Saturday, December 5, 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                        1975-2768
                                    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 to slightly upbeat: above estimates: the November Dallas Fed manufacturing index, month to date retail chain store sales, the November Markit manufacturing PMI, October construction spending, October factory orders, November light vehicle sales, weekly purchase applications, the November ADP private payroll report and November nonfarm payrolls; below estimates: the November Chicago PMI, October pending home sales, November ISM manufacturing and nonmanufacturing indices, weekly mortgage applications, third quarter unit labor costs and the November trade deficit; in line with estimates: third quarter nonfarm productivity and weekly jobless claims.

The primary indicators were also mixed to positive: construction spending [+], factory orders [+], nonfarm payrolls [+] November ISM manufacturing and nonmanufacturing indices [- -].   Finally, the anecdotal evidence was negative: Black Friday sales [-], Cyber Monday sales [+], truck loadings [-], the latest Atlanta Fed fourth quarter GDP growth estimate [-] and Citi sees the odds of a recession at 65% [-].

In addition, the attacks in California raise the prospect that the war on terror may have reached our shores with same ramifications as the attacks in Paris---less travel, less entertainment outside the home, added costs of stepped up security.  Of course, we won’t know this for a while.

In sum, the data this week was again mixed (now one upbeat week, two mixed weeks and eleven negative weeks in the last fourteen), providing some limited evidence that the economy is not losing strength but can in no way be interpreted as ‘improving’ (sorry, Janet).

Still, we can’t ignore those three weeks of mixed to better numbers; that keeps me hopeful the slide in economic activity has stabilized and the threat of recession lessened. However, three nonnegative weeks out of fourteen is a pretty thin reed on which to hang those hopes.  For the moment, I am sticking with our current forecast; but the risk of recession remains above average.

Helping out the prospects of economic stabilization were the improved overseas data.  This is the first week in a long time that the numbers were actually upbeat.  That said, one week does not a trend make.

The Fed remained center stage this week with two speeches from Yellen and the release of the latest Fed Beige Book.  Both supported the latest Fed narrative that a December rate hike is in the cards.  Aside from reiterating the questionable storyline that economy was progressing, Yellen made the ridiculous statement that the Fed needed to raise rates soon because the economy was improving so fast that to delay the rate hike would be to risk being too late.   News flash Janet, you are already too late by eighteen months.

In summary, the US economic stats took another pause in their downward trajectory.  That is the third in the last seven weeks, so it may be that the numbers are stabilizing.  Meanwhile, the international data remains sub-par---this week’s stats notwithstanding.  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.

                        Update on big four economic indicators (medium):

       The negatives:

(1)   a vulnerable global banking system.  This week, the news was actually good:  the Fed adopted measures to curb its emergency lending power, including the ability to offer below Market rates.  This is yet another step to avoid the bail out another ‘too big to fail’ bank and will hopefully further improve the public’s confidence that [a] the US financial system is increasingly sound and [b] the game isn’t rigged for the big boys. 

I have spent volumes of ink in these pages criticizing the criminal behavior of the banksters and complicity of the regulatory authorities.  But credit where credit is due---both the EU and US banking powers have been enforcing measures to address the capital inadequacies of the big banks and speculative behavior of their proprietary trading desks.  As a result, US and UK banks have been passing increasingly stringent ‘stress tests’.

Unfortunately, S&P views this as a negative.  This week it downgraded the credit rating of eight large US banks because the odds of them getting bailed out has risen.

Of course, we are not going to know just how effective these steps will be until the next crisis.  However, they clearly will have some impact and, hence, whatever problems may arise, they are certain to be less than they would have been if nothing were done.  The biggest question in my mind is how much risk is embedded in the derivative portfolios currently on bank balance sheets.  Unfortunately, I don’t think anyone will know the answer to that until after the fact.

Here is an attempt to answer that question.  It is a bit long and a bit in the weeds, but a must read:

Bottom line, while I still consider this a risk, as the result of recent rules and regulations imposed by the regulators, it is likely that the risks are not as big as they were in the prior crisis.

 ‘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, senate and house conferees reached an agreement on a $305 billion highway bill which they say will require no debt financing.  The good news is that this measure not only addresses the deteriorating US infrastructure but also creates jobs both directly and indirectly.  The bad news was that it would be financed with smoke and mirrors which means our ruling class still can’t manage an honest budget even when it tries to do the right thing. 

(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.  

As I noted above, Yellen reiterated that a December rate hike was likely to occur.  She made it more emphatic by saying that if the Fed didn’t raise rates now, it risked being too late---a statement that I believe that she will come to regret.  In my opinion, the preponderance of evidence is that the Fed is already too late and that the economy is weakening from an already below average historical rate of recovery.

Making matters worse is that the rest of the world’s central banks recognize that economic conditions are frail and are planning new QE measures.  That became a point of confusion this week as Draghi/ECB made hawkish sounds on Thursday.  When the Market reacted violently to those comments, they were quickly walked them back on Friday.  The point here being that a huge divergence in central bank monetary policy is upon us and there is uncertainty as to the economic/Market consequences.

‘To be clear, I am not concerned about the economic effect of a 25 basis point rise in the US Fed Funds rate.  That won’t likely make a difference one way or the other.  What I am worried about is investors’ concluding that (1) not one of the globe’s central bankers have a f**king clue what they are doing, i.e. the Fed is pretending to be tightening because economic condition in the US are just swell when in fact they are not yet the ECB, the Bank of Japan and the Bank of China are cranking up QE because their economic growth rates are just as feeble as our own and (2) decide that valuations don’t properly reflect reality.  Think about the perverse logic here and tell me all is well.’ 

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: after the Paris tragedy, the question was, is the war now expanding geographically?  I am not sure if the California shootings are the answer.  But if it is yes, there will likely be more such incidents in the near future.  Of course, the real problem is that no one has the foggiest notion how to solve the Middle East/Islamic radicalism quagmire, all that neocon bulls**t notwithstanding.  How many times do we have to kill young Americans only to make the Middle East turmoil all the greater?  This country needs a radical change in direction in its Middle East policy; and I fear that only a second 9/11 type tragedy will cause that to happen.

This is a great analysis of the problem but offers no solution, making it useless (medium):

(5)   economic difficulties in Europe and around the globe.  This week’s overseas economic stats improved [mixed] for the first time in months:  November Chinese manufacturing PMI was at a three year low while the services PMI was up slightly; November Japanese and EU Markit manufacturing PMI’s were up; EU November services and composite PMI’s came in below expectations while the Chinese November composite PMI was above; EU jobless rate was down; November EU inflation was lower than anticipated.

The bad news is that the emerging markets still have mega-problems (medium):

More on that subject (short):

And even more (medium and a must read):

As I am fond of saying, one week of good news does not mean a change in trend and the trend in the rest of the world’s economic has been nothing to be enthusiastic about.  As a result, the yellow flashing on our global ‘muddling through’ assumption continues to flash; and 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. 

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 pending home sales were down much more than anticipated; weekly mortgage applications were down but purchase applications were up,

(2)                                  consumer: month to date retail chain store sales were strong versus the prior week; November light vehicle sales were slightly over consensus; the November ADP private payroll report was stronger than expected; weekly jobless claims were in line; and November nonfarm payrolls were better than projections,

(3)                                  industry: the November Chicago PMI was very disappointing; the November Market manufacturing PMI was slightly above estimates; both the November ISM manufacturing and nonmanufacturing indices were well below forecast; October factory orders were slightly above consensus; October constructions pending was better than anticipated; the November Dallas Fed manufacturing index was down but not as much as expected,

(4)                                  macroeconomic: third quarter nonfarm productivity rose in line while unit labor costs were twice what was estimated; the November US trade deficit was larger than forecast.

The Market-Disciplined Investing

The indices (DJIA 17847, S&P 2091) had a roller coaster week, though little changed technically speaking.  The Dow ended [a] above its 100 moving average, which represents support, [b] above its 200 day moving average, now support having negated Thursday’s challenge, [c] within a short term trading range {16919-18148}, [c] in an intermediate term trading range {15842-18295}, [d] in a long term uptrend {5471-19343}, [e] and still within a series of lower highs.

The S&P finished [a] above its 100 moving average, which represents support, [b] above its 200 day moving average, now support, having negated Thursday’s challenge [c] in a short term trading range {2016-2104}, [d] in an intermediate term uptrend {1975-2768}, [e] a long term uptrend {800-2161} and [f] still within a series of lower highs. 

Volume rose; breadth improved.  The VIX (14.8) was down 19%, ending [a] below its 100 day moving average, now resistance, [b] in a short term downtrend, having negated Thursday’s challenge and [c] in intermediate term and long term trading ranges. 

            Insider selling near highs.  Tell me that is a good thing (short):

The long Treasury was strong on Friday after Thursday’s shellacking, remaining below its 100 day moving average, now resistance and within very short term, short term and intermediate term trading ranges.

GLD smoked on Friday but still ended [a] below its 100 day moving average, now resistance and [b] within short, intermediate and long term downtrends.  The rally may have been the result of Draghi walking back his hawkish tone (easy money/low rates are good for gold).

Bottom line: despite the intraweek volatility, the Averages ended fractionally off their close last week.  So their technical position didn’t really change, including the fact that they remain in a series of lower highs---that is the bad news.

The good news is that we are in a period of historically strong seasonal upward bias---which is demonstrable given that economic data reflects stagnation at best, the Fed is hell bent on raising rates whatever the numbers even as the rest of the world’s central banks are easing and the recent spread of the war against radical islam outside the Middle East.  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.

Technical damage control (short):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17847) finished this week about 45.1% above Fair Value (12300) while the S&P (2091) closed 37.1% overvalued (1525).  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 got another boost this week.  So I am not giving up on the notion just yet that conditions could be leveling out; but three mixed to upbeat weeks in the last fourteen is not a lot to hang that hope on.  Further poor aggregate data will continue to push the risk of recession higher, especially if the anecdotal evidence keeps deteriorating. 

In addition, the global economy remains a mess, this week’s better economic data notwithstanding.  Finally, the heightened risk of more terrorists attacks and the potential economic fallout if those attacks prove not to be one off events, will make it all the more difficult for the US to continue to grow.

In sum, the US economic picture is a bit murky 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 lousy and the recent terror attacks could likely spawn additional weakness. 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, Yellen reaffirmed that a December rate hike was highly likely.  As you know, I believe that a return to normalized monetary policy will be bad for stocks; and it could be made all the worse if the rest of the world’s central banks are easing---which it seems apparent that they are going to do.  The ECB has already loosen monetary policy; and though the initial Market reception to a less aggressive easing was quite negative, Draghi quickly crawfished back to his ‘whatever is necessary’ narrative.  The one caveat is that I am not sure just how fast Markets will react to the divergence of central bank monetary policy.  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.
            More on valuation (must read):

DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 12/31/15                                12300            1525
Close this week                                               17847            2091

Over Valuation vs. 12/31 Close
              5% overvalued                                12915                1601
            10% overvalued                                13530               1677 
            15% overvalued                                14145                1753
            20% overvalued                                14796                1830   
            25% overvalued                                  15375              1906   
            30% overvalued                                  15990              1982
            35% overvalued                                  16605              2043
            40% overvalued                                  17220              2135
            45% overvalued                                  17835              2211
            50% overvalued                                  18450              2287

Under Valuation vs. 12/31 Close
            5% undervalued                             11685                    1448
10%undervalued                            11070                   1372   
15%undervalued                            10455                   1296

* 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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