Saturday, April 30, 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                                 17692-18646
Intermediate Term Trading Range           15842-18295
Long Term Uptrend                                  5541-19413
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend  (?)                              2106-2208
                                    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 provides no upward bias to equity valuations.   The stats this week were again weighted to the negative:  above estimates: month to date retail chain store sales, weekly jobless claims, March personal income, the April Richmond Fed manufacturing index, the March trade deficit; below estimates: weekly mortgage and purchase applications, March new home sales, April consumer confidence and consumer sentiment, March personal spending, March durable goods orders, the April Chicago PMI, the April Dallas Fed manufacturing index and first quarter GDP; in line with estimates: the February Case Shiller home price index.

The primary indicators were also negative: the March personal income (+), March new home sales (-), March personal spending (-) and March durable goods (-).  In the last 34 weeks, seven have been positive to upbeat, twenty six negative and one neutral. 

On the other hand, this week’s international economic stats, especially from Europe, were largely to the plus side--- something that hasn’t happened for months.  It is, of course, far too soon to assume that this is the first sign of a turnaround in the EU economy; but it could be.  We just have to wait for more data.

The Fed maintained its ‘when confused, dazzle them with your bulls**t’ routine following the latest FOMC meeting.  On the other hand, the Bank of Japan gave the world a real shocker by doing nothing at its meeting this week.  The reasoning is not entirely clear as yet; but it appears that the US gave them a stern warning (see below).  But whatever it was, the world is a better place because its inaction.

In summary, the US economic stats were negative while the international data was surprisingly upbeat.  Meanwhile, I am hoping that the BOJ’s inertia is the first sign of the end of egregious central bank overreach.

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 is a great interview with Jim Bianco on negative rates and global banking system:

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.  A follow up to last week’s Central States pension insolvency:  I noted that it was likely not an isolated incident.  Well, it didn’t take long for the second shoe to drop.  In this case, a UK retirement plan that is converting from a defined benefit to a defined contribution plan---in other words, a cut in benefits.  The ultimate consequence: lower consumer spending. 

The shockingly high cost of federal regulations (medium):

                         The future problem of rising debt levels (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.  

The Fed policy statement this week pretty much followed the expected script which was in a word---nondescript.  More mealy mouth blather, again confirming these guys (and gal) have tied themselves in a granny knot and have no clue what to do next.

On the other hand, the Bank of Japan surprised almost everyone by doing nothing.  Initially, I hoped that it might reflect the recognition that this whole aggressive central bank intervention policy has come to naught.  But the real reason is apparently a warning from the US Treasury to cease and desist any currency devaluation policies [this in the name of unfair trade practices].  Sounds familiar to the supposed warning from the Chinese at the last G20 meeting.  The attached article makes it sound like the whole G20 had a ‘come to Jesus’ agreement to stop such practices.  I have a hard time buying that.

But it doesn’t really matter what the cause was because the effect is all that counts---and that is that China, the US or both basically told the rest of the world to either stop any policies that could be viewed as aiding competitive devaluation or risk anti-trade steps from the US/China/both.  In other words, either halt any further steps toward more QE or negative interest rates---or suffer the consequences.  That threat may not stop further devaluations but it will likely reduce them. 

If I am reading this all correctly, this is a huge move.  It stops the trend to more QE/negative interest rates [and competitive devaluation] in its tracks and shifts the onus of government efforts to stimulate its economy back to fiscal policy---where it should have been all along.  More important, it means that securities markets have lost a major psychological bulwark---the further easing in monetary policy.

These developments also assume that the US/Chinese powers-that-be likely acted on the belief that the global slowdown is behind us.  Either that or it wasn’t the Japanese who figure out that all this QE bulls**t doesn’t work, it was the US/China.  Why else would they limit their own ability to utilize levers of monetary policy?

This doesn’t mean, of course, that the global slowdown is behind us nor does it mean that the process of unwinding asset mispricing and misallocation is about to begin; it just means the process QEInfinity is over.

To be clear, much of what I have said is just me speculating about motives and results; but it is not idle speculation.  Recent developments certainly make my conclusions reasonable. However, I could be wrong about the Treasury’s assumptions, motives and possible policy consequences. For the moment, I regard the above as a thesis that needs to be proven.

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. 

The end game from JP Morgan (medium):

(4)   geopolitical risks: about the only news this week was new US boots on the ground in Syria.  The good news is that there were only a few new boots.  The bad news is that it still more than there ought to be. 

Nonetheless, the risks from a step up of 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.  The international economic stats released this week made a positive showing for the first time in a long time:

[a] the April German business climate index fell, but consumer confidence rose and unemployment declined,

[b] first quarter UK GDP growth slowed; however, Italian, French and EU first quarters were better than anticipated; first quarter EU inflation was below projections,

[c] March Chinese industrial profits were quite strong---if you believe it,

[d} Italian unemployment was below forecasts,

The relative consistency of the positive EU data is noteworthy.  As I indicated above, I don’t think that we assume that Europe has turned around and is heading out of the doldrums.  However, I don’t know how you could get a better first sign.  Clearly, this is something to which to pay close attention.  That said, if the numbers are signaling economic improvement, Draghi et al will soon be faced with the same dilemma as the Fed, to wit, the transition from easy to normalized monetary policy and with it all risks associated with tightening too fast [stymieing a nascent recovery] or too slow [inflation].
Bottom line:  a lot may be potentially changing.  To be sure, the US data in aggregate continues to point toward a recession.  However, the EU economy showed the first sign of life in months.  And the Bank of Japan inaction may indicate that peak QE and negative rates are behind us.  To be clear, neither of these possible changes to the economic landscape should be taken seriously at this point.  They are simply an alert that transformations could be afoot.  And remember, four weeks ago I thought that there was a possibility that the US economy could be turning and that came to naught.

Subject to more data, 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 fell; March new home sales were terrible; the February Case Shiller home price index was in line,

(2)                                  consumer: month to date retail chain store sales were stronger than the prior week; both the April consumer confidence and consumer sentiment were below projections; jobless claims fell less than estimates,

(3)                                  industry: March durable goods orders were well below forecasts; the April Chicago PMI was below expectations; the April Dallas Fed manufacturing index came in below consensus, while the Richmond Fed’s index was better than anticipated,

(4)                                  macroeconomic: the March US trade deficit was lower than estimates; first quarter GDP was below projections;  March personal income was higher than forecasts while personal spending was below.

  The Market-Disciplined Investing

The indices (DJIA 17773, S&P 2065) had their first rough week in last six. Volume on Friday increased.  Breadth was weak.  The VIX continues to act as if it has made 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 {17692-18646}, [c] in an intermediate term trading range {15842-18295} and [d] in a long term uptrend {5541-19413}.

The S&P finished [a] above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] below the lower boundary of its short term uptrend for the second day {2106-2208}; if it remains there through the close on Monday, it will reset to a trading range, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {830-2218}. 

The long Treasury performed a bit better this week.  But it is still in a congested range marked by a key Fibonacci level on the downside and the upper boundary of its intermediate term trading range on the upside.  As long as it remains in this area, it does not provide much informational value.

On Friday GLD (123) broke above its recent high and is a mere 1.25 points away from the upper boundary of its intermediate term trading range.  If that level is breached, 140 is the next resistance level,

Bottom line:  the bulls got their first taste of cognitive dissonance in over six weeks. If the S&P negates its short term uptrend, then this decline is apt to be more than just a pause that refreshes.  Still the Dow remains within its short term uptrend and the breadth while weakened is not flashing disaster.  I am changing nothing in my technical outlook at the moment.  But maintaining it could prove difficult next week.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17773) finished this week about 42.9% above Fair Value (12432) while the S&P (2065) closed 34.2% 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 again this week which I believe lessens the probabilities of improvement.   On the other hand, the international economic releases were surprisingly upbeat.  However, one week of plus numbers is not enough to remove this factor as a headwind to our own recovery.

Oil prices continued to advance. While the stats currently don’t support the notion that supply/demand is coming into balance, still stocks have a way of anticipating change.  So 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.  To be clear, I am not saying that energy fundamentals have improved; but like so many other changes that may potentially be occurring, this is a factor that must be watched.

In sum, our forecast of recession appears to be unfolding, though improving energy fundamentals and an EU economy could potentially be mitigating factors.  Nonetheless, most Street forecasts for the economy and corporate earnings are exceedingly optimistic; and stock valuations are priced for perfection.  Even if all these forecasts are met (1) there remains little upside in stock prices and (2) global central bankers are going to be faced with adjusting what has been a far too aggressive expansion of monetary policy and (3) markets will sooner or later be faced with the readjustment of asset pricing and misallocation.

And speaking of central banks, the Bank of Japan’s decision not to go further down the QE road may be the beginning of this process.  I am not saying that is occurring; I am saying that it could be and we need to be alert to that development.  Because, as I noted above, if central banks start reversing QE, they will be one step closer unwinding asset mispricing and misallocation; and that is not likely to be well received by the market.

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                                               17775            2065

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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