Saturday, June 21, 2014

The Closing Bell

The Closing Bell

6/21/14

Next week is the last of my month long hiatus.  We are headed to the beach for our annual anniversary fling.  Nothing next week.  I will be watching the Markets and in communication if necessary.  See you Monday June 30.

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                               16045-17524
Intermediate Uptrend                              16271-20636
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                                     1875-2045
                                    Intermediate Term Uptrend                        1821-2621
                                    Long Term Uptrend                                    757-1974
                                                           
                        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.   Not a lot of data this week; and what we got was mixed: positives---weekly retail sales, weekly jobless claims. May industrial production, the June NY and Philadelphia Fed manufacturing indices; negatives---May housing starts, weekly mortgage and purchase applications, May CPI, June leading economic indicators and the first quarter trade deficit; neutral---none.

The standout datapoints were: (1) stats on two key sectors of the economy [May industrial production and May housing starts] were released.  One a plus, the other a negative.  Thus, keeping the ‘slow sluggish growth’ scenario alive and well, and (2) May CPI.  This put its six months rolling average over the Fed’s 2% target range.  One more high reading will put the year over year average at the same threshold. 

The latter would suggest a tightening in Fed monetary policy.  But as you know, Yellen dismissed this data as ‘noise’.  As I noted in Thursday’s Morning Call, I believe that this is a solid signal that the Yellen Fed will stay too easy, too long and will follow in the footsteps of its predecessors, botching the transition to a normalized monetary policy.  More on that later.

It also raises the risk that the economy may be about to suffer another period of stagflation.  Remember the economic narrative of the last six weeks has been whether or not the US growth rate will slow.  While I haven’t altered our forecast, the recent data leave open that possibility (risk).   Now with the pickup in inflation, we may face the risk of an economy still restrained by fiscal, regulatory and monetary mismanagement but with excess liquidity finding its way beyond the securities markets.   Bottom line---I leave the outlook in tact but the yellow light flashing:
 
 ‘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.’
           
            Weekly recession indicator (short):


        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.

Clearly, this factor becomes even more important as the turmoil in Ukraine and Iraq threaten global oil supplies.


       The negatives:

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

 ‘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.  While nothing related to directly to fiscal policy is happening, the election season has begun with a stunner---the defeat of house majority leader, Eric Cantor in the Virginia GOP primary.  I don’t want to read too much into this event.  But the least we can say is that immigration is likely to be a much bigger issue in 2014 than in previous elections. 

I will note, however, that my contention has been that the only way this country re-sets itself to a more fiscally responsible, less intrusive course was to throw out the whole ruling class or enough of it to scare the shit out of the rest.  I have no idea whether or not the Cantor defeat was a first step in that direction.  But we can hope.

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. 

The Fed gave its first clear signal this week that there is nothing new about the current regime and that it intends to pursue the same reactive policies of the past Feds, insuring that it will be a day late and a dollar short with any tightening move and thereby increasing the risk of inflation going to unhealthy levels.  The tipoff: (1) Yellen dismissing the recent rise in inflation data as ‘noise’, (2) her refusal to provide any guidelines whatsoever as to the timing of any prospective monetary tightening [‘it depends’] and (3) her unwillingness to comment on the overextended metrics of the securities’ markets.

My bottom line is that I continue to believe that the Fed hasn’t a clue how to extricate itself from its current historically overly expansive monetary policy.  That, in turn, has rendered it frozen in the headlights of oncoming inflation.  QEInfinity is not likely to end well, especially for the Markets.
                         http://www.nakedcapitalism.com/2014/06/feds-ever-burgeoning-market-manipulation-support.html  (must read)

                          The latest from Marc Faber (medium):

(3)   rising oil prices.  This risk is now front and center brought on by the turbulence in Ukraine and Iraq.  Pipelines and refineries are being destroyed as we speak; and, at least in the case of Iraq, sooner or later, the oil fields themselves may be in danger of lost production.

Given our ongoing diplomatic ineptitude, I am concerned that things will only get worse.  World energy supplies are now in danger of disruption from either a cynical economic/political move from Russia or a splintering of the Middle East or both.  Even if that doesn’t occur, oil prices may likely be driven higher and that is not going to help our rising inflation problem.

Iraq just got messier (medium):

Ukraine just got messier (medium):

(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.

China’s real estate market is imploding.  On top of that vast quantities of warehoused commodities that were used as collateral for loans have disappeared; and all signs are that this problem also exists at multiple warehouses.  Even worse it appears that these commodities could have been used as collateral for multiple loans.  I have no idea the extent to which this touches the banking systems outside China; but if it does, our banks could be in for another round of losses/failures.  Even if it is confined to the Chinese banking system, the potential losses there would likely be sufficient to threaten that country’s economic growth with at least some spillover effect on the rest of the globe.

And (must read):

The ECB recently lowered interest rates and promised that some new form of QE was in the offing.  Why it believes this will do any good when (1) the same exact policies haven’t worked in the US or Japan and (2) its sovereigns are already overly indebted and its banks over leveraged, is beyond me.  http://www.realclearmarkets.com/articles/2014/06/19/draghi_hits_savers_to_salvage_faux_recovery_101132.html

And:

I remain dumbfounded 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 even attempted the unwinding process and the last chapter has not been written on the Chinese real estate implosion. 

Bottom line:  the US economy continues to progress. However, Fed policy (or perhaps a lack thereof) remains a growing 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 are mounting.

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 trying to do something to wind down its expansive monetary and fiscal policies.  However, the commodity re-hypothecation scandal could very well get out of hand and negate any efforts by the authorities to do the right thing.  Whatever the outcome, some heartburn seems inevitable, [c] the ECB looks to me like it has the same deer in the headlights syndrome as our own Fed.  What they have done so far hasn’t worked.  Indeed, like Japan and the US, it hasn’t worked because it was the wrong thing to do---trying to save the banking class, greedy politicians and other rent seekers have only made things worse.

Finally, military/political turmoil reigns supreme in Ukraine and Iraq.  I have no idea if either or both drive up energy prices further; but I believe that the odds grow every day that they will.  And that won’t be good for economic growth.

In sum, the US economy remains a plus, though the recent growth and inflation numbers are somewhat worrisome.  Unfortunately, those are not the only potentially troublesome headwinds. 

This week’s data:

(1)                                  housing: May housing starts were well below expectations; weekly mortgage and purchase applications were both down,

(2)                                  consumer:  weekly retail sales were up; weekly jobless claims were better than estimates,

(3)                                  industry: May industrial production was above forecasts as was the  June NY and Philadelphia Fed manufacturing indices,


(4)                                  macroeconomic: May CPI was hotter than anticipated; June leading economic indicators were less than consensus; the first quarter trade deficit was above expectations.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 16947, S&P 1962) had a great week, finishing above their 50 day moving averages and remain within uptrends across all time frames: short [16045-17524, 1878-2045], intermediate [16271-20636, 1821-2621] and long term [5081-18193, 757-1924].

Volume on Friday was up, largely as a function of quadruple witching (option expiration); breadth improved.  The VIX rose, but still closed within its very short term, short term and intermediate term downtrends, below its 50 day moving average and near the lower boundary of its long term trading range.  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 had a roller coaster week.  On Friday, it bounced off its previous low and back above its 50 day moving average.  However, it remains below the lower boundary of its short term uptrend.  A close below that trend line on Monday will confirm its break.  At this point, the TLT chart is sufficiently confusing that I am uncertain about the near term direction---which means that it is also unclear whether or not the bond guys are buying the higher inflation thesis.
 
While GLD was down fractionally on Friday, it had already executed a major turnaround for the week, breaking out of its very short term and short term downtrends and above its 50 day moving average.  Unlike the TLT, it left little doubt about a change in direction.  That said, GLD can be quite volatile; so I am going to be patient in the interest of not getting suckered by a head fake. 

Bottom line: technically speaking, the Averages acted superbly this week, overcoming an already overbought condition and multiple servings of bad news.  That said, it continues to advance on lousy volume and in spite of a growing number of divergences.  Of course, all these non-confirming indicators could re-sync with the indices.  But the point is that at present they are becoming less not more in sync.  My assumption remains that the Averages will assault the upper boundaries of their long term uptrends if not the next set of ‘round numbers’ (Dow 17,000/S&P 2000). 

 Our strategy remains to do nothing save taking advantage of the current momentum to lighten up on stocks whose prices are pushed into their Sell Half Range or whose underlying company’s fundamentals have deteriorated.

A word of caution.  If you absolutely, positively just can’t help but buy something be sure to set very tight trading stops.

From the Sentiment Trader:

‘Precious metals jumped on Thursday, with gold showing its largest one-day gain in more than six months. In the past 30 years, the S&P 500 has closed at a 52-week high on a day gold spiked the most in six months 6 other times. All 6 saw stocks decline over the next three weeks, averaging -2.1%. The dates were 6/7/89, 9/14/92, 2/13/97, 11/4/10, 7/22/13 and 9/18/13.’

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16947) finished this week about 44.2% above Fair Value (11750) while the S&P (1962) closed 34.4% overvalued (1459).  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 continues to reflect a slow sluggish recovery though it is now faced with the potential of a rise in inflation.  At the moment, investors seem positively giddy about these prospects.  To be clear, I continue to stick with our economic outlook. 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 done little (save QE1) to help the economy and has made a mess of asset pricing (the securities markets).  With this week’s FOMC meeting, it appears that it will now ignore mounting inflationary forces until it is too late to prevent the resultant damage.  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 continues to talk up the greatest expansion in money supply by a major nation since the Weimar Republic.  The only thing saving it from a similar outcome is its productive capacity (at least there are some goods to chase).  We haven’t seen the end game to this experiment; but any further impairment to its economy could impact our own while a forced unwind of the yen ‘carry trade’ 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 have been trying to do the right thing by wringing speculation out of its financial system.  Regrettably, it is now faced with a second problem---commodity re-hypothecation, i.e. using the same collateral to back multiple loans.  To date, it has been traced to a series warehouses in only one Chinese city; but the rumor mill is speculating this scandal is more widespread.  I have no clue how either or both of these difficulties will ultimately impact that country’s banking system.  Clearly the risk is of a Chinese Lehman Brothers and its effect on the global financial community.

Ukraine has been replaced by Iraq as the source of rising oil prices.  How much worse conditions can get in Iraq is anyone’s guess.  But if you take the ISIS jihadists at their word, the answer is a lot.  Plus we don’t know if Putin will use the Middle East crisis to help Russia put the squeeze on Ukraine or even the EU.  Whatever the outcome, a continuing advance in oil prices will not help our inflation or consumer discretionary spending numbers.

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 if this week’s bond and gold market signals are correct, our inflation forecast may have to be revised up).  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.
                            
               For the bulls (medium):
  
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 6/30/14                                  11750                                                  1459
Close this week                                               16947                                                  1962

Over Valuation vs. 6/30 Close
              5% overvalued                                12375                                                    1531
            10% overvalued                                12925                                                   1604 
            15% overvalued                                13512                                                    1677
            20% overvalued                                14100                                                    1750   
            25% overvalued                                  14687                                                  1823   
            30% overvalued                                  15275                                                  1896
            35% overvalued                                  15862                                                  1969
            40% overvalued                                  16450                                                  2042
            45%overvalued                                   17037                                                  2115

Under Valuation vs. 6/30 Close
            5% undervalued                             11162                                                      1386
10%undervalued                            10575                                                       1313   
15%undervalued                             9987                                                    1240

* 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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