Saturday, November 21, 2015

The Closing Bell

The Closing Bell


Family begins to arrive on Tuesday for Thanksgiving.  No Morning Calls or Closing Bell next week.  Have a great holiday.

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                        1963-2756
                                    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 mixed quantitatively but negative qualitatively: above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, the Kansas City and Philly Fed indices and October leading economic indicators; below estimates: the NY Fed manufacturing index, October industrial production, the November housing index, October housing starts and building permits; in line with estimates: weekly jobless claims and October CPI.

The primary indicators were negative: housing starts [-], industrial production [-] and the leading economic indicators [+].  In addition, (1) with 90% of the S&P companies reporting, aggregate earnings are down 2.4% and (2) the anecdotal evidence was weak: base metals’ prices continue to crash, the Baltic Dry Index is at all-time lows, and imports at the three largest US ports fell in September and October.

Is the commodity decline over?  (medium):

In sum, the data remains disappointing, provides scant evidence that the economy is not losing strength and can in no way be interpreted as ‘improving’ (sorry, Janet).

Still, we can’t ignore the recent two weeks of better numbers; that keeps me hopeful the slide in economic activity has stabilized and the threat of recession lessened. However, two good weeks out of twelve is a pretty thin reed on which to hang those hopes.  For the moment, I am sticking with our current forecast; but if the last two weeks are a sign of further weakness to come, then this can only go on for so long before recession has to be considered a decent probability.

Weighing on our economic prospects is the continuing stream of poor data from abroad---the data this week was virtually all bad.  In addition, if the Middle East war has expanded geographically, it will likely serve as an additional burden on the global economy.    

The Fed was back in the spotlight this week with the release of the minutes from its latest FOMC meeting.  They reiterated that the odds of a December rate hike were high---based on the improving US and global economies.  I have already commented on the idiocy of this statement.  Anyone who can read and listen knows that is not the case. 

Of course, anyone who can read and listen knows that the Fed cares a great deal more about the Markets than it does about the economy.  And based on the free pass the Markets are giving the Fed to date, I don’t know how a December rate hike is not a lock. The problem is how this plays out if the economy continues to deteriorate and if the ECB institutes another round of QE easing (which also appears a lock at this time)---which further strengthens the dollar, hurting US foreign earnings and sales even more.  Probably not well; but then that has been the history of Fed policy transitions since the beginning of time.  So why should anything be different this time?

In summary, the US economic stats may to be fading again 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.  This week:

[a] Barclay’s was fined additional monies for fraud in foreign currency trading.

[b] the ECB said that nine large EU banks have a cumulative capital shortfall of $1.9 billion.

The multi trillion dollar liquidity problem (medium):

The multi trillion dollar currency problem (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.  This week the US Treasury announced it has instituted a new set of rules to counter ‘tax inversion’ deals [companies moving off shore to avoid US taxes].  Which begs the question, why not lower taxes so there is no incentive to move?  But that would be too simple for a progressive regime.

Read this on the cost of regulations for small businesses (medium):

(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 released the minutes from its latest FOMC meeting on Wednesday; and they read pretty much like the statement issued following the meeting, i.e. it is on track to raise rates in December.  Driving the decision, they say, is that everything is just hunky dory in both the US and global economies---which, as I noted above, is pure hogwash. 

The result of this fantasy is that the Fed would be raising rates [and strengthening the dollar] in the midst of a further weakening in US economic activity and right before a lowering of rates in Europe [strengthening the dollar even more]---which probably won’t do much for all the optimists looking for an upbeat 2016. 

My thesis is:

[a] QE {except QEI} has had a long term negative impact on the economy; so unwinding it will have a positive long term 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 {i} in a desperate attempt to extricate itself from the problem, it may make another equally disastrous misjudgment and only make matters worse, {ii} and/or the ECB lowers rate.  Speaking of which, on Thursday, we got yet another reminder from Draghi that more EU QE is on the way.  Unfortunately, that only aggravates the tendency towards further strengthening of the dollar, which makes the US economy weaker, which……. you get the point.

What happens to corporate profits when the dollar strengthens (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.
This is a little deep in the weeds, but it is an excellent analysis of the Fed’s current problem (long):

                                   Fed to hold expedited, closed meeting on Monday (short):

(4)   geopolitical risks: after the Paris tragedy, the question is, is the war now expanding geographically?  I am not sure ISIS has the manpower and resources to sustain a campaign of terror in the West.  But the actions in Belgium and Mali belie that.  Still the ability to maintain long term operations remains to be seen.  If it can, then that will almost certainly have a negative impact at least on the EU economy---lower tourism, reduced recreational activity, more resources devoted to security. 

More on the economic impact of the Paris attack (medium):

***overnight, new problems in Brussels (medium):

However, the longer term is more critical; that is, has the West finally had enough of the politically correct notion that Islamic terrorism is a criminal activity rather than a war of cultures?  That also remains to be seen; but if political correctness wins out, better start looking for a home in Costa Rica.

The danger in thinking Saudi Arabia is our friend and ally (medium and a must read):

(5)   economic difficulties in Europe and around the globe.  This week’s overseas economic stats continued an awful string of releases:  Japanese third quarter GDP fell and the second quarter figure was revised down; plus its October imports and exports were disastrous numbers; October UK inflation was down and its factory output was also down.  All this made worse by the potential for an expanded Middle East war. 

We did get one piece of good news: the Greek parliament approved reform measures that will smooth the way to more bail out money.

Truth telling on the Chinese economy (medium):

Japan joins China and the US in making up the numbers to fit desired narrative (medium and a must read):

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.  However, 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 I may have to do so again. 

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: October housing starts were down much more than anticipated; weekly mortgage and purchase applications rose; the November NAHB index was below estimates,

(2)                                  consumer: month to date retail chain store sales were up slightly; weekly jobless claims were down slightly less than forecast,

(3)                                  industry: October industrial production was very disappointing; the November NY Fed manufacturing index was below expectations, while the Kansas City and Philly Fed index were above,

(4)                                  macroeconomic: October CPI was in line; October leading economic indicators were above projections.

The Market-Disciplined Investing

The indices (DJIA 17823, S&P 2089) managed to follow through to the upside on Friday.  The Dow ended [a] above its 100 moving average, which represents support, [b] above its 200 day moving average, now support, [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] above its 100 moving average, which represents support, [b] above its 200 day moving average, now support, [c] in a short term trading range {2016-2104}, [d] in an intermediate term uptrend {1963-2756} [e] a long term uptrend {800-2161}. 

Volume rose, but that was influenced by option expiration; breadth improved.  The VIX (15.5) was down 9%, ending [a] below its 100 day moving average, now resistance, [b] in a short term downtrend and [c] in intermediate term and long term trading ranges. 

The long Treasury fell, retreating from its 100 day moving average, which it touched on Thursday and within very short term, short term and intermediate term trading ranges.

GLD was down, ending [a] below its 100 day moving average, now resistance and [b] within short, intermediate and long term downtrends. 

Bottom line: the bulls held the field this week overcoming many of the potential breaks of support that were occurring at the end of last week.  In addition, their very short term downtrends were negated and, at least as of the close Friday, had managed to avoid making lower highs. 

As I noted several times this week, it appears that the historically strong seasonal upward bias is kicking, seemingly oblivious to the poor economic data, the potential negative economic consequences of an expanding war on terror within the EU and the increased likelihood of a higher Fed Funds rate (and with it a stronger dollar and weaker corporate profits).   I can only assume that this positive bias will be with us through the New Year, which cranks up the odds in the interim of challenges to the indices all-time highs and upper boundaries of their long term uptrends.  But as you know, I don’t believe that those challenges will be successful.

Did the Santa Claus rally start this week? (short):

More data on the seasonal bias (short):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17823) finished this week about 45.3% above Fair Value (12267) while the S&P (2089) closed 37.3% 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 recent trend towards more stable economic numbers took a blow this week.  I am not giving up just yet that conditions could be leveling out; but two upbeat weeks in the last five (12) is not a lot to hang that hope on.  Further poor aggregate data will push the risk of recession back to the forefront.  At the moment, it remains too soon to know.

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, getting worse and will likely be exacerbated by recent terrorists’ attacks. 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 minutes reaffirmed the hawkish comments in the statement released after the last FOMC meeting, raising the odds of a December rate hike.  I am a bit confused by what this could mean for stocks because on Monday, stocks roared on the notion that the Paris attack made a rate hike less probable; then smoked again of Friday after the release of the aforementioned hawkish FOMC minutes.  As you know, I believe that a return to normalized monetary policy will be bad for stocks, though I am not sure how fast that becomes manifest if the Fed does a one and done or something akin to it.  Nonetheless, I stand by the forecast; and the good news is that we are apt to know if I am right or wrong in the next couple of months---assuming that rates go up in December.

  However, whenever and whatever happens, I believe that the cash generated by following our Price Discipline will be welcome when investors wake up to the Fed’s malfeasance because I suspect the results will not be pretty. 

Net, net, my two biggest concerns for the Markets are (1) declining profit and valuation estimates resulting from the economic effects of a slowing global economy and (2) the unwinding of the gross mispricing and misallocation of assets following the Fed’s wildly unsuccessful, experimental QE policy.

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 own 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 and around the world) 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                                               17823            2089

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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