Saturday, January 23, 2016

The Closing Bell

The Closing Bell


Statistical Summary

   Current Economic Forecast
            2015 estimates

Real Growth in Gross Domestic Product (revised)      -1.0-+2.0%
                        Inflation (revised)                                                          1.0-2.0%
                        Corporate Profits (revised)                                            -7-+5%

2016 estimates

Real Growth in Gross Domestic Product                     -1.0-+1.0%
                        Inflation (revised)                                                          1.0-2.0%
                        Corporate Profits (revised)                                            -10-0%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Downtrend                            16872-17620
Intermediate Term Trading Range           15842-18295
Long Term Uptrend                                  5471-19343
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Downtrend                                1929-2018
                                    Intermediate Trading Range                        1867-2134
                                    Long Term Uptrend                                     800-2161
                        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.   This week’s dataflow continued in the negative: above estimates: December existing home sales, weekly mortgage applications, the January flash PMI; below estimates: December housing starts and building permits, weekly purchase applications, the January homebuilders’ confidence index, month to date retail chain store sales, weekly jobless claims, the December Chicago Fed national activity index, and December CPI; mixed results: the December/January Philly Fed index and the November/December leading economic indicators.

The primary indicators were mixed: December housing starts and building permits (-), existing home sales (+) and leading economic indicators (0)---so no real upward bias to offset the magnitude of the negative stats.  The Fed thankfully kept its mouth shut---likely because of being paralyzed with fear.

In sum, the data this week remained negative, though it was hardly overwhelmingly so. Still it did not help the thesis that the economy has found a new level of slower growth (four mixed to upbeat weeks and seventeen negative weeks in the last twenty-one).  Indeed, it is starting to look like that sporadic string on mixed to positive weeks was little more than a gratuitous hiccup.  A couple more weeks of solidly negative data, I will likely revise our forecast even lower with a strong probability of recession.

The international data was again disappointing with particularly weak numbers out of China.  In addition, the IMF and a former official from the BIS joined the skeptics on the global economy.  So the poor overseas data continues to be a headwind to any improvement in the US economy.

In summary, the US economic stats this week were not good; and the international numbers weren’t much better. In the meantime with the US Markets are getting hammered, the Fed is on likely its collective knees praying the Market holds. 

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:

       The negatives:

(1)   a vulnerable global banking system.  This week, the news became a bit unsettling.  Following the problems in the Portuguese banks mentioned last week: 

[a] several Italian banks disclosed that they were insolvent,

[b] the former chief economist with the BIS warned that the world faces multiple bank defaults,

[c] Deutschebank recorded a $7 billion loss.

And this (must read):

As you may recall, when first listing this factor as an economic negative, my primary concern was for our own banking system.  However, as I have pointed out, a number of steps by regulators has led to more capital on US bank balance sheets and well as their exit from many of the speculative trading and lending policies that led to the 2008/2009 financial crisis.  To be sure, that is a plus especially for the US banking system.

Of course, that didn’t eliminate speculative behavior, it just transferred into other financial systems.  Now we are getting warnings from multiple countries about troubles with their banks as well as the Chinese and Saudi governments attempting to quell speculation in their respective currencies. 

Clearly, potential bank defaults/insolvencies and unstable currencies do not bode well for global or US economic activity.

(2)   fiscal/regulatory policy.  Not much news this week.  Though one development holds great hope.  The Supreme Court has agreed to hear a case involving Obama’s mandated immigration policies.  As part of that review, the Court asked the parties to comment on whether or not the executive branch has the constitutional authority to propound and enforce those regulations.  (must read):

We should all get down on our knees and pray that the Court rules this a usurpation of power by the executive branch.  If so, multiple new cases will hopefully brought related to other executive issued regulation and the states/people will be given a weapon to combat presidential overstep of authority.

(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.  

Who wants to bet on whether or not the Fed will reverse its recent rate hike?  With its most important objective [higher stock prices] rapidly becoming a wet dream, these guys must be deep into prayer mode.  One would think that no amount of rationalization could possibly allow them to avoid the realization that their failed QE policies have done nothing to improve the economy and, indeed have only made things worse---like the mispricing of assets which may now becoming manifest in stock prices.  The operative words being ‘one would think’.  Regrettably, in the 46 years I have been a Market participant, I have never ceased to be amazed at the ability of bureaucrats, especially egghead bureaucrats, to ignore the truth in front of them, double down on an already failed policy or come up with something just as dim witted and imprudent. 

God only knows what the Fed will come up with next.  But the odds of its escaping the consequences of a seven year reckless monetary policy appear to be quite low at the moment.  In short, it appears likely that the Markets are beginning to inherit the results of years of asset mispricing and misallocation

      Laughing at the Fed (a bit long but today’s absolute must read):

All that said, the Chinese continue to pump liquidity into their financial system; and this week, Draghi, in his usual Oracle of Delphi presentation, promised that the ECB will continue to monitor the EU economy and if more stimulus is needed it will be forthcoming [data dependent anyone?].  And to put a cherry on top, after poo pooing further QE as useless, the Bank of Japan is rejoining the ranks of the QE’ers.  So it appears that there is no end to the heavy injection of money into the global economy---despite the fact that it has done no good for anyone.

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: things are about to get really interesting in the Middle East.  With the sanctions over and a new war chest of $150 billion, who knows what kind of mischief the Iranians can unleash.  Unfortunately, we may are about to find out.

(5)   economic difficulties in Europe and around the globe.  This week, it was reported that fourth quarter Chinese GDP grew at the slowest rate  in 25 years, December Chinese industrial output, retail sales and fixed investments were all below expectations, January Markit EU composite flash PMI fell to the lowest level in eleven months and the IMF lowered its 2016/2017 global growth estimates.        
In addition, remember that sanctions against Iran will end soon and with it comes even more oil choking the market.  Given that lower oil prices have been a negative for the global economy, then it seems reasonable that more oil will likely be a weight on oil prices and hence an even bigger negative for the global economy.

      In sum, global economic stats continue to deteriorate.

Bottom line:  the US data continues to reflect very sluggish growth in the economy, perhaps in recession.  My hope that the rate of slowing may have stabilized is dwindling.  Of course, the global economy is certainly not doing anything to brighten the outlook.    Meanwhile, several of the major global central banks have not backed off the QE policies even though to date those policies have only made matters worse.  Unfortunately, that may not stop the Fed from reversing its policies if the Markets continue to get pummeled.  Given the recent Market pin action, the Fed is likely paralyzed by fear of the consequences of prior policy mistakes and the probability that it 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: December housing starts and building permits were disappointing; December existing home sales were up more than forecast; weekly mortgage applications were up, but purchase applications were down; January homebuilders confidence was lower than expected,

(2)                                  consumer: month to date retail chain store sales were down versus the prior week; weekly jobless claims were short of estimates,

(3)                                  industry: the January Philly Fed manufacturing index was down slightly less than anticipated, but the December reading was revised down substantially; the Chicago Fed national activity index was down big; the January flash PMI was better than forecast,

(4)                                  macroeconomic: December leading economic indicators were better than consensus, but the November reading was revised substantially; December CPI was lower than expected.

The Market-Disciplined Investing

The indices (DJIA 16073, S&P 1906) closed up on Friday after an extremely volatile week.  The Dow closed [a] below its 100 day moving average, now resistance, [b] below its 200 day moving average, now resistance, [c] below the lower boundary of a short term downtrend {16872-17620}, [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] below its 100 day moving average, now resistance, [b] below its 200 day moving average, now resistance [c] below the lower boundary of a short term downtrend {1929-2018}, [d] in an intermediate term trading range {1867-2134}, [e] in a long term uptrend {800-2161}  and [f] still within a series of lower highs. 

Volume was flat; breadth improved.  The VIX was down 16% but ended [a] above its 100 day moving average, now support and [b] in short term, intermediate term and long term trading ranges. 

The long Treasury had a good week but closed lower on Friday.  It finished above its 100 day moving average, now support and within short term and intermediate term trading ranges.

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

Bottom line: at the end of the week, we finally got the much anticipated oversold bounce.  Now the big question on everyone’s mind is, is it truly an oversold bounce (i.e. fizzle out and then make new lows) or was the Thursday/Friday turnaround the end of a correction?  Of course, no one knows.  But there are guideposts for answer.  They include the indices’ 100 day moving averages, the upper boundaries of their short term downtrends and an important retracement level (circa S&P 1928).  Until one or more of those resistance levels are successfully challenged, the prevailing assumption is that there is more downside.

Is the bottom in (medium):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16073) finished this week about 30.3% above Fair Value (12333) while the S&P (1906) closed 24.7% overvalued (1528).  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.

This week’s economic data was disappointing. So the hope of an economy stabilizing at a lower rate of growth is fading; and the risk of recession is on the incline.  The global economy remains a mess---the primary focus now centered on a slowing Chinese economy and the probability of further big declines in the yuan.  However, not to be ignored is the fragility of global banks---a problem that is getting increased attention, at least from the experts.

Finally, the heightened risk posed by the Saudi/Iranian cat fight, the lifting of sanctions against Iran (its ability to sell oil plus a $150 billion cash bonus) encourages mischief and the stepped up terrorist attacks around the world keep this multifaceted explosive situation primed for any misstep turning into a disaster.

In sum, the US economy is almost surely slowing, edging ever closer to tipping over into recession.  In the meantime, the global economy is lousy, its banking system increasing infirm, the Chinese ruling class is unsuccessfully thrashing around attempting to halt the decline in economic activity and the weakness in its currency and the escalation of tension in the Middle East raises the risk of some untoward event igniting all-out war.  The risk here is that many Street economic forecasts too optimistic (and they assume none of the above occurs); and if they are revised down, it will likely be accompanied by lower Valuation estimates.

This week the Fed likely maintained its latest principal policy position---prostration, praying the Market rebounds.  Unfortunately for this group, nothing undoes asset mispricing and misallocation like a good old fashion dose of reality---which we appear to be getting in spades.  The truth is that the Fed is in a pickle.  If it responds to the Market decline by reversing itself, it will likely lose investor confidence.  On the other hand, if it continues to raise rates in the face of poor data, it will probably suffer the same consequence. 

Meanwhile, most of the other major central banks continue to pursue easy money policies in the hope that if a lot of extra liquidity didn’t work, maybe a whole lot of extra liquidity will.  Fat chance.  That said, judging by Thursday and Friday’s pin action, investors apparently are still wedded to the notion that QE is a plus.  Frankly, that is how we know that the worse isn’t over.  Until investors realize that QE (except QE1) has been nothing but a giant clusterf**k and it sole achievement has been to fund the mispricing and misallocation of assets, sooner or later, the worst is yet to come.

 Whenever that 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.  As a secondary objective, I would reconsider any thoughts of ‘buying the dip’.

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.
            Mohamed El Erian on the Market (medium):

                Bull, bear or humble?

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 1/31/16                                  12333            1528
Close this week                                               16073            1906

Over Valuation vs. 1/31 Close
              5% overvalued                                12949                1604
            10% overvalued                                13566               1680 
            15% overvalued                                14182               1757
            20% overvalued                                14799                1833   
            25% overvalued                                  15416              1910   
            30% overvalued                                  16032              1986
            35% overvalued                                  16649              2062
Under Valuation vs. 1/31 Close
            5% undervalued                             11716                    1451
10%undervalued                            11099                   1375   
15%undervalued                            10483                   1298

* 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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