Saturday, June 11, 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 Uptrend (?)                               2077-2300
                                    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.   In a very slow data week the stats were slightly negative: above estimates: weekly mortgage and purchase applications, weekly jobless claims and wholesale inventories and sales; below estimates: month to date retail chain store sales, April consumer credit, initial June consumer sentiment and the May US budget deficit; in line with estimates: first quarter productivity.

Plus, there were no primary indicators this week, making this a very dull week indeed.

Even though the numbers on balance were downbeat, due the paucity of data, I am leaving open the question of whether or not the US economy is starting to stabilize.  At the moment, I believe the odds are low that this is occurring; but I leave it as a possibility.  The score is now: in the last 39 weeks, nine have been positive to upbeat, twenty eight negative and two neutral. 

The numbers from abroad were ever so slightly upbeat, which is clearly better than being negative.  However, the international stats have been bad enough, long enough that a mixed to modestly positive week barely warrants notice and is certainly no reason to be questioning the overall trend.

Yellen spoke on Monday and reversed the hawkish comments of other FOMC members from the prior week, pushing the probability of a June/July rate hike to very low levels.  Aside by being confusing as hell, it also lends credence to the notion that these guys have no idea what they are doing.  At the very least, it shows that their economic forecasting ability is only slightly better than my two year old granddaughter.

I raised the question last week: ‘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.’ Methinks that we are a step closer to the answer.

Supporting that thesis, this week (1) Soros slammed Fed policy and the extreme asset mispricing and misallocation that has accompanied it, (2) the Japanese opposition demanded that the BOJ’s negative interest rate policy be reversed and Japan’s largest bank withdrew as a primary dealer in government bonds and (3) Deutsche Bank hammered the ECB for it ‘whatever it takes’ monetary policy.  Is this the beginning of the end of central bank credibility?
Finally, on Friday, a British poll showed that majority of voters favor a Brexit---which has been one of the potential geopolitical problems that has languished in the background.  I say languished because all the polls until Friday indicated that the British electorate wanted to remain in the EU.  It now appears that this issue has moved above the fold; and with the vote coming very soon, it will likely stay there.  I have tried to present a balanced view of the likely consequences.  But most of the headlines have been made by the doomsayers.  However, the bottom line is that we all likely have no clue.

In summary, this week’s US data did little to allay my concern about a slowing economy.  Nor did the international data numbers.  The big issue remains is the Fed at the beginning of a growing credibility gap?

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.  Another banking scandal in the EU (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.  

Central banks continue to be the objective of all things economic and investment.  In the US, Yellen did what is apparently a 180 by mewing dovishly in a Monday speech.  After the parade of Fed chiefs parroting a hawkish line the prior week, this dramatic turnaround likely reflects the shock coming from the jobs report last Friday.  Either that or she is setting the Market up for one of the great trick f**ks in Fed history [i.e. it raises rates in June]. 

In any case, after having been joyous over the aforementioned Fed heads  advocating rising rates due to an improving economy, economists and investors alike were equally jubilant over Yellen’s suggesting that there would be no rate increase due to a softening economy.  So it would appear that no one really cares about what is occurring in the real economy; they only care about what the Fed has to say about it. 

Yellen isn’t following her own favorite indicator (medium):

So at the moment, the Fed seems bulletproof no matter how clear the indication that it hasn’t a clue what is happening in the real world.  Somewhere out there, this lack of logic will likely overwhelm the current euphoria.

Could it be happening now?  As I noted above, this week the central banks of the US, Japan and Europe were all subject to some pretty tough criticism from respected sources.  Suggesting that central bank credibility may be on the decline would be talking my book.  But pointing out the appearance of some cognitive dissonance from reliable sources is just stating the facts.  We await the consequences.

Banks rebel against negative interest rates (medium):

Ed Yardini on failed monetary policy (medium):

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: news this week was [a] the US accusing North Korea of restarting a plutonium production plant and [b] the rapidly approaching Brexit vote.  Much has been written about the possible consequences of a negative vote.  Whether or not it proves as disastrous long term as the doomsayers predict, short term, a Brexit vote likely will prove upsetting---as indicated by Friday’s sell off following the release of a poll showing a majority of those polled favoring a departure from the EU.

The costs versus the benefits of Brexit (medium):

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 a slightly upbeat week:

[a] EU first quarter GDP was a bit better than expected; April German industrial output was much better than anticipated though industrial orders were worse: April UK industrial output was above forecasts,

[b] first quarter Japanese GDP growth was revised up from the original estimate; but May machine orders declined 11%,

[c] May Chinese trade data continued to deteriorate, while retail sales were above consensus,

[d] the ECB began its corporate bond buying program; the World Bank lowered its 2016 and 2017 global economic growth expectations.

The trend in poor global data went flat this week, though that hardly shines as a hope for better things to come.  Still there was a single one upbeat week recently which raises the question, could one up and one flat week of stats be a sign of a turn.  At the moment, I think not.  Indeed, I believe the more important question is, is the global economy sufficiently weak to keep downward pressure on the US economy?
Bottom line:  the US economy remains weak though there is an outside chance that it could be stabilizing.  At this early stage, we can’t know.  In addition, there is little promise that the global economy is growing; so no help there.  Meanwhile, the Fed is back doing its best impression of Alfred Hitchcock while the central banks of Europe and Japan are starting to get some serious pushback on their total ineffective QEInfinity programs,

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 were up,

(2)                                  consumer: month to date retail chain store sales were weaker than the prior week; April consumer credit grew much less than estimates; weekly jobless claims were lower than forecast; the initial June consumer sentiment index was slightly below projections,

(3)                                  industry: wholesale inventories and sales were better than anticipated,

(4)                                  macroeconomic:  first quarter US productivity fell but was in line; unit labor costs rose more than expected; the year to date US budget deficit is up 12.5% due to increased social spending and lower corporate tax receipts.

  The Market-Disciplined Investing

The indices (DJIA 17865, S&P 2096) had a good week, if you don’t count Friday; but alas, you do.  Darn. Volume on Friday increased.  Breadth weakened.  The VIX was up 16%, finishing right on its 100 day moving average.  If it successfully challenges this resistance line, it would not be good for stocks.  On the other hand, if it bounces back down, it would indicate that the bulls are still in firm control.

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 uptrend {2082-2305};  however, Friday it was pounded back below the upper boundary of the short term trading range that reset on Thursday’s close.  So there is now a question as to the validity of that successful challenge.  Next week’s pin action will likely point to the true trend, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {830-2218}. 

The long Treasury was up again on heavy volume on Friday, closing above the upper boundary of its intermediate term trading range.  If it remains there through the close next Tuesday, the intermediate trend will reset to up.  That would indicate the bond guys believe pretty strongly that either the economy is weakening or that TLT has suddenly become a safe haven.  Either way, the implications are for some unpleasant news ahead.

GLD was up of Friday.  It has clearly been performing better of late.  It is now well above the lower boundary of its short term trading range and its 100 day moving average.  However, it is still well below the upper boundary of its short term trading range.  So the best that can be said is that GLD is solidly within a trading range.

Bottom line:  the bulls got a serious challenge on Friday as the S&P reversed itself strongly and pushed well below the upper boundary of the short term trading range which it had completed a successful challenge of on Thursday.  It is not unusual for this kind of thing to happen.  The problem is that it confuses the direction of the underlying trend.  In other words, I can’t say whether the short term trading was successfully breached and Friday was just a temporary trade below that level or the upside break itself was a head fake.  We will just have to wait further developments next week.

The TLT may be trying to give us a hint on what is going on the stock market.  It is now challenging the upper boundary of its intermediate term trading range, suggesting that either the US economy is weakening or there is trouble developing overseas or both.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17865) finished this week about 42.7% above Fair Value (12512) while the S&P (2096) closed 35.5% 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.

This week’s US and global economic numbers did little to influence our or likely anyone else’s outlook.  So I am sticking with our forecast of recession. 

What concerns me is that, (1) most Street forecasts for the moment are more optimistic regarding the economy and corporate earnings than our own but (2) even if all those forecasts prove correct, our Valuation Model clearly indicates that stocks are overvalued on even the positive economic scenario and (3) that raises questions of what happens to valuations when reality sets in.

Perhaps the biggest issue this week is recent developments that could impact central bank credibility.  In the US, the Fed ended up with egg on its face after the  disappointing jobs number and then Yellen nixing what had become the operational Street scenario, to wit, a June rate hike.  So far that hasn’t seemed to shake US investors’ confidence.  However, the subsequent events described above taking place in Japan and Europe have to have, at least some investors, asking the same questions as the largest Japanese bank, the Japanese opposition and Deutsche Bank. 

At some point, investors are going to realize that the Fed and its foreign cohorts have screwed up the transition from extremely accommodative and normalized monetary policy just like they have every other single time throughout history.  When that happens, I believe that the cash generated by following our Price Discipline will be welcome.

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 [which may be occurring now]; 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.
            Comments from Richard Fisher (medium and a must read):

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 6/30/16                                  12512            1547
Close this week                                               17865            2096

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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