Saturday, February 20, 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                     -1.25-+0.5%
                        Inflation (revised)                                                          0.5-1.5%
                        Corporate Profits (revised)                                            -15-0%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Downtrend                            16748-17499
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                                1888-1975
                                    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 was again tilted to the negative side: above estimates: weekly mortgage applications, weekly jobless claims, month to date retail chain store sales and January industrial production; below estimates: January housing starts, purchase applications, February homebuilder confidence, the New York and Philadelphia Fed February manufacturing indices and January PPI and CPI; in line with estimates: the January leading economic indicators.

The primary indicators were evenly matched: January housing starts (-), January industrial production (+) and January leading economic indicators (0).  With the quantity factor negative and the quality factor neutral, I score this another negative week though only mildly so.

The January FOMC minutes released this week (aided by comments from St. Louis Fed chief Bullard) revealed a Fed that seems confused over whether or not to hike interest rates further but in all likelihood reflects its realization that it has been wrong on its economic projections, late to the table in starting a move to monetary normalization and scared s**tless that it will have to reverse itself in short order.

In sum, the US stats this week was discouraging again, keeping an overwhelmingly disappointing series of data intact (four mixed to upbeat weeks and twenty negative weeks in the last twenty-four).  As I noted last week, I have again lower our 2016 economic forecast to reflect a recession/zero growth.

The international economic numbers were again overwhelmingly negative.  Plus, worries continued to mount regarding the strength of European bank balance sheets.  So no help for the US from this source.

In addition, Draghi gave another of his ‘whatever is necessary’ speeches; and, following some pretty awful economic data, the Bank of Japan seemed to be considering another drop in its already negative interest rate policy.  In my opinion, any further monetary easing will simply exacerbate the current unhealthy trend in competitive devaluations.

In summary, the US economic stats this week were not good, the international data were awful and the central banks’ renewed love affair with QE will only make matters worse.

Our forecast:

a recession or a zero economic growth rate, caused by 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.
            Sam Zell: we are already in a recession (3 minute video):

       The negatives:

(1)   a vulnerable global banking system.  My focus over the last month has shifted   away from the US banking system toward the rising risks overseas.  Recent warnings from multiple countries, in particular Germany, Italy and Portugal, about troubles with their banks keeps the risks of potential bank defaults/insolvencies and unstable currencies on the table.   What is worrisome is the extent of the leverage on these foreign bank balance sheets as well as their common ownership of so much sovereign as well as corporate debt [in other words, if one thing goes wrong, they all own it].

As a reminder, I am not saying that all is well at home.  But I stand by my recent comments that our financial system is much less at risk than it was seven years, five years or even two years ago.

 Mohammed El Erian on this problem (medium):

This great article is a bit long but is illustrative of why the TBTF banks still don’t have their respective houses in order.
(2)   fiscal/regulatory policy.  Not much news this 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.  

The central banksters continued their nefarious policies this week.  Draghi gave another of his ‘whatever it takes’ speeches, the Bank of Japan hinted at even deeper negative rates and our own Fed produced a set of dialectic FOMC minutes whose bottom line was ‘we’re confused’.

In short, global central bankers are pushing further into their experimental QE, negative interest rate Never Neverland.  To be sure, it is impossible to say with certainty that this will all end badly because the world has never been in these circumstances before.  However, we do know what has occurred since these policies’ inception---sluggish economic performance and gross asset mispricing and misallocation.  So it is not unreasonable to assume that these after-effects would be reversed---and as you know, that is my forecast.  Our economy is not going to improve until the Fed stops believing itself all powerful and all-knowing and goes back to doing what it was originally designed to do---maintain the value of the dollar and be the lender of last resort in case of financial crisis. 

The failure of central bank policy (medium):

Monetary repression cannot create a recovery (medium and a must read):

As I have said repeatedly, the above doesn’t mean that the central bankers’ anxiety over recession is unfounded.  I just changed our forecast to reflect it.  My point has been and remains, a recession will be largely a function of results of an experimental, ill thought out, overly aggressive QE policy.

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 Mideast is heating up as Saudi Arabia and Turkey are starting to take a more active role in the Syrian fight.  I will repeat my position: the US should leave and let them get busy killing each other.  The Saudi’s aren’t our friends, the Iranians aren’t our friends, the Russians aren’t our friends and the Turks are more focused on killing the Kurds [who are one of our few friends in the area] than deposing Assad or defeating ISIS.  What worries me is that the Saudi’s/Turks get involved, get their collective asses kicked by the Russians and then come whining to us to do something.  The more parties involved in this conflict the greater the chance of something unexpected occurring.

(5)   economic difficulties in Europe and around the globe.  There were few international economic stats released this week:  fourth quarter Japanese GDP was down versus estimates and January exports fell for the fourth month in a row; January Chinese exports and imports declined more than projected, January PPI declined and  CPI was up less than expected.  On a brighter note, January UK retail sales were ahead of forecast.    In short, another week of solid under performance.

In other economic news:

[a] the Organization for Economic Cooperation and Development lowered its 2016 global GDP outlook, mentioning Brazil, Germany and the US as slowing,

[b] oil prices rebounded on news that Russia and Saudi Arabia had agreed to a freeze in oil production at current levels IF other OPEC members also complied.  Iran, a most important vote, said it would agree to a production ‘ceiling’.  Even if this all comes about {i} if history is any guide, OPEC members are notorious for cheating on production quotes and {ii} freezing production at current high levels is virtually meaningless at the present with demand declining as a result of slowing economic activity.  The cure to this difficulty is production cuts; so I doubt the current efforts will have much more than a temporary psychological impact.

      Counterpoint (short):

      In sum, the global economic outlook has not improved.

Bottom line:  the US data continues to point to a recession.  My hope that the rate of slowing may have stabilized has, alas, been squashed.  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. 

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: January housing starts were awful while building permits were less than anticipated; weekly mortgage applications were up, but the more important purchase applications were down; February home builder confidence was below estimates,

(2)                                  consumer: month to date retail chain store sales growth rose slightly versus the prior week; weekly jobless claims declined,

(3)                                  industry: both the February New York and Philadelphia Fed manufacturing indices were below expectations; January industrial production was surprisingly strong,

(4)                                  macroeconomic: both the January PPI and CPI headline and ex food and energy readings were hotter than projected; January leading economic indicators were off, but in line; however, December’s reading was revised lower.

The Market-Disciplined Investing

The indices (DJIA 16391, S&P 1917) had a great up week, but they ended quietly as volatility declined, volume rose and breadth remained mixed.

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 {16748-17499}, [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] within a short term downtrend {1888-1975}, [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. 
The long Treasury had another good week, having challenged and then failed to break a very short term uptrend.  It finished above its 100 day moving average, now support and within short term and intermediate term trading ranges.

GLD ended in very short term and short term uptrends, as well as substantially above its 100 moving average.  There is every sign that it has at last bottomed. 

Bottom line: the Averages rebounded strongly this week, with the S&P negating the recent reset of its intermediate term downtrend. The rally did fizzle on Thursday and Friday though not materially so---which suggests there is more to come on the upside.  That said, the trend since May 2015 of lower highs could not be broken and that hints at limited upside.  At this point, we wait for follow through.

Both risk off trades---GLD and the long Treasury---performed reasonably well in the rebound.  Indeed, GLD was a champ.  TLT tried to break a very short term uptrend but couldn’t.  This pin action supports the case for limited upside.

The correlation between stock and oil prices (short):

Garbage stock rally? (medium)

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16391) finished this week about 32.5% above Fair Value (12366) while the S&P (1917) closed 25.1% overvalued (1532).  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 again disappointing, reflecting our newly revised forecast for recession or zero growth.  The global economy remains a mess, its banking system increasingly infirm and the tensions in the Middle East raise the risk of some untoward event igniting all-out war.  The risk here is that many Street economic forecasts are 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 encouraged the Markets when the minutes from the January FOMC meeting read more dovish than the statement following the meeting.  St. Louis Fed chief Bullard piled on, saying that another rate hike would be ‘unwise’.   They were joined in this easy money theme by Draghi and the Japanese.  I don’t need to piss and moan over this silliness any more than I already have.  Short term, the Markets clearly continue to love QE despite its abysmal record in generating economic growth---but it does keep mispriced assets in nosebleed territory.  Long term. I believe that the longer easy money policies of the central banks last and the larger the magnitude of QE, the greater the Market pain when it is finally over or when the Markets finally figure out the shell game.

 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 (and other central bank) 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.
            More investment thoughts from Lance Roberts (medium):

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 2/29/16                                  12366            1532
Close this week                                               16391            1917

Over Valuation vs. 2/29 Close
              5% overvalued                                12984                1608
            10% overvalued                                13602               1685 
            15% overvalued                                14220               1761
            20% overvalued                                14839                1838   
            25% overvalued                                  15457              1915   
            30% overvalued                                  16075              1991
            35% overvalued                                  16694              2068
Under Valuation vs. 2/29 Close
            5% undervalued                             11747                    1455
10%undervalued                            11129                   1378   
15%undervalued                            10511                   1302

* 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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