Saturday, August 29, 2015

The Closing Bell

The Closing Bell


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                            17044-17957
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                          2031-2094
                                    Intermediate Term Uptrend                        1898-2671
                                    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:  weekly mortgage and purchase applications, month to date retail chain store sales, August consumer confidence, July durable goods orders, the July Chicago national activity index, revised second quarter GDP; below estimates: June new home sales, July pending home sales, the June Case Shiller home price index, weekly jobless claims, July personal spending, August consumer sentiment, the August Richmond and Kansas City Fed manufacturing indices and second quarter corporate profits; in line with estimates: July personal income.

The primary indicators included July durable goods (+), revised second quarter GDP (+), July new home sales (-), July personal spending (-) and second quarter corporate profits (-).  In sum, the balance of both all the indicators as well as the primary indicators was negative.  However, the anecdotal evidence was a bit more positive, at least for oil: SLB acquiring another oil services company and rising oil prices.  That said, the Atlanta Fed again lowered its third quarter GDP forecast.

Overseas, the Chinese government spent the week intervening in both its stock and currency markets in an attempt to stem losses.  In addition, the economic data was on balance negative: better numbers from China (though many continue to have doubts about their veracity), poor stats from Japan, a failed bond offering in Vietnam and recession in Brazil.

Also this week, the NY Fed head made some dovish comments.   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; so debating a rate hike or no rate hike is a giant circle jerk.  All QE has done is create asset mispricing and misallocation of major portions.

In summary, both total and primary stats were negative, anecdotal data was mixed to positive, 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.
        A neutral and getting less so:

(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.  In addition, [a] there is mounting evidence that the continuing decline in oil prices is at least partly a function of falling demand and [b] lower oil prices have a pronounced negative impact on countries in which oil is a primary export and highly leveraged oil companies.  The failure of either or both would feed the global economic slowdown [deflation] story.

       The negatives:

(1)   a vulnerable global banking system.  A week free of bankster misdeeds.

(2)   fiscal/regulatory policy. A week free of ruling class misdeeds.

(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 ‘no rate increase’ crowd received a boost this week from NY Fed chief Dudley, who, in a speech, accounted as how a rise in the Fed Funds rate was ‘less compelling’ now, given the turmoil in the international markets. 

On the flip side, long rates have been rising due primarily to the heavy liquidation of Treasury holdings held in Chinese and emerging market foreign exchange reserves.  In addition, these sales have the effect of tightening money supply [money is spent to buy the bonds].  Clearly, this represents, at least, a partial usurpation of the Fed’s prerogative to expand or tighten monetary policy.  Given the dovish bent of our Fed [i.e. it is scared sh*tless to make a 25 basis point increase in the Fed Funds rate], it could potentially lead, believe it or not, to QEIV.

Just to summarize my continuing theses on Fed policy:

[a] QE rate cuts had little to no positive effect on the economy, so a rate increase will also likely have no consequence,

[b] what they did do was create major distortions in asset pricing and allocation,

[c] even if the Fed did initiate an increase, a quarter point rise from such a low base wouldn’t have an impact anyway,

[d] in any case, the Fed has waited too long to begin the transition from an extraordinarily accommodative policy; so that when it does undo this mistake, it will likely result in a lot of pain in the asset pricing and allocation spheres,

[e] keeping perfect its long term record of never getting its timing right.

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 Iranian nuke deal, the secession vote in eastern Ukraine and the hot war in the Middle East remain the trouble spots.  There was only one notable bit of news related to any of the above; and that was a Ukrainian/creditors deal to write off a portion of its debt, providing some much needed relief.  Nevertheless, all these situations have the potential to escalate and spill over into the economic arena.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  China held the spotlight this week which included:

[a] another small decline in the value of the yuan, accompanied by increasing efforts to stabilize it, including massive liquidation of reserves to support the yuan,

[b] a dive in the Chinese securities markets followed by another round of government intervention in the form of interest rate cuts, enhanced tactics to cower sellers and new money pumped into the markets,

[c] improvement in official economic data {electric power generation, leading economic indicators} but a disturbing report from an outside party that estimates that the Chinese economic activity is declining.

None of the above is a plus in that more central government intervention hinders price discovery and the best and highest use of assets.  The worry is that the market will ultimately prevail and the consequences negatively impact the global economy---like the report this week that global trade is shrinking.

The impact of Chinese government meddling (medium):

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, developments is China reinforce the notion that economic conditions there are worse than portrayed by official pronouncements. In addition, the news out of emerging markets reflects rapidly deteriorating economic conditions.  The biggest economic risk to our forecast is growth problems in the rest of the world.  The warning light is flashing. 

This week’s data:

(1)                                  housing: June new home sales were below expectations; July pending home sales were below forecast; mortgage and purchase applications were up; the June Case Shiller home price index was below estimates,

(2)                                  consumer: July personal income was up, in line, however personal spending was below consensus; month to date retail chain store sales growth was up; August consumer confidence was better than anticipated though consumer sentiment was less; weekly jobless claims fell less than expected,

(3)                                  industry: July durable goods orders were much better than forecast, though ex transportation the ‘beat’ was slight; both the August Richmond and Kansas City Fed manufacturing indices were disappointing; the July Chicago Fed national activity index was above estimates, but June’s reading was revised down,

(4)                                  macroeconomic: revised second quarter GDP improved, though revised corporate profits were worse.

The Market-Disciplined Investing

The indices (DJIA 16643, S&P 1988) finished a stomach churning week with something of a whimper---the DJIA down fractionally and the S&P up slightly.  The Dow ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term downtrend {17044-17959}, [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 and 200 day moving averages, both of which represent resistance, [b] below the upper boundary of a very short term downtrend, [c] in a short term downtrend {2031-2087}, [d] within an intermediate term uptrend {1898-2661} and [e] a long term uptrend {797-2145}. 

Volume spiked during the week but fell back near normal levels on Friday; breadth was negative, with the flow of funds indicator having been negative for almost the entire week. The VIX broke several trends to the upside and remained there, ending [a] above its 100 day moving average, now support, [b] within a short term uptrend, [c] within an intermediate term trading range {it remains well above the upper boundary of its former intermediate term downtrend and [d] a long term trading range.

A look at margin debt (medium):

The long Treasury performance this week was a bit of cognitive dissonance for me, in that I am a proponent of the no Fed rate hike/economic slowing camp.  The most significant item being that it broke down below the lower boundary of a very short term uptrend---suggesting a Fed rate hike and/or a stronger economy is a possibility.

However, as I have noted, much of the move is being attributed to substantial US Treasury sales by the Chinese and emerging markets central banks.  While that could certainly mean higher rates in the short term, it actually supports the notion that the Fed won’t raise rates (if it is as worried as much about the spillover effects of overseas turmoil as it says).  In addition, those Treasury sales are a back door form of US monetary tightening which suggests an increase likelihood of either slowing economic growth or another round of QE.

TLT remained [a] above its 100 day moving average, now support and [b] within short and intermediate term trading ranges.

GLD rose again, remaining below its 100 day moving average and within short, intermediate and long term downtrends.  However, it traded back above the lower boundary of its very short term uptrend, voiding the challenge initiated on Thursday.  The odds of a bottom having been made are up.

Oil was strong again and broke above the upper boundary of its short term downtrend; if it remains there through the close on Tuesday, that trend will re-set to a trading range.  It remained below its 100 day moving average and within short (temporarily?), intermediate and long term downtrends.

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

Bottom line: after all that volatility, the indices finished basically flat for the week---though remember last Friday was a big down day.  Nothing occurred that undid the technical damage done earlier.  True, it rendered the challenges to the DJIA intermediate term trading range and the S&P intermediate term uptrend void.  However, until there is some test of this very short term uptrend created by the bounce this week, we can’t really say a bottom has been made.  Plus as I noted above, the VIX is in no way suggesting that the worst is over.  Still my ultimate conclusion remains that the volatility has been so extreme it is almost impossible to make any meaningful comment on the Market’s direction.

The long Treasury continues to challenge the notion that there will be no Fed rate hike and no recession.  However, as I noted above, there are short term outside factors, only tangentially related to the US economy, driving Treasury bonds down (yields up)---that being selling of Treasury securities by China and other emerging markets attempting to defend their currencies.   

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16643) finished this week about 36.7% above Fair Value (12169) while the S&P (1988) closed 31.7% 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.  On the other hand, the turmoil in the Chinese currency and stock market as well as the numbers from emerging markets are not signs of economic health and that was reflected in this week’s international trade data.  My primary concern is that American business and labor can’t overcome the hurdles presented by this problem.  Clearly this poses a risk to the economy, and hence our forecast, and hence, the assumptions in our Valuation Model.

Here is the problem stated in more apocalyptic terms (medium):

NY Fed chief Dudley backed up last week’s narrative from the FOMC minutes, to wit, the 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.  What worries me is the complete loss of investor faith in our Fed as well as the other major central banks in the world as a result of having pursued an unproven, ineffective, nay, harmful policy [asset mispricing and misallocation] and the subsequent reaction of the Markets. 

To be fair, Wednesday’s powerful rally on the same day as Dudley’s speech and the imposition of strong currency and stock market measures by the Chinese central bank directly conflicts with that notion.  Whether that rally was a function of those circumstances or simply a dead cat bounce off an extremely oversold condition will likely be determined this coming week.
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 the 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, our 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 any further bounce in stock 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                                               16643            1988

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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