Saturday, November 7, 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)      -1.0-+2.0%
                        Inflation (revised)                                                          1.0-2.0%
                        Corporate Profits (revised)                                            -7-+5%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                       16919-18148
Intermediate Term Trading Range           15842-18295
Long Term Uptrend                                  5471-19343
                        2014    Year End Fair Value                             11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Trading Range                          2016-2104
                                    Intermediate Term Uptrend                        1950-2742
                                    Long Term Uptrend                                     800-2161
                        2014   Year End Fair Value                                     1470-1490

                        2015   Year End Fair Value                                      1515-1535
                        2016 Year End Fair Value                                      1560-1580          

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 solidly positive.  This is the second time in three weeks that the data has been either a neutral or a plus: above estimates: the  October ISM manufacturing and service indices, September construction spending, month to date retail chain store sales, October light vehicle sales, the October ADP private payroll report, October nonfarm payrolls, the September trade deficit, October consumer credit, third quarter productivity and unit labor costs; below estimates: September factory orders, weekly mortgage and purchase applications, weekly jobless claims, October retail sales; in line with estimates: the October manufacturing and services PMI’s.

Likewise, the primary indicators were also upbeat: September construction spending (+), the October ISM indices (++). October light vehicle sales (+), October nonfarm payrolls (+) and September factory orders (-).

While these numbers are unquestionably positive and while they represent the second time in three weeks that the data has exhibited something other than a nose dive, it is still too soon to conclude that the declining rate of growth has leveled off.  To be clear, even if it has, it won’t change the fact that growth has decelerated; it may, however, take the possibility of recession off the table.  Whether or not that is the case is now, to coin a phrase, ‘data dependent’.

Overseas, the data flow remained lousy. 

But once again, the lead economic story of the week was the Fed:

(1)   yet another flip flop by the Fed on the timing of a rate hike.  On Wednesday, Yellen reversed the prior Fed dovish comments by declaring a December rate increase as a strong probability.  I don’t think that is any commentary on the economy because for years Fed policy has never been about the economy but rather the Market.  So my original thought was that in light of the latest Market moon shot, Yellen decided to test out the ‘rate hike scenario’ for Market reaction.  Calm acceptance would likely mean a December rate hike; panic would mean another excuse to do nothing.   But then:

(2)   this was followed by a stunning comment from a Fed member [before the release of the jobs report], basically saying that a weak nonfarm payroll number was not really bad economic news---in other words, even if Friday’s employment was below expectations, that wouldn’t take a December rate hike off the table.  Of course, Friday’s payroll report smoked the estimates, so those comments aren’t particularly relevant---unless, the Fed has a rate hike planned irrespective of the economic numbers.  In that case, it could put Yellen et al in an uncomfortable position---what do they do if the data between now and December rocks but the Market sinks?  Answer: weasel, again.

In summary, the US economic stats may be showing signs of stabilizing while the international data remains sub-par.  In the meantime, the Fed is praying the Market holds in the face of a more likely December rate hike so it can make at least a token move toward monetary normalization.  Good luck with that Janet.

Our forecast:

a much below average secular rate of recovery, exacerbated by a declining cyclical pattern of growth with an increasing chance of a recession 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.

            Odds of a recession are rising (medium):
            A more optimistic view (medium):

                        Update on the big four economic indicators:

       The negatives:

(1)   a vulnerable global banking system.  There was a mix of news this week on the health of global financial institution:

[a] Draghi endorsed a measure to insure the safety of EU bank deposits,

[b] the Financial Stability Board said major banks still have much to do to avoid the need of a bail out (medium):

[c] one analyst said that China is sitting on a nonperforming loan bomb (medium):

Which explains the lack of economic growth as a product of debt expansion (short):

[d] unfortunately, in the US, student and auto loans are soaring, potentially setting us up for a similar problem.

 ‘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.  We have a new speaker of the house that is making all kinds of promises of fiscal responsibility.  On the other hand, he voted for the budget measure that forfeited budget caps.  Do as I say…..

Meanwhile, Obama DK’ed the XL Pipeline, proving once again that, in Washington, ideology always trumps common sense [note: all that Canadian oil will still come to the US, it will just do so in trucks and trains which cause more pollution than a pipeline.]

(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.  

QE worshipers received a boost this week from the central bank of Australia [saying that there was plenty of room for more QE there] and Draghi [who in a speech having nothing to do with QE] anticipated more QE in December.

On the other hand, Yellen in congressional testimony [and with support of Bill Dudley] put a December rate hike squarely in the middle of the table.  This was confirmed by a later statement from another Fed member that lousy data doesn’t mean no rate hike.  Talk about the schizophrenic nature of Fed rate hike statements over the last year! 

My conclusion from all of this is that Yellen et al have decided to raise rates in December so they are giving everyone a heads up.  But having put an interest rate increase in December on the table and then said that it wasn’t data dependent, Ms. Yellen has a big problem if the stats stay good but the Market doesn’t.  It will be interesting to see how the Fed reacts if that scenario were to develop.

My thesis has changed slightly:

[a] QE {except QEI} has had a negative impact on the economy; so unwinding it will have a positive 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.  Indeed, if I am correct about the December rate hike, it will be raising rates in the midst of a slowdown in economic growth. 

[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.
                                  From Bill Gross (medium):

                                  The Fed’s grand delusion (medium):

(4)   geopolitical risks: talk about a clusterf**k.  The situation in Syria is getting more complicated: [a] US is sending ‘advisors’ into Syria [b] to assist Kurdish rebels which are considered terrorists by NATO ally, Turkey, [c] while Russia builds its naval presence in eastern Mediterranean. 

And it just keeps getting worse (medium):

 I am not worried about who is killing who in this war.  As far as I am concerned, the US is a net winner in any case.  However, the more players and the more pervasive their presence, the greater the odds of an ‘accidental’ confrontation that could lead to something much bigger.  

I am also uneasy about the continuing erosion of respect accorded to the US.  Weakness is not a quality admired by our major adversaries and could lead them to pursue even more aggressive anti-US policies. 

Given the cluelessness of our current foreign policy, the risks exist of either [a] further humiliation which will be difficult for the next administration to walk back or [b] an inappropriate US response in an attempt to prove it has cojones.  While I have no idea about the odds of either transpiring, they are not zero and that makes me a bit nervous.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  This week’s overseas economic stats included:  disappointing October Chinese manufacturing and services indices, leading to a negative composite PMI; better than expected manufacturing EU PMI but a lower than estimated services PMI; terrible German factory orders and poor industrial output; a decline in October EU retail sales; and slightly improved UK manufacturing and services PMI’s.  In sum, the international dataflow remains negative.

Add to it this bit of lousy anecdotal news (medium):

There is some good news, to wit, at least in Europe, officialdom is attempting to address the issue of bank solvency.  The bad news is that those poor economic numbers encourage the aggressive pursuit of QE, however ineffective it has been to date.

Finally, there is one big unknown lurking out there; and that is the state of the Chinese financial system.  To be sure, the Chinese only report what they want to report and much of that is lies.  But enough non-Chinese China analysts believe that there are massive amounts of nonperforming assets on Chinese bank balance sheets [see link above]---perhaps sufficient to rival the Lehman Brothers, Bear Stearns, AIG debacle.  That being said [a] no one really knows and [b] the Chinese government has more resources to deal with a similar situation were it to occur than the US did.  So, the point here is merely to point out a potential problem and the necessity of watching closely for confirming/nonconfirming evidence.

In sum, the international economic news was lousy, so the monetary spigots will likely be opened wider---enabling the central bankers to push the misallocation and pricing of assets to its logical conclusion.   This combo keeps the yellow flashing on our global ‘muddling through’ assumption; a flashing red light is not that far away.

Bottom line:  the US data continues to reflect very sluggish growth in the economy, though its rate of slowing may have stabilized.  In addition, global economic trends are still deteriorating; and the Fed, paralyzed by fear of the consequences of prior policy mistakes, has potentially put itself in an untenable position. 

As you know, I recently lowered our economic forecast for a second time.  And while I may have to do so again, the data from the last three weeks provides the hope that I may not and that recession is off the table. 

A deteriorating global economy and a counterproductive central bank monetary policy are the biggest economic risks to our forecast. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications fell,

(2)                                  consumer: month to date retail chain store sales improved from the prior week but October retail sales were weak; October light vehicle were better than anticipated; the October ADP private payroll report was better than estimates; October nonfarm payrolls were well ahead of consensus; weekly jobless claims were below forecast, growth in consumer credit was very strong,

(3)                                  industry: the October services PMI was flat with September; October ISM manufacturing index was slightly ahead of expectations; September factory orders were a disappointment,

(4)                                  macroeconomic: the September trade deficit was less than consensus; third quarter nonfarm productivity and unit labor costs were much better than projected.

The Market-Disciplined Investing

The indices (DJIA 17910, S&P 2099) slowed their meteoric advance late in the week as the rising probability of a December rate hike began to sink in.  The Dow ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term trading range {16919-18148}, [c] in an intermediate term trading range {15842-18295}and [d] in a long term uptrend {5471-19343}.

The S&P finished [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term trading range {2016-2104}, [d] in an intermediate term uptrend {1950-2742} [e] a long term uptrend {800-2161}. 

Volume increased slightly; breadth was mixed.  The VIX (14.3) was off 5%, finishing [a] below its 100 day moving average, now resistance, [b] within a short term downtrend and [c] in intermediate term and long term trading ranges.  A return to the 12-13 zone would again represent an opportunity to buy cheap portfolio insurance.
The long Treasury got whacked, ending [a] below its 100 day moving average, still support; but if it trades there through the close on Tuesday, it will revert to resistance, and (2) below the lower boundary of the developing pennant formation; this violation points to more downside in bond prices.  Just as important, not only did the long Treasury take it in the snoot, bond prices across all spectrums were down sharply.  Clearly, bond investors are finally getting serious about a December rate hike, presumably a result of the Friday jobs report and/or the Yellen/Bullock comments. 

GLD also got hammered, closing [a] below its 100 day moving average, now resistance, [b] in a short term trading range, [c] in intermediate and long term downtrends.  GLD remains a disappointment.

Bottom line: stocks closed at elevated levels on Friday, though in a minor pause likely the result of not only some consolidation after being overbought but also investor hesitation as the odds of a December rate hike increase.  To be sure, the Market did not act with the same violence as it did on prior occasions when higher rates were threatened. 

So it seems to me that the Market still has some upside. Any further advance would not only set up a challenge of the Averages all-time highs and the upper boundaries of their long term uptrends but will also be a major test of my thesis that rising rates will have a negative impact on stock prices. 

If we do get those challenges of the all-time highs and long term uptrends, I don’t think that those challenges will be successful---which, if followed by a rollover in the Market could end up supporting my thesis.  In the meantime, I am drawing near to being proved right or wrong

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17910) finished this week about 46.0% above Fair Value (12267) while the S&P (2099) closed 38.0% overvalued (1521).  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 may be stabilizing, signifying a leveling out at a lower rate of growth.  We can’t conclude that yet because it is too soon.  But it is hopefully a sign that a recession is not in the offing.  That said, the global economy is giving no signs of strengthening.  That in turn makes it all the more difficult for the US to continue to grow.

In sum, the US economy may have hit a new lower rate of growth while global economy remains weak.  The risk here is that many Street forecasts are too optimistic; and if they are revised down, it will likely be accompanied by lower Valuation estimates.

This week, the Fed made hawkish comments leading many to believe that a December rate hike is back on the table.  Confused?  So is the Fed.  Unfortunately, whatever it does at this point is probably meaningless. The cold, hard facts, as I see them, are that 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, and (3) its only choices are to do the right thing [i.e. return to a normalized monetary policy], which will be painful, or to continue to pursue a disastrous strategy hoping and praying for a miraculous way out, which I believe will end even more painfully when hope and prayer prove an empty strategy.

That said, I have no idea at what point investors figure out this no win equation.  However, whenever and whatever happens, I believe that the cash generated by following our Price Discipline will be welcome when investors wake up because I suspect the results will not be pretty. 

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; a potential escalation of violence in the Middle East) 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 11/30/15                                12267            1521
Close this week                                               17910            2099

Over Valuation vs. 11/30 Close
              5% overvalued                                12880                1597
            10% overvalued                                13493               1673 
            15% overvalued                                14107                1749
            20% overvalued                                14720                1825   
            25% overvalued                                  15333              1901   
            30% overvalued                                  15947              1977
            35% overvalued                                  16550              2053
            40% overvalued                                  17173              2129
            45% overvalued                                  17787              2205
            50% overvalued                                  18400              2281

Under Valuation vs. 11/30 Close
            5% undervalued                             11653                    1444
10%undervalued                            11040                   1368   
15%undervalued                            10426                   1292

* 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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