Saturday, August 20, 2016

The Closing Bell

The Closing Bell

8/20/16

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                                 17627-19363
Intermediate Term Uptrend                     11333-24160
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                                     2069-2308
                                    Intermediate Term Uptrend                         1920-2522
                                    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%

Economics/Politics
           
The economy provides no upward bias to equity valuations.   The dataflow this week was a wash:  above estimates: July housing starts, weekly jobless claims, July industrial production and capacity utilization and the July leading economic indicators; below estimates:  July building permits, weekly mortgage and purchase applications, month to date retail chain store sales, the August NY Fed manufacturing index; in line with estimates: the August housing index, the August Philly Fed manufacturing index, July CPI.

However, the primary indicators were quite positive: July housing starts (+), the July leading economic indicators (+) and July industrial production and capacity utilization (+).  Neutralizing those housing numbers was the worse than expected building permits.  However, even with that, the balance was still positive.  So I score this week as a plus.  Still even if we include that four week stretch of upbeat stats, this is not enough to warrant a change in our forecast; though it could be a signal that the rate of decline in economic activity has lessened.  The score is now: in the last 48 weeks, fourteen have been positive to upbeat, thirty-one negative and three neutral. 

Just to be clear about something: the economy’s rate of decline may be flattening out.  But characterizing that as ‘improvement’ is a relative statement, i.e. the economy may be improving but only in the sense that it may not be getting worse.  That is not to say that it won’t get better.  But all those opinions you hear about the economy getting better are misleading.  The economy may not be getting worse; but we can’t even say that with any certainty.  If it was doing as well as Fed participants and others say, rates would be higher.

Corporate default rates heading higher (medium):

Overseas, the data improved.  But much of it was out of the UK where the numbers reported were better than expected; but remember that following Brexit, experts were all in agreement that it would have a terrible impact on the UK economy.  Accordingly, forecasts were lowered.  So beating lowered estimates maybe nothing more than proving all the Brexit doomsayers wrong.

Meanwhile, the developing problems in the Italian, German, Portuguese and Greek banking systems remain a question mark.  

Central bank obfuscation proceeded with vigor this week as three Fed chiefs (Dudley, Bullard, Williams) gave conflicting versions of the future course of US monetary policy; and the FOMC minutes revealed a group that is, at best, in total disagreement  and, at worst, clueless.  The good news is that, as far as the economy goes, all their QEInfinity efforts [post QEI] have done little to help the US economy and in all likelihood will be shown to have had a negative impact---so if this disagreement/confusion/cluelessness keeps them from doing more QEInfinity, that is a plus.  The bad news, of course, is that Fed policy has severely distorted asset pricing and allocation for which a penalty will ultimately be paid, in my opinion.

The Fed has only made things worse (medium):

In summary, this week’s US and international economic stats were better.  The Fed continued its strategy of doing the green apple two step, hoping investors don’t notice the abject failure of their policies and praying for a miracle to extract it from the hole in which it has dug itself.  For the moment, I am not altering our outlook though the yellow warning light for change is flashing. 

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.  Following last week’s brazen request by several of the major US banks asking the Fed for an extension of the implementation of the Volcker Rule [requiring them to exit private investments], this week, no less than the Vice Chairman of the FDIC, slammed those banks’ balance sheets and accounting procedures, stating that their capital is woefully inadequate---showing us the real reason for asking for that extension.

And in yet another example of major bank criminality, JPMorgan, Citigroup and Morgan Stanley are being sued by funds in the U.S. for allegedly manipulating a key Australian interest rate benchmark to generate hundreds of millions of dollars in illicit profits. The class action claims they sought to fix the bank bill swap rate, the local equivalent of Libor, which is used to price floating-rate bonds and syndicated loans.

(2)   fiscal/regulatory policy.  While I hate to contemplate what post-election fiscal/regulatory policy might look like, I don’t have to wait to get worried.  Here are updates on two of my favorite concerns which may only get worse.

More on student loans (medium):

Obamacare death spiral (medium):

Bonus ‘extreme government lack of accountability’ fact of the day (medium and a must read):

(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 frequently opined that the Fed is clueless about how to extract itself from the QE trap it has created for itself.  Nowhere was it clearer than in this week’s release of the latest FOMC meeting minutes.  I blistered them in our Thursday Morning Call; so I don’t want to be repetitive.  But my bottom line was: ‘Its (the Fed) latest stab at monetary profundity was little more than a bunch of schizophrenic nonsequiturs which it then was foolish enough to reveal to the public.  This blizzard of bulls**t aside, I remain convinced that there will be no September rate hike. 

Joining me in deriding the irresponsible monetary policies of the central banks was a BIS report highlighting the negative consequences of artificially low rates (see Monday’s Morning Call for the link).

The Fed’s ineptitude (medium and today’s must read):
And if you are not yet sick and tired of having to listen to the nonsensical pontifications of central bankers, then you are in for a treat; because Yellen is scheduled to make a major speech next Friday. As you can imagine, I wait breathlessly.

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 Fed’s liquidity trap (medium):


(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 positive side.

[a] July UK CPI rose, June unemployment was unchanged and July retail sales were better than expected---much of the reason for this seemingly better data is likely the result of lowered forecasts due to the Brexit.

[b] second quarter Japanese GDP and corporate investment were below forecast while July trade numbers were terrible,

[c] July Chinese home prices increased more than anticipated.


The above notwithstanding, the trend to a weaker global economy is so long and so pronounced that one week’s slightly positive dataflow hardly promises better things ahead.  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 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: July housing starts were much stronger than anticipated though building permits were less; weekly mortgage and purchase applications were down; the August housing market index was in line,

(2)                                  consumer: month to date retail chain store sales were less than the prior week; weekly jobless claims fell more than estimates,

(3)                                  industry: July industrial production and capacity utilization were better than forecast; the August NY Fed manufacturing index was very poor, while the Philly Fed index was in line,


(4)                                  macroeconomic: July CPI was flat; ex food and energy it was less than expected; July leading economic indicators were much better than projected.

The Market-Disciplined Investing
         
  Technical

On Friday, the indices (DJIA 18552, S&P 2183) sold off fractionally.  Volume was up but remained low; breadth weakened slightly.  The VIX was down, 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.  

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 {17627-19363}, [c] in an intermediate term uptrend {11333-24160} 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 {2069-2308}, [d] in an intermediate uptrend {1920-2522} and [e] in a long term uptrend {862-2400}. 

The long Treasury declined, but ended above its 100 day moving average and well within very short term, short term, intermediate term and long term uptrends.  It has broken out of a pennant formation to the downside indicating lower prices (higher yields).  However, given the strong upward bias provided by the trends, it is way too soon to be thinking of a meaningful move down. 

GLD also fell, but also finished above its 100 day moving average and within short term and intermediate term uptrends.  Like TLT, the trend lines point higher.  But I am concerned about its failure at its second try to surmount a key Fibonacci level, then its negating a very short term uptrend. 

Bottom line: the charts of the Averages, TLT and GLD all point up; but all have worrying short term technical problems.  Conversely, the VIX is headed down but has its own technical hurdles to overcome for that to continue.  All these problems are, for the moment, individually minor but in aggregate, they warrant attention.  That is the reason that I have been stewing over the pin action in the VIX and the bond, gold, oil and currency markets and worrying that something is amiss.  That said, it could be a function of nothing more than the late summer doldrums.  Still be careful.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18552) finished this week about 47.9% above Fair Value (12543) while the S&P (2183) closed 40.8% 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 turned positive again.  They may be another of the erratic signs of late that the weakening in the economy is slowing down.  ‘May be’ being the operative words. I leave open the possibility that the economy is stabilizing---though I am not close to altering our forecast. 

Overseas, there was also a slight improvement in the dataflow though much of that, I suspect, is the result of the UK beating Brexit related lower expectations.  Japan, on the other hand, recorded some terrible numbers---QEInfinity quadrupled notwithstanding.  Further, 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 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.  The Fed kept that hope alive this week via its favorite route---confuse everyone so that those who want to be fooled can continue to hope for QE. 

In the short run, that may help investors rationalize a goldilocks scenario but somehow, some way, 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. 

As you know, I 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 8/31/16                                  12574            1554
Close this week                                               18552            2183

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.