Saturday, June 4, 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 Trading Range                       17498-18726
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 Trading Range                          2037-2110
                                    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.   With an exceeding negative set of stats on Friday, this week ended up to the downside:  above estimates: month to date retail chain store sales, April personal spending, the March Case Shiller home price index, the May Markit PMI, the May ISM manufacturing index and the April trade deficit; below estimates: weekly mortgage and purchase applications, the May ADP private payroll report, the May nonfarm payrolls report, May consumer confidence, the May Chicago PMI, the May Markit services PMI, the May ISM services index, the May Dallas Fed manufacturing index; in line with estimates: the April personal income and the April core PCE price index, May light vehicle sales, weekly jobless claims, March/April construction spending and March/April factory orders.

The primary indicators were neutral: the March personal spending (+), March personal income (0), and March/April factory orders (0), March/April construction spending (0) and May nonfarm payrolls (-).  What was somewhat surprising to me was the volume of not only the overall ‘in line’ estimates but also the ‘in line’ primary indicators.  That goes a ways to dampen the negativity of the week.  However, the magnitude of lousy numbers was simply overwhelming. 

That said, there has been enough upbeat data of late to leave open the question as to whether or not the US economy is starting to stabilize.  I am staying with our recession forecast but with lower odds than a couple of weeks ago.  The score is now: in the last 38 weeks, nine have been positive to upbeat, twenty seven negative and two neutral. 

Not helping matters was yet another lousy week of stats from around the globe.  This set of numbers has been much more consistently bad for longer than our own.  The recent spate of better data in the US may be giving some a ray of hope that our economy could be stabilizing.  However, it is getting no assistance from the rest of the world, begging the question that I have raise several times in the recent past: to what extent can the US economy recover when the rest of the globe is slumping? 

The Fed held to its new theme: everything is awesome, so rates are going up. All seemed to be going well until that punk Friday jobs report.  Now what will it do?  I suspect that a June hike is off the table; but then I already had a low probability on that happening.  More important, the question now is, was the jobless number a fluke or will it turn out to be one of those defining moments when investors suddenly realize that the Fed has been, is and will forever be, full of s**t.  If the Fed’s credibility gets seriously challenged, then all that misallocation and mispricing of assets will likely start to unwind.  To be clear, it is far too early to make that a prediction; but if the jobs number turns out not to be aberration, economic perceptions will likely change dramatically.

 On the other hand, other central banks have been doing the opposite.  China is gradually devaluing the yuan, Japan is delaying the imposition of a second sales tax increase and the ECB stepped up its bond purchase program.  Of course, with their economic stats so dismal that is hardly surprising. 

In summary, the three week sizz that the US economic stats were on hit a brick wall this week.  Plus, the very poor nonfarm payrolls number has potential implications far beyond just making this a lousy week.  Meanwhile the international data remains moribund.  The big issue coming out of this week is---what happens to Fed policy if that jobs number is real?

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.
                        JP Morgan recession indicators move to new highs (short):

       The negatives:

(1)   a vulnerable global banking system.  A proposal to end bank alchemy (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.  I expect little to occur on this factor as the US moves into the presidential campaigning season.  On the other hand, who knows what cockamamie scheme we may be subjected to as our politicians promise the moon to buy votes.

(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.  

As I noted above, the Fed has been pushing a new script---the economy is great so it’s time to raise rates.  However, at least the economy is awesome part of that routine ran off track on Friday; so God only knows what this clown circus is thinking now.  I still believe it reasonable to assume that a June rate hike is off the table.  On the other hand, if the Market decides [and as of the close on Friday, it appears that it has] that it loves the jobs number [poor economy = low rates] and maintains its upward thrust, Yellen et al may decide to risk it.

A rate hike amidst declining inflationary expectations? (short):

The Fed is behind the curve (medium and an absolute must read):

The rest of the globe continues to battle recession/deflation.  China has been systematically devaluing the yuan while everyone else is seemingly responding to the US/Chinese threat to stop their own devaluations by focusing on other means---the Japanese delaying a sales tax hike and the ECB stepping up its bond buying program.  I think this significant because if it continues, it would stymie the drive towards a trade war.

You know my bottom line: QE [except QE1] and negative interest rates have done nothing to improve any economy, anywhere, anytime; so its absence will do little harm.  What it has 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: the news this week was just more of same dull thud of battles in Syria/Iraq where the US boots on the ground continue to die and terrorists’ attacks.

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 turned in another poor week:

[a] May EU inflation remained negative; the Markit manufacturing PMI was flat while the composite PMI was down; the UK second quarter GDP growth rate is expected to slow from its first quarter pace; and Greece continues to struggle to earn additional bail out funds,

[b] April Japanese factory output, household spending and job availability were better than expected while May Japanese manufacturing PMI declined.  In addition an official of the Bank of Japan said that the economy in 2016 would not grow at the projected rate,

[c] May Chinese manufacturing PMI was unchanged while the services PMI slowed in growth and both the Caixin manufacturing and services PMI fell below forecasts,

[d]  Swiss first quarter GDP was below expectations.

The trend in poor global data seems endless.  It did have one upbeat week recently but that has turned out to be a flash in the pan.  The issue here is, is the global economy sufficiently weak to thwart what may be a nascent US recovery.
Bottom line:  the chances that the US economy has ceased deteriorating were dealt a blow this week.  At this early stage, we can’t know; but clearly there is some hope that this could be occurring.  There is no such promise from the rest of the world’s economies.  They continue to generate negative growth comparisons.  Meanwhile, the Fed threatens to tighten while the rest of the globe fights recession/deflation.  The good news is that, at least for the moment, competitive devaluations no longer pose a risk. 

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; the March Case Shiller home price index rose more than anticipated,

(2)                                  consumer: April personal income was in line, while personal spending was better than forecast; month to date retail chain store sales were stronger than the prior week; May light vehicle sales were in line; May consumer confidence was below projections; the May ADP private payroll report was slightly below estimates; weekly jobless claims were in line; May nonfarm payrolls grew much less than expected,

(3)                                  industry: the May Chicago PMI fell below forecasts; the May Dallas Fed manufacturing index came in below consensus; the May Markit manufacturing PMI was above estimates as was the May ISM manufacturing index; the May Markit services PMI was less than anticipated and the May ISM services index was very poor; April construction spending was down but the March number was revised up, making the two months a wash; likewise April factory orders were disappointing but a March revision offset it,

(4)                                  macroeconomic: the April core PCE price indicator was in line; the April trade deficit was less than consensus.

  The Market-Disciplined Investing

The indices (DJIA 17807, S&P 2099) had a lot of intraday pin action this week but basically ended up only slightly from last Friday. Volume on Friday increased fractionally.  Breadth was weak.  The VIX finished back near the lower boundary of its short term trading range which it has rebounded off of four times.  A break below it would be a plus for stocks.

The Dow closed [a] above its rising 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term trading range {17498-18726}, [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 rising 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term trading range {2037-2110}, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {830-2218}. 

The long Treasury soared on heavy volume on Friday, reflecting the declining odds of a June rate increase.  In the process, it negated a very short term downtrend and is now nearing the upper boundary of its intermediate term trading range.  It remained within a short term uptrend and above its 100 day moving average.

On Friday GLD also spiked on volume for same reason as bonds.  It is now well above its 100 day moving average and the lower boundary of its short term trading range; both of which it had been threatening to void.

Bottom line:  the bulls held their ground all week, making a particularly strong showing on Friday following the disappointing jobs report. They continue to hold on to their euphoria, having vacillated from giddiness over the Fed raising rates because the economy was awesome to excitement over the Fed not raising rates because the economy is weaker than expected.  I am not going to even try to explain that; and technically speaking, I don’t have to.  At the moment, all that matters is that the Averages are churning slightly below the upper boundaries of the short term trading ranges.  We await a challenge of those resistance points---or not.

More on the eighth year of a presidential term (short):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17807) finished this week about 42.3% above Fair Value (12512) while the S&P (2099) closed 35.6% overvalued (1547).  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 negative this week.  But this one had a cherry on top in the form of an abysmal nonfarm payrolls report.  Remember, the most important data on which the Fed is supposedly ‘data dependent’ are employment and inflation.  So this number is likely to tighten a lot of sphincters in the Eccles Building. 

Of course, we need the proverbial follow through to be sure this report wasn’t just a fluke.  But if it is not, (1) the Fed watching will get a lot more interesting and (2) the end of asset misallocation and mispricing could be at hand.  That said, stock investors seem to remain loyal to the Fed.  As I noted above, after an initial sell off early Friday, stocks rallied into the close on the thesis that since the economy is worse than expected, there will be no rate increase in June.  That follows on the earlier strength in equities based on the thesis that the Fed was raising rates because the economy is so strong. Confused?  Join the crowd.  Someday this manic behavior will end; I just have no clue when.  But the bottom line is that the key to Market at this point is exactly how it interprets that the jobs report.

The global economy continues to deteriorate.  Indeed, the poor jobs number may answer the question that I posed above: can the US economy grow in the face of a weakening global economy?

In sum, I am sticking with our forecast of recession, though (1) the recent improvement in data and (2) the more positive pin action in oil prices give me pause.    We just need more data. 

Nonetheless, (1) most Street forecasts for the moment are exceedingly optimistic for the economy and corporate earnings, even if all these forecasts prove correct, (2) and stock valuations are priced for perfection.  

The current trend in dividend increases/cuts (medium and a must read):

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.  Near term that could be influenced by whether or not the employment data was a fluke and how the Market interprets the outcome.

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.

Update on Buffett indicator (short):

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 6/30/16                                  12512            1547
Close this week                                               17807            2099

Over Valuation vs. 6/30 Close
              5% overvalued                                13137                1624
            10% overvalued                                13763               1701 
            15% overvalued                                14388               1779
            20% overvalued                                15014                1856   
            25% overvalued                                  15640              1933   
            30% overvalued                                  16265              2004
            35% overvalued                                  16891              2088
            40% overvalued                                  17516              2165
            45% overvalued                                  18142              2243

Under Valuation vs. 6/30 Close
            5% undervalued                             11886                    1469
10%undervalued                            11260                   1392   
15%undervalued                            10635                   1314

* 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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