Saturday, March 12, 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                            16655-17426
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.   There were few stats released this week and what was, was mixed to negative: above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, week jobless claims and February US import and export prices; below estimates: the February small business optimism index, January consumer credit, the February wholesale inventory/sales numbers and the February budget deficit as well as the trade deficit; in line with estimates: none.

In addition, there were no primary indicators reported. So in the economic stats record book, this week hardly existed.  I do think that the negative data carried more weight than the positive did.  However, that may just be me talking my book.

 Bottom line, I don’t think that this week even qualifies to be rated. That leaves our forecast unchanged and me still stewing over whether I jumped the gun on my recession call.

Nevertheless, higher oil prices are raising hopes that oil industry recession is over and that will lead to an improvement in the gross economic numbers.  I can buy the idea that the worst may be over but to assume conditions are going to improve anytime soon is probably pushing it.  Every oil industry statistic I have seen indicates that supply/demand won’t be in balance for at least another year.  Yes, we could get some production cuts but I think that is wishful thinking.  However, what is more likely is demand reduction due to a lousy economy.  So the optimism stemming from recent lift in oil prices may be a bit premature.

The Fed was quiet this week; though Fed whisperer Hilsenrath suggested that the
Fed would likely do nothing next week.

While somewhat sparse, the international economic numbers were mixed for the first time in a number of weeks.  But I wouldn’t qualify them as being positive for our own economy.

The big news of the week was (1) the ECB meeting in which Draghi rolled out a howitzer and (2) a proposal [now being drafted into law] from the Chinese government that would allow banks to convert their nonperforming loans to equity, freeing up their balance sheets to lend more money and (3) another on again, off again round trip on a possible meeting of oil producers.

In summary, the US economic stats this week were virtually meaningless and the international data was sparse and mixed.  Meanwhile, the central bankers have quadrupled down on QE and negative interest rates---which if history repeats itself, I suspect will end up looking like Custer’s last stand.

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.  No news this week.

(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.  

This was the principal focus of economists and investors alike this week.

The ECB gave the world the full Monty, lowering interest rates, jacking up QE and expanding the assets that qualify for central bank purchases.  That is more than most everyone had hoped for.  Later, Draghi said that there would be no further rate reductions.  I think that reflects his realization [finally] that if this latest round of QE doesn’t work, no additional amount of QE ever will.  And if history is any guide, it won’t.  At that point, surely he and every other central banker in the universe will face the ugly truth that this was, is and always will be a failed policy. 

Hopefully, the central bankers will recognize the error of their ways and do something helpful---like normalize monetary policy. Of course, these academics have perfected the art shutting out cognitive dissonance.    So who knows what they will do?  But at that point, it likely won’t matter, because the rest of the world will see that the emperor has no clothes and start acting accordingly, i.e. undoing the damage of asset mispricing and misallocation.  My hope is that this week’s ECB actions are the beginning of the end.

In addition, the Chinese government announced that a rule was being drafted to have its banks convert all nonperforming loans to equity, freeing up their balance sheets for more lending.  Yeah, that ought to work: nationalize all those failed companies [remember the government is a major owner of the banks] and then let the banks lend them even more money.  I recall the phrase ‘throwing good money after bad’.  The only hope the Chinese have is that someone will figure out what a disaster that policy would be and squelch it.

Finally, of considerably lesser importance, the Bank of New Zealand lowered its key interest rates.  As I noted on Thursday, this action isn’t going to change anybody’s global economic forecast.  But it could encourage other countries to join the crowd of competitive devaluations.

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. 
The central banks are clueless (medium and today’s must read:  

                                  The Fed has a problem (medium):

(4)   geopolitical risks: Iran threatened to walk away from the nuclear deal.  Of course, it never intended to honor the terms in the first place, so this isn’t exactly a big surprise.  The big question is what will Obama do, if it does? 

(5)   economic difficulties in Europe and around the globe.  The international economic stats released this week were also sparse and somewhat mixed:  January German factory orders fell though its industrial production rose, February Chinese exports and imports plunged and CPI shot up 2.3%.  The bottom line, like the US dataflow, not much volume this week though what we got was not encouraging.  The global economy remains a major headwind.

In addition, the oil producers threw the rest of the world another head fake this week, first announcing a meeting on March 20 of both OPEC and non OPEC producers [ostensively to discuss production levels] and then reversed itself.  I am convinced these guys are trading off their own announcements and laughing their way to the bank.

In sum, the global economic outlook has not improved.

Bottom line:  this week’s US data was of no informational value, though I continue to stew over whether I acted too quickly in calling for a recession.  The global economy did nothing to brighten the outlook.    Meanwhile, the ECB and the Bank of China may have used their last QE bullet, leaving us all to contemplate what happens next.

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: weekly mortgage and purchase applications were up,

(2)                                  consumer: January consumer credit grew much slower than expected; month to date retail chain store sales was up slightly versus the prior week; weekly jobless claims fell more than anticipated,

(3)                                  industry: the February small business optimism index was lower than estimates; January wholesale inventories rose but only because sales plunged,

(4)                                  macroeconomic: the February US budget deficit came in slightly greater than forecast;   February import and export prices fell less than projected.

The Market-Disciplined Investing

The indices (DJIA 17231, S&P 2022) had a volatile week but ended on a very strong note.  Volatility has been cut in half in the last four weeks and is getting close to a level that offers an attractive value as portfolio insurance.  Meanwhile, the current advance has been on low volume and mixed breadth.

The Dow closed [a] above its 100 day moving average, now resistance; if it remains there through the close on Tuesday, it will revert to support, [b] above its 200 day moving average, now resistance; if it remains there through the close on Wednesday, it will revert to support, [c] above the lower boundary of a short term downtrend {16655-17386}, [c] in an intermediate term trading range {15842-18295}, [d] in a long term uptrend {5471-19343}, [e] and has made a third higher high and is working on a fourth.

The S&P finished [a] above its 100 day moving average, now resistance; if it remains there through the close on Tuesday, it will revert to support, [b] above its 200 day moving average, now resistance; if it remains there through the close on Wednesday, it will revert to support, [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] has made a second higher high and is working on a third. 

The long Treasury continued to drift lower, but not enough to challenge its short term uptrend or its 100 day moving average.  However, it has developed a very short term downtrend and busted through a key Fibonacci retracement level.  Since the global central banks are cutting rates (higher bond prices), this pin action only makes sense if investors are in a risk-on mood (sell safety, buy risk).

GLD spent the week consolidating after a massive run higher.  It still looks a bit overextended to me.  But it has held its very short term and short term uptrends, as well as remaining substantially above its 100 moving average. 

Bottom line: the bulls maintained control despite the Market being extremely overbought.  The indices have pushed through, though not confirmed the break of, two major moving averages.

After a big day like Friday, it is easy to get concerned about being left behind on the upside.  But remember (1) the breaks of the 100 and 200 day moving averages have yet to be confirmed, (2) neither the short or intermediate term trends are up and (3) the upper boundary of the S&P long term uptrend is only 6% away.   

That said, I have been harping all week on how overbought stocks were, how puny the volume has been and the lack of real power in the breadth; and prices keep going up anyway.  So what do I know?   

However wrong I may have been reading the tea leaves short term, I still believe that the bull market is likely over and that mean reversion is the principal risk right now.

Update on best stock market indicator ever (medium):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17386) finished this week about 40.2% above Fair Value (12399) while the S&P (2022) closed 31.7% 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.

We received no new information on the US economy this week, leaving me sticking with my recession forecast---but a little uneasy about it.  On the other hand, (1) the US corporate revenue, earnings and dividend data are getting worse and (2) the global economic data remains discouraging; both of which support my outlook.    If correct, many Street economic forecasts are too optimistic; and if (when) they are revised down, it will likely be accompanied by lower Valuation estimates.  (must read):

That said, investors have been jiggy of late because of

(1)   the perception of a declining probability of recession.  That could happen but even if there is no recession, US growth will still be subpar at best, the world economy continues to stink [so no help there] and the rest of the globe’s central bankers are driving to hoop on devaluation---which, to date, has been a big fat minus for US corporate revenues and profits,

(2)   more and more QE.  With the ECB’s new and improved monetary easing, we may just have seen the last and best attempt to prove this policy works.  If this newest version is a dud, like all the rest, then hopefully it will prompt a great re-think of the value of QE/negative interest rates---which the Markets will undoubtedly not like.

And unfortunately, there is potentially even more, if the Chinese go through with the latest proposal to cram down bank debt into the equity of virtually  bankrupt companies so that the Bank of China can provide more money to lend to more virtually bankrupt companies.  What could go wrong here?

(3)   higher oil price.  Do you remember when not so long ago lower oil price were [supposed to be] a major plus?  My how things change.  Now everyone is praying for OPEC to cut production, allowing oil prices to rise thereby avoiding multiple bankruptcies that could threaten the banking system. 

However, even if oil prices do stabilize and oil industry bankruptcies are minimized, that is not going to correct the overall weakness in the financial system.  I repeat in these notes chapter and verse every week about the problems in global banking system.  This week’s hair brain scheme by the Chinese to somehow paper over billions and billions of nonperforming loans is another perfect example. 

While the US banks may have improved their balance sheets, the rest of the world’s banking system is much more highly leveraged and packed with bad loans many of which were made with government encouragement.  Those aren’t going away whatever happens to the price of oil.

Unfortunately, as long as this ill-conceived euphoria lasts, mispriced assets will remain in nosebleed territory. 

When it ends, 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. 

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                                               17386            2022

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.

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