Friday, March 25, 2016

The Closing Bell

The Closing Bell

3/26/16

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 Trading Range                       15431-17758
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%

Economics/Politics
           
The economy maybe providing a temporary upward bias to equity valuations.   The stats this week remained on the negative side of the ledger:  above estimates: month to date retail chain store sales, the February Markit flash services index, the March Richmond Fed manufacturing index and fourth quarter GDP; below estimates: February existing home sales, February new home sales, weekly mortgage and purchase applications, February durable goods orders, the February Chicago Fed national activity index, the March flash manufacturing PMI, the March Kansas City Fed manufacturing index and weekly jobless claims; in line with estimates: none.

Likewise the primary indicator were downbeat: fourth quarter GDP (+), February existing home sales (-), February new home sales (-) and  February durable goods orders (-)  For those keeping a running score, in the last 29 weeks, six have been positive to upbeat, twenty two negative and one neutral.  Finally, the Atlanta Fed revised its first quarter GDP estimate down to 1.4%.  This is the second downgrade in as many weeks.  Clearly these numbers support my recent recession call, although I am still not dismissing the recent two week run of upbeat stats. 

In addition, oil prices started to retreat again.  It is too soon to know if this is just some consolidation after the recent gains or a realization that OPEC is just jerking the world off with its on-again, off-again oil production freeze meetings. As I have oft repeated of late, (1) every statistic and analysis of the oil market that I have seen is unsupportive of the notion that the supply and demand of oil will be in balance anytime soon and (2) history and politics suggest that OPEC will not freeze or lower output; and if it does, the cheating will be so rampant as to make the freeze irrelevant.  The point here is less about the actual price of oil and more about its impact on the financial condition of both oil companies and the banks that lend to them---lower oil prices meaning the increased likelihood of impaired balance sheets.

Another big story of the week was the seeming walk back of the dovish tone coming out of last week’s FOMC meeting.  As I reported, three regional Fed heads spoke this week in which they adopted a much more aggressive stance towards a possible rate hike.  Indeed, the impression was that an increase could come as soon as April. 

I covered this subject in our Morning Calls; but to reiterate the bottom line: (1) nothing in the data provides any reason for the dramatic shift in the Fed narrative; indeed, as noted above, things have only gotten worse [see the newly revised Atlanta Fed first quarter GDP forecast above], (2) continuing this back and forth, on again, off again rate hike dialectic is likely to destroy what little credibility the Fed still has left and (3) if the Mauldin thesis that I introduced last week is correct, then this latest Fed speak is all bulls**t.

Just ask the Chinese (short):

Theft by government fiat (medium and a must read):

On the international economic front, the numbers, what there was of them, were mixed, leaving the current trend in global stats even worse than our own.  Hence, there is nothing here to qualify as a positive for our economy.

In summary, the US economic stats this week were negative again while the international data sparse and mixed.  Meanwhile, the Fed is doing its utmost to confuse and confound.

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, we received two pertinent news items:

      [a] Moody’s put Deutsche Bank on its watch list for a credit downgrade,

[b] Canadian bank regulators have determined that their banks are woefully under reserved.  Immediately on the heels of that news, a Canadian oil company declared bankruptcy after its bank called its loans.   And to put a cherry on top, Canadian regulators are proposing to make depositors of any bankrupt bank take equity in the bank {versus their deposit}.

I am not going to jump up and down on either of the above points {although the Canadian equity cram down could severely impair the banks} except to say that global banks are overleveraged with sufficient levels of nonperforming assets to keep us all up at night.  The above are but examples thereof.


(2)   fiscal/regulatory policy.  With the election season now in full swing, we are likely to get no new developments by way of fiscal/regulatory policy [except for more empty promises] until at least early 2017.  Along those lines, it appears that republican leaders have decided not to challenge Obama’s FY2016 budget in any meaningful way.  Shameful.

The eight biggest barriers to economic growth (medium):

(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.  

With the completion of last week’s central bank trifecta, we were thankfully blessed with little more cognitive dissonance from those yahoos.  ‘Little’ being the operative word, because the Fed did manage to confuse its own rate hike policy when three governors commented in speeches that the economy was sufficiently strong to handle another rate hike, possibly as soon as April---this but one week after the ultra-dovish statement and Yellen press conference following the FOMC meeting. 

I have railed against this ‘on the one hand, on the other hand’ crap that we have been fed for far too long.  In my opinion, this is another perfect example that the Fed has painted itself into a box, it knows it and is trying to buy time by blowing smoke our skirts in the hopes that some miracle will bail them.

The inexorability of the numbers (medium):

In the meantime, the Japanese yield curve is doing its best impression of the  wave, demonstrating that the Fed is not the only central bank that is in a corner and doesn’t know how get out.  Even worse, on Thursday, there was an unsubstantiated report that Japan will unveil its version of ‘helicopter’ money [checks to poor citizens that can’t be deposited, ergo, must be spent].   What could possibly go wrong with that?

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 terrorists’ bombing in Brussels clearly added to the concerns about radical islam whether in the Middle East or closer to home.   As I noted last week, all this takes is one final explosive event to turn propel this risk to center stage.

This is an excellent article on the danger posed by the willful ignorance of islam by western leadership (medium and a must read):

(5)   economic difficulties in Europe and around the globe.  The international economic stats released this week were sparse and mixed:  February Chinese auto sales plunged 44%; the March EU Markit composite PMI came in better than anticipated while UK inflation was reported at zero; and German business confidence rose, though I suspect the Brussels bombing will negate that.

In other news, (1) Greece and its creditors were still unable to reach an agreement on a third bailout and (2) Iran said that it would consider joining in an oil production freeze ‘at a later time’.  I have no idea what that means and it is likely that neither do all those folks who were making bets on it.

The bottom line: what data we got was not encouraging.  The global economy remains a major headwind.
           
Bottom line:  this week’s US data points toward a recession, though I continue to stew over whether I acted too quickly in making that call.  The global economy did nothing to brighten the outlook.    Meanwhile, the global central banks are doing everything possible to confuse and confound the Markets in hopes that a miracle allow them to exit QE without much damage.

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: February existing home sales was down twice what was expected while new home sales were less than projected; weekly mortgage and purchase applications declined,

(2)                                  consumer: month to date retail sales grew more than in the prior week; weekly jobless claims increased more than consensus,

(3)                                  industry: February durable goods orders were down, ex transportation, they were especially disappointing; February Chicago Fed national activity index was extremely poor; the March flash manufacturing PMI was below estimates, however the services PMI was better than projected; the March Richmond Fed manufacturing index was much better than anticipated while the Kansas City Fed index was much worse,

(4)                                  macroeconomic: the final revision of fourth quarter GDP was reported at +1.4% versus consensus of +1.0.

  The Market-Disciplined Investing
         
  Technical

The indices (DJIA 17515, S&P 2035) churned in place Thursday, again on very low volume and mixed breadth.  The VIX was off fractionally, but continues to support high and rising equity prices.

The Dow closed [a] above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] in a short term a trading range {15431-17758}, [c] in an intermediate term trading range {15842-18295} and [d] in a long term uptrend {5471-19343}.

The S&P finished [a] above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term trading range {1867-2104}, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {800-2161}. 

The long Treasury moved up again, voiding a very short term downtrend and remaining above a Fibonacci support level.  After a six week period of consolidation, this may be a sign that the recent decline is over.

GLD was lower.  While it remains within a short term uptrend and above its 100 day moving average, it is still above visible support.  So more consolidation seems likely.

Bottom line:  the indices continue their solid performance given how over extended they were and the amount of negative news they have had to overcome this week.  True low volume and mixed breadth are not helpful.  Plus both voided very short term uptrends.  That said, they have plenty of near end support.  So my assumption remains that they challenge their all-time highs until/unless they negate the aforementioned support levels.

Broadest index hitting resistance (short):

The latest from Doug Kass (medium):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17515) finished this week about 41.2% above Fair Value (12399) while the S&P (2035) closed 32.5% 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 US economic data this week was again quite negative, putting that recent two streak of upbeat numbers further behind us.  Clearly, the more poor stats we get, the stronger my case for recession. 

Not helping matters, oil prices reversed their recent strong uptrend.  This may be just some consolidation after a big run up; but if it is more than that, then the lack of financial viability of many oil companies and the banks that serve them is back on the table.  And as I have noted several times, there is currently little evidence to support higher oil prices. 

In sum, if our forecast is anywhere near correct, most Street forecasts for the economy, corporate earnings and, hence, stock valuations are too high. 


As always, Fed policy will play a role in Street formulations.  Last week, the central banks delivered what investors wanted in the form of triple down, QE forever policies---which in turn helped stocks continue to rally.  As you know, I think that that game will be over when investors finally realize that QE (except QE1) hasn’t, isn’t and likely won’t do anything to improve the outlook for the economy or corporate profits.  Clearly the operative word in that statement is ‘when’.  Based on my record of late, I don’t have a clue ‘when’ is.  I only note that the more the Fed pursues this dovish/hawkish double talk, the more likely the ‘when’ is sooner rather than later.  Unfortunately, as long as investors’ 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 as investors wake up to the Fed’s (and other central bank) malfeasance because I suspect the results will not be pretty. 

The Fed’s impact on stock valuation (medium and a must read):

A bunny market (short):

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. 

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                                               17515            2035

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
            45% overvalued                                  17978              2225

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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