Saturday, July 25, 2015

The Closing Bell---Broken boundaries

The Closing Bell


Number two granddaughter and number three grandson arrive today for a week.  That means Six Flags, the aquarium, putt putt golf, etc.  No Morning Calls next week; though clearly with the Market in its present precarious state, I will be paying close attention.  Any actions will be reported via Subscriber Alerts.

Statistical Summary

   Current Economic Forecast

                        Real Growth in Gross Domestic Product                       +2.6
                        Inflation (revised)                                                           +0.1%
                        Corporate Profits                                                             +3.7%

            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                                 17652-20574
Intermediate Term Uptrend                      17855-23995
Long Term Uptrend                                  5369-19241
                        2014    Year End Fair Value                             11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2083-3062
                                    Intermediate Term Uptrend                        1872-2638
                                    Long Term Uptrend                                    797-2145
                        2014   Year End Fair Value                                     1470-1490

                        2015   Year End Fair Value                                      1515-1535        

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          53%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        53%

The economy provides no upward bias to equity valuations.   The dataflow this week was paltry but mostly upbeat: above estimates: June existing home sales, June leading economic indicators, weekly mortgage and purchase applications, weekly jobless claims, the July Kansas City Fed manufacturing index and the Chicago National activity Index; below estimates: month to date retail chain store sales, June new home sales; in line with estimates: the July Markit flash manufacturing index.

There were several important indicators (existing [+] and new home [-] sales, leading economic indicators [+]) which were weighed to the plus side.  So overall, total as well as primary indicators this week were positive.  However, there were several anecdotal reports that were not so upbeat: Caterpillar’s global sales (not good anywhere) and the National Retail Federation estimate of 2015 retail sales (lower).  These taint the more encouraging dataflow, diminishing the degree of its positiveness (is that a word?)  Therefore, my conclusion from last week remains the same: the recent trend towards stabilization continues but that doesn’t mean that growth is accelerating---it just means that it has stopped decelerating.  Our forecast remains:

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 conflicting profit incentives 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 never saw the ‘unmitigated’ positive forecast by the pundits when oil prices initially cratered.  Last week marked the beginning of a second round of whackage---and still no ‘unmitigated’ positive.

       The negatives:

(1)   a vulnerable global banking system.  Once again JP Morgan is at the top of the bankster fraud hit parade.  This week’s episode entails the bank’s agreement to pay $388 million to settle a suit by investors who claim it misled them on the safety of mortgage backed securities that it sold them.

That said, there was also two huge pieces of good news this week:

[a] the Fed finalized the capital surcharges for the too big to fail banks, creating an additional $200 billion cushion,

[b] this week, Wall Street will begin complying with the ‘Volcker rule’ banning taxpayer insured banks from making bets with their own money {i.e. prop trading desks}.

Clearly both of these measures will be very helpful in mitigating my concerns and preventing the implosion in financial institutions experienced in 2007.

My concern here is that: [a] investors ultimately lose confidence in our financial institutions 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 from either subprime debt problems in the student loan or auto markets or turmoil in the EU financial system resulting from a Greek default or exit from the EU.

(2)   fiscal policy.  No news this week on the national level.  We did get more from Puerto Rico: [a] the island’s credit was downgraded by the major rating services and [b] UBS announced that it was no longer accepting PR bonds as collateral.  Not a positive for our muni bond ETF’s in our ETF Portfolio.

(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, consensus seemed to build [based on the pin action in gold, the dollar and bonds] for a September Fed rate hike.  May be.  But the inflation data doesn’t suggest it nor does the US/global macroeconomic data [i.e. all weak].  While a rate increase doesn’t make economic sense, as I suggested last week, Yellen et al may want to do it just to prove that they know how.     

Who do you believe, commodities or the Fed (medium and a must read):

Not that it matters, because the Fed is already too late in the timing of its transition to tighter monetary policy.  Unfortunately, all those QE inspired reserves still sit on the bank balance sheet and all that debt still sits on the Fed’s balance sheet---waiting for investors to recognize the futility of the QEInfinity and the harm that it has done to the US economy via the mispricing and misallocation of assets. 

                                    The same applies to global asset mispricing and misallocation (medium):

You know my bottom line: sooner or later, the price will be paid for asset mispricing and misallocation.  The longer it takes and the greater the magnitude of QE, the more the pain.

(4)   geopolitical risks: little occurred of consequence this week other than the now raging debate over whether the Iran deal is good or bad.  Again, leaving aside the long term political and foreign policy issues, an approval of the treaty would have several short term positive economic impacts: [a] oil prices are likely to decline further as a result of Iran being able to export its production, and [b] relief from current trade sanctions are likely to lift Iranian economic activity which will benefit global growth. 

Liar, liar pants on fire (medium):

Counterpoint from the former head of Israeli internal security (medium):

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

[a] the Greek struggle to meet the terms set out by the Troika in order to receive bailout funds.  So far, they have done so; this week approving a second bill complying additional Troika mandated reforms.  There are still those that believe that Greece will ultimately be unable or unwilling to fulfill the terms necessary to remain within the EU.  However for the moment, the potential threat of default has been taken off the table. 

This is a very pessimistic assessment of not just the Greek, but the entire EU, economic situation.  I would not accept it in full; but it does come from the source that was reasonably accurate in the latest act of the Greek tragedy (medium):

 [b] in China, markets has remained stable and at recovery levels---which, I guess, answers the question that I posed two weeks ago: who is stronger, a totalitarian government or the free market?  Like Greece, it has removed immediate concerns about the consequences of a Market crash. 

And, how much impact did all that money China spent really have?

However, two important issues remain.  Short term, if the Market turmoil was reflective of a rapidly decelerating Chinese economy, then the resulting consequences will be much less susceptible to the whims of imperial edit simply because of the magnitude of China’s trade with the rest of the world.  Not that the government can’t or won’t lie about their own import/export numbers; but they can’t control what China’s trading partners report.  What I am driving at here is that if, in fact, China’s economy is slowing that will impact global growth.  And seemingly to put a finer point on this issue, several disappointing stats were reported this week [see below].

The second but longer term issue is, does the Chinese government’s short term victory over stock market pricing spell the end to that country’s economic liberalization.  If so, its consequences for the long term economic growth in China is likely to be negative and of long duration.

In other economic news, Chinese business sentiment plunged 14%; Italian and British retail sales declined while those in Canada rose.  Both the Chinese and EU June Markit flash manufacturing PMI’s were disappointing.

In sum, our global economic ‘muddling through’ assumption has improved somewhat from two weeks ago.  I am still concerned that conditions in either Greece or China (but especially China) could suddenly worsen and again threaten our Economic Model.

Bottom line:  the US economy continues to recover from the doldrums of the first five and half months of the year, putting the threat of recession even further behind us.  On the other hand, this improvement has not been robust enough to assume a return to the recovery rate of this cycle much less to the average secular rate of the past several decades.

The international data, in particular that out of China, did little to demonstrate any kind of pick up in global economic growth.  Indeed if anything, the Chinese stats suggest that the Chinese stock market, pre-government interference, could well have been signaling impending trouble in one of our biggest trading partners. 

This week’s data:

(1)                                  housing: June existing home sales were strong; June new home sales were awful; weekly mortgage and purchase applications were up,

(2)                                  consumer: month to date retail chain store sales growth declined from the prior week; weekly jobless claims fell more than anticipated,

(3)                                  industry: the June Chicago National Activity Index came in better than forecast; the July Kansas City Fed manufacturing index remained in negative territory but improved slightly,

(4)                                  macroeconomic: June leading economic indicators were well ahead of estimates; the July Markit flash manufacturing PMI was in line.
The Market-Disciplined Investing

The indices (DJIA 17569, S&P 2079) fell this week, falling on a number of earnings disappointments and more weak economic data out of China.  In the process,

(1)   the Dow [a] fell below its 100 day moving average and was there long enough      to re-set that MA from support to resistance, [b] dropped below its 200 day moving average; if it remains there through the close on Wednesday, that MA will re-set from support to resistance, [c] declined below the lower boundary of its intermediate term uptrend; if it remains below that boundary through the close on Tuesday, the intermediate term trend will re-set from up to a trading range and [d] fell below the lower boundary of its short term trading range; if it remains there through the close on Tuesday, the short term trend will re-set from up to a trading range.

(2)   the S&P [a] dropped below its 100 day moving average; if it remains there through the close on Wednesday, it will re-set from support to resistance, [b] declined below the lower boundary of its short term uptrend; if it remains there through the close on Tuesday, it will re-set from up to a trading range.

 Longer term, the indices are, for the moment, within their uptrends across all timeframes: short term (17652-20574, 2083-3062), intermediate term (17856-23995, 1872-2638) and long term (5369-19241, 797-2145).  

Volume rose; breadth was negative.  The VIX was up 9%, but is still below its 100 day moving average and remains within a short term trading range, an intermediate term downtrend and a long term downtrend.  So far, it is not confirming the pin action of the Averages.

The long Treasury was up, but still closed below its 100 day moving average and within its short term downtrend.  However, it has established a very short term uptrend.

Surprise, surprise, GLD was actually up, though it remained below its 100 day moving average and within short, intermediate and long term downtrends.

And this from Jim Grant (medium):

Oil was down, finishing below its 100 day moving average and below the lower boundaries of its [a] short term trading range; if it closes below that boundary on Tuesday, the short term trend will re-set from a trading range to a downtrend, [b] intermediate term trading range; if it remains below that boundary through the close on Wednesday, the intermediate term trend will re-set from a trading range to a downtrend. 

The dollar lifted, remaining above [a] its 100 day moving average, [b] the lower boundaries of its short and intermediate term trading ranges and [c] the lower boundary of a very short term uptrend. 

Bottom line: clearly, following Thursday and Friday’s negative pin action, the indices are now challenging numerous support levels.  As I noted in Friday’s Morning Call, a break of these trend levels would sustain the notion that the Market is in a topping process.  However, that is getting way ahead of events.  It will take a good deal more whackage to complete the successful challenge of those trends.  So for now, best to stay patient and focus just on the follow through of the assaults on those trends.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17568) finished this week about 44.7% above Fair Value (12137) while the S&P (2079) closed 38.0% overvalued (1506).  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.

The US economic data continues to support our forecast and hence the economic assumptions in our Valuation Model. 

Ignore the screams about a Market crash and just concentrate on the poor economic data (medium):

Overseas, the economic data has been nothing to cheer about, in particular, some very rough numbers out of China.  That suggests that while the Chinese government’s smack down of its equity market may have been a rousing success, it can do nothing to alter the impact of slowing economic activity on global/US growth. 

Still, the financial/market risks posed by the Greek political/economic situation clearly subsided last week.  That is not to say that they have gone away; but there is at least a reasonable probability that nothing untoward is coming from that direction.

Finally, with the downgrade of Puerto Rican debt, odds have likely increased of an outcome in the government’s negotiations with creditors that incorporates principal loss.  Whether this would include all PR public debt and how much spill over there might be to other US city, county and state municipal debt issues is not clear at this time. I am not so much worried about any fallout’s impact on equity markets as I am about the potential effect on the muni market---to which our ETF Portfolio has exposure.

Bottom line: the assumptions in our Economic Model are unchanged.  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 for equities. 

The assumptions in our Valuation Model have not changed either; though at this moment, there appears to be more events (greater than expected decline in Chinese economic activity; miscalculations by one or more central banks that would upset markets) that could lower those assumptions than raise them.  That said, our Model’s current calculated Fair Values under the best assumptions are so far below current valuations that a simple process of mean reversion is all that is necessary to bring Market prices down significantly.

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; but 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.
                More on earnings estimates and ‘beats’ (short):

DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 7/31/15                                  12137            1506
Close this week                                               17568            2079

Over Valuation vs. 7/31 Close
              5% overvalued                                12743                1581
            10% overvalued                                13350               1656 
            15% overvalued                                13957                1731
            20% overvalued                                14564                1807   
            25% overvalued                                  15171              1882   
            30% overvalued                                  15778              1957
            35% overvalued                                  16384              2027
            40% overvalued                                  16991              2108
            45%overvalued                                   17598              2183
            50%overvalued                                   18205              2259
Under Valuation vs. 7/31 Close
            5% undervalued                             11530                    1430
10%undervalued                            10923                   1355   
15%undervalued                            10316                   1280

* 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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