Saturday, September 26, 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                            17139-17874
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                          2004-2068
                                    Intermediate Term Uptrend                        1920-2713
                                    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 negative---though not so much so among the primary indicators: above estimates: weekly mortgage and purchase applications, August new home sales, weekly jobless claims and revised second quarter GDP; below estimates: August existing home sales, month to date retail chain store sales, August durable goods orders ex transportation, the September Richmond Fed manufacturing index, the August Chicago Fed national activity index and revised second quarter corporate profits; in line with estimates: August durable goods orders, the September Markit manufacturing and services PMI’s, the September Kansas City Fed manufacturing index and September consumer sentiment.

The primary indicators included August new home sales (+), revised second quarter GDP (+), August existing home sales (-), August ex transportation durable goods orders (-) and August durable goods orders (0); so evenly matched among these numbers. 

Overseas, the data flow remained lousy.  In addition, Volkswagen admitted to a massive fraud scheme designed to understate emissions from its diesel models.  Estimates of the fines and potential legal settlements are the billions.  This could be big enough to impact the German economy which has been the engine of EU growth.  ‘Could’ is the operative word; but we still need to pay close attention to developments.

The Fed was active this week with (1) Yellen sounding more hawkish in a Thursday speech---this being the first leg of her third or fourth round trip from dovish to hawkish and back again, and (2) a regional Fed chief saying that zero bound interest rate policy has been a failure.  That anyone pays any attention to what these guys (gal) are saying anymore is amazing because we know and they know that (1) it is clear that QEInfinity didn’t work (2) raising interest rates 25 basis points is irrelevant to the economy, (3) the only point of Fed policy is to control the Markets and (4) the Fed seems to be losing that control. 

On the fiscal side, our ruling class is getting perilously close to another government shutdown. But Boehner appears to have made the ultimate sacrifice to keep it from happening (this time).

In summary, the economic stats both here and abroad remained sub-par while the Fed is scrambling to hold off the ultimate price that will be paid for its ill-conceived policies.  For the time being, I am staying with our forecast but it appears increasing likely that I will have to revise it down again.
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.
        A neutral and getting less so:

(1)   our energy picture.  The discovery of new oil supplies in this country 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 and, hence, is a negative for global growth.

       The negatives:

(1)   a vulnerable global banking system.  A quiet week.

 ‘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. The odds of a government shutdown continued to rise this week; that is, until Speaker Boehner resigned.  The reasons that he stepped down primarily seem to be that (1) he could have lost the speakership anyway and (2) this move will free him to cut a deal with house democrats to avert a shutdown.  Short term, no shutdown is a plus for the economy.  Longer term, internecine battles in the GOP ranks may make great theater, but I am not sure what it does for moving the government toward policies of less spending, less taxes and less regulation.

(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 continued its strategy to dazzle investors with their footwork and hope that they don’t notice that there is no there, there.  Somewhat surprisingly [or not], in a speech on Thursday, Yellen switched her stance again---now she is hawkish.  In my opinion, this is just more of same ‘data dependent’ smoke that she blows up our collective skirts in hopes that we think that she knows what she is doing.  When in reality, she is praying that she can delay recognition that the empress has no clothes long enough that some miracle bails her and her cohorts out of one of the worse monetary policies in history.  Indeed, earlier in the week, a regional Fed chief said basically that zero bound interest rates is a failed policy.

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.

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.  The news this week remained focused on Syria as [a] both Russia and Iran continue to step up their support of the Assad regime, [b] China appears to be joining them and [c] the refugee problem in Europe is mushrooming.  What concerns me about this mess is the risk of some accidental confrontation between Russian and US forces that could escalate.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  This week’s overseas economic stats included: weaker than anticipated EU and Chinese manufacturing indices, French unemployment at new highs and August Japanese core CPI fell [how is that QE working for you, Mr. Abe?]

Signs of deepening distress in China (medium):

There was one bit of anecdotal evidence: Volkswagen admitted to having deliberately altered its onboard software to reflect much lower levels of emissions than mandated.  Correcting this fraud is estimated to be hugely expensive.  Further rumors abound that BMW may get caught up in the same scandal.  Aside from the sheer magnitude of the likely expense to correct the fraud and deal with any legal matters, the importance is that one of six jobs in the German economy is related to the auto industry.  And remember that Germany is the engine pulling the EU economy.  If this scandal ends up negatively impacting the German economy, it clearly is not going to help the EU or global economies.

Further, keeping QE alive and well, the Norwegian and Taiwanese central banks stayed with the global QE/currency devaluation theme by cutting key interest rates.

Finally as if the EU doesn’t have enough problems, Catalonia votes on secession from Spain on Sunday.

In sum, the international economic news was lousy.

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 up; August existing home sales were rotten while new homes sales were above consensus,

(2)                                  consumer: month to date retail chain store sales declined significantly from the prior week; weekly jobless claims were up less than anticipated; September consumer sentiment was .1 above expectations,

(3)                                  industry: August durable goods were in line, however, ex transportation, they were below estimates; the September Richmond Fed manufacturing index was very disappointing; the Kansas City Fed index was slightly improved from August, though still negative; the August Chicago Fed national activity index declined; the September Markit manufacturing PMI was fractionally below expectations while the services PMI was slightly above,

(4)                                  macroeconomic: revised second quarter GDP was a bit better than the prior reading while corporate profits were worse.
The Market-Disciplined Investing

The indices (DJIA 16314, S&P 1931) gave us a split decision on Friday (Dow up, S&P down).  The Dow still ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term downtrend {17139-17874}, [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 {2004-2068}, [d] within an intermediate term uptrend {1920-2713} and [e] a long term uptrend {797-2145}. 

I thought it unusual for the S&P not to have more follow through on Friday after the bounce off of a major trend.  That may mean that it is ready to mount a third challenge to its intermediate term trend.  On the other hand, stocks recent schizophrenic behavior make anything possible.  From a technical standpoint what happens next is important.

Volume rose; breadth was better. The VIX (23.6) was up slightly, remaining [a] above its 100 day moving average, now support, [b] right on the lower boundary of its short term uptrend and seems to be tracking its rate of ascent, [c] within an intermediate term trading range {it remains well above the upper boundary of its former intermediate term downtrend} and a long term trading range.  In addition, it continues to climb above the 20 level. 
The long Treasury rose, closing above its 100 day moving average, still support; and it ended within short and intermediate term trading ranges.  The takeaway is that it remains in a very short term trading that has existed since the August Market lows.  A pattern that is being copied by both oil and the dollar.

GLD fell, finishing [a] back below its 100 day moving average, voiding Thursday break, [b] but remained above the upper boundary of its short term downtrend; if it remains there through the close on Monday, it will re-set to a short term trading range, [c] within intermediate and long term downtrends and [d] is now developing a very short term uptrend. 

Bottom line: schizophrenia remains the watch word.  As I noted above, I thought that the S&P’s successful challenge of its intermediate term uptrend on Thursday would be cause for a re-test of 1970 or at least some follow through to the upside.  There was none.  Does that mean a re-test of the intermediate term uptrend?  Ordinarily, I would say, yes; especially with the VIX inching higher.  Now, it would be just a guess.  Time to watch.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16314) finished this week about 33.7% above Fair Value (12201) while the S&P (1931) closed 27.6% 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 weaken making our already downwardly revised forecast increasingly suspect.  A couple more weeks of this and I will likely have to lower our outlook even further.

The rest of the world is in no better shape; in fact, the US is probably the bright spot in the global economy.  I am little bit concerned that this German auto scandal could act as an accelerant to EU economic weakness.  There is clearly no proof of that yet; but it is an added risk.

In sum, the US and global economies are weak and getting weaker.  The risk here 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 back to its old game this week---keep investors confused with a lot of empty metaphysical dialectic so that they won’t notice that it knows that it is in a pickle and has no notion how to salvage the mess that it is made.   After the Fed declined to raise rates in its September meeting, Yellen said in a Thursday speech that she was now in the rate hike camp---despite the relentless flow of lousy economic data.  Tortured logic.  But when you consider that the Fed is more worried about the Market than the economy, it makes all the sense in the world in view of the selloff that occurred after the aforementioned FOMC meeting. 

That said, we got a peek under the curtain earlier in the week when one of the regional Fed heads acknowledged that zero rates are a failed policy.  At least someone in that ivory tower gets it.  And what is ‘it’?   The Fed (1) 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.

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 they 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.
            Thoughts from a bull (medium):

DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 9/30/15                                  12201            1513
Close this week                                               16314            1931

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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