Saturday, September 12, 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                            16989-17908
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                          2018-2084
                                    Intermediate Term Uptrend                        1909-2682
                                    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 quite negative---though not so much so among the primary indicators: above estimates:  the July Department of Labor job openings reports, the August budget deficit and August PPI; below estimates: weekly mortgage and purchase applications, weekly jobless claims, the August small business optimism index, July wholesale inventories and sales, the initial September consumer sentiment indicator and August import and export prices; in line with estimates: month to date retail chain store sales.

The primary indicators included August PPI (+) and July wholesale inventories and sales (-); so evenly matched among these numbers.  There was one bit of anecdotal evidence---the final tally of the S&P second quarter corporate revenues, which were off 3%+.  In addition, our ruling class is at it again---this time threatening another government shutdown.  I score this as the third week in a row of negative data.

Overseas, the data flow remained lousy, the Chinese government continued intervening in both its stock and currency markets, the Japanese government is threatening another QE and multiple new parties are getting involved in the Syrian conflict.  There was one bit of good news: both China and Japan pledged to lower taxes.  This isn’t the first time that they have promised to do it, then didn’t.  But I will take good news however I can get it.

The Fed was quiet this week ahead of its meeting next week.  I say quiet.  There weren’t any officials out making comments.  However, Fed mouthpiece Hilsenrath crawfished on his prediction that the Fed would raise rates at their meeting.  That makes sense to me given the dataflow.  On the other hand, I don’t think that a decision either way will make a hill of beans to the economy.  Indeed, I am not sure it will make any difference to the Markets since they seem to be taking the unwinding of QE into their own hands.  On the other hand, it could exacerbate that process.

In summary, (1) the economic stats both here and abroad were poor, (2) in my opinion, the Fed has reached the point where virtually any action it takes will only make Market conditions worse, (3) the turmoil in Syria is escalating and (4) now our ruling class is talking government shutdown.  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.  However, there has been no ‘unmitigated’ economic positive for the US from lower oil prices.  In addition, lower oil prices have had a pronounced negative impact in countries in which oil is a primary export.  Loss of oil revenues is negative for national income and tax receipts. Aside from feeding recessionary/deflationary forces, it also forces governments to sell reserves to cover the loss of income.  In doing so, much of those reserves being liquidated are US Treasuries which puts upward pressure on US interest rates.  Further, taken by itself, it shrinks money supply which is deflationary in its implications.

       The negatives:

(1)   a vulnerable global banking system.  They just can’t help themselves.  This week New York regulators sent letters to primary Treasury dealers seeking information regarding the manipulation of bond auctions.  Meanwhile the Boston public employee pension fund have sued those dealers alleging manipulation.

This is a must read article on the risks posed by too big to fail banks with large operations in emerging markets.

More on the problem of inter bank credit (short):

‘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 in the international financial system.’

(2)   fiscal/regulatory policy. If you can believe it, another government shutdown seems a possibility.  It seems to stem primarily from the controversy over funding Planned Parenthood; that is, many lawmakers are unwilling to vote for any continuing resolution that contains funding for that agency.  I can understand the political/social/moral issue; but I am not sure risking exacerbating a weakening economy is the best way to address it.

(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 Fed was on radio silence this week [a blessing] ahead of next week’s FOMC meeting; although just to keep the state of confusion at elevated levels, Fed whisperer Hilsenrath walked back his prediction that the Fed would raise rates next week.  As you know, I don’t think it makes a tinker’s damn one way or the other. My thesis remains:

[a] QE {except QEI} has had little impact on the economy; so unwinding it will have an equally small effect on the economy,

[b] however, QE led to significant asset mispricing and misallocation; unwinding it will have an equally significant effect on asset prices,

[c] in any case, the Fed has once again waited too long to begin the process on monetary normalization.  That compounds their asset mispricing problem because the Markets appear to be taking matters into their own hands and they will be less circumspect in correcting the pricing problem,

[d] the Fed knows that it has made a mistake, but appears to think that its only alternative is to bulls**t the Markets and pray for luck.  The danger here is that in a desperate attempt to extricate itself from the problem, it may make another equally disastrous misjudgment and only make matters worse.

Here is an argument that the Fed has been sly like a fox, keeping investor attention on interest rates while slamming the brakes on money supply growth.  It has merit.  On the other hand, a shrinking money supply could be a manifestation of the flood of foreign Treasury sales {aggravating deflationary pressures} (medium):

Further support (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.

                                   How is this for central bank money printing (short)?
(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.  The news this week was the growing Syrian refugee problem which has now prompted Western Europe [the primary recipient of those refugees] to get involved in the government’s conflict with ISIS. In addition, Iran [our bosom buddies in the nuke treaty] sent more ground troops to Syria. Too many cooks……exacerbate tensions and hence raise the potential to escalate the violence and/or the geographic scope of the war.

The latest (medium):

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  Lots of overseas economic stats this week: the good news:  August German exports and imports improved; Italian industrial output increased; second quarter EU GDP was up 0.4% versus expectations of up 0.3%; the bad news:  August Chinese imports plunged, exports off 5.5%; August Chinese CPI rose 2% but PPI fell 5.9%; German CPI and PPI declined; Spanish CPI dropped; second quarter Japanese GDP dropped 1.2%; July Japanese machinery orders were down 3.5%; French manufacturing and industrial production both fell; UK trade numbers, industrial production and manufacturing production all declined; S&P downgraded Brazil’s credit rating to junk.  On balance---not so hot.

Ground zero in Canada’s recession (medium):

There was some government response to the weakening data:  the good news: both China and Japan pledged to lower taxes; the bad news: a Japanese official predicted more QE; China reportedly sold $94 billion US Treasuries in August, has spent 600 billion yuan to date in stock market ‘plunge protection’ and further tightened capital controls.

In sum, the international economic news was, with a couple of exceptions, lousy and the government actions to counter it was, with a notable exception, not constructive.

Clearly, the problems being experienced in the rest of the world keep the yellow flashing on our global ‘muddling through’ assumption.

Bottom line:  the US data continues to reflect very sluggish growth in the  economy.  In addition
, global economic trends are still deteriorating; and the Fed remains paralyzed by fear of the consequences of prior policy mistakes.  The latter two are the biggest economic risks to our forecast.  The warning light is flashing. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were down,

(2)                                  consumer: month to date retail chain store sales grew at the same pace as last week; the July Department of Labor jobs openings report was very upbeat; weekly jobless claims fell less than anticipated; the initial September consumer sentiment number plunged 6 points,

(3)                                  industry: the August small business optimism index was slightly below forecast; July wholesale inventories and sales were disappointments,

(4)                                  macroeconomic: both August import and export prices were down more than consensus; both the August headline and ex food and energy reports were higher than forecast, the August US budget deficit was $64.4 billion down from $149.2 billion in July.

The Market-Disciplined Investing

The indices (DJIA 16433, S&P 1961) had another quiet calm (up) day.  The Dow ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term downtrend {16989-17908}, [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 {2018-2086}, [d] within an intermediate term uptrend {1909-2682} and [e] a long term uptrend {797-2145}.  In addition, it closed between the lower boundary of a very short term uptrend [series of higher lows] and 1970, a gap of about 9 points---so one of these boundaries are apt to break in the near term.  I want stocks to get out of this range and then see if there is any technical clarity.

Volume was down; breadth mixed. The VIX fell 5%, but still ended [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.  As long as remains roughly above the 20 level, uncertainty is at elevated levels.
The long Treasury rose, remaining above its 100 day moving average, leaving it as support and finished within short and intermediate term trading ranges. 

GLD fell, closing in downtrends across all timeframes and below its 100 day moving average.  It can still build a bottom were it to fail to successfully challenge its July/August lows (104).  But that is yet to be seen. 

Oil increased another 2%, but stayed below its 100 day moving average and within a short term trading range and intermediate and long term downtrends.

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

Bottom line: the Averages remain (1) on a long term basis, within a very wide gap between the lower boundaries of their intermediate term trends and the upper boundaries of the short term downtrends and (2) on a short term basis, in a much narrow zone marked by S&P 1970 on the upside and the trend of higher lows on the downside. 

The quiet late week trading was likely a result of investors going to the sidelines ahead of not just the FOMC meeting but similar meetings by the central banks of Japan and Switzerland next week.  If correct, then trading should be calm in the first days of next week, then pick up later with the conclusion of the FOMC meeting and Friday’s quadruple witching.

That said, I continue to think that trying to decipher short term direction in a highly volatile but trendless Market is an exercise in futility.  However, longer term, as long as the lower boundaries of the indices intermediate term trends hold, the Market is in a simple correction in a bull market.

The long Treasury’s pin action continues to suggest a Fed rate hike and a stronger economy.  As you know, I don’t think that this scenario will occur. 

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16433) finished this week about 34.6% above Fair Value (12201) while the S&P (1961) closed 29.6% overvalued (1513).  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---although we now have three weeks in a row of relatively weak stats.  Another three or so weeks of this kind of performance, I may have to lower our economic forecast again. 

Not helping matters are the numbers from the rest of the world---the concern obviously being that the slowdown in the global economy will wash on to our shores.  Clearly, this also poses a risk to our outlook.  More importantly for the Market, the risk is that many Street forecasts are more optimistic than our own; and if they are revised down, it will likely be accompanied by lower Valuation estimates.

The Fed was quiet this week; but that doesn’t alter the fact that (1) it has pursued a policy that has created another asset bubble, (2) it has waited too long to attempt to correct that mistake, (3) and any further policy error move from here runs of the risk making the problem even worse. Of course, the latter maybe irrelevant, because the Markets appear to have started to self-correct and that will likely be less kind and gentle than a Fed managed unwind (which itself would not be pain free). 

Of course, we will get some good feedback next week from the FOMC meeting.  The pundits seem roughly divided on whether or not the Fed will raise rates.  However, at the close yesterday, the bond market was pricing in a less than even chance of a rate increase occurring. 
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 know that I sounded negative for the last eighteen months.  The primary reason being that more and more of our Portfolios’ holdings were hitting their Sell Half prices.  Secondarily, our Market Valuation Model basically reflected the same thing; that is, a 2015 S&P year end Fair Value of around 1525.  So my focus has been on gap between Market price and Fair Value and the triggers that could cause mean reversion.  The article below reminds me that in arguing for mean reversion, I am not suggesting an economic/Market calamity the proportion of 2008/2009.  As I state below, ‘this is not a recommendation to run for the hills’ but an admonition that you prepare your Portfolio for some damage.

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 9/30/15                                  12201            1513
Close this week                                               16433            1961

Over Valuation vs. 9/30 Close
              5% overvalued                                12811                1588
            10% overvalued                                13421               1664 
            15% overvalued                                14031                1739
            20% overvalued                                14641                1815   
            25% overvalued                                  15251              1891   
            30% overvalued                                  15881              1966
            35% overvalued                                  16471              2042
            40% overvalued                                  17081              2118
Under Valuation vs. 9/30 Close
            5% undervalued                             11590                    1437
10%undervalued                            10980                   1361   
15%undervalued                            10370                   1286

* 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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