Saturday, June 25, 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.   The dataflow this week was negative: above estimates: weekly mortgage applications, month to date retail chain store sales, weekly jobless claims, the June Markit manufacturing flash PMI; below estimates: weekly purchase applications, May new and existing home sales, the May Chicago national activity index, May durable goods, June consumer sentiment, May leading economic indicators; in line with estimates: none.

In addition, the primary indicators were universally downbeat: May new home sales (-), May existing home sales (-), May durable goods (-) and May leading economic indicators (-).  Clearly, this week was solidly in the negative column. The score is now: in the last 40 weeks, nine have been positive to upbeat, twenty nine negative and two neutral.  While these numbers in aggregate point at recession, the past eight weeks stats have see sawed back and forth, raising the question as to whether the economy is attempting to stabilize at an even slower rate of growth than before.  At the moment, I believe the odds are low that this is occurring; but I leave it as a possibility. 

The numbers from abroad were almost nonexistent and, hence, of little consequence this week.  That said, the international stats have been bad enough, long enough that there is no reason to question the overall trend.

Central banks remained active.  Yellen did her semiannual Humphrey Hawkins testimony before congress, confirming the Fed’s dovish reversal.  She did one other extraordinary thing---suggest that stocks were overvalued and that perhaps Fed policy wasn’t working as it should. 

I mentioned two weeks ago that it seemed that the world was finally waking up to the fact that QE and ZIRP have done little to foster economic growth and, indeed, may have been a determent.  Whether Yellen’s half-baked mea culpa was recognition of this fact and a hint that policy changes are in the offing is anyone’s guess.  But if it is the latter and the state sponsor of the mispricing and misallocation of assets is about to alter course, the Market could be in for a rough ride.

In addition to Janet’s comments, we got more evidence that the central banks were waking up to their misdeeds as the Bank of Japan confessed that its aggressive pursuit of ‘free money’ has not worked. 

Finally, the Brexit.  I am not going to repeat the analysis in yesterday’s Morning Call except for the bottom line.  The fundamentals are not as negative as the establishment crowd suggests.  Remember, it is this group that made a mess of things in the first place.  Of course, it could scare the s**t out of the central banks and delay or eliminate the chances that they will take any corrective policy steps.  However, as I suggested above, it could the epiphany in which investors realize just how overvalued many asset types have become.

In summary, this week’s US data did little to allay my concern about a slowing economy/recession.  Nor did the international data numbers.  And the consequences of the Brexit vote, while likely not nearly as bad as portrayed by the doomsayers, will probably not help in the short run. The big question, are the central banks about to follow in the footsteps of the Brexit vote (i.e. lose credibility like the EU)?

The new normal (medium):

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.  In the first phase of the latest Fed stress test, the US banks continued to build capital strength---so US banks’ financial condition further improved.  In the very near term, they will likely be tested by Brexit fallout.  But given the reforms that have taken place, I think US banks will be okay.  That doesn’t mean that all is well in the international ‘too big to fail’ land.

(2)   fiscal/regulatory policy.  A good old fashioned college ‘sit in’ in congress.  Need I say more?

(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.  

Yellen confirmed the Fed’s 180 on future interest rate hikes by providing a long list of economic concerns not the least of which were lofty stock valuations and the risk that the Fed had delayed too long a transition to normalized monetary policy.  She was joined in her self-criticism by Bank of Japan which has been the most profligate of all the central banks. 

This comes on top of a growing chorus of disparaging comments from outside sources. Whether this marks the end of central bank credibility is still open to question.  Certainly the Markets to date have taken it all in stride. And their reaction to Brexit could make it a moot point---or simply exacerbate it.  We will likely know soon enough.

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: one word---Brexit.  As I have already noted, I believe it is a long term plus.  However, in the short term, there could be disruptions; but not enough to alter our economic forecast.  But remember, our outlook already calls for a recession---which I hypothesize is a function of lousy monetary, fiscal and regulatory policies. 

To be sure there is no short supply of Cassandra’s whining about the potential disasters coming out of Brexit---but they are all part of cadre that implemented the aforementioned lousy monetary, fiscal, regulatory policies in the first place.  So for me, their pissing and moaning counts for naught.  But if economic conditions do worsen, ten bucks says that they will point to Brexit as the convenient target to deflect their own incompetence.

Now what (short):

Greenspan on the Brexit (medium):

(5)   economic difficulties in Europe and around the globe.  There was a dearth of international economic stats this week:

[a] Japanese exports fell for the fifth month in a row,

[b] the June Japanese Markit flash PMI came in flat with May’s report.

This hardly deserves being counted.  So I will conclude with the question that I posed several weeks ago: 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.  Further, there is little promise that the global economy is growing and the Brexit won’t help short term.  Meanwhile, our Fed remains confused; its policy subject to the slightest change in the data.  Central bank credibility is a growing issue; though to date, investors don’t seem to care.

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 were up, but purchase applications were down;  May existing home sales rose less than expected; May new home sales fell less than consensus but largely due to a big downward revision in the April number,

(2)                                  consumer: month to date retail chain store sales were stronger than the prior week; weekly jobless claims declined more than estimated; June consumer sentiment declined slightly,

(3)                                  industry: May durable goods were well below forecast; the May Chicago national activity index fell versus an anticipated increase; the June Markit manufacturing flash PMI was slightly above projections,

(4)                                  macroeconomic:  May leading economic indicators declined versus consensus for an increase.

  The Market-Disciplined Investing

The indices (DJIA 17399, S&P 2037) had a volatile week, investors having completely botched the bet on Brexit. Volume on Friday increased; but much of that was related to the rebalancing of the Russell.  Breadth was terrible.  The VIX was up 49% (not a misprint), reflecting the turmoil in the Market.  That staggering one day increase notwithstanding, there is plenty of room left on the upside if the Averages start breaking support levels (see below).

The Dow closed [a] right on its rising 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] below the lower boundary of its short term trading range {17498-18726}; if it remains there through the close on Tuesday, it will reset to a downtrend, [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] right on the lower boundary of its 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 was up on heavy volume on Friday, reversing an otherwise really lousy week of trading.  While it is above its 100 day moving average and well within very short term, short term, intermediate term and long term uptrends, it is bumping up against a stiff resistance level which has already rejected TLT once.  That resistance needs to be overcome before I would get too optimistic about still lower interest rates.

GLD was strong on Friday, pushing through the upper boundaries of both its short term and intermediate term trading ranges.  If it is able to confirm those breaks next week, there is no resistance until it gets to 140 (the upper boundary of its long term downtrend).  If it does reset those two trends, I will likely add to our GDX position.

Bottom line:  as a result of Friday’s carnage, the DJIA is challenging several support levels while the S&P hovers above its comparable levels. So as bad as Friday seems, it would take more downside momentum to have any impact on the overall direction of the Market---making it too soon to be talking about even a modest correction. 

Indeed, the universe of media pundits talked all day about how contained the decline was and how few the signs of panic. That leaves open the chance of a rebound from the current level based not only on the lack of panic but also on the fact that the indices are right on support levels.  I am watching for follow through before getting too beared up.

I am paying particular attention to GLD because it busted through to major resistance levels on Friday.  Again, follow through is the key; but the clock is now ticking on a major change in trend.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17399) finished this week about 39.0% above Fair Value (12512) while the S&P (2037) closed 31.6% 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.

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.

More on valuations (must read):

In two days of congressional testimony, Yellen did her part to contribute to declining central bank credibility by (1) confirming the recent reversal in the Fed economic outlook and (2) worrying about stock valuations [to which the Fed contributed mightily] and the timing of a transition to normalized monetary policy [which is a poster child for closing the barn door after the horse is out].  To be sure, investors haven’t yet reacted to this phenomena---perhaps they either don’t believe it or just don’t care.  Whatever the reason, the key point at the moment is that the central banks apparently retain carte blanche to do anything they want, however destructive it may be in the long term.

However, Brexit could be the big challenge to equity prices.  As you well know, I have railed ad nauseum about the stock overvaluation.  Typically, corrections come from one of those ‘huh oh’ moments, often some exogenous event.  Brexit may qualify as such.  We will just have to see.

Whether it is or not, at some point, investors are going to realize that the Fed and its foreign cohorts have screwed up the transition from extremely accommodative to 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 Brexit.

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.

At the moment, we need to see if the Brexit is the catalyst that triggers the mean reversion of valuations.  I am sticking with the values as determined by our Model so it is too soon to be buying.  It is not too soon to be working on our Buy List.  Patience, that is why we have all that cash.

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 6/30/16                                  12512            1547
Close this week                                               17399            2037

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.

No comments:

Post a Comment