Saturday, October 22, 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 Trading Range                      17092-18693
Intermediate Term Uptrend                     11503-24348
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 Trading Range                          1995-2103
                                    Intermediate Term Uptrend                         1966-2568
                                    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.   This week was a modestly positive one for the data:  above estimates: September building permits, weekly mortgage and purchase applications, September existing home sales; month to date retail chain store sales, the Philly Fed manufacturing index and the latest Fed Beige Book; below estimates: September housing starts, weekly jobless claims, September industrial production and the October NY Fed manufacturing index; in line with estimates: the October housing index, September leading economic indicators and September CPI.

However, the primary indicators were mixed: September building permits (+), September existing home sales (+), September industrial production (-) and September housing starts (-) and September leading economic indicators (0).  Overall, I score the week as marginally positive: in the last 55 weeks, seventeen were positive, thirty-five negative and three neutral. 

Overseas, the data was also mixed and some of it of questionable value.  Still it is better than being all negative.  But the weight of evidence continues to point to a struggling global economy.

Other factors figuring into the global outlook:

(1)    the hope remains for an OPEC production cut, ‘….it would clearly be a positive if (1) it is actually enacted…., (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.’

(2)    the solvency of Deutschebank.  On that front, we had both bad and good news this week:  Merkel reiterated that the government would not come to the bank’s rescue; but several sovereign wealth funds are rumored to be interested in making an investment.  That may help Deutschebank (‘may’ being the operative word) but it doesn’t solve the problem of a global banking system that is too leveraged and carrying too many nonperforming loans on its collective balance sheet.

Finally, we knew that the central banks couldn’t hold their tongues for more than a week.  The BOJ and ECB both backed off recent hawkish statements, while our own beloved Fed sent out contradictory indicators: nine Fed regional bank heads said they wanted higher rates, while Yellen suggested that the Fed may be preparing to move the inflation goal posts (higher) which would indicate a willingness to not raise rates even if inflation reaches or exceeds the current 2% objective.

In summary, this week’s US economic stats were barely positive while the international data was mixed---providing little new directional insight.  The central banks remained on theme, which is to say, giving multidirectional statements leaving us all confused about future policy moves. This was enough to keep the ‘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.

                        Updated third quarter GDP forecasts (short):

       The negatives:

(1)   a vulnerable global banking system.  Deutschebank remains the focal point of this concern as Merkel reiterated that the government would not bail out the bank in case of insolvency. 

In addition, it was reported that [a] Deutschebank’s CEO has been unable to date to negotiate a settlement with the DOJ over its $14 billion fine, [b] the bank said that it was reducing the size of its derivatives portfolio and [c] it was revealed that the ECB allowed the bank to cheat on its latest stress test---a clear sign that the regulators are worried, [d] Qatar is rumored to be making an investment in the bank.

Clearly this is a very fluid situation; so any conclusion, at the moment, 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, [b] whether a much reduced settlement with the US DOJ is in the making and [c] if the bank will receive outside financing. 

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; though the bank itself is doing what it can to reduce it [c] the ECB is worried enough to give the bank a pass on its stress test [d] but none of which have as yet put the bank’s solvency in question.

One other item: on Friday, data was released showing a decline in US oil company defaults.  That clearly is a plus for the banks; but not for the Saudi’s whose primary purpose in pushing oil prices lower was to destroy the US fracking industry.

On the other hand, the overall risk of defaults is growing (medium):

(2)   fiscal/regulatory policy.  What fiscal policy?  The annual deficit is soaring, the national debt is growing, both major party presidential candidates promise more spending---one promising higher taxes, one lower taxes.  Yeah, that ought to work. 

After Wednesday’s night debate in which Trump made one of the stupidest, ill-advised political statements of all time, I am now praying that the dems won’t sweep congress, giving them a free hand to raise spending, raise taxes, increase regulations.  Please recognize that this is not a political/social statement, but an economic one.  Whatever one thinks of the social value of such an agenda, the economic consequences are likely to only exacerbate current economic problems.

Cooking the books (short 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.  

This week, the central banks were back at it again, which is to say, vacillating between threatening to end QE/ZIRP and whining that the economy wasn’t strong enough to do so. 

(1)   BOJ moved out the date for when it will achieve its 2% inflation goal.  It also stated that while it was not going to lower rates at present, it was still prepared to initiate more QE,

(2)   both Yellen and Draghi suggested that they might join the BOJ in its yield curve ‘steepening’ policy---a chickens**t way of holding on to QE but appearing to be doing something. 

(3)   the ECB then left rates unchanged at its latest meeting but declined to discuss tapering, scheduled to begin in 2017---suggesting that it is not abandoning QE anytime soon.

As more EU corporate bonds get downgraded, ECB problems grow (medium):

(4)   meanwhile, nine of the twelve Fed regional bank heads called for higher rates.  Apparently they haven’t been watching the flow of economic data. Or are they starting to worry about inflation?

(5)   speaking of which, worries about inflation and money supply growth are starting to creep into the narrative. 

[a] concern is mounting that inflation is about to accelerate---which is likely the reason behind Yellen’s comments that it might be wise to let the economy ‘run hotter’ than might otherwise be appropriate.  Her intent apparently being to find an excuse not to raise rates even though the Fed’s inflation objective may be reached or exceeded.  The difference here is that the Market’s won’t give a s**t about the Fed’s policy mumbo jumbo.  If the fear suddenly becomes inflation, rates will rise with or without Fed.  So far, it is not clear at all that is occurring; but attention is necessary.

[b] shrinking money supply.  It is difficult to know how relevant this is; after all, how important is removing $1 billion in high powered money when you have added $4 trillion.   Nonetheless, there was a time when this signaled monetary tightening, usually based on rising inflation fears and usually resulting in an economic slowdown.

I am not sure how the mix of (potentially) raising interest rates, shrinking the money supply, a lousy economy and increasing inflation all figure into the Fed’s QE [or not] plans.  More importantly, I don’t think that it does either.  So if this is all very confusing, don’t despair. It is only natural that investors/Markets would be uncertain since the central bankers don’t have a clue. 

My bottom line here is that while I would welcome a rate hike as a step toward monetary policy normalization, if it happens, it [a] will likely be similar to last December’s hike---small, insignificant and solitary, [b] have little impact on the economy, since all those rate cuts had little effect, [c] will be potentially disruptive to the Markets, since all those rate cuts served as rocket fuel to security prices.

            Economists are blind to how little they know (medium):

(4)   geopolitical risks: Syria just keeps getting worse.  The US and Russia are now standing toe to toe in a d**k measuring contest which I believe is a lose, lose for the US---if Obama blinks, which is His modus operandi, US is gets another humiliation and if He doesn’t, Putin ups the ante moving us closer to a shooting war.

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

[a] the August German trade numbers were better than consensus; September UK inflation was above forecasts while unemployment was in line,

[b] September Chinese services and composite PMI’s fell slightly; third quarter Chinese GDP growth was line, industrial production was less than expected and retail sales in line; growth was driven by increased government spending, record bank lending and a red hot property market.

In short, a mixed week

Investors remain hopeful that the tentative OPEC decision to cut oil production will pan out.  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.
And speaking of cheating, Nigeria dropped the price of its crude a dollar a              barrel (medium):

            Bottom line:  the US economy continues 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: September housing starts were well below estimates while building permits were better than projections; September existing home sales were better than anticipated; weekly mortgage and purchase applications were up; the October housing index was in line,

(2)                                  consumer: month to date retail chain store sales growth was up versus the prior week; weekly jobless claims were more than consensus,

(3)                                  industry: September industrial production and capacity utilization were up less than expected; the October NY Fed manufacturing index was a big disappointment, while the Philly Fed index improved,

(4)                                  macroeconomic: September CPI was in line; the September leading economic indicators were also in line; the latest Fed Beige Book continued to paint a rosy picture of the economy.

The Market-Disciplined Investing

The indices (DJIA 18148, S&P 2141) traded in a very tight range this week.  Volume picked up on Friday; but not nearly as much as I would have expected on an options expiration day.  Breadth was weak.  The VIX fell 2 1/2%, 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 but is approaching the lower boundary.  If it cannot successfully challenge that lower boundary, it could be a tell that stocks have seen their highs. 

The Dow ended [a]  below its 100 day moving average, now resistance, [b] above its 200 day moving average, now support, [c] within a short term trading range {17092-18693}, [c] in an intermediate term uptrend {11503-24348} and [d] in a long term uptrend {5541-19431}.

The S&P finished [a] below its 100 day moving average, now resistance, [b] above its 200 day moving average, now support, [c] within a short term trading range {1995-2193}, [d] in an intermediate uptrend {1966-2568} and [e] in a long term uptrend {862-2400}. 

The long Treasury has been struggling in a narrow trading range the last couple of weeks.  It has broken below its 100 day moving average and is developing a very short term downtrend.  However, it seems to have found support at a key Fibonacci level and, more importantly, remains in short, intermediate and long term uptrends.  I would characterize this chart as sound long term but in the midst of a big hiccup.

GLD is the worse chart of the lot, with gold finishing below its 100 day moving average, in the middle of challenging its 200 day moving average to the downside and and within a short term downtrend.  However, like TLT and the S&P it has been in a very narrow trading range over the last two weeks, holding above a key Fibonacci level. 

Bottom line: at the risk of sounding like a broken record, the Averages appear to be at an inflection point---trading in a very tight range as investors stew over a number of fundamental issues that currently lack clarity.  I have no insight as to which way prices will break; but I think that stocks are at a point where the technical indicators will tell us how the aforementioned fundamental issues are getting resolved in investors’ minds.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18148) finished this week about 43.5% above Fair Value (12644) while the S&P (2141) closed 37.0% 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 only marginally so.  The global stats were equally inconclusive.  Still I give the week’s numbers a plus rating though I don’t believe they helped the odds of no recession.

The potential OPEC production cut and the solvency issues surrounding Deutschebank remain in the background as factors that could impact economic growth stability.  There was little new news on either this week; but they have not gone away.

Finally, while this earnings season started out negatively, it has since improved considerably.  Still it is early in the process, so no sweeping conclusions can be made yet.  That said, even if the outcome is more positive than expected, the rate of progress is so puny that, in my opinion, it would have little impact on valuations.

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.

It was back to business as usual for the central banks this week, that is, reverse your most recent statement but cover it up with more oblique rhetoric.  I continue to believe that the lot of them have realized what a dangerous corner into which they have backed themselves; and they have no idea how to extricate themselves.  Hence the strategy: muddy the waters and hope for a miracle.  The big fly in their ointment is if inflation starts to pick up noticeably.  If that happens, bond markets will fall even more than they have to date and the Fed will likely cease to retain its magical psychological hold over the Markets.

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

One last note, I think that the political situations both here and abroad have the potential to start impinging on economics and Markets in a meaningful way.  On the international side, a US/Russia showdown has never been a plus.  Unfortunately, the situation in the Middle East, especially as it relates to the escalation of violence in Syria, is pushing both powers toward a moment when either someone has to blink or the s**t hits the fan.  I am not sure this standoff has reached the crisis point, but clearly we are getting closer.

In the US, barring an extraordinary occurrence, a Clinton victory seems almost inevitable.  That by itself isn’t so bad as long as congress can act as a governor.  But my concern is rising of a dem sweep of congress; and solely from an economic growth standpoint, I think that would be a long term negative for the economy because it would enhance an already deleterious combination of too much taxes, too much spending and too much regulation---which sooner or later will get factored into the equity discount rate.

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---though the political situation is getting dicey.

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. 

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.

DJIA             S&P

Current 2016 Year End Fair Value*              12700             1570
Fair Value as of 10/31/16                                12644            1562
Close this week                                               18148            2141

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.

No comments:

Post a Comment