Saturday, August 27, 2016

The Closing Bell

The Closing Bell

8/27/16

We are going to Italy to celebrate my wife’s sixtieth birthday.  We will be gone for three weeks---back on September 19.  As always, I will have my computer with me.  So if something big occurs, I will be in touch.  That said, stocks would have to be down 30-40% before reaching Fair Value and warranting any action.

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                                 17724-19458
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                                     2080-2316
                                    Intermediate Term Uptrend                         1923-2525
                                    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                        55%

Economics/Politics
           
The economy provides no upward bias to equity valuations.   The dataflow this week was a wash:  above estimates: July new home sales, July Chicago national activity index, July durable goods orders, weekly jobless claims, the July trade deficit; below estimates:  weekly mortgage and purchase applications, July existing home sales,  August consumer sentiment, the August Markit manufacturing index and the August Richmond Fed manufacturing index; in line with estimates: month to date retail chain store sales, the August Kansas City Fed manufacturing index, the August Markit flash services PMI,  revised second quarter GDP and corporate profits.

However, the primary indicators were slightly positive: July new home sales (+), July durable goods orders (+), July existing home sales (-) and revised second quarter GDP (0).   So I score this week as a plus by a hair.  This keeps alive the notion that the economy could be stabilizing but is not enough to warrant a change in our forecast.  The score is now: in the last 49 weeks, fifteen have been positive to upbeat, thirty-one negative and three neutral. 

Overseas, the data was also evenly divided.  That leaves the current lengthy dreadful trend in the global economy solidly to the downside.  Meanwhile, the developing problems in the Italian, German, Portuguese and Greek banking systems remain a question mark.  

Central banks didn’t alter their strategy this week.  In the US, all the recent dovish/hawkish see sawing back and forth among the FOMC members continued with Yellen’s speech on Friday as she first sounded a bit hawkish, then made a very dovish  statement.  This was followed by hawkish comments from Fischer---in short, keep everyone confused because that’s what the Fed is.  Across the pond, the ECB has begun buying private placement corporate debt issues; which is about as close to ‘helicopter money’ as you can get without actually doing it.  In other words, central bank QE continues unabated and with it, the severe distortion in asset pricing and allocation.

In summary, this week’s US economic stats were marginally better, while the international data treaded water.  The Fed continued its strategy of talking a lot, doing nothing, masking it with double talk 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. 

Business cycle risk report (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.  This article says all that needs to said for this week’s coverage of this issue:

Deutschebank sends up a warning flag (medium):

(2)   fiscal/regulatory policy.  What fiscal policy?

And:

(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.  

We started the week with a statement from Fed vice chair Fischer which had a hawkish tone.  [recall last week, two regional Fed heads gave hawkish comments, one a dovish comment and the latest FOMC minutes were indecipherable].  Everyone assumed that Janet would put a cherry on top with her Jackson Hole speech on Friday---and she did with another rendition of her ‘on the one hand, on the other hand’ waltz. 

A summary of her remarks (medium):

Markets’ reactions (short):

Then in a follow up interview, Fischer said that Janet’s comments were consistent with a September rate hike---which led to a second 180 in the Markets.

Bill Gross on Friday’s events (short):

The yield curve on Friday’s events (short):

As you know, I have no problem with a September rate hike; indeed, I thought that normalization should have begun two years ago.  That is not the problem.  The problem is that the Fed members can’t get on the same page, whether deliberately to generate a smoke screen or because they are truly confused.  They all see the same data, but their promise of open and transparent communication with the Markets ain’t workin’; and it is confusing the hell out of everybody---whatever the reason.

I will never forget what my freshman English teacher told me:  you are only as smart as you can communicate that intelligence to others.  In other words, you could be Albert Einstein; but if you can’t explain the theory of relativity, you might as well have the IQ of a sack of rocks.  By that definition, this Fed has the IQ of a sack of rocks. 

And how is this for dazzling with your footwork (short):

As I noted in Thursday’s Morning Call, the mass confusion the Fed has created, in my opinion, is ‘(U)unfortunately,…. the result of the Fed’s pursuit of an ill-conceived monetary policy, lying about the goals of that policy, failing to achieve even a modicum of success in improving the economy, driving asset prices to extreme speculative levels, neglecting to admit any of the above and creating the fantasy that they have matters under control when in fact they are clueless and powerless to correct the disaster which they have created for the economy and the Markets.’ 

The reckoning looms (medium and a must read):

And speaking of reckoning, how would you like to be a Japanese pensioner? (medium):

And if all this wasn’t enough, it now appears that the ECB, which has been desperate for any measure that would expand its QE program, is now buying private placement corporate debt.  If they were buying private placement government debt, it would be called ‘helicopter money’.   One has to wonder when central bankers will recognize the futility of their efforts and, more importantly, the damage they are doing to the financial markets?

What is especially important is that despite central bank efforts to keep interest rates low, Libor rates are rising---not the outcome that was planned.  To be fair, some experts are pointing to the change in rules regulating US money market funds which has created a lot of cross currents in the short term interest rate Markets.  Others disagree.  This is something to watch because a flattening yield curve has historically been associated with recession.

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. 

There is no recovery for central banks to create (medium and today’s must read):

(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 directionless.

[a] the August EU flash composite and services PMI were better than expected while the flash manufacturing PMI was worse; the August German flash manufacturing PMI and the German Info Institute business climate index was below estimates; the July UK sentiment index rose,

[b] the August Japanese manufacturing PMI remained in negative territory but was slightly better than forecast and July PPI was the highest in ten months,

[c] is Portugal the next shoe to drop?
  
So this week is neutral---which hardly matters in the midst of an otherwise abysmal trend. Plus, it says nothing about by the mounting banking problems in Italy and Germany.

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 inconsistent further increasing the loss of central bank credibility; 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 new home sales were substantially better than expected while July existing home sales were equally bad; weekly mortgage and purchase applications were down,

(2)                                  consumer: month to date retail chain store sales growth were flat with the prior week; weekly jobless claims were slightly better than estimates; August consumer sentiment was below projections,

(3)                                  industry: July durable goods orders were better than consensus; the July Chicago national activity index was better than forecast;  the August Markit flash manufacturing PMI was lower than anticipated while the services PMI was in line; the August Richmond Fed manufacturing index was very disappointing,


(4)                                  macroeconomic:  revised second quarter GDP was in line; the GDP price index rose more than projected; corporate profits fell; the July trade deficit was less than expected.

The Market-Disciplined Investing
         
  Technical

On Friday, the indices (DJIA 18395, S&P 2169) sold off slightly.  But that in no way portrays the intraday volatility generated by the confusion created by the Yellen/Fischer combo statements.  That volatility was present in all Markets.  If you look at the charts of TLT, GLD, VIX, UUP, they all had major intraday price swings on huge volume.  That said volume on the equity exchanges rose only slightly, while breadth weakened further. The VIX was up modestly; but intraday, it pushed above its 100 day moving average only to retreat later and has now made a fourth higher low---not a great signal 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 {17724-19458}, [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 {2080-2316}, [d] in an intermediate uptrend {1923-2525} and [e] in a long term uptrend {862-2400}. 

The long Treasury declined, ending above its 100 day moving average, well within very short term, short term, intermediate term and long term uptrends, but is near challenging the low of the recent tight trading range. 

GLD also fell, but finished above its 100 day moving average and within short term and intermediate term uptrends.  Like TLT, it is near dropping out of a recent trading range.

Bottom line: the charts of the Averages, TLT and GLD continue to point up; but all have worrying short term technical problems---which I have talked about ad nauseum for the last two weeks.  And Friday’s intraday volatility on big volume did nothing to decrease my concerns.  There are enough contradictory signals from different Markets to suggest that something is amiss. Be careful.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18395) finished this week about 46.6% above Fair Value (12543) while the S&P (2169) closed 49.9% 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 positive again; but just barely.  Certainly not on the scale of last week and hardly improve the case that the economy is stabilizing.  While I am leaving open that possibility, I am not close to altering our forecast. 

Overseas, the economic numbers were a wash.  But we received an indication that the Portuguese government is on the verge of default.  Adding that to the ongoing problems in the German, Greek and Italian banking systems, there remains little hope that the US could expect any global improvement to ease its unsteady growth (or lack thereof) pattern.  ‘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.  However, the Fed seems to have a death wish because it seems to be doing everything in its power to disabuse investors of the notion that it has clue about what it is doing policy wise.  Of course that is SOP of late; and, I believe that its genesis is the hope by the Fed that if it can blow smoke up our skirts long enough then it will somehow be miraculously rescued from the hole it has dug for itself.

Judging by Friday’s pin action, investors are still hanging on every word uttered by this group of eggheads; though at some point skepticism ought to set in.  Indeed of late, there are growing signs of just that among some economists and large investors.  I have no idea when the realization dawns on investors that the Fed policy has done little to help the economy and much to distort price discovery.  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 latest from Doug Kass (medium):

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                                               18395            2169

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.