Saturday, May 31, 2014

The Closing Bell

The Closing Bell

5/31/14


Statistical Summary

   Current Economic Forecast

           
            2013

Real Growth in Gross Domestic Product:                    +1.0-+2.0
                        Inflation (revised):                                                           1.5-2.5
Growth in Corporate Profits:                                            0-7%

            2014 estimates

                        Real Growth in Gross Domestic Product                   +1.5-+2.5
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                               16021-17500
Intermediate Uptrend                              16143-20500
Long Term Uptrend                                 5081-18193
                                               
                        2013    Year End Fair Value                                   11590-11610

                    2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1855-2022
                                    Intermediate Term Uptrend                        1803-2603
                                    Long Term Uptrend                                    748-1960
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          43%
            High Yield Portfolio                                     51%
            Aggressive Growth Portfolio                        46%

Economics/Politics
           
The economy is a modest positive for Your Money.   The data weighed to the negative side this week: positives---the March Case Shiller home price index, weekly jobless claims, April durable goods orders, May Chicago PMI, the May Markit flash services PMI and first quarter corporate profits; negatives---weekly mortgage and purchase applications, April pending home sales, May personal income and spending, May consumer sentiment, the Richmond and Dallas manufacturing indices and first quarter GDP; neutral---weekly retail sales and May consumer confidence.

The standout datapoints were: (1) solid April durable goods orders; that number along with a host of supporting stats portrayed an industrial sector still chugging along, (2) revised first quarter GDP---although the universe is dismissing this figure as irrelevant and (3) April personal income and spending---both of which were disappointing, both of which question the irrelevance of the aforementioned GDP data.

I recognize that questioning the strength of the economy would put me three standard deviations from consensus; but consider:

(1) unanimity among the pundits that the first quarter GDP reading was totally a function of weather.  Aren’t January and February always cold and stormy?  If so, why aren’t all first quarter GDP numbers down?

(2) April isn’t winter [re; personal income and spending],

(3) the bond market is suggesting economic weakness and the gold market is screaming economic weakness,

(4) the Japanese economy is sliding deeper into recession if it not already there,

(5) China’s real estate market is crashing; it is doing so with the implicit consent of the government, so there is likely no fiscal or monetary bailout coming,

(6) Europe is slipping into recession.  The world believes that some form of QE is coming in June, but [a] what if it is as limp wristed as prior initiatives, [b] what if it works as well as it has in the US and Japan---which is to say, not at all, [c] it does nothing to address the EU real problems which are overly indebted sovereigns and overleveraged banks.

I am not building a case for a US recession.  I am pointing out that there are stats (and not insignificant ones at that) that are suggesting one and a host of other potential problems which, if they worsened, would contribute to a recession.  The proof of the pudding is that I am not altering our forecast; however, I believe it would be the height of folly to ignore the current data.  Accordingly, I leave the outlook in tact but re-start the flashing yellow light:
  
 ‘a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet, and a business community unwilling to hire and invest because the aforementioned along with...... the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.’
           
        The pluses:

(1)   our improving energy picture.  The US is awash in cheap, clean burning natural gas.... In addition to making home heating more affordable, low cost, abundant energy serves to draw those manufacturers back to the US who are facing rising foreign labor costs and relying on energy resources that carry negative political risks.

       The negatives:

(1)   a vulnerable global banking system.  It was a slow week for bankster malfeasance.

Although our Justice Department is going after a bank---just not an American one:

 ‘My concern here.....that: [a] investors ultimately lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly a collapse of the EU financial system.’

(2)   fiscal policy.  Election season is approaching so much of the activity of our ruling class is unsurprisingly focused on self-preservation and scoring political points [abundant hearing on the VA scandal, the GOP doing its best to further fuck up our immigration policy and volumes of righteous indignation over Ukraine] versus doing anything to help the unwashed masses. 

(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. 

Over the past two weeks, the Fed has made it clear that it is totally unclear about how it will extricate itself from QEInfinity. In a series of speeches from regional Fed chiefs, every possible alternative has been advocated but no course has been defined.  This uncertainty wouldn’t be quite so bad if not for the fact that [a] Fed policy is in totally uncharted territory and [b] the Fed has never successfully transitioned from easy to tight money even when its monetary expansion had been just run of the mill.

I continue to believe that QEInfinity will not end well and that the price will be paid primarily by the Markets.
                       
(3)   a blow up in the Middle East or someplace else. Ukraine isn’t going away until Putin gets what he wants.  Since the last note, Ukraine held a presidential vote and elected a pro-western businessman.  Unfortunately, the only result has been an increase in violence. 

Given our pathetic diplomatic response to this situation, it is probably a waste of time to stew over the longer term geopolitical implications---negative though they may be.  So my concerns are shorter term: [a] impact on oil prices---the current Ukrainian gas contracts expire in June.  What will Russian do? [b] Obama misjudges Putin and takes a hard right to the groin.

(4)   finally, the sovereign and bank debt crisis in Europe and around the globe.  Despite pursuing a ‘QEInfinity on steroids’ monetary policy, the Japanese economy continues to sink of its own weight, demonstrating, in my opinion, beyond a reasonable doubt that monetary policy is the problem not the solution.  And yet, on it goes; and where it stops, nobody knows.  But the likelihood that it will be a plus for the Japanese economy or securities markets is not zero.

China’s real estate market is imploding.  This week, I linked to an interview with that country’s largest real estate developer---who wasn’t exactly upbeat. So far the government has managed to contain the fallout.  Given the size of the real estate market relative to the whole economy, the risk remains that it will not.

The EU economy is close to slipping into deflation.  Draghi has sworn that he will take all steps necessary to bail out the economy; but to date, he has been all talk and no do.  Last weekend, the EU voted in parliamentary elections and the overall result was a rejection of the status quo.  In other words, current policies aren’t working, so try something new.  As fate would have it, the ECB will meet in June and apparently that ‘something new’ is going to be QE---not fiscal or banking reform which is what is needed; but then that would disturb the fat lives of the eurocrats and banksters.  Quite unbelievably, in my opinion, the world seems to think that it will actually work---the US and Japanese failures notwithstanding. 

I am flummoxed by the economic and securities communities’ willingness to accept at face value that QE has, is and will work anywhere, anytime.  To be sure, nothing untoward has occurred yet.  But then no one except the Chinese has started the unwinding process and the last chapter has not been written the Chinese real estate implosion.  This remains a big risk to our forecast.

Bottom line:  the US economy continues to progress. However, Fed policy (or perhaps a lack thereof) remains a risk in that the unwinding of QEInfinity could result in economic, or more likely, unanticipated Market disruptions.  I am not saying that this is a foregone conclusion; I am saying that history suggests that the odds of this risk materializing is well above zero.

‘Likewise, unconventional monetary policy is causing problems around the globe: [a] Japan seems intent on seeing how close its monetary policy can come to Zimbabwe’s without destroying the economy, [b] the Chinese actually appear to be doing everything possible to wind down its expansive monetary and fiscal policies.  That will pay dividends in the long run; but short term it could cause some heartburn both at home and abroad, [c] the European ruling class is doing everything it can to impose its dream of a transnational government on a bunch of sovereigns that spend the bulk of their time trying to ‘game’ the new ideal.  It may work; but so far it hasn’t.  And if it doesn’t, there are some awfully indebted sovereigns and leveraged national banks that could take it in the snoot---none of which will be good for the EU economy or its banking system.’

Finally, military confrontation continues in Ukraine, despite some mewings from Putin undoubtedly designed to make incompetent western diplomats feel all warm and fuzzy.  While I have no idea what the final solution looks like, my best guess is that in the end, Putin will be happy.  I just hope he spares us Obama’s public humiliation and leaves the price of oil alone.

In sum, the US economy is something about which to rejoice but is it facing a number of potentially troublesome headwinds. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were both down; the March Case Shiller home price index rose; April pending home sales were below expectations,

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims were better than estimates; April personal income increased less than forecast and personal spending was down; May consumer confidence was in line, while consumer sentiment was below consensus,

(3)                                  industry: the April durable goods orders were strong; ditto the May Markit flash services PMI; ditto the May Chicago PMI; both the Richmond and Dallas Fed manufacturing indices were disappointing,


(4)                                  macroeconomic: first quarter GDP was down more than anticipated but first quarter corporate profits rose.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 16717, S&P 1923) had a great week.  Both broke above recent highs and remain above their 50 day moving averages.  The Dow fulfilled the time element of our discipline, remaining above the upper boundaries of its short and intermediate term trading ranges through Thursday/Friday thereby (1) re-setting both to uptrends: short [16021-17500]; intermediate [16143-20500] and (2) putting it back in sync with the S&P.  Their join the long term uptrend:  5081-18193.  The S&P closed within uptrends cross all timeframes: short (1855-2022), intermediate (1803-2603) and long (748-1960). 

Volume on Friday was up, largely as a function of rebalancing of the S&P; breadth was not good, except for the flow of funds indicator which has been strong of late.  The VIX fell, finishing within its short and intermediate term downtrends and below its 50 day moving average.  This measure of complacency should be a plus for stocks near term.  In the meantime, internal divergences within the Market persist.  If they can’t be reversed, they should act as a governor on upward momentum.

The long Treasury also had a good week, breaking above the upper boundary of its intermediate term downtrend and then confirming it.  That leaves it within very short term and short term uptrends and within an intermediate term trading range.  It is also above its 50 day moving average.
 
GLD’s chart is as ugly as ever.  It is within both short and intermediate term downtrends and below its 50 day moving average.

Bottom line: the Averages moved up and out of their very recent trading ranges.  Both are now in uptrends across all timeframes.  That would be very positive were it not for almost nonexistent volume and a multitude of nonconfirming technical measures.  That is not to say that those indicators won’t catch up to the indices just as the Dow did with the S&P this week.  It is simply a word of caution to not get overly aggressive if you just have to buy something and to be sure to set tight trading stops.

My assumption remains that the Averages will assault the upper boundaries of their long term uptrends but, due to the growing number of divergences, fail in that challenge.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16717) finished this week about 42.5% above Fair Value (11725) while the S&P (1923) closed 32.1% overvalued (1455).  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.

The economic data flow in general remains upbeat and supportive of our economic forecast---though I think it a bit too naïve to totally ignore that down 1% GDP number and April personal income and spending.  That said, I am not sure that any of this matters to investors since, at the moment, all news is excellent news. Unfortunately, our Valuation Model has this good news very generously priced into stocks; and that ignores a plethora of potential problems that could negatively impact the economy or the securities markets or both.  To be sure, nothing disastrous has occurred to date.  The risk is what could happen tomorrow.

The Fed is at the top of the list of those headwinds.  It has driven bank reserves to historically unprecedented levels and now appears to be grappling with how to undo its mischief.  Unfortunately, a huge part of this whole experiment (QEI admittedly stabilized our financial system) accomplished nothing.  Indeed, it may have done great harm in that it screwed the savings class, enriched the banksters and likely pulled forward demand that will eventually push the economy into recession.  I maintain my belief that the Fed will botch the return to a normal monetary policy and that the Markets will pay dearly for the Fed’s mistake.

Of course, the Fed isn’t the only central bank capable of mischief.  Japan is the paragon of fiscal and monetary irresponsibility and it is starting to pay the price.  This week’s data showed conditions exactly the opposite of what these masters of the universe intended---slowing growth and rising inflation.  A recession there would impact our own growth; and increasing inflation/interest rates would likely lead to an unwind of the yen ‘carry trade’ which could destabilize securities prices in the US market.

The EU continues struggling to get out of recession/deflation.  While the ECB has stated that it will take whatever measures necessary to avoid another downturn, that is all that it has done---all talk and no do.  Expectations are for some sort of QE to come out of the ECB June meeting.  It could happen.  Regrettably, it would do nothing to address the EU main problems. My concern here is about a disruption in our financial system resulting from either a default of one of the EU’s many heavily indebted sovereigns or the bankruptcy of one of its many overleveraged banks.

The Chinese are trying to do the right thing by wringing speculation out of its financial system.  To date it has done an admirable job preventing this problem from infecting the international markets.  I worry that it will not be so lucky/skillful going forward.

Ukraine is something of a wild card.  I have little doubt that Putin will get what he wants when all is said and done.  Aside from this spectacle being yet another foreign policy humiliation for the US, my more immediate concern is the control Putin exercises over the price of energy in Europe.  Oil/gas prices, of course, don’t have to rise; but the political/military costs for that not happening may be prove even more unbearable in the long run.

Overriding all of these considerations is the cold hard fact that stocks are considerably overvalued not just in our Model but with numerous other historical measures which I have documented at length.  This overvaluation is of such a magnitude that it almost doesn’t matter what occurs fundamentally, because there is virtually no improvement in the current scenario (improved economic growth, responsible fiscal policy, successful monetary policy transition) that gets valuations to Friday’s closing price levels. 

Bottom line: the assumptions in our Economic Model haven’t changed (though this week’s data supported by the bond market could be signaling that they are about to).  The assumptions in our Valuation Model have not changed either.  I remain confident in the Fair Values calculated---meaning that stocks are overvalued.  So our Portfolios maintain their above average cash position.  Any move to higher levels would encourage more trimming of their equity positions.

 I can’t emphasize strongly enough that I believe that the key investment strategy today is to take advantage of the current high prices to sell any stock that has been a disappointment or no longer fits your investment criteria and to trim the holding of any stock that has doubled or more in price.

Bear in mind, this is not a recommendation to run for the hills.  Our Portfolios are still 55-60% invested and their cash position is a function of individual stocks either hitting their Sell Half Prices or their underlying company failing to meet the requisite minimum financial criteria needed for inclusion in our Universe.
        
            It is a cautionary note not to chase this rally.
                               
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 5/31/14                                  11725                                                  1455
Close this week                                               16717                                                  1923

Over Valuation vs. 5/31 Close
              5% overvalued                                12311                                                    1527
            10% overvalued                                12897                                                   1600 
            15% overvalued                                13483                                                    1673
            20% overvalued                                14070                                                    1746   
            25% overvalued                                  14656                                                  1818   
            30% overvalued                                  15242                                                  1891
            35% overvalued                                  15828                                                  1964
            40% overvalued                                  16415                                                  2037
            45%overvalued                                   17001                                                  2109

Under Valuation vs. 5/31 Close
            5% undervalued                             11138                                                      1382
10%undervalued                            10552                                                       1309   
15%undervalued                             9966                                                    1236

* 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 with somewhat higher inflation. 

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 40 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 hard way.








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