Saturday, August 15, 2015

The Closing Bell

The Closing Bell


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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 Trading Range                       17385-18295
Intermediate Term Trading Range           15842-18295
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 Trading Range                          2043-2135
                                    Intermediate Term Uptrend                        1886-2650
                                    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 weighed to the positive: above estimates: weekly mortgage applications, month to date retail chain store sales, July retail sales, the July small business optimism index, the July export and import prices, July PPI and July industrial production; below estimates: weekly purchase applications, weekly jobless claims, June wholesale and business inventories/sales, second quarter nonfarm productivity and August consumer sentiment; in line with estimates: none.

The primary indicators included July retail sales (+), July industrial production (+) and second quarter nonfarm productivity (-).  So in total, the stats as well as the primary indicators while mixed still were upbeat.  In short, the data pretty much reflects 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 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.  This week saw a continuation of a second leg lower---and still no ‘unmitigated’ positive here and, I might add, anywhere else in the world.  And remember that this latest decline is occurring at exactly the supposed ‘peak’ of the summer driving season.  It seems logical then that the risk is rising that these lower prices have been brought on not just by increased supplies but because of declining demand---and that feeds the global economic slowdown [deflation] story. 

       The negatives:

(1)   a vulnerable global banking system.  This week Credit Suisse and Barclays entered settlement negotiations with the SEC and NY attorney general over facilitating unfair advantages, incorrect stock pricing and other wrongdoing in their dark pools. Credit Suisse is in talks to pay a fine in the high tens of millions, which would be the largest fine ever levied against a private trading venue operator, while Barclays' discussions also suggest a large fine.

In addition, five more banks have settled U.S. investor lawsuits tied to a global currency-rigging scandal, which claimed the institutions conspired to manipulate the $5.3T-a-day foreign-exchange market. HSBC, Barclays, Goldman Sachs, BNP Paribas, Royal Bank of Scotland now join a list of nine firms which previously settled the class actions, bringing the total amount investors have recovered to $2B.

Thus, it would seem that despite ongoing efforts to curb their misconduct, the banksters are still giving it the old college try.  That said, our ruling class has attempted to put a governor on financial institutions ability to wreak economic havoc by imposing the capital surcharges for the too big to fail banks and commencing enforcing compliance with the ‘Volcker rule’ [banning taxpayer insured banks from making bets with their own money {i.e. prop trading desks}].  These measures should over the long term help mitigate the ability of the banksters to endanger the financial system.

(2)   fiscal/regulatory policy.

Budget deficit is down to 2.2% of GDP (medium):

On the other hand, debt to GDP has risen to levels that are likely unsustainable, [a] demonstrating that, like QE, deficit spending hasn’t really worked in stimulating economic activity and [b] hence calling into question the viability and effectiveness of any future attempts at stimulus.

(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.  

The debate over whether the Fed will raise rates in September took a sudden turn to the negative this week with China’s decision to devalue the yuan.  As you know, an appreciating currency [like a yuan devaluation versus the dollar] and higher interest rates [like a Fed rate hike] tend to strengthen a currency which in turn, at least in the short term, have a negative impact on a country’s economic growth.  Hence, a September rate on top of the yuan devaluation would further increase jeopardize the already fragile US economic progress.    

Not that a rate increase would make any difference one way or the other economically.  As you know, I have long maintained that QE [except QE1] did little to nothing to stimulate the economy.  While some investors worry that a rate hike will hasten a recession, I can’t imagine one 25 basis point rate increase hike making that kind of difference. 

I think that the real worry is that the Fed has once again botched the transition from easy to a more normal monetary policy and that all the ills from multiple QE’s [asset mispricing and misallocation] may be coming home to roost.  Indeed, this would fit with my long term thesis that while a return to normal monetary policy won’t impact the economy, it will have a dramatic influence on the Markets since that is where QE has had the most effect. 

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. 

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

[a] whether Faustian or not, the Greek’s made and approved their deal with the Troika.  The deal also received approval from most of the parties within the Troika, though at this writing not from the Germans who continue to piss and moan that the terms are not tough enough.  So Greece should be receiving E86 billion bailout funds shortly.  The near term result is that the tail risk associated with a Grexit or a default is off the table.

[b] unless you are living in a hole, you know that the key development this week was the Chinese government’s devaluation of the yuan. By itself, it was a minor adjustment {circa 3%}.  But it was one of those kind of surprises that few expect but everyone recognizes after the fact that not only does it make sense but it could have a significant impact on the global economy, to wit, that the Chinese economy is not growing as fast as many assumed and that liquidity injections {QE} haven’t worked either to stimulate the economy or to devalue the currency. 

There are two issues going forward:

{i} since most pundits agree that the yuan was overvalued by about 10%, will the Chinese government continue the devaluation process until that number is met?  On Thursday, the government said that there would be no further move to deduce the value of the yuan; and on Friday, it allowed the yuan to appreciate slightly.  But we all know that these guys lie; plus almost every government does that with respect to currency valuation.  That is, they swear there will be no devaluation up until the mille second before they do it. 

Meanwhile, the Chinese are not backing off their (stock) plunge protection policy (medium):

{ii} will the Chinese move to direct intervention versus the current generally accepted QE back door devaluation be the event that triggers recognition by investors and governments that QE hasn’t, isn’t and won’t work---with the resulting loss of faith in central bankers and the adjustment in asset price valuations?
Another gloomy piece from David Stockman, this time on China (medium):

[c] elsewhere around the globe, EU second quarter GDP was up less than anticipated with the three biggest countries {German, France, Italy} all reporting disappointing numbers; and Japanese consumer sentiment was the lowest in six months.
In sum, I am holding to our global economic ‘muddling through’ assumption; though China is something of a wild card.

A more sanguine view (short):
Bottom line:  the US economy dataflow continues to reflect very sluggish growth in the US economy.  However, the flow of anecdotal numbers remains discouraging; and perhaps more important, if the latest moves by the Chinese government are a signal that its economy is growing much slower than currently assumed, that has negative implication for the global as well as own outlook.  Indeed, the biggest economic risk to our forecast is growth problems in the rest of the world. 

This week’s data:

(1)                                  housing: weekly mortgage applications rose 0.1% while purchase applications fell 4.0%,

(2)                                  consumer: month to date retail chain store sales growth rose from the prior week; July retail sales advanced slightly more than expected; weekly jobless claims were up more than estimates; August consumer sentiment was below consensus,

(3)                                  industry: July industrial production was better than anticipated; the July small business optimism index was slightly better than forecast; June wholesale inventories were up but sales fell; as did business inventories and sales,

(4)                                  macroeconomic: second quarter nonfarm productivity was less than consensus; July export and import prices were down a bit less than expected; July PPI rose more than expected; ex food and energy, it was also above estimates.
The Market-Disciplined Investing

The indices (DJIA 17477, S&P 2091) quietly ended a volatile week.  The Dow ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term trading range {17385-18295}, [c] in an intermediate term trading range {15842-18295} and [d] in a long term uptrend {5369-19175}.

The S&P finished below [a] its 100 day moving average, now resistance, [b] within a short term trading range {2043-2135} and [c] within intermediate term uptrend {1886-2650} and a long term uptrend {797-2145}. 

Volume fell; breadth was positive.  The VIX was down, closing below its 100 day moving average and remaining within a short term trading range, an intermediate term downtrend and a long term trading range.

The long Treasury remains strong, ending [a] above its 100 day moving average, now support, [b] within short and intermediate term trading ranges and [c] above the lower boundary of a very short term uptrend.

GLD declined on Friday, remaining below its 100 day moving average and in short, intermediate and long term downtrends.  However, during the week, it managed to negate a very short term downtrend.  While not terribly significant, it could be signal that a bottom is being made.

Oil continues to crash, finishing below its 100 day moving average and within short and intermediate term downtrends. Tellingly, it is plunging during the summer driving season which is generally the peak oil consumption time of the year.

The dollar rose, closing below its 100 day moving average, now resistance, and within short and intermediate term trading ranges. 

Bottom line: this week, the S&P began to re-sync with the Dow to the downside.  The very least one could say is that this signals a loss of upside momentum.  So the bulls have some work to do to re-gain control.  However, this move could be also indicate that a Market top has been made.  It is going to take more technical damage (both indices trading below their 200 day moving averages and re-setting their short term trends to down) before we can make that call with any confidence.   This is not a technical environment in which I would be buying stocks.

Bonds at the moment are suggesting no Fed rate hike and/or a weakening economy.  They are receiving support from oil, which seems to be screaming deflation.  Here too it is a too soon to make that call.  But for the first time is some time, stocks, bonds and oil are pointing in the same direction---slowing global growth accompanied perhaps by a whiff of deflation.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17477) finished this week about 43.6% above Fair Value (12169) while the S&P (2091) closed 38.5% overvalued (1509).  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.  But the flow of negative anecdotal economic stats hasn’t let up; and that is a growing concern, especially now that the Chinese have, at least, implicitly let it be known that all is not well in the Middle Kingdom.  Unfortunately, conditions are not much better in the rest of the world.  The risk being that try, as they might, American business and labor simply can’t overcome the hurdles presented by declining global economic activity.  Sooner or later that gets reflected in earnings and, hence, the Market.

The Fed continues to send mixed signals to the Market via committee participants’ public statements.  As you know, I believe that they are doing so because they know that they are in a box of their own making, haven’t a clue how to extricate themselves so they prevaricate and pray for a last minute reprieve from heaven.  The odds, of course, is that is not apt to happen.  But as long as a majority of investors believe their routine, then it is so. 

The problem is that Fed policy has done little else than cause severe distortions in asset pricing and allocation and when it starts reversing, it is apt to be as painful as euphoria was as it was induced.  In my opinion, several things could trigger that ‘reversing’ process: (1) no matter what the Fed does about rates, the consequences will be negative and/or (2) if the Chinese keep their devaluation process going, it could precipitate the ‘emperor’s new clothes’ catalyst which finally brings the realization that QEInfinity has been a losing proposition.

Net, net, my two biggest concerns for the Markets are (1) the economic effects of a slowing global economy and (2) Fed policy actions whatever that are or are not.

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.
DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 8/31/15                                  12169            1509
Close this week                                               17477            2091

Over Valuation vs. 8/31 Close
              5% overvalued                                12777                1584
            10% overvalued                                13385               1659 
            15% overvalued                                13994                1735
            20% overvalued                                14602                1810   
            25% overvalued                                  15211              1886   
            30% overvalued                                  15819              1961
            35% overvalued                                  16428              2037
            40% overvalued                                  17036              2112
            45%overvalued                                   17645              2188
            50%overvalued                                   18253              2263
Under Valuation vs. 8/31 Close
            5% undervalued                             11560                    1433
10%undervalued                            10952                   1358   
15%undervalued                            10343                   1282

* 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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