

‘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.

Update on Buffett’s favorite valuation metric (medium):

Everything is overvalued: an interview with Robert Shiller (medium):

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                                               18010                                                  2107

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 47 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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