Saturday, April 9, 2016

The Closing Bell

The Closing Bell


My granddaughter arrives this afternoon and will be staying till Thursday.  So I am not sure how much writing I will do next week.  I will be in town and in touch with the Market. 

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                          1867-2081
                                    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.   The stats this week were somewhat sparse and weighted to the negative: above estimates: weekly mortgage applications, weekly jobless claims, the March Markit services PMI and the March ISM nonmanufacturing index; below estimates: weekly purchase applications, month to date retail chain store sales, March retail chain store sales, February consumer credit, February factory orders, February wholesale inventories and sales and the February trade deficit; in line with estimates: none.

The primary indicators were mixed: the March ISM nonmanufacturing index (+) and February factory orders (-).  Bolstering the overall negative case for the week were two anecdotal datapoints: (1) the Atlanta Fed revised its first quarter GDP growth estimate down to 0.4%.  This is the fourth downgrade in as many weeks, and (2) heavy truck orders plunge 37%.  In the last 31 weeks, seven have been positive to upbeat, twenty three negative and one neutral. 

On a point that I made in last week’s Closing Bell, (i.e. that the stats out of the manufacturing sector had improved markedly over the last two weeks) the ink was hardly dry on the paper when I discovered a release from the Fed revising industrial production data downward.  That was followed on Monday by a disappointing February factory orders number.

In the aforementioned Closing Bell I noted: ‘(1) two weeks in not enough data to warrant a change in outlook, (2) remember the government revised its seasonal adjustment factors for the first quarter---which could, at least partially, explain the improvement, (3) the international economic numbers have been and remain terrible; if US industry manages to overcome this enormous headwind, then it will be impressive, indeed.  I am just not sure how probable that is, and (4) nonetheless, I am impressed with these results and have turned on the flashing yellow light to indicate that I may have jumped the gun on my recession call.’

My only revision to those comments would be that the flashing yellow light is a good deal dimmer; and, subject to future data flow, a candidate to be turned off.

Recession alert index (short):

Here is another alert (medium):

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

The other big story of the week was the release of the minutes from the latest FOMC meeting, the bottom line of which was they generally supported Yellen’s dovish approach to monetary policy.

In summary, the US economic stats were negative while the international data remains depressing.  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 slowdown that won’t stop slowing down (medium and a must read):

       The negatives:

(1)   a vulnerable global banking system.  Nothing this week----except this (short):

And this (short):

(2)   fiscal/regulatory policy.  There were two potentially significant political events this week that could (indeed one already has] impact the regulatory environment:

[a] the so called Panama Papers, a list of shell companies domiciled overseas that were seemingly used to hide money of the rich, were released.  While few Americans were implicated, it nonetheless plays to the theme of ‘the rich are getting richer’ and not paying their fair share of taxes.  Not helping matters, immediately following this disclosure there were a number of accusations {seemingly well founded} that the US was currently the world’s largest tax haven.  To be clear, I am not condoning tax avoidance.  Indeed, I agree with the notion that our financial system, as it is not constructed, does favor the rich.  What concerns me is that this is the kind of news that can be seized upon by the politicians and potentially lead to all kinds of pernicious legislation/regulations that will only make our complicated, special interest oriented tax code worse.

[b] the US Treasury markedly changed the tax laws related to tax inversion merger activity {a US company gets acquired by a foreign company headquartered in a country with a much lower corporate tax rate than the US}.  Politicians have been bellyaching about these transactions for years; and there is no doubt that many of these transactions are for tax related purposes. However {i} tax inversions are legal and {ii} the rationale for doing one is perfectly reasonable---because the US’s tax rates are high relative to other countries, making it economically uncompetitive as a domicile for many corporations. 

Nonetheless, there is a big political element to this issue which has the risk of being solved by legislation/regulations that only makes doing business in the US all the more difficult.
In addition, {i} this new regulation had a three year look back on one particularly relevant aspect of an inversion merger (in other words, the treasury changed the rules as of three years ago); as a result, Pfizer and Allegan called off their merger due to this change in regulations, {ii} the US Justice Department filed a lawsuit to stop Haliburton’s acquisition of Baker Hughes and {iii} the chairman of the house transportation and infrastructure committee has come out against the Canadian Pacific/Norfolk Southern merger.
Without commenting of the goodness or badness of increased government scrutiny of corporate M&A activity, it will nonetheless likely have an impact on the ability of corporate America to continue to manufacture margin improvements and earnings growth.



(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.  

Several tidbits this week:

[a] the minutes from the last FOMC meeting were released on Wednesday, the bottom line of which was that the committee supported Yellen’s dovish comments last week as opposed to the more hawkish messages delivered the prior week by several Fed officials.
On Friday, I linked to a note that the Fed would hold an expedited meeting on Monday to review interest rates.   I thought that might be significant. However subsequently, there was no further coverage in either the live or print media.  So apparently, no one else thinks it important.

[b] a representative of the Bank of Japan reiterated that more easing measures remain on the table as potential policy moves, including still more cuts in negative rates. 

[c] the Bank of India lowered key interest 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: while all was quiet on the western front this week, that doesn’t mean that the risks are any less from terrorists’ bombings, turmoil in the EU over immigration and assimilation policies and adventurist polices by Russia, Iran and North Korea.

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 were quite negative: German factory orders declined, most major EU countries’ March services PMI declined, the IMF was out talking about slowing global growth.  However, the March Chinese services PMI was better than expected [remember they lie].

Has the Chinese debt bubble already burst? (medium):

Meanwhile, OPEC members Kuwait and Russia kept dribbling the freeze/no freeze oil production ball, keeping the rest of world confused.  I have this image of an OPEC meeting, members with their feet up on their desks, smoking cigars, sipping scotch and laughing uncontrollably about what their next move will be to jerk the rest of the world’s chain and how to place their bets on Markets reactions.

The bottom line: the data we got was not encouraging.  And Ms. Yellen seems to agree that the global economy remains a major headwind.
Bottom line:  the US data in aggregate continues to point toward a recession.  The global economy did nothing to brighten the outlook. OPEC as well as the global central banks are doing everything possible to confuse and confound the Markets.

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,

(2)                                  consumer: month to date retail chain store sales were much weaker than the prior week, and March retail chain store sales slowed from their pace in February; February consumer credit rose driven by student and auto loans; weekly jobless claims were down more than projected,

(3)                                  industry: February factory orders declined more than forecast; the March Markit services PMI was up versus February’s reading; the March ISM services index was slightly better than estimates; February wholesale inventories and sales were down,

(4)                                  macroeconomic: the February US trade deficit was larger than expected.
  The Market-Disciplined Investing

The indices (DJIA 17576, S&P 2047) stumbled last week, failing to successfully challenge the upper boundaries of their short term trading ranges and voiding very short term uptrends.  Breadth was poor; and the VIX appears to have found a bottom, mirroring the Averages by bouncing off the lower boundary of its short term trading range and negating a very short term downtrend.  The only good news in this picture was that it was all done on anemic volume.

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 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 {1867-2081}, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {800-2161}. 

The long Treasury had a good week, ending in both very short term and short term uptrends as well as above its 100 day moving average and above a Fibonacci support level.  However, it is still facing a challenge of the upper boundary of its intermediate term trading range.

GLD also did better; but remains in a very short term downtrend.  So it has more work to do get back on the winning track.

Bottom line:  the indices did not have a particularly good week, though I warned that they were in heavily congested territory and not to expect the pace of momentum to be sustained.  While there were some troubling short term developments (inability to push out of their short term trading ranges, voiding their very short term uptrends, weak breadth), it is too soon to count the run up from February over.  So the assumption remains that they challenge their all-time highs but fail to push above them.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17576) finished this week about 41.3% above Fair Value (12432) while the S&P (2047) closed 33.0% 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 back to the negative side this week.  Further, the bright spot in last week’s data---manufacturing stats--was almost completely voided by subsequent Fed revisions in industrial releases and a lousy February factory orders report. In addition, the Atlanta Fed revised its first quarter GDP growth estimate down for the fourth time in a row.  And finally, the international economic releases remain quite discouraging.

Not helping matters, OPEC continues to yank the world’s chain with its freeze/no freeze dialectic, sending oil prices into a drug induced see sawing.  At this point, I am not sure who’s on first; but as I have noted several times, in the absence of a production cut, there is currently little evidence to support higher oil prices. If that is the case, then (1) I would expect to see more troubles in the energy sector and with the banks who serve them and (2) if oil prices continue to affect stock prices, then the Market will have yet another headwind.

In sum, even if our forecast of recession is wrong, the economy is still growing at a snail’s pace and faces a huge headwind from the rest of the world’s economies.  That would render most Street forecasts for the economy, corporate earnings and stock valuations too high. 

My favorite optimist gives a stunningly accurate description of the problems our economy faces, then makes an Alfred Hitchcock conclusion by stating that his optimism is based on investors’ pessimism---which he conveniently fails to define.  My question is, how can investors be pessimistic and stocks be at both all-time price and valuation highs?

Fed policy again made the headlines as the minutes from the last FOMC meeting were released on Wednesday.   Bottom line: after some confusion over exactly how hawkish/dovish the Fed members were, the doves prevailed.  Importantly from the Market’s standpoint, investors continued their euphoria over easy money.  My question remains, how much more return can they expect when a huge percentage of global fixed income securities are at a negative yield and stock prices are near all-time highs as corporate earnings fall? 

I have proven that I don’t have the answer.  But when investors do figure it out, 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.  I suspect the results will not be pretty. 

Also worth mentioning in the list of negatives is the growing anti-business sentiment found in not only the political rhetoric but also in a newly aggressive bureaucracy that is changing the law on the fly and a stepped up regulatory enforcement.  This group of clowns love the bully pulpit to forward their self-aggrandizing agenda to gain fame and fortune---which historically has not been good for stocks.

Last but not least, earnings season is upon us.  The universe knows that the numbers are not going to make good reading; so some of this is also certainly in stock prices.  The question is, how much?  If investors are too pessimistic, then Market reaction could be positive; and, of course, visa versa.

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                                               17576            2047

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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