Saturday, September 24, 2016

The Closing Bell

The Closing Bell

9/24/16

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                                 18033-19767
Intermediate Term Uptrend                     11420-24247
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                                     2122-2358
                                    Intermediate Term Uptrend                         1946-2548
                                    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                          55%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        55%

Economics/Politics
           
The economy provides no upward bias to equity valuations.   It was a  slow week for data, but what we got was negative:  above estimates: the September housing index and weekly jobless claims; below estimates: weekly mortgage and purchase applications, August housing starts and building permits, August existing home sales, month to date retail chain store sales, September consumer sentiment, the August Chicago national activity index, August CPI and the August leading economic indicators; in line with estimates: none.

In addition, the primary indicators were awful: August housing starts and building permits (-), August existing home sales (-) and August leading economic indicators.     The score is now: in the last 53 weeks, fifteen were positive, thirty-five negative and three neutral.  In addition, both the Atlanta and New York Fed’s released their latest update on GDP growth---and they are lower.   Sounds awfully supportive of our forecast.

Overseas, there was virtually no stats---only two datapoints: Chinese loan demand fell to all-time lows and the Markit EU Composite PMI was below estimates.

Of course, the Bank of Japan and the Fed were center stage this week.  Both basically did nothing though there were some telling nuances in their messages: the BOJ attempting to reverse some of the ill effects of its QEInfinity policy; the Fed telling us everything is awesome, but providing multiple examples of why it is not.  I would think that this would begin to raise doubts among investors that these guys have a clue.  But not so.  All seem overjoyed just to have another couple of months of easy money.

In summary, this week’s US economic stats were really poor, while the international data was nonexistent.  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.  The yellow warning light for change is flashing much slower.  

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.
                                               
                        This discussion of the high level of private debt builds on Rogoff and Reinhart’s thesis that high government debt levels inhibit economic growth.  It suggests that global economic growth will be impaired in the foreseeable future.

       The negatives:

(1)   a vulnerable global banking system.  This week featured Wells Fargo as the latest bankster which attempted to defraud the public:

The Brookings Institute asks and answers the question: are US banks really any safer today than before Dodd Frank?

In addition, German and Italian banks remained in the headlines:

Can Deutschebank avoid a state bailout?

German politicians are now starting to worry (medium):

Update on Italy’s banking crisis (medium):

The unintended consequences of higher bank capital requirements.  This is interesting (medium):

The UN fears a third leg of the financial crisis (medium):

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


(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.  

As noted above, the BOJ and FOMC met this week, did nothing but altered the tone of their messages.  I pounded them hard enough in Thursday’s Morning Call that I don’t need to add anything else to make my position clear.  But I will include my bottom line:

‘the BOJ and FOMC did roughly what I had expected; although judging by the pin action, others were clearly worried about a more hawkish tilt in policy.  QEForever remains the underlying investment theme; as such, the assumption has to be that stocks are going higher. 

That said, there is some cognitive dissonance starting to creep into this story.  (1) the BOJ all but admitted that its QE, NIRP and ZIRP haven’t produced the results that were anticipated, (2) the Fed’s ‘the economy is doing great’ narrative is not quite as solid as it has been because the Fed itself is producing forecasts that suggest that the economy is not doing so great, (3) even Fed supporters like CNBC’s Steve Leisman, are asking, ‘if the economy is so great, why aren’t you raising rates?’ and (4) the number of policy dissenters on the FOMC is growing.   

Whether this is a temporary phenomenon or a sign of things to come is anyone’s guess.  I will say that I have maintained that this drunken Market binge will likely come to an end when either some major exogenous event reveals that the central bankers are naked or the cumulative evidence of central bankers’ hubris, poor judgement and lack of courage becomes obvious to all but themselves.  The above examples could be the first sign of the latter---emphasis on ‘could be’.’

Here is a better assessment from a much smarter guy than me (today’s must read):

(4)   geopolitical risks: after an ineffective cease fire, Syria is heating up again.

Why Syria matters (medium):

(5)   economic difficulties in Europe and around the globe.  As noted above, there were only two international economic stats---Chinese loan demand and the EU Markit Composite Flash PMI---both of which were negative.

This on Chinese bad debt:
 
This on the ECB’s QE failure:

This is hardly a reason to pound a bearish drum; but it is a continuation of what has been an abysmal trend. And when coupled with the banking problems in Italy and Germany, it hardly provides a hopeful sign of support from the global economy.

Bottom line:  the US economy has gotten weaker in the last four weeks, calling into question any thought that it could be stabilizing.  Moreover, there is little aid coming from the global economy.  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: weekly mortgage and purchase applications were down; August housing starts and building permits were very disappointing as were August existing home sales; the September housing market index was very upbeat,

(2)                                  consumer: month to date retail chain store sales growth was down from the prior week; weekly jobless claims fell more than anticipated, the preliminary September consumer sentiment was below expectations,

(3)                                  industry: the August Chicago national activity index was down versus estimates that it would be up,


(4)                                  macroeconomic: August leading economic indicators were below forecast; August CPI came in higher than forecast.

The Market-Disciplined Investing
         
  Technical

On Friday, the indices (DJIA 18261, S&P 2164) sold off, ending a volatile week mostly driven by the central banks.   Volume rose but was still quite low; breadth weakened after a strong week.  The VIX was up modestly also having experienced a very unstable week; still in the end, its pin action was 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 {18033-19767}, [c] in an intermediate term uptrend {11420-24247} 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 {2122-2358}, [d] in an intermediate uptrend {1946-2548} and [e] in a long term uptrend {862-2400}. 

The long Treasury declined after an upbeat week, ending above its 100 day moving average and well within very short term, intermediate term and long term uptrends. 

GLD also had a good week, finishing above its 100 day moving average and within a short term trading range.  While it successfully challenged a short term uptrend, it recovered back above the lower boundary of that uptrend two days after the break.  Since then, it has been rising along with that lower boundary.  If it can pull away from this trend line, I will likely reinstate the uptrend.

Bottom line: the charts of the Averages remain solidly to the upside, trading above their key moving averages and within uptrends across all timeframes.  This week their advance was driven by the continuing hope for accommodative central bank monetary policy.  That investment theme will likely be in place for another couple of months, so the assumption has to be that prices are headed higher.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18261) finished this week about 44.7% above Fair Value (12616) while the S&P (2164) closed 38.8% overvalued (1559).  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 data continued a four week string of really poor numbers, diminishing the prospect that rate of decline in growth could be any slowing.  

The good news is that the dataflow from overseas, which has been awful for as long as I can remember, was at a trickle.  The bad news is that there were signs of mounting problems in the Chinese, German and Italian banking systems.  ‘Muddle through’ continues to be our scenario for the global economy; but that is increasingly looks like a bad assumption. 

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.

Of course, the main headlines this week were once again central bank related; and as usual, they were incomprehensible as ever.  The Bank of Japan left rates unchanged while it continued to talk up QE.  However, it took a big step towards admitting that its policies haven’t worked when it stated that it would begin targeting the government bond yield curve---a concession to Japanese financial institutions that are getting hammered by current policy.

Our own Fed also left rates unchanged but this time omitted its usual ‘on the one hand, on the other hand’ narrative to justify doing nothing---it just did nothing.  In addition, it said that everything was awesome, then proceeded to lower its forecast for GDP growth, suggesting everything isn’t awesome.

That said, the Markets were positively ecstatic over these non-moves.  As hard as that is for me to understand, the fact remains that investor psychology is a slave to an accommodative Fed irrespective of how poorly the US economy is performing---this week’s data, the Fed policy statement and the Market performance being a perfect example. 

When ultimately the irrational linkage ends of a weak economy = easy Fed = rising stock market breaks is anyone’s guess.  Clearly, I have been wrong on the timing; but sooner or later, the math of that equation will cease to make any sense to enough investors that it will change.  Either that or the historical framework for investment decision making completely changes.  You can decide if that is a good or bad thing.  I suggest the latter.

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.

                Use the current price strength to sell a portion of your winners and all of your losers.


DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 9/30/16                                  12616            1559
Close this week                                               18261            2164

Over Valuation vs. 9/30 Close
              5% overvalued                                13246                1636
            10% overvalued                                13877               1714 
            15% overvalued                                14504               1792
            20% overvalued                                15139                1870   
            25% overvalued                                  15770              1948
            30% overvalued                                  16400              2026
            35% overvalued                                  17031              2104
            40% overvalued                                  17662              2182
            45% overvalued                                  18293              2260
            50% overvalued                                  18924              2338

Under Valuation vs. 9/30 Close
            5% undervalued                             11985                    1481
10%undervalued                            11354                   1403   
15%undervalued                            10723                   1325



* 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.