Saturday, April 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                     -1.25-+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 Uptrend                                 17529-18484
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 Uptrend                                     2080-2182
                                    Intermediate Trading Range                        1867-2134
                                    Long Term Uptrend                                     830-2218
                        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 (for at least another week).   The stats this week were again somewhat sparse and again weighted to the negative:  above estimates: weekly mortgage applications, weekly jobless claims and March existing home sales; below estimates: weekly purchase applications, the NAHB index, March housing starts, month to date retail chain store sales, the April Philly Fed index, the March Chicago Fed National Activity index, the April PMI manufacturing index and the March leading economic indicators; in line with estimates: none.

The primary indicators were also negative: the March existing home sales (+), March new home sales (-) and the March leading economic indicators (-).  In the last 33 weeks, seven have been positive to upbeat, twenty five negative and one neutral. 

One final note on that two week run of better stats out of the manufacturing sector---given the last three weeks data, it appears to have been an apparition.  Hence, my concern about jumping the gun on our recession forecast is no more.

Similar to the US, the international economic stats were few but negative--- continuing to act as a headwind to our own economy.

The central banks maintained their push to even easier monetary policy as the both the Bank of Sweden and the ECB stepped up asset purchases.  We should get more of the same next week as both the Bank of Japan and the Fed have regular scheduled meetings.

In summary, the US economic stats were negative while the international data remains depressing.  Meanwhile, the central banks are doing their utmost to create a paper shortage.

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:

[a] the Fed sent a scathing letter to JP Morgan pointing out numerous unresolved risks in its financial statements,

[b] Deutschebank admitted to rigging the gold and silver markets and to having E21 trillion notional value of derivatives in its portfolio,

[c] in a speech this week, George Soros outlined his concerns about the financial strength of Chinese banks.  Here is some more analysis (medium):

US banks are certainly in stronger financial condition than in 2008.  That doesn’t mean that all is well in ‘too big to fail’ land.

(2)   fiscal/regulatory policy.  Two items that I think bear mentioning:

[a] the insolvency of the Central States pension fund and the likelihood of severe reductions in benefits {I linked to this on Thursday}.  One of the points in the aforementioned article was that two individuals, ages 64 and 68, would have their monthly joint benefits reduced from $7,000 to $4,000.  Think about that.  $7,000 is a huge monthly payout for two people that young---no wonder Central States has a problem.  Regrettably, this is most probably not an isolated incident.  It is going to happen again and again as these big defined benefit plans can’t meet their obligations {reminder me, Janet, of the benefits of lower interest rates}.  The ultimate consequence: lower consumer spending.  That ought to help spur economic growth.

[b] the growing influence of high frequency trading on the Market.  Doug Kass has been complaining about this for some time.  The point here is that like so many other financial ‘innovations’ {think securitized debt} this will also likely come to an ignominious end and the Market repercussions will be painful.

(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 banks kept up their good work this week.  The Bank of Sweden stepped up bond buys and the ECB left rates unchanged but increased their asset purchases. 

ECB unleashes global QE (medium and a must read):

And next week should offer more of the same as both the Bank of Japan and the FOMC meet.  Current expectations are [a] for more easing from the BOJ {which were supported by a news release Friday suggesting a further move into negative interest rate territory} as {i} it attempts to offset the decline in economic activity resulting from the recent earthquakes and {ii} current data continues to get worse and [b] more happy talk from the Fed about all the reasons why it is not going to raise rates.

You know my bottom line: QE [except QE1] and negative interest rates have done nothing to improve any economy, anywhere, anytime.  What they have done is lead to asset mispricing and misallocation. Sooner or later, the price will be paid for that. The longer it takes and the greater the magnitude of QE, the more the pain. 

(4)   geopolitical risks: there only a few minor incidents this week: Russia buzzing a couple of US naval vessels, terrorists bombings in Israel and Afghanistan and the growing discord between the US and Saudi Arabia over the 9/11 investigative documents. 

Nonetheless, the risks from a step up from terrorists’ bombings, turmoil in the EU over immigration and assimilation policies and adventurist polices by Russia, Iran and North Korea all remain.  There is a decent chance of an explosive event stemming from one or more of the aforementioned, though I have no idea just how big it could be or which one is more likely to occur.

(5)   economic difficulties in Europe and around the globe.  Like the US, the international economic stats released this week were sparse and downbeat:

[a] German investor confidence rose despite the German government’s downgrading of the country’s 2017 economic growth prospects,

[b] March UK retail sales fell more than anticipated,

[c] March Japanese trade figures deteriorated.  Since China is one of their major trading partners, that seems to argue against all the cheery economic news out of that country.  I am not saying that it is impossible for China’s economy to be improving at the same time that Japan’s trade numbers are worsening.  I am saying that the Chinese lie a lot and this bit of anecdotal evidence supports that thesis.   

As expected, OPEC could barely agree to disagree, though the ‘potential production freeze’ propaganda machine just keeps on truckin’.  Meanwhile, demand keeps falling making a production freeze largely irrelevant.  

In short, the data we got was not encouraging. 
Bottom line:  the US data in aggregate continues to point toward a recession.  The global economy did nothing to brighten the outlook. OPEC is doing everything possible to confuse and confound the Markets and the central banks refuse to face the fact that their policies have not worked and, indeed, are adding to the risks in the global financial system.

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 applications rose but purchase application were down; the April National Homebuilders index was below forecast, March new home sales were terrible while existing home sales were better than expected,

(2)                                  consumer: month to date retail chain store sales were much weaker than the prior week; weekly jobless claims were better than projected,

(3)                                  industry: the April Philadelphia Fed manufacturing index was a disaster; the March Chicago Fed National Activity index was below consensus as was the April PMI manufacturing index,

(4)                                  macroeconomic: the March leading economic indicators were below forecast.

  The Market-Disciplined Investing

The indices (DJIA 18003, S&P 2091) rose modestly on the week as the upward progress got a little tougher. Volume on Friday increased but off of a very mediocre level on the week.  Breadth was been good but not great.  The VIX appears to have found a bottom.

The Dow closed [a] above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term uptrend {17529-18484}, [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 uptrend {2080-2102}, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {800-2161}. 

The long Treasury ran into some congestion this week, voiding a very short term uptrend.  The bad news is that if it continues to fall, it could be signaling either higher inflation or a tighter Fed (say, what?).  The good news it held above a key Fibonacci level and remained within its short term uptrend as well as above its 100 day moving average.   

GLD is still struggling to consolidate recent gains.  Failure to do so could also suggest higher interest rates.

Bottom line:  the indices plodded forward this week, though I have warned that they were in heavily congested territory and not to expect sustained upward momentum.  However, my assumption remains that they challenge their all-time highs but fail to push above them.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18003) finished this week about 44.8% above Fair Value (12432) while the S&P (2091) closed 35.9% overvalued (1538).  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 numbers were negative this week.  Further, the temporary bright spot in recent data---manufacturing stats---proved to be just that, temporary.  In addition, the international economic releases remain quite discouraging.

As I noted above, the OPEC production freeze meeting was a flop.  But that didn’t stop oil prices from continuing to advance.  This could be an indication that real supply/demand is coming into balance, though the stats currently don’t support that notion.  If the fundamentals in energy are improving, then that would (1) at least begin to remove a negative [oil company bankruptcies] hanging over the banks and (2) serve as a positive for stock prices---if the current correlation between oil and equity prices continues to hold. 

In sum, our forecast of recession appears to be unfolding. That would render most Street forecasts for the economy, corporate earnings and stock valuations too high. 

Thankfully the Fed was nowhere to be seen this week; but other central banks were busy little beavers as both the Bank of Sweden and the ECB increased QE.  Unfortunately, these efforts continue to produce zero positive economic results.  Equally unfortunate, they have generated negative results (just ask those aforementioned pensioners) which the bankers, in their infinite wisdom, have chosen to ignore.

As you know, earnings season is upon us; and results to date have been pretty much as expected---which means down.  Investors are finding salvation in the rationale that the profits are at or near their bottom and that by year end they will again be in an upswing.  Far be it from me to argue with the Street sages (but, of course, I will), however, I have tried to document their continually over optimistic forecasts (note: they get paid to create reasons for you to buy stocks) versus what actually was reported.  In short, this could be a positive but not one on which to place a big bet.

I continue to 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.  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 caused by 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 4/30/16                                  12432            1538
Close this week                                               18003            2091

Over Valuation vs. 4/30 Close
              5% overvalued                                13053                1614
            10% overvalued                                13675               1691 
            15% overvalued                                14296               1768
            20% overvalued                                14918                1845   
            25% overvalued                                  15540              1922   
            30% overvalued                                  16161              1999
            35% overvalued                                  16783              2076
            40% overvalued                                  17404              2153
            45% overvalued                                  18026              2230

Under Valuation vs. 4/30 Close
            5% undervalued                             11810                    1458
10%undervalued                            11188                   1384   
15%undervalued                            105678                 1307

* 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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