Saturday, August 13, 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 Uptrend                                 17545-19281
Intermediate Term Uptrend                     11312-24139
Long Term Uptrend                                  5541-19431
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2058-2297
                                    Intermediate Term Uptrend                         1917-2519
                                    Long Term Uptrend                                     862-2400
                        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 again:  above estimates: weekly mortgage and purchase application, month to date retail chain store sales and June wholesale and business inventories and sales; below estimates: July retail sales, weekly jobless claims, August consumer sentiment, July PPI, second quarter nonfarm productivity and unit labor costs and the July US budget deficit; in line with estimates: July small business optimism index and July import/export prices.

The primary indicators were also disappointing: July retail sales (-) and second quarter nonfarm productivity (-). While not primary indicators, the terrible PPI (deflation?) and budget deficit numbers (how can tax receipts be down when everything is awesome?) are worrisome.  With another really poor week for stats, it is looking more like that four week stretch of upbeat numbers a while back was more of an outlier than a sign that the economy was improving.  I am not making that call yet; but clearly I feel more comfortable with our current forecast.  The score is now: in the last 47 weeks, thirteen have been positive to upbeat, thirty-one negative and three neutral. 

Overseas, the data wasn’t much better with China turning in some really lousy numbers.  And don’t forget, these guys lie a lot; so there is no telling how really bad things are. 

Meanwhile, the developing problems in the Italian, German, Portuguese and Greek banking systems remain a question mark.  The only (supposed) bright spot was the results of the latest EU banking ‘stress’ test, released a couple of weeks ago.  However, those findings were challenged by a German economic research institute report this week that indicated that Deutschebank was basically insolvent.  Plus the Bank of Italy announced that its banking system’s nonperforming loans grew an additional 1% in July.

The global central bankers joined the Fed’s campaign to confuse the Markets sufficiently to avoid having to admit QEInfinity has and will accomplish nothing. Tuesday the Bank of Japan issued a more dovish statement than its prior one.  The Bank of China also sounded dovish and then reversed itself the next day.  So far they have been successful. 

However, the cognitive dissonance on QEInfinity’s value increased this week when the Bank of England announced that it was having problems implementing its brand spanking new bond buying program because no one would sell to it.  All that said, investors continue to be mesmerized by all the central bankers’ esoteric bullsh*t.  Until that ends, belief in central bank wisdom, Santa Claus and the Easter bunny will apparently go unchallenged.

In summary, this week’s US stats were very poor as was the international data.  Central banks appear to have adopted our Fed’s policy of doing nothing, dazzling investors with their foot work and praying for a miracle exit from QE.  Meanwhile, lest we forget, we still haven’t even seen the potential fallout from Brexit and/or the mounting EU banking difficulties.  For the moment, I am not altering our outlook though the flashing warning light for change is now yellow. 

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.  Deutschebank and the Italian banking system got more bad news this week: [a] Italian bank bad loans grew another 1% in July and [b] a German economic research institute found that Deutschebank had a capital shortfall greater than its market capitalization.

In addition, Warren Buffett eliminated his entire credit default swap position.  I have harped on the, as yet unquantifiable risk, posed by the derivative positions on bank balance sheets.  Mr. Buffett’s actions seem to suggest that he too is worried about the potential hazard that they represent.

As you know, I have been giving the US banks and regulators the benefit of the doubt when it comes to their balance sheet repair efforts.  However, this week several of the major US banks have asked the Fed for an extension of the implementation of the Volcker Rule [requiring them to exit private investments].  This is on top of three extensions already granted by the Fed.  The bottom line here is that the Fed and the banks can yak all they want about improved balance sheets, but clearly if the banks haven’t solved their nonperforming loan problems in seven years, those balance sheets are not nearly a sound as we have been led to believe.  [must read]

Staying with potential US banking problems, it appears that US farmers are starting to have credit issues (medium):

Finally, under the category of ‘history repeats itself, but we never learn’, US life insurers are now in a bind due to their ownership of energy related bonds that are now nonperforming and the regulators are considering alleviating the capital requirements as they relate to those nonperforming assets (medium):

(2)   fiscal/regulatory policy.  What do you say when faced with the worse choice for a President in your life time?  ‘May the Lord bless you and keep you; may ………’  I despair with what further abuse our economy will have to endure for another four years.  Instead of worrying about a stagnating economy, declining real wages, trillions spent on an endless war [see the July budget deficit], our candidates are too busy shooting themselves in the foot to even address these issues effectively.  And that group of morons in congress, they can’t even get together on zika funding because of their inability to compromise.  My first hope is that I am dead wrong and that somehow, some way, this clown show gets serious.  If that fails, my second hope is that the government will somehow remain split and gridlock prevails until 2020.

The lies that politicians are telling us (medium):

(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.  

Two weeks ago, I wistfully contemplated a potentially less dovish stance to monetary policy by the global central bankers.  This week that notion has changed to ‘I have no idea what these guys are doing’ because [a] on Tuesday the Bank’s of China and Japan trumpeted their ongoing bond buying programs; then on Wednesday, the Bank of China walked back its dovish statement and [b] remember that I had already made a point of the Bank of Japan mimicking our Fed with its ever popular ‘on the one hand, on the other hand’ routine; well Tuesday was yet another flip flop. 

So it appears that most central banks are reaching the same conclusion as our own Fed---QEInfinity hasn’t worked, they believe that admitting it would undermine their credibility and so the only alternative is to obfuscate.  The notion of central bank infallibility was also dealt a blow this week when the Bank of England lamented that it couldn’t find enough sellers to fully implement its new bond buying policy.  [must read]

You know my bottom line: QE [except QE1] and negative interest rates have done nothing to improve any economy, anywhere, anytime; so their absence will do little harm.  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. 

The declining relevance of the Fed (medium):

The Fed’s inability to match their model with reality (medium and a must read):

Déjà vu all over again (short):

(4)   geopolitical risks: Brexit, Turkey, war in the middle east, global terrorism, Chinese aggression in the South China Sea and now Ukraine [again] are on ‘simmer’.  While each has the potential to develop into something bigger, none of them have risen to the level of crisis.  Barring some dramatic development or the appearance of a general negative narrative to which they could contribute, this risk will remain of lesser importance.

(5)   economic difficulties in Europe and around the globe.  The international economic stats, while in short supply this week, were was tilted to the negative side.

[a] June UK industrial production was up, in line; June German industrial production and first quarter GDP rose more than estimates; July UK existing home sales fell,; first quarter Italian GDP was below forecasts; the second quarter flash EU GDP was in line,

[b] July Chinese retail sales, industrial production, fixed investment, imports and exports declined much more than anticipated plus consumer and industrial inflation were below expectations.

So the trend in international stats continues to point to a weakening global economy.  Add 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 a diminishing chance that it could be stabilizing.  However, there is little aid from the global economy; and the potential consequences of the Brexit and the mounting EU banking crisis (?) could make things worse.  Meanwhile, our Fed remains confused, inconsistent and seemingly oblivious to 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: July retail sales were a disappointment; month to date retail chain store sales were better than the prior week; weekly jobless claims fell less than anticipated; August consumer sentiment was below forecasts,

(3)                                  industry: June wholesale inventories and sales were better than projected as were June business inventories and sales; the July small business optimism index was in line,

(4)                                  macroeconomic: second quarter nonfarm productivity and unit labor costs were really bad; July import and export prices were mixed; the July budget deficit soared; July PPI plunged.

The Market-Disciplined Investing

On Friday, the indices (DJIA 18576 S&P 2184) once again couldn’t generate any follow through off of Thursday’s move up.  Volume fell and breadth weakened slightly.  The VIX was down 1.25%, finishing below its 100 day moving average, within a short term downtrend but very close to the lower boundary of its intermediate term trading range (support).  Given the trouble the VIX had in taking out its short term trading range, it could have even more difficulty with the intermediate term.  That said, the reset to a short term downtrend has to be viewed as a plus for stocks. 

The Dow ended [a] above rising 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term uptrend {17545-19281}, [c] in an intermediate term uptrend {11312-24139} and [d] in a long term uptrend {5541-19431}.

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 {2058-2297}, [d] in an intermediate uptrend {1917-2519} and [e] in a long term uptrend {862-2400}. 

The long Treasury rose, ending above its 100 day moving average and well within very short term, short term, intermediate term and long term uptrends.  On Friday, it tried to break to the upside out of that pennant formation on which I have been focused but failed.  A successful challenge would mean lower interest rates, suggesting a weaker economy.

GLD fell, ending above its 100 day moving average and within short term and intermediate term uptrends.  However, this week it failed at its second try to surmount a key Fibonacci level, then negated a very short term uptrend.  That has me concerned about our GDX holding.

Bottom line: forget the economic data, forget the confusion being spread by the central banks, forget volume and breadth, forget everything.  Stocks want to go up, so they are.  That said, I still think that the pin action in the VIX and the bond, gold, oil and currency markets are indicating that something is amiss.  Be careful.
Fundamental-A Dividend Growth Investment Strategy

The DJIA (18576) finished this week about 48.0% above Fair Value (12543) while the S&P (2184) closed 40.9% 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 were quite negative---continuing the reversal of that four weeks period of improved data.  To be sure, we can’t ignore those four weeks.  So I leave open the possibility that the economy is stabilizing---though the odds of that occurring are slipping. 

Overseas, it was the same old song---more poor stats; and we haven’t yet seen any of the potential economic consequences of the Brexit or the banking problems in Germany and Italy.  ‘Muddle through’ continues to be our scenario for the global economy; but that is increasingly in question. 

What concerns me about all this is that, (1) most Street forecasts for the moment are more optimistic regarding the economy and corporate earnings [down 3% in the second quarter at the latest count] than either the numbers imply or our own outlook suggests 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.

‘That said, the Market to date has been inversely correlated to the economy because of the heavy influence of monetary policy [weak economy = easy Fed = rising stock prices].  So you would think that a recession would be good for the Market.  The obvious problem with this rationale is that by extension, if we got a depression, stock prices would soar---which defies logic, I don’t care how easy the Fed may be.  On the other hand, by implication, an improving economy would suggest a decline in stock prices especially when they are already in nosebleed territory.

So as I see it, stocks are at or near a lose/lose position.  If the economy is in fact going into recession, sooner or later the deterioration in corporate income, dividends and balance sheets will overwhelm the present positive psychological predisposition toward an irresponsibly easy monetary policy.  If the economy does improve, then sooner or later the fixed income market will force the Fed to tighten and the QE magic will be gone.  Or it may be that some exogenous event hits investors between the eyes and they suddenly recognize Fed policy for the sham that it is.’

 In any case, at the moment, investor psychology seems inextricably tied to its confidence in the Fed/global central banks remaining accommodative.  On that score, the central banks are exhibiting some troublesome behavior.  The Banks of both China and Japan have sent conflicting messages over the last two weeks---a strategy that our own Fed has perfected.  In the short run, that may help investors rationalize a goldilocks scenario but over the long term, waffling has never proven an effective policy tool.  Also clouding the monetary ‘confidence’ policy picture is the UK fixed income Market’s muted reception to the new Bank of England bond buying program. 

I have no idea how long this central bank shadow boxing around any firm policy moves can last.  Clearly, it has worked magnificently to date.  But sometime either unwinding QEInfinity or QEInfinity’ lack of success will become a Market issue.  Stocks may be 1%, 5%, 10% higher when that happens; but it seems very likely to occur.  From my point of view, I am already getting nosebleed from the lofty valuation levels; so making the ‘how much higher can the Market go’ bet, seems a foolish undertaking.

As you know, I believe that sooner or later, the price will be paid for flagrant mispricing and misallocation of assets.

‘There is no alternative’ is BS (medium):

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 8/31/16                                  12574            1554
Close this week                                               18576            2184

Over Valuation vs. 8/31 Close
              5% overvalued                                13202                1631
            10% overvalued                                13831               1709 
            15% overvalued                                14460               1787
            20% overvalued                                15088                1864   
            25% overvalued                                  15717              1942
            30% overvalued                                  16346              2020
            35% overvalued                                  16974              2097
            40% overvalued                                  17603              2175
            45% overvalued                                  18232              2253
            50% overvalued                                  18856              2331

Under Valuation vs. 8/31 Close
            5% undervalued                             11945                    1476
10%undervalued                            11316                   1398   
15%undervalued                            10687                   1320

* 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 74hard way.

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