Saturday, March 5, 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                            16678-17426
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 Trading Range                          1867-2104
                                    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 maybe providing a temporary upward bias to equity valuations.   This week’s dataflow by volume was overwhelming negative: above estimates: the February ADP private payroll report, February nonfarm payrolls, the February ISM manufacturing and nonmanufacturing indices, January construction spending, fourth quarter productivity and unit labor costs; below estimates: weekly mortgage and purchase applications, January pending home sales, month to date retail chain store sales, February light vehicle sales, weekly jobless claims, the February Chicago PMI, the February Markit nonmanufacturing PMI, January factory orders, the February Dallas Fed manufacturing index and the January trade deficit; in line with estimates: the February Markit manufacturing PMI.

In addition, the most recent Fed Beige Book was released this week and painted a picture of an economy generating slow growth---sort of like our prior outlook.

However, the primary indicators were strongly upbeat: February ISM manufacturing and nonmanufacturing indices (++), fourth quarter productivity and unit labor costs (++), January construction spending (+), February nonfarm payrolls (+) and January factory orders (-). 

While the overall showing was weak, the strength in the primary indicators for the second week in a row not only raises more questions regarding my newly revised forecast but also gives hopes to investors that recession is off the table.  Nevertheless, two factors holding me back from any changes at this time: (1) the longer term trend is still quite negative---six mixed to upbeat weeks and twenty negative weeks in the last twenty-six weeks; though clearly two positive weeks in a row is something of short term trend, and (2) this week’s revelation by the Bureau of Economic Activity that it had raised the seasonal adjustment factors because of the two prior hard winters---the net effect of which is to raise this year’s seasonally adjusted raw data in what has been a mild winter.  In other words, this year’s numbers could be overstated.

The economy in nine charts (short):

I am not arguing that we ignore the past two weeks’ positive data.  I am saying that there is reason to pause before taking them at full face value.  The impact on our forecast will be to delay a reversal of my recent revised forecast, if at all.  Further, I point out that even if I do revise again, it will still reflect an economy that is struggling to grow. 

New York Fed chief Dudley reiterated St Louis Fed head Bullard’s comments last week in which he proclaimed that the economy was just fine but that another interest hike could be harmful.  That may likely be a sign that nothing will occur at the Fed’s March meeting except more oblique commentary. 

In sum, the US stats overall this week were negative but the primary indicators were quite positive for a second week in a row.  Certainly, I am wondering if I jumped the gun on my recession call; however, more data is needed before I get too serious about it.

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

Importantly, the G20 met this week and produced little of substance except a recommendation of less QE and more fiscal stimulus.  However, immediately following that meeting, both Japan and China announced policies that were the exact opposite of the G20 recommendation.  In addition, the ECB meets next week and, based on a recent letter from Draghi to member states, expectations are that further QE and/or negative interest rates will be authorized.

In summary, the US economic stats this week were better than what has been the norm of late but the international data were very poor.  Meanwhile, the central bankers are pursuing the same old tired, ineffective policies that got us into this mess in the first place.

Jim Rogers: 100% probability of a recession within a year (4 minute video):

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.
       The negatives:

(1)   a vulnerable global banking system.  This week, the only datapoints we received were anecdotal:

[a] Barclay’s cut its dividend.  Certainly, not enough to get exercised over; but it is another sign of financial weakness among the major global banks.

[b] energy company default rates are rising and the recovery rates [what the debt holders ultimately recoup] are declining (medium):

[c] the market for bulk shipping has never been worse, so the entities financing them face problems (short):

[d] and on a brighter note, the Fed is proposing to limit the counterparty exposure of the TBTF banks (medium and good for the Fed):

(2)   fiscal/regulatory policy.  With the election season now in full swing, we are likely to get no new developments by way of fiscal policy [except for more empty promises] until at least early 2017.  On the other hand, Obama could continue or even step up His efforts to impose new regulations on the economy via executive action---anything to build a legacy.

(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.  

News flash, Fed discovers problems in the student and auto loan markets (medium):

The news this week included [a] the G20 doing nothing but yakking about needed fiscal stimulus [b] immediately thereafter, Japan confirmed that it would go through with its planned sales tax hike and China provided additional liquidity to its financial system, [c] New York Fed chief Dudley supported Bullard’s comments from last week that more rate increases at this time are unnecessary, and [d] Draghi sent a letter to the ECB’s member sovereign bankers reiterating his ‘whatever is necessary’ theme.

In last week’s Closing Bell I said:  ‘Of course, the G20 could always agree to pursue more of the same useless QE or negative interest rate policies as some sort of substitute for fiscal action.  And barring a dramatic turnaround among the policy makers that would likely be exactly what they do.  Which is to say more Keynesian monetary stimulus in the hopes of generating consumer spending’.  

I would love to claim prescience, but I was doing nothing but extrapolating past performance into the future.   These guys are too arrogant to ever learn from their mistakes.  Nothing that they have done thus far has worked and any add on QE or negative interest rate policies will likely only make matters worse.

However as usual, those policies continue to inject euphoria among the stock guys because the central bankers’ only true accomplishment has been to drive asset prices ever higher as earnings decline ever further.  Sooner or later something has to give because the logical conclusion of this trend is to pay infinity for no earnings/no earnings growth.   I think it likely to be ugly when that happens.

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.
                              There is no clear way out (medium and a must read):

(4)   geopolitical risks: the cease fire in Syria appears to need a second tweaking, whatever that means.  My chief concern is that if the Saudi’s/Turks keep getting more involved, there is the potential that they get their collective asses kicked by the Russians and then come whining to us to do something. 

(5)   economic difficulties in Europe and around the globe.  The international economic stats released this week were awful…again:  the February EU CPI declined, the February Markit EU composite PMI fell to a 13 month low while the February UK services index declined to a three year low, both the February Chinese manufacturing and services PMI’s and the February EU manufacturing PMI declined, South Korean factory output as well as exports fell, Moody’s reduced China’s credit rating.   The bottom line here is that whether or not the US economy is doing better than I may have thought, it is getting no help from abroad.  Indeed, the global economy is a major headwind.

In a somewhat related matter, the US imposed tariffs on cold rolled steel.   The chief source of the problem is China dumping its excess production; and, hence, our actions are most likely justified.  However, it doesn’t mean any less with respect to the growing ‘beggar thy neighbor’ trend most visibly manifest of late in currency devaluation.   The cause is still the same---a shrinking global economy, resulting in excess production which motivates countries to cheapen exports in order to keep employment rates up.  And the outcome is still the same---everyone does it to preserve market share and ultimately a trade war ensues that is both deflationary and recessionary.

In sum, the global economic outlook has not improved and if US imposed tariffs are a sign of things to come, it has gotten worse.

Bottom line:  the aggregate US dataflow continues to point to a recession though the last two week’s primary indicators give me pause.  On the other hand, the global economy did nothing to brighten the outlook.    Meanwhile, the central bankers are doing what they do best---which is to pursue policies that haven’t worked, aren’t working and likely will never work.

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 pending home sales declined versus an expected increase; weekly mortgage and purchase applications dropped,

(2)                                  consumer: month to date retail chain store sales growth fell versus the prior week; February light vehicle sales were less than forecast; February nonfarm payrolls were better than projections; the February ADP private payroll report showed job growth stronger than estimates; weekly jobless claims were above consensus,

(3)                                  industry: both the February ISM manufacturing and nonmanufacturing indices were better than anticipated; the February Chicago PMI was well below forecast; the February Dallas Fed manufacturing index was below consensus; the February Markit manufacturing PMI was in line, while the services PMI was lower than expected; January factory order were disappointing; January construction spending was above projections,

(4)                                  macroeconomic: fourth quarter productivity fell less than forecast, while unit labor costs rose less than expected; the January trade deficit was larger than estimated.

The Market-Disciplined Investing

The indices (DJIA 17006, S&P 1999) had another great up week, as volatility declined, volume remained low and breadth mixed.

The Dow closed [a] below its 100 day moving average, now resistance, [b] below its 200 day moving average, now resistance, [c] above the lower boundary of a short term downtrend {16678-17426}, [c] in an intermediate term trading range {15842-18295}, [d] in a long term uptrend {5471-19343}, [e] and is developing a third higher high.

The S&P finished [a] right on its 100 day moving average, now resistance, [b] below its 200 day moving average, now resistance [c] within a short term trading range {1867-2104}, [d] in an intermediate term trading range {1867-2134}, [e] in a long term uptrend {800-2161} and [f] is developing a second higher high. 

Forecasting an incumbent party defeat? (short):

The long Treasury continued to drift lower, enough to break its very short term uptrend but not enough challenge its short term uptrend, its 100 day moving average and a key Fibonacci retracement level.  This pin action is to be expected in the current risk on trade (sell bonds, buy stocks) environment.

GLD ended in very short term and short term uptrends, as well as substantially above its 100 moving average.  However, the rally is getting a bit overextended.  In fact, it could retreat circa 4% and not challenge its very short term uptrend.

Blackrock suspends new share issues of gold ETF:

Bottom line: the bulls controlled the week.  The S&P broke its short term downtrend and is challenging its 100 day moving average.  The Dow is trailing on both counts, so I don’t see an open field to the all-time highs.  But clearly the bulls are on the offense.  Nevertheless, I don’t know how there can be much short term follow through from current levels because of the extreme overbought condition of the Market, the lack of volume and the continued divergences. 

That doesn’t mean that stocks can’t consolidate and then mount an upward assault eventually.  It just doesn’t seem likely now.  In any case, when, as and if stocks do go higher, I remain firmly convinced that [a] we will not see a new all-time high and [b] we haven’t seen the lows of this cycle yet.

Update on best stock market indicator ever (short):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17006) finished this week about 37.1% above Fair Value (12399) while the S&P (1999) closed 30.2% overvalued (1535).  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 primary indicators were very strong again this week.  Two weeks in a row represents something of trend; though we need (1) more data and (2) clarity on the effect of the revised seasonal adjustment factors.  However, even if I ultimately reverse my recent recession call and move back of a ‘sluggish growth’ scenario, the global economy will help keep a lid on US growth at a minimum and could push us into recession anyway---and that assumes no crisis in the financial system or an expanded war in the Middle East.  This along with the recent data showing declining earnings growth and increased dividend cuts suggest that many Street economic forecasts are too optimistic; and if (when) they are revised down, it will likely be accompanied by lower Valuation estimates.

That said, I think that the current rally is being at least partially driven by investor perceptions that a recession is declining probability---which may be true.  Though if there is any economic growth, it will be paltry at best and do little to help EPS or dividend growth.

This week, New York Fed chief Dudley supported the notion that ‘another rate hike would be unwise’.  In addition, the latest Fed Beige Book portrayed an economy progressing very slowly.  I think that this means no rate increase in the Fed’s March meeting.

In addition, (1) the Bank of China has already pushed more liquidity into its financial system, (2) Draghi has given a firm sign that new QE measures will be introduced in next week’s ECB meeting and (3) given its history, there is no telling what the Bank of Japan will do in its upcoming meeting.

Of course, the Markets clearly continue to love QE despite its lengthy, abysmal record in generating economic growth.  Plus as I noted above, the perception that recession is no longer on the table gives investors a goldilocks investment scenario. Regrettably, as long as this ill-conceived euphoria lasts, mispriced assets will remain 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.

More on dividends (short):

More on earnings (medium):

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. 

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.

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 3/31/16                                  12399            1535
Close this week                                               17006            1999

Over Valuation vs. 3/31 Close
              5% overvalued                                13018                1611
            10% overvalued                                13638               1688 
            15% overvalued                                14258               1765
            20% overvalued                                14878                1842   
            25% overvalued                                  15498              1918   
            30% overvalued                                  16118              1995
            35% overvalued                                  16738              2072
            40% overvalued                                  17358              2149
Under Valuation vs. 3/31 Close
            5% undervalued                             11779                    1458
10%undervalued                            11159                   1381   
15%undervalued                            10539                   1304

* 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.

No comments:

Post a Comment