The Closing Bell
7/12//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 16168-17647
Intermediate Uptrend 16422-20781
Long Term Uptrend 5083-18464
2013 Year End Fair Value
11590-11610
2014 Year End Fair Value
11800-12000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 1900-2064
Intermediate
Term Uptrend 1846-2646
Long Term Uptrend 762-1999
2013 Year End Fair Value 1430-1450
2014 Year End Fair Value
1470-1490
Percentage Cash in Our Portfolios
Dividend Growth
Portfolio 44%
High
Yield Portfolio 53%
Aggressive
Growth Portfolio 46%
Economics/Politics
The
economy is a modest positive for Your Money. There was
almost no data released this week; and what we got was mostly secondary
indicators: positives---weekly mortgage and purchase applications and weekly
jobless claims; negatives---the June Small Business Optimism Index; neutral---weekly
retail sales and May wholesale inventories and sales.
With such a
paucity of stats, it makes little sense to opine on how they might impact our
forecast, since clearly there is none.
That said, there was a notable economic event of sorts---the release of
the minutes from the latest FOMC meeting.
While on the surface there was not much new, to me, it was clear from
reading those minutes that the Fed has decided not to take a proactive role in any
further tightening (raising interest rates) on monetary policy.
As I noted in
Thursday’s Morning Call, following the market has been the Fed’s traditional
approach to a monetary transition---which is precisely the reason that it has
failed so miserably at it. In short,
interest rates are not likely to rise until the bond boys get fed up and refuse
to buy government paper at historically low yields. When that occurs is anybody’s guess. But until it does, Fed policy will likely keep
a bid under the securities markets.
That scenario,
of course, increases the probability of inflation getting out of hand. The gold market seems to be agreeing. On the other hand, this week’s global economic
news (lousy numbers plus a bank default) suggests something very different---recession
among our trading partners and another crisis in the financial system. The operative words are ‘this week’---meaning
that it is a bit early to project this into a trend. However, it does give me pause from accepting
as a foregone conclusion the easy money/higher growth/inflation scenario. At this point, we just need to await further data.
A review of the
current inflation stats (medium):
Our forecast:
‘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
The US is now
the largest energy producer in the world.
That has enormous economic and geopolitical implications all of which
are positive. Regrettably, we have achieved
this status in spite of our government’s policies on coal, drilling on Federal
lands and the Keystone pipeline. I don’t
think it unreasonable to suggest that our overall economic state would improve considerably
with a bit more enlightened energy policy.
Here is a very
negative take on US energy resources (medium):
The
negatives:
(1) a
vulnerable global banking system. Citicorp
got whacked this week for mortgage fraud and Commerzbank for violation of trading
sanctions. To be clear, the point of
this keeping this potential negative in front of us is to underline [a] the
wanton disregard for rules and regulations {most designed to either prevent a financial
meltdown or the damage depositors} by bank management and [b] the inability of
the regulators to stop this behavior before the fact {read disastrous
consequences}
‘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. ‘With election season in full swing, nothing
is likely to happen to alleviate the problems of an inefficient tax code, too
much irresponsible spending and too much government regulations. The one bright spot is that the growing
economy is generating sufficient tax revenue to drive down the budget deficit.’
(3)
the potential negative impact of central bank money
printing: The key point here is that [a] the Fed has inflated bank reserves
far beyond any comparable level in history and [b] while this hasn’t been an
economic problem to date, {i} it still has to withdraw all those reserves from
the system without creating any disruptions---a task that I regularly point out
it has proven inept at in the past and {ii} it has created or is creating asset
bubbles in the stock market as well as in the auto, student and mortgage loan
markets.
As I stated above,
it has become increasingly clear that any transition to tighter money will in
driven by market actions [higher bond yields] not the Fed. This week’s evidence was the FOMC equivocating
over policy ‘normalization’ [higher interest rates] in its latest minutes.
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. It apparently has chosen to do nothing until
forced to do so by the bond market; and if history is any guide, the outcome
will be higher inflation.
(3)
rising oil prices.
Violence in Ukraine, Iraq and now Israel/Palestine remains a threat to
global oil supplies. That said, oil
prices have been down nine days in a row.
Whatever the threat of rising prices, it clearly is diminishing in investors’
minds.
(4)
the sovereign
and bank debt crisis in Europe and around the globe. Europe was front and center this week with the
missed interest payment by a Portuguese bank.
That in turn negatively impacted not only the securities of banks that owned its shares but Portuguese
bank stocks and bonds in general and to a lesser extent the banks of other southern
European countries. To be clear, this is
not now a Lehman Bros moment and may never be; but it does illustrate some of the
points that I have been making [a] EU bank balance sheets are overleveraged and
[b] there is too much counterparty risk {they all own pieces of each other and
pieces of the same securities that can potentially fail}.
Germany blesses
‘bail in’ solution to bank insolvency (medium):
new
And the IMF
gives the ‘all clear’ on Bulgarian banks two weeks before a bank run (medium):
Japanese
economic news this week remained dismal, indicating that Abe’s money for
nothing policy hasn’t worked and still is not working. I don’t know how this
play ends; but my money is riding on its being a tragedy.
Not much out of
China this week, though problems in the real estate market and collateralized of
warehoused commodities have not shown any signs of improvement. Until there is, China will remain a potential
trouble spot.
Credit
guarantee companies are folding right and left (medium):
‘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 despite
little to no help from fiscal and monetary policy. Plus the risk is rising that
at some point it may be battling inflationary forces brought on by QEInfinity and
the uncertainty of the Fed about how to undo what it has wrought.
Overseas, the
environment is worse. To start, this
week’s terrible economic news out of both Europe and Japan raises the specter
of a global recession. Of course, we
knew that these economies were struggling to stay above water. But the magnitude of the numbers suggested
that recession could come faster and go deeper than previously expected. It also emphasized how worthless QE has been
in Japan and is apt to be in Europe.
That said, I have emphasized that one week doesn’t make a trend. However, if the numbers continue to
disappoint, this could turn many economic forecasts (including our own) on their
heads.
China is trying
to do something to wind down its expansive monetary and fiscal policies. But either a collapsing housing market or the
commodity re-hypothecation scandal or both 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.
Finally, violence
continues in Ukraine and throughout the Middle East. Somewhat surprisingly, the Markets have taken
this strive in stride and may continue to do so. That doesn’t mean oil prices aren’t at risk
of moving higher on already existing geopolitical circumstances.
In sum, the US
economy remains a plus, though the risk of mounting inflation is growing. Unfortunately, that is not the only potentially
troublesome headwinds.
This week’s
data:
(1)
housing: weekly mortgage and purchase applications were
both up,
(2)
consumer: weekly
retail sales were mixed; weekly jobless claims rose,
(3)
industry: May wholesale inventories were slightly below
estimates but sales were strong; the June Small Business Optimism Index was
below expectations,
(4)
macroeconomic: na.
The Market-Disciplined Investing
Technical
The
indices (DJIA 16943, S&P 1967) had a volatile week, finishing above their
50 day moving averages and remaining within uptrends across all time frames:
short [16168-17647, 1900-2064], intermediate [16422-20781, 1846-2646] and long
term [5088-18464, 762-1999].
Volume on Friday
fell; breadth improved. The VIX fell, but
closed above the upper boundary of its very short term downtrend for the second
day, thereby confirming that break. It is also above its 50 day moving
average. On the other hand, it remains
within short and intermediate term downtrends. Its latest pin action could be pointing to a
rise in volatility; it is just a bit early to tell. I will be watching for signs of a change in
direction.
The long Treasury
staged a major comeback this week. At
Friday’s close, it confirmed the break above the upper boundary of its very
short term downtrend. In addition, it is
back above its 50 day moving average and remains within short and intermediate
term trading ranges. The sudden
turnaround was undoubtedly due to the rise in the value of the ‘safety’ trade
as global economic numbers and the problems in Portugal’s banking system
surfaced.
The question is,
are these problems just temporary blips in the long term economic outlook or is
global economic growth not as robust as was thought at the start of the week? The answer to that question is particularly important
for bonds because prices will react
entirely differently in each of these scenarios (i.e. down prices if global
growth and inflation are picking up; up prices if growth is slowing and the EU
banking system is weaker than thought). The
bottom line is that the news pointing to slow growth and bank insolvency has a
lot less longevity; and so if I had to bet right now, I would go with the easy
money, growth and inflation scenario.
That, of course, doesn’t mean that I am right; so I maintain my confused
state on what the bond guys are trying to tell us---assuming that they even
know.
GLD was also up on
Friday, closing above the upper boundary of a very short term downtrend for the
second day, thereby confirming that break (notice the pattern?). It remains above its 50 day moving average
but within a short term trading range and an intermediate term downtrend. Like
bonds, this pin action could be pointing to a change in momentum
(direction). The difference is that GLD
could rise whichever of the aforementioned economic scenarios play out---as an
inflation hedge in the easy money, growth, inflation outlook and as a source of
safety for the economic slowdown, bank crisis scenario.
Bottom line: technically
speaking, the Averages remain in uptrends across all timeframes, the growing
number of divergences and the less certain global economic outlook
notwithstanding. This is a circumstance
where ultimately something has to change.
Either the outlook clarifies and the divergences resolve themselves or
stocks have to start discounting something other than perfection.
Bonds still have
me confused as to exactly what is being discounted. On the other hand, my uncertainty notwithstanding,
gold will likely benefit from either growth/inflation or as a flight to
safety. Our Portfolios will likely start
to nibble GLD next week.
On stocks, 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.
Stock
performance in July option expiration week (short):
Fundamental-A Dividend Growth
Investment Strategy
The DJIA (16943)
finished this week about 43.8% above Fair Value (11775) while the S&P (1967)
closed 34.5% overvalued (1462). 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 information
value of this week’s US economic data flow was virtually nil. Nonetheless, the overall trend continues to reflect
a slow sluggish recovery though the risk of higher inflation is now greater
than reflected in our forecast. However,
I want to see second quarter GDP numbers and more global economic data before
revising our estimate.
Unfortunately, since
I don’t believe that the US economy is going to grow any faster, any upward revision
in inflation will lower the discount factor in our Valuation Model. As you know, our Model already shows that
stocks are very generously priced---and that ignores a plethora of potential
problems that could negatively impact the economy or the securities markets or
both.
Somewhere out
there is an event that will force the ‘decompression’ of future value out of
stock prices; I just don’t know what and when.
As long as the ‘buy the dip’ crowd is hanging around, this market is not
apt to fall of its own weight. So I wait,
comfortable with the price/value stability of cash.
The Fed is at
the top of the list of problems that could go wrong. Given the tone of the FOMC minutes released
this week, it seems clear to me that the Fed is not going to do anything else
(raise interest rates) by way of tightening under forced to do so by the bond
market.
If history is any guide, this will be a repeat
of past botched transitions and will lead to higher inflation at a
minimum. Since interest rates are
already mispriced (too low), once the markets start to price in inflation they
will likely also start to price in a more normal ‘real’ interest rate. That is a double whammy on the discounting
mechanism for stocks. In short, once the
bond guys decide not to accept government paper at its current low prices,
rates are apt to spike and that will likely not be well received by the stock
crowd.
Of course, the
Fed isn’t the only central bank mucking up the works. Japan received another blow to its economic
outlook this week with an atrocious industrial equipment order number. Yet it continues to pursue a policy that hasn’t,
isn’t and won’t work. Indeed, like our
own Fed’s policy, it is only making matter worse. I can’t fathom what the end game is here; but
it probably won’t be pleasant for the Japanese workingman and will likely
generate fallout that will impact our own economy and banking system.
The EU continues
struggling to get out of recession/deflation but will little luck. Like Japan, it got some really lousy economic
data this week. On top of that, a Portuguese bank failed; and while it was a
small bank, it nonetheless shows that the EU banks remain fragile. This all may prompt the ECB to institute some
form of QE, though (1) I don’t know why it would work there since it hasn’t
worked anywhere else and (2) it doesn’t really address Europe’s biggest economic
problems---overly indebted sovereigns and overleveraged banks. My
concern here is about a disruption in our financial system resulting from
problems in either.
Further, the data
this week could be presaging a more rapid and steeper decline in global
economic activity. I emphasize that it
is much too early to tell whether this was an outlier or a sign of things to
come; but it does add one more worry to already big list.
Portuguese bank
jitters intrude on QE euphoria (medium):
Unfortunately,
Portugal is a proxy for most of Europe (medium):
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.
Despite the
turmoil in Ukraine and the Middle East oil prices have actually declined over
the last week. Clearly, the oil market
is telling us that as long as the any violence remains contained, oil/gasoline
prices in the US are unlikely to reach a level that starts to impact economic
activity. That said, the last act has
not been played in either Ukraine or Middle East; and either conflict could
blossom out of control which could push prices to a level that effects our
economy.
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 our inflation
forecast may have to be revised up and our global ‘muddle through’ scenario seems
more at risk than a week ago). 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.
This
from Lance Roberts:
However, let
me pose another idea. What if "bubbles" really aren't about asset valuations,
volatility or price levels? Rather, what if they are all about "psychology" instead. If we look back in history,
we can clearly see that valuations in 2007 were substantially lower than in
2000, yet the markets crashed anyway. The same is true for 1929 which was even
lower still.
Yet, what all "bubbles" have in common is a "psychological" factor. A "belief" that the current trend, either
positive or negative, will not end. It is at during these times that "everyone is on the same side
of the boat" and what causes the rapid deflation is the rush to
the other side.
In other words, whatever "trigger
event" occurs that creates a "rush
for exits" will have nothing to do with fundamentals,
valuations, volatility, or prices. It will be a psychological "panic" that spreads through the financial
markets like a pandemic which causes financial instability, increases
volatility and destroys prices.
For now, there is no visible sign that the current bullish
trend is ending. However, when it does, questions will be asked, fingers
pointed, and blame laid. The answer will simply be; "no one could
have seen it coming."
"If everyone is thinking alike, then no one is
thinking." Benjamin
Franklin
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 7/31/14 11775 1462
Close this week 16943
1967
Over Valuation vs. 7/31 Close
5% overvalued 12363 1535
10%
overvalued 12952 1608
15%
overvalued 13541
1681
20%
overvalued 14130 1754
25%
overvalued 14718 1827
30%
overvalued 15307 1900
35%
overvalued 15896 1973
40%
overvalued 16485 2046
45%overvalued 17073 2119
Under Valuation vs. 7/31 Close
5%
undervalued 11186 1388
10%undervalued 10597
1315
15%undervalued 10008 1242
* 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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