Saturday, July 9, 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                      17498-18167
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                                     862-2246
                        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 the strongest in 42 weeks: above estimates: weekly mortgage and purchase applications, month to date retail chain store sales, June nonfarm payrolls, the June ADP private payroll report, weekly jobless claims, June services PMI and the June ISM services index; below estimates: the May trade deficit; in line with estimates: May factory orders and June retail chain store sales.

The primary indicators were weighed to the plus side: June nonfarm payrolls (+) and May factory orders (0).  So this was clearly a very upbeat week, the second in a row.  Plus most of the positive weeks have come in the last twelve weeks, suggesting a decline in the rate of deceleration in economic growth and perhaps even a turnaround.  That said, (1) it is too soon to make that call, (2) primarily because the pattern of the economic indicators over the past couple of years has been a lousy first quarter, a bounce back in the second quarter and then a return to mixed to negative numbers for the rest of the year. 

On the other hand, we can’t ignore the recent progress.  So I am turning on the flashing yellow light indicating that a change in trend may be occurring; but I am not altering our recession forecast---at least for the time being. The score is now: in the last 42 weeks, eleven have been positive to upbeat, twenty nine negative and two neutral. 

Unfortunately, the numbers from abroad continued to be negative.  Ironically, what improvement there was came in Europe.  Given the as yet unknown consequences of Brexit and the developing problems in the Italian, German and Greek banking systems, it hardly makes sense at this time to be getting jiggy about progress there.

The minutes from the most recent FOMC meeting were released this week.  They reflected the same confused/cowardly group of academics that we have become accustomed to---meaning the likelihood of a return to normalized monetary policy is still in the distant future.  This seems a step back from the recent hints from central bankers in general that they realized QE and ZIRP haven’t worked and policy changes were in order.

While the FOMC’s pabulum will undoubtedly make that QEInfinity crowd happy, it will do nothing to correct the 1000 pound gorilla in the room---asset pricing and allocation have been distorted beyond recognition and there is a price to be paid for it.

In summary, this week’s stats from the US were positive.  In addition, the US dataflow has been sufficiently upbeat in the last eight weeks to bring into question our recession forecast.  On the other hand, the international data continues to stink; and we haven’t even seen the potential fallout from Brexit and/or the mounting EU banking difficulties.  So for the moment, I am not altering our outlook though I did switch on the warning light. 

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.
                We are all Keynesians now (a bit long but a must read):

       The negatives:

(1)   a vulnerable global banking system.  While the US banks continue to improve their balance sheets, the same cannot be said for their EU counterparts. Concerns are now blossoming over the solvency of Deutschebank as well as the entire Italian banking system.  Either one of these could simulate a Lehman Brothers type crisis in their respective countries and increase the likelihood that the contagion could spread throughout Europe.  Remember all these EU banks are tied via counterpart risk in the derivatives markets.  I can’t tell you that this risk could be devastating to the European banking system [and perhaps beyond]; but neither can anyone else---and that’s the risk.  We do know that the notional value of these derivatives are in the trillions.  All it takes is one default and the dominoes start falling.

Contagion from the Italian banking system (medium and a must read):

More banker mischief: 

(2)   fiscal/regulatory policy.  None and there won’t be until next year---although we do know that the FBI is at the top of its game.

(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.  

I have provided enough disparaging commentary that there shouldn’t be any questions on my thoughts on the FOMC minutes released on Wednesday.  The bottom line is that I doubt there will be any rate hikes this year; and if the confusion portrayed in the aforementioned minutes persists, there may never be.

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: Brexit fall out is by far the greatest issue under this risk. I have said before that I doubted the doom and gloom consequences to the UK espoused by its opponents.  However, they may be different for the rest of the EU, especially if Brexit leads other countries voting to withdraw---and that precipitates problems in the financial system. 

That said, the suspension of redemptions in seven UK property funds is clearly not a plus for the UK or the Markets.  Remember, when the brown stuff hits the fan, investors don’t sell what they want to sell, they sell what they can sell.  And now we have the first subsector of an asset class that can’t be sold.  That is not a positive indicator of what happens next.

Not helping matters are already minor banking crises developing in Germany and Italy that are largely the result of the papering over of massive nonperforming loans in already highly leveraged balance sheets.  Nor is the fact that sovereign credit ratings are deteriorating at an increasing rate.  I have no idea how this story ends; but I know what has already happened and that is the bank stocks are getting crushed.  That is at least a hint that bankruptcy is a possibility---which would add another subsector of an asset class that can’t be sold. 

Judging by our Market’s reaction, investors clearly at this point believe that the consequences are minimal.  And they may be.  But I can’t dismiss this risk so easily.  There remains, in my opinion, some probability that Brexit and/or the growing banking crisis in Germany and Italy could catalyze the undoing of years of lousy [collective and individual] monetary, fiscal and regulatory policies. 

(5)   economic difficulties in Europe and around the globe.  There international economic stats this week were mixed to negative.

[a] the June EU Markit flash composite index was above estimates; May German factory orders were flat while industrial output declined; May German and Japanese trade surpluses declined,

[b] the June China Markit flash services PMI was better than expected,

[c] May UK industrial production fell less than forecast but retail sales were lousy.                 

Add the potential fallout from the Brexit and the mounting banking problems in Europe and little support for the US economy can be expected from abroad.

Bottom line:  the US economy remains weak though there is an outside chance that it could be stabilizing.  Further, there is little aid from the global economy 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 and purchase applications were up,

(2)                                  consumer: month to date retail chain store sales were stronger than the prior week; June retail sales were mixed; the June ADP private payroll report showed a better than anticipated increase in jobs; June nonfarm payrolls were exceptionally strong; weekly jobless claims fell versus an expected rise,

(3)                                  industry: May factory orders were in line; the June services PMI as well as the June ISM nonmanufacturing index were above estimates,

(4)                                  macroeconomic: the May trade deficit was bigger than consensus.

  The Market-Disciplined Investing

With Friday’s Titan III shot, the indices (DJIA 18146, S&P 2129) have now shaken off the Brexit surprise.  Volume on Friday rose slightly but was still low.  Breadth was strong.  The VIX (13.3) fell 10%.  It remains below its 100 day moving average and appears to be setting up to challenge the lower boundary of its short term trading range (12.7) for a sixth time.

The Dow closed [a] above rising 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term trading range {17498-18167}, [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] above the upper boundary of its short term trading range {2037-2110}; if it remains there through the close on Tuesday, it will reset to an uptrend, [d] in an intermediate term trading range {1867-2134} and [e] in a long term uptrend {862-2246}. 

The long Treasury was up on good volume on Friday.  It continues to trade above its 100 day moving average and well within very short term, short term, intermediate term and long term uptrends. 

GLD was up on Friday, ending above its 100 day moving average and within short term and intermediate term uptrends.

Bottom line:  the indices kicked in the afterburners on an ‘everything is awesome’ scenario on Friday.  Both are either challenging or near challenging multiple resistance levels.  I noted previously, this zone of heavy congestion is likely to make the upward progress an effort--- though Friday’s moonshot certainly doesn’t support that notion.  The only negative wrinkle in an otherwise bullish chart pattern is the lack of volume. 

That TLT and GLD are also both rallying is somewhat confusing to me.  The best explanation that I have is that TLT and GLD are up based on a lousy outlook for everywhere but the US; and stocks are up based on the prevailing belief that the Fed can do no wrong---no matter what is reported in the US dataflow.  I don’t need to tell you what I think of that notion.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18146) finished this week about 44.6% above Fair Value (12543) while the S&P (2129) closed 37.3% overvalued (1550).  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 economic numbers made for very good reading.  It was one of the strongest weeks in the last year and was the second upbeat week in a row---something we haven’t seen.  We got a cherry on top on Friday as the June nonfarm payroll number greatly exceeded expectations---which had investors wee weeing in their pants.  Before you do the same, read the following analysis of the number.  Both of these are from bulls.

At the moment, the issue in my mind is, is the recent improvement in the dataflow a true sign of stabilization or just a temporary rebound of a very poor first quarter?  Time will give us the answer.  But as I have said repeatedly, the health of the Market right now is less dependent on the health of the economy and more related to the gross mispricing of assets.

That said, international developments are not contributing to any improvement in our own economy, assuming that there even is one.   Global datapoints have shown economic weakening in all quarters; and the fallout from the Brexit (even though I don’t think it will be nearly as bad as many others do) plus the problems within the EU banking system could potentially lead to an EU Lehman Brothers moment---‘potentially’ being the operative word.

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.

On the other hand, the Fed is doing its dead level best to keep QEInfinity crowd in la la land.  This week’s release of the minutes of the most recent FOMC showed a Fed that it completely unwilling to make a decision on the state of the economy or to alter its grossly irresponsible monetary policy. 

As you know, I believe that this is the direction from which a Market correction will come.  To be sure, investors to date haven’t given a rat’s ass.  But I also believe that sooner or later, the price will be paid for flagrant mispricing and misallocation of assets.

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; an EU banking crisis [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.

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 7/31/16                                  12543            1550
Close this week                                               18146            2129

Over Valuation vs. 6/30 Close
              5% overvalued                                13170                1627
            10% overvalued                                13797               1705 
            15% overvalued                                14424               1782
            20% overvalued                                15051                1860   
            25% overvalued                                  15678              1937   
            30% overvalued                                  16305              2015
            35% overvalued                                  16933              2092
            40% overvalued                                  17560              2170
            45% overvalued                                  18187              2247

Under Valuation vs. 6/30 Close
            5% undervalued                             11915                    1472
10%undervalued                            11288                   1395   
15%undervalued                            10661                   1317

* 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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