Saturday, August 22, 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 Downtrend                            17083-17970
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 to the negative side of mixed: above estimates: July housing starts, July existing home sales, weekly mortgage applications, the July Philly Fed manufacturing index; below estimates: July building permits, weekly purchase applications, weekly jobless claims, month to date retail chain store sales, the July NY Fed manufacturing index and July leading economic indicators; in line with estimates: July CPI.

A note to start with.  I listed July CPI (which was below estimates) as a neutral because one’s perspective would define whether was positive or negative.  If you are the Fed or worried about deflation/recession, it is negative.  If you view inflation as a negative, it is positive.

The primary indicators included July housing starts (+), July building permits (-) July existing home sales (+) and July leading economic indicators (-).  So the primary indicators were balanced.  However, the anecdotal evidence remains negative (plunging oil and copper prices) and the latest Atlanta Fed third quarter GDP estimate remains well below consensus.  In addition, overseas developments this week were very concerning: currency valuations, capital outflows, poor data. 

Also this week, the Fed released the minutes from the latest FOMC meeting.  I covered that in our Morning Calls and re-hash a bit of it below.   But the bottom line is that monetary policy (except for QE1) has not, is not and is not apt to be of any help to our economy.  All it has done is create asset mispricing and misallocation of major portions.

So in total, the stats were negative, the primary indicators were neutral, anecdotal data was negative, the Fed is a menace and the global economy provided no relief.  For the time being, I am staying with our forecast but it appears increasing likely that I will have to revise it down again.

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.  On the other hand, there has been no ‘unmitigated’ positive from lower oil prices; plus there is mounting evidence that the continuing decline in oil prices is at least partly a function of falling demand---and that feeds the global economic slowdown [deflation] story. 

Here is another upbeat piece from our in house optimist; this one on why falling oil prices are a plus.  What his analysis leaves out is the global repercussions; there are some big emerging market economies in which oil is a huge source of national income.  Pushing them into recession has consequences.

       The negatives:

(1)   a vulnerable global banking system.  This week JPMorgan was in advanced talks with the SEC to pay more than $150M for steering clients to its own investment products without proper disclosures. Citigroup agreed with the New York attorney general to return $4.5M in management fees charged on some 15,000 frozen accounts, while BNY Mellon will shell out $14.8M to settle several intern-related bribery cases.  Will it ever end?

That said, recent developments should curb 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.

(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 received a minor shock this week when the minutes from the latest FOMC meeting were released.  The tone of the narrative, aside from sounding as confused as ever, was more dovish than assumed on the Street---meaning the probability of a rate hike in September just went down.  That is not really a surprise if you have been watching the bond market, which always seems to be a step ahead of the stock jockeys.

I think that the import of the minutes also reflect the Fed’s worry that it has once again botched the transition from easy to a more normal monetary policy, has no idea what to do other than pray for a miracle and fears the ills from multiple QE’s [asset mispricing and misallocation] may be soon be upon us.

Adding to this sad narrative was a study released by the St. Louis Fed confirming what we have known all along: QE hasn’t and won’t lead to inflation or economic growth, but has had a significant impact on the Markets [read asset mispricing and misallocation].
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: the joke of the week is the revelation that a provision of the Iranian nuke deal is that the Iranians will self-inspect their nuclear facilities.  Yes, you read that correctly.  If the administration’s green apple two step around many of the terms of this agreement has managed to confuse and confound the electorate to date, this will surely clarify the workability of the deal and whether the world is going to be safer as a result. 

It appears that Russia is not done with Ukraine.  It was reported this week that the eastern portion of Ukraine will hold a vote in November similar to that of Crimea---in which it would secede from Ukraine and join Russia.  That is not going to make US/NATO/Russia relations any friendlier.  Whether that spills over into the economic arena remains to be seen.

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

[a] most of the EU parliaments signed off on the Greek bailout; particularly significant was the approval from Germany, which has been the principal advocate for the harshest punishment for the Greeks.  The near term result is that the tail risk associated with a Grexit or a default is off the table.

[b] China continued to defend both the yuan and its stock market though it did allow a big drops in the latter on Monday and Friday.  So it seems to be trying to stand by its stabilization pledge.   However, there are several forces working against those efforts:

{i} for reasons related to prestige, China wants the yuan to be included the IMF’s basket of benchmark currencies and to do so, it must show ‘flexibility’ in managing the yuan---meaning that if it stages too strong a defense of the yuan, the IMF (which believes that the yuan is roughly 10% overvalued) will consider it ‘inflexible’ and deny entry into its basket of currencies.  (And deny it did on Wednesday.  The big question is, will the Chinese government back off too strong a defense of yuan?  Stay tuned.)

{ii} China is experiencing massive capital outflows (citizens/companies selling yuan to buy another currency), which puts downward pressure on the yuan as well as chewing up its massive reserves.  This makes the stabilization effort all the more difficult.

The spillover effects of a volatile Chinese currency and stock market are important because:

{i} a depreciating yuan makes Chinese products more price competitive in a world in which total demand appears to be shrinking, which in turn damages other economies, in particular, emerging markets.  That ups the risk of recession and trade war,

{ii} a falling stock market (1) could be signaling a weaker than assumed Chinese economy and that it could spill over into other regional markets and (2) big losses could cause internal dissent because the Chinese government had encouraged speculation in stocks and provided the money for margin debt.

[c] elsewhere around the globe, {i} Japanese second quarter GDP fell 1.6% and {ii} news out of the emerging markets is turning decidedly negative (slowing growth, capital outflows and currency devaluations).  Much of the latter is tied to the mounting difficulties in China (August manufacturing PMI down for fifth straight month) and provides further evidence of the weakening in the global economy.
Turmoil in the emerging markets (medium and a must read):

Turmoil in Europe (short):

For the moment, I am holding to our global economic ‘muddling through’ assumption; but the yellow light is flashing.

Bottom line:  the US economic data continues to reflect very sluggish growth in the US economy.  However, the flow of anecdotal numbers remains discouraging; and this week we were flooded with a host of bad news from the emerging markets.  Much of it was directly related to the Chinese economy, reinforcing the notion that economic conditions there are worse than portrayed by official pronouncements.  The biggest economic risk to our forecast is growth problems in the rest of the world.  The warning light is now flashing. 

This week’s data:

(1)                                  housing: July housing starts were up slightly but building permits were down; July existing home sales were up versus estimates of a decline; weekly mortgage applications rose while purchase applications fell; the August National Homebuilders index was in line,

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

(3)                                  industry: the August NY Fed manufacturing index was terrible while the Philly Fed index was up,

(4)                                  macroeconomic: July leading economic indicators fell versus an anticipated increase; the headline July CPI number as well as the ex food and energy figure were below forecasts.
The Market-Disciplined Investing

The indices (DJIA 16459, S&P 1970) got pulverized on Friday.  The Dow ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term downtrend, re-setting from a trading range {17083-17970}, [c] in an intermediate term trading range {15842-18295} and [d] in a long term uptrend {5369-19175}.

The S&P finished [a] below its 100 day moving average, leaving it as resistance, [b] below its 200 day moving average; if it remains below that MA through the close next Tuesday, it will revert from support to resistance, [c] below the upper boundary of a very short term downtrend, [d] below the lower boundary of its short term trading range {2043-2135}; if remains there through the close on Monday, it will re-set to a downtrend and [e] within an intermediate term uptrend {1889-2651} and a long term uptrend {797-2145}. 

Volume spiked but that was heavily influenced by option expiration; breadth was awful.  The VIX soared 46%, finishing [a] above its 100 day moving average; if it remains there through the close next Tuesday, it will revert to support, [b] above the upper boundary of its short term trading range; if it remains there through the close next Tuesday, the short term trend will re-set to up, [c] above the upper boundary of its intermediate term downtrend; if it remains there through the close next Wednesday, it will re-set to a trading range and [d] a long term trading range.

            Further correction or a bottom? (medium):
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 was up again on Friday, but remained below its 100 day moving average and in short, intermediate and long term downtrends.  However, it is in a very short term uptrend.  This could be signaling that a bottom has been made; however, that very short term uptrend needs to be challenged, at least once, before I would have any confidence in that judgment.

Oil continues to crash, finishing below its 100 day moving average and within short and intermediate term downtrends.

Excess supply or lower demand (short):

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

Bottom line: Wheww! this week was brutal; not just in the magnitude of the drop in prices but also in terms of the trends that were broken.  If the S&P ends below the lower boundary of its short term trading range on Monday, that trend will re-set to down and will join the DJIA.  Along with breaking below the 100 and 200 day moving Averages, that alters the momentum to the downside---for the first time in a number of years. 

That doesn’t mean that the bear market has begun.  But, at the least, considerable technical damage has been done; so it will likely take time for repair.  That said, the first two steps toward a bear market have been taken (breaking the moving averages and the short term uptrends).  If this down move takes out the intermediate term uptrends, strap in.

Bonds continue to suggest no Fed rate hike and/or a weakening economy---though admittedly as a safe haven trade, they were helped by the plunge in equity markets this week.  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 (16459) finished this week about 35.2% above Fair Value (12169) while the S&P (1970) closed 30.5% 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 I should add, just barely.  Unfortunately, a number of factors are working against the numbers maintaining their current positive bias---negative anecdotal economic stats, currency and stock market problems in China, growing economic turmoil in emerging markets and collapsing commodity prices.  I am not ready to say that American business and labor can’t overcome the hurdles presented by declining global economic activity.  But I am getting close; and this clearly poses a risk to the economy and the Market.

The Fed continues to send mixed signals to the Market; the latest being a seeming retreat from a September rate hike.  Don’t get me wrong.  I don’t think the FOMC’s decision will make a hill of beans to the economy one way or the other.  However, we may have reached the point where any Fed action won’t matter to the Market---something that I have worried about persistently in these pages. 

By that I mean, if the falling currency valuations and lousy economic data (finally) convince investors that QEInfinity is a sham, then the notion that the Fed (central banks) have investors’ backs (i.e. QE = higher stock prices) is toast.  Then reality sets in: that all the QEInfinity foisted on the global economy has accomplished nothing and, indeed, the global economy is now stumbling in spite of it and that currency devaluation is becoming the new remedy for slowing economic growth---and does have an impact on economies and asset prices and it is negative. 

In short, investors may be at or near that ‘emperor’s new clothes’ realization that asset prices are high not because of fundamentals but because of an irresponsible decision to experiment with an unproven policy tool (QE) that has not only failed but left the global economy in tatters.  

Net, net, my two biggest concerns for the Markets are (1) the economic effects of a slowing global economy and (2) Fed [central bank] policy actions whatever that are or are not and/or loss of confidence in those actions.

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.  Unfortunately, those assumptions may be too optimistic, making matters worse.

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; turmoil in the emerging markets and commodities; 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.
            Where investors believe the tail risk is now (medium):
            Is the bull market over (medium)?

            More on valuation (medium and a must read):

DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 8/31/15                                  12169            1509
Close this week                                               16459            1970

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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