Saturday, October 1, 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                                 18144-19848
Intermediate Term Uptrend                     11437-24282
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                                     2133-2369
                                    Intermediate Term Uptrend                         1949-2551
                                    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%

The economy provides no upward bias to equity valuations.   It was a  busy week for the statisticians and a positive one for the data:  above estimates: August new home sales, weekly mortgage applications, September consumer confidence and consumer sentiment, weekly jobless claims, September Markit Services flash PMI, Chicago PMI, August durable goods orders, the September Dallas and Richmond Fed manufacturing indices, second quarter GDP and the August trade deficit; below estimates: the July Case Shiller home price index, August pending home sales and August personal spending; in line with estimates: month to date retail chain store sales, August personal income.

In addition, the primary indicators were upbeat: August new home sales (+), August durable goods orders (+), second quarter GDP (+), August personal spending (-) and August personal income (0).  On the other hand on Friday, the Atlanta Fed revised its third quarter GDP growth estimate down again to 2.4%.  Nevertheless, in total, the stats were quite positive---so the score is now: in the last 54 weeks, sixteen were positive, thirty-five negative and three neutral. 

Overseas, the data was mixed and some of it of questionable value.  Still it is better than being all negative, so I have to count that as a plus.  Outside of the potential OPEC production cut, the weight of evidence continues to point to a struggling global economy.

As to that OPEC cut, it would clearly be a positive if (1) it is actually enacted [to that point, within two days of the announcement, several members began tossing monkey wrenches into the plans, raising questions on whether this proposal will ever get off the ground], (2) there is no cheating and (3) the non OPEC don’t spoil the party by jacking up production to fill the gap and (4) demand doesn’t fall due to declining global economic activity.   

Unfortunately, the solvency of Deutschebank remains center stage; and if history repeats itself, the longer it remains there and the more denials of problems there are (three this week), the more likely it is that there is something rotten in Denmark.  To be sure, a settlement with the Justice Department on the $14 billion fine would be a major plus; and rumors of such is precisely what we got on Friday.  I await the confirmation.

In summary, this week’s US economic stats were improved, while the international data was mixed.  And rejoice, rejoice, the central banks were relatively quiet this week.  This is was enough to keep a stabilizing global economy on the table as a possibility, but not enough the raise the odds of its occurrence.  The yellow warning light for change continues to flash slowly. 

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 held the headlines this week as Merkel publicly stated that the government would not bail out the bank in case of insolvency. 

That was followed by rumors that financial authorities were working on a plan to aid the bank if it failed to raise the necessary capital to pay the $14 billion US fine.  Whether this is all political rhetoric or statements of fact is a big question to which only the German political class knows the answer---and they might not even know. 

Then on Friday, the rumors circulated that the Justice Department and Deutschebank were close to a settlement of $5.4 billion.

Clearly this is a very fluid situation; so any conclusion would be highly suspect.  But to summarize, what we don’t know is [a] whether financial authorities are working to come to Deutschebank’s aid and [b] whether a much reduced settlement with the US DOJ is in the making.  

What we do know is that Deutschebank [a] has a very weak balance sheet, [b] has a giant notional position in derivatives which we have no clue about the inherent risk, [c] to that point, on Thursday, several hedge funds began withdrawing funds from their accounts at Deutschebank and on Friday, the same group began aggressively hedging its counterparty risk [d] but none of which have as yet put the bank’s solvency in question.

(2)   fiscal/regulatory policy.  What fiscal policy?  Aside from a temporary funding measure to keep the government open a couple more months, deadlock remains the theme---which, of course, is the good news; because the bad news is that these morons get to together and agree on some measure that further screws the electorate/taxpayers.

(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.  

Thankfully, the universe got something of a respite this week from more central bank malfeasance.   There was, of course, an ongoing debate in the media about the ultimate meaning of last week’s BOJ and Fed {in} actions.  But it is only natural that investors/Markets would be uncertain since the central bankers don’t have a clue---the most obvious example of which is their rhetoric [everything is awesome] versus the facts [the economic numbers are lousy]. 

But we couldn’t get through the entire week without some bit lunacy.  This week the prize goes once again to Yellen who suggested, not once but twice, that the Fed could begin buying corporate bonds and stocks if the economy turns south again---because just look at how well it has worked in Japan.

Some advice from one of my favorites---Rick Santelli (3 minute video):

My bottom line here is that I doubt any tightening measures are forthcoming in the foreseeable future.

(4)   geopolitical risks: Syria just keeps getting worse,

(5)   economic difficulties in Europe and around the globe.  This week:

[a] September EU and German business confidence were strong; German unemployment rose, EU inflation and unemployment were in line, second quarter UK economy was better than expected,

[b] August Chinese industrial profits were up 19% {remember these guys lie}, the September Markit manufacturing index was flat,

[c] September Japanese inflation declined, unemployment rose and household spending fell,

[d] the World Trade Organization lowered its estimates for 2016 global economic growth and for 2016/2017 global trade.

The big news of the week was the tentative OPEC decision to cut oil production, though no a formal agreement has been made.  While clearly a potential positive, the hard part still lies ahead, because there has been no allocation as yet as who has to absorb the cut and by how much.  Plus remember that even if an agreement is reached, OPEC members have a history of cheating and there are a lot of non-OPEC producers in the world that will more than likely jack up production to fill the gap.

Net, net, it all wasn’t bad news though I would put an asterisk on that Chinese profits number indicating doubt and remind you that the oil production cuts are not a done deal.  The WTO’s downwardly revised world trade and economic growth forecasts are important datapoints, suggesting that the trend in downbeat global stats is not about to end anytime soon.  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 remains weak with 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 applications were down while purchase applications were up; August new home sales fell less than expected, while pending home sales was very disappointing; the July Case Shiller home price index was lower than forecasts,

(2)                                  consumer: month to date retail chain store sales growth was flat with the prior week; weekly jobless claims rose less than consensus; August personal income rose but spending was flat; both September consumer confidence and consumer sentiment were above projections,

(3)                                  industry: August durable goods orders were better than anticipated; the September Markit Services Flash PMI was stronger than forecast as was the September Chicago PMI; the September Dallas and Richmond Fed’s manufacturing indices were down but less than estimates,

(4)                                  macroeconomic: the final reading for second quarter GDP was slightly better than consensus while corporate profits slid a bit less than projections; the August trade deficit was less than expected.

I want to do a sidebar here:  a commonly accepted truism of the Market is that it ‘climbs a wall of worry’---which we continue to hear from Market pundits.  The above list of risk represent those worries.  I list them generally every week to verbalize where I think our forecast could be wrong.  So in times of Market undervaluation, fair valuation or even moderate overvaluation, they are the ‘wall of worry’.  In this Market cycle, that would have been the case until early 2014 when the S&P began to ascend above the 15% overvalued level.  Once the S&P pushed past 1800, it entered grossly overvalued territory and those worries become something more---they become potential trigger mechanisms.  And that is where we are now.  I think it misguided to assume the ‘wall of worry’ aphorism carries the same degree of truth from the bottom of a Market cycle until the day before stock prices rollover. It just can’t.

The Market-Disciplined Investing

Proving once again that nothing can keep this Market down, the indices (DJIA 18308, S&P 2168) rebounded sharply Friday.  Volume picked up and breadth improved.  The VIX fell 5%, closing below its 100 day moving average and in a short term downtrend---which remains supportive of stocks.  Nonetheless, it is still in a very short term uptrend---a negative. 

The Dow ended [a]  above its 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term uptrend {18114-19848}, [c] in an intermediate term uptrend {11437-24282} 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 {2133-2369}, [d] in an intermediate uptrend {1949-2551} and [e] in a long term uptrend {862-2400}. 

The long Treasury had its worse day in a couple of weeks, likely reflecting an unwinding of the safety trade following the rumors of a DOJ/Deutschebank reduced settlement.  Still it remained above its 100 day moving average and well within very short term, intermediate term and long term uptrends. 

GLD fell again, finishing below its 100 day moving average and within a short term trading range.  It has now made a fourth lower high.  This is not a healthy chart and it is getting more unhealthy---not a plus for our GDX holding,
Bottom line: the Averages staged a sharp rebound on decent volume on Friday.  As I noted there was an upbeat rumor on Deutschebank which seemed to fuel it.  This Market continues to demonstrate tremendous resiliency.  As long as it does, look for a challenge of the indices former all-time highs (18668/2194).

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18308) finished this week about 44.7% above Fair Value (12644) while the S&P (2168) closed 38.8% overvalued (1562).  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 improved though much of the data can be characterized as being less bad rather than more positive.  Still I give it a plus rating though I don’t believe it helped the odds of no recession.

The global stats also carried a firmer tone.  However, it was largely due to the surprise announcement from OPEC of a potential oil production cut.  Unfortunately, there are a number of factors that could cause a slip between the cup and the lip; so I am not sure just how positive this development is at this time---save for the initial upbeat response from oil prices. 

This bit of possibly good news was offset by the mounting signs of problems at Deutschebank.  Aside from the numbers themselves, this situation was exacerbated by (1) denials from multiple sources that there was no problem---a sure sign that the powers that be are wee weeing in their pants and (2) multiple actions by institutional investors to reduce their exposure to the bank.  On the other hand, a reduced settlement with the DOJ would be a big help.

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.

Thankfully, the central banks were on hold this week---a part from Draghi’s disavowal of any responsibility for the Deutschebank mess and Yellen’s hinting that the Fed might want to buy stocks sometime in the future.  Which is good because every time they do or say something, their cluelessness becomes all the more apparent.

That said, investor psychology remains a slave to an accommodative Fed irrespective of how poorly the US economy is performing.  ‘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.

                I would use the current price strength to sell a portion of your winners and all of your losers.

                The latest from Lance Roberts (medium):

                For the optimists (medium):

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 10/31/16                                12644            1562
Close this week                                               18308            2168

Over Valuation vs. 10/31 Close
              5% overvalued                                13276                1640
            10% overvalued                                13908               1718 
            15% overvalued                                14540               1796
            20% overvalued                                15172                1874   
            25% overvalued                                  15805              1952
            30% overvalued                                  16432              2030
            35% overvalued                                  17069              2108
            40% overvalued                                  17701              2186
            45% overvalued                                  18333              2264
            50% overvalued                                  18966              2343

Under Valuation vs. 10/31 Close
            5% undervalued                             12011                    1483
10%undervalued                            11379                   1405   
15%undervalued                            10747                   1327

* 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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