Saturday, November 14, 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                        1957-2749
                                    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 negative: above estimates: weekly purchase applications, September wholesale inventories and sales and November consumer sentiment; below estimates: weekly mortgage applications, month to date retail chain store sales, October retail sales, the October small business confidence index, October import/export prices, the October budget deficit and October PPI; in line with estimates: weekly jobless claims and the September business inventories/sales combo.

If there is any bright spot in this otherwise downbeat week, it is that there was only one primary indicator: October retail sales.  The bad news is that it was negative.

While the recent back and forth in economic numbers from negative to positive and back again may be indicating that the economy could be stabilizing at a still lower (than originally forecast) rate of growth, it provides little evidence of any uptick.  On the other hand, it is hopefully a sign that recession is less likely.  That said, see saw data over a four week timeframe is just enough to make matters confusing.  For the moment, I am sticking with our current forecast; but a dramatic change in the data one way or the other could lead to a third modification in our outlook.

Weighing on our economic prospects is the continuing stream of poor data from abroad---from all our major trading partners: Canada, China and Europe.  Not helping is Greece sliding toward another economic/political crisis; and it could be joined shortly by Portugal.    

The above notwithstanding, investors eyes remained glued to Fed this week attempting to decipher whether or not a December rate hike is in the cards.  Indeed, most of the economic data was being analyzed in terms of its impact that Fed decision. 

Of course, based on this week’s numbers, one might assume a lesser chance of a rate hike.  But since the Fed is not ‘data dependent’, and since the Market was doing fine up until Thursday, and since the Fed is really ‘Market dependent’, on Thursday, the Fed executed a double hat trick when six of its officials all suggested that it was on track for a rate hike---again, the above data notwithstanding.

As I observed in Friday’s Morning Call:  ‘six Fed officials spoke yesterday and, overall, they did nothing to alter the view that a December rate hike is coming---which suggests that [a] either they aren’t paying attention to (1) above {the lousy stats here and abroad} or [b] as I have proposed, they have made their minds that they have to raise rates because it will be easier to argue that they were too late to raise rates due to an overabundance of caution than to have to defend themselves for having completely missed the opportunity to normalize monetary policy.----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. 

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.

       The negatives:

(1)   a vulnerable global banking system.  There was a concerning news item this week, relating to the solvency of the Chinese banking system.  The Financial Stability Board said that Chinese banks could be undercapitalized by as much as $400 billion under new global capital requirements.

Here is a summary of the steps being taken to curb the risks of ‘too big to fail’ banks (medium and a must read):

Clearly, these measures are a long term plus for the world’s financial system.  There is a short term risk that many banks’ equity are still well below requirements and the time to correct that deficiency is long enough, that another liquidity event could occur [I am thinking of China, in particular] and do its damage in the interim.

Or will there be mass bankruptcies in the energy space? (short):

Corporate leverage at record levels (medium):

 ‘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.  Quiet week.

(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 keeps getting support on a global basis.  This week Draghi et al made not one, not two, but three pretty strong statements about the likelihood of additional ease from the ECB.

On the other hand, the noise out of the Fed continues to sound hawkish.  Whether it will hold that line in the face of so so economic data here and really rough numbers abroad is the $64,000 question.  Of course, if you believe Bullock’s statement last week that even if the jobs’ figures weaken, the rate hike is still on the table, then it is coming. 

That said, this group of eggheads are scared sh**less of the consequences of their irresponsible monetary policy and if the Market starts getting whacked, they could very well chicken out of increasing rates.

My thesis is:

[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 they go through with 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. (must read):

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 political landscape in the Middle East remains as Byzantine as ever.  There are so many players with so many conflicting agendas, that any move by any one player is going to gore somebody else’s ox.

 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 in Europe and around the globe.  This week’s overseas economic stats continued an awful string of releases:  October Chinese exports fell while imports dropped precipitously; Chinese CPI, PPI, industrial production and urban fixed investment were all below expectations; however, retail sales were better than estimates; German exports were better than forecast; third quarter EU GDP was below consensus; Japanese machinery orders were above forecast.

In related news, Canada [one of our largest trading partners] appears to be slipping into recession; the OECD lowered its global growth estimates for 2015 and 2016; several members of the ECB said that there was growing consensus to push interest rates further into negative territory; the Financial Stability Board said that Chinese banks may need as much as $400 billion new equity in order to meet new global capital requirements.

In ecopolitical news,

[a] Greece and its EU creditors are in a dispute over implementation of reforms, delaying the latest tranche of bail out funds; and now the Greeks are in the street,

[b] Portugal’s newly formed government was brought down by a coalition that wants to reverse [EU imposed] austerity measures.  Greece part two?

Finally, one additional piece of anecdotal evidence: base metals now down 50% off 2011 highs.

So the international data remains poor, especially that coming out of China---which, as I noted last week, is the 800 pound gorilla lurking in the weeds. And aside from the lousy numbers, the FSB says that their banks are woefully underfunded. 

Add to that the potential problems in Greece and Portugal and the global economic risks seem to be growing.

                  Counterpoint (medium):

As a result, this keeps the yellow flashing on our global ‘muddling through’ assumption; but 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 four 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 applications fell, while purchase applications were up slightly

(2)                                  consumer: month to date retail chain store sales dropped precipitously from the prior week; October retail sales were well below consensus; weekly jobless claims were unchanged; the preliminary November consumer sentiment index was above forecasts,

(3)                                  industry: the October small business optimism index was below expectations; September wholesale inventories grew more than estimated as did sales; September business inventories were up more than projected, but sales were flat,

(4)                                  macroeconomic: October PPI was dramatically lower than anticipated; October import prices were well below consensus while export prices were slightly lower; the October budget deficit was up versus the prior year.

The Market-Disciplined Investing

The indices (DJIA 17245, S&P 2023) took a second body blow yesterday.  The Dow ended [a] above its 100 moving average, which represents support, [b] below its 200 day moving average for a second day, now support; if it remains below this MA through the close next Tuesday, it will revert to resistance, [c] within 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 moving average, which represents support; if it remains there through the close on Tuesday, it will revert to resistance, [b] below its 200 day moving average for a second day, now support; if it remains below this MA through the close next Tuesday, it will revert to resistance, [c] in a short term trading range {2016-2104}, [d] in an intermediate term uptrend {1955-2747} [e] a long term uptrend {800-2161}. 

Has the post-crash rally run its course (medium)?

Volume rose; breadth was mixed---a little unusual for such a negative price day.  The VIX (20) was up 9%, ending [a] above its 100 day moving average, now resistance; if it remains there through the close on Tuesday, it will revert to support, [b] above the upper boundary of its a short term downtrend; if it remains there through the close on Tuesday, it will re-set to a trading range and [c] in intermediate term and long term trading ranges. 
The long Treasury rose (not really indicative of fear of rising interest rates), remaining below its 100 day moving average, now resistance but within very short term, short term and intermediate term trading ranges.

GLD was down, ending [a] below the lower boundary of its short term trading range; if it remains there through the close on Tuesday, it will re-set to a downtrend, [b] below its 100 day moving average, now resistance, [c] in intermediate and long term downtrends. 

Bottom line: multiple indices are now challenging multiple support levels.  Clearly, underlying investor sentiment began to swing dramatically on Thursday and Friday.  As always, more follow through its required before we can assume a change in momentum.  If the decline continues, it would be a very negative signal for the long term direction of the Market (the Averages have unsuccessfully tested their highs three times then fell short on their fourth attempt).  A rebound above the most recent high would likely portend a challenge of the indices all-time highs and the upper boundaries of their long term uptrends.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17245) finished this week about 40.5% above Fair Value (12267) while the S&P (2023) closed 33.0% 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; but then again, given this week’s stats, it may not be.   At this point, it is too soon conclude whether the last four weeks are just a pause in a decline or if the economy is steadying. Although hopefully it is a sign that a recession is not in the offing. 

Unfortunately, the global economy remains a mess and it’s not being helped by growing political turmoil in Europe---and that in turn makes it all the more difficult for the US to continue to grow.

In sum, the US economic picture is a bit muddy at the moment; although, not so much so that we can’t conclude that it is weaker than it was three months ago.  In the meantime, the global economy is not the least bit murky---it is crappy.  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 kept up with the hawkish comments, becoming ever more convincing that a December rate hike is likely.  Perhaps more important than whether or not the Fed does raise rates, is what it is doing to its own credibility. 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---as it has in every single other attempt it has made to transition from easy to normal monetary policy, 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.  

In either case, sooner or later, investors are going to figure out the corner in which the Fed has placed the economy and Market---and it probably won’t enhance its reputation. 

  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                                               17245            2023

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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