The Closing Bell
7/26/14
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 16232-17711
Intermediate Uptrend 16593-20891
Long Term Uptrend 5101-18464
2013 Year End Fair Value
11590-11610
2014 Year End Fair Value
11800-12000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 1916-2082
Intermediate
Term Uptrend 1858-2658
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. The
majority of this week’s data releases were constructive: positives---weekly
mortgage and purchase applications, June existing home sales, weekly jobless
claims, June durable goods orders, the July Richmond and Kansas City Feds’
manufacturing indices and the CPI ex food and energy: negatives---the Chicago
Fed National Activity Index, the July Market flash PMI and June new home sales;
neutral---weekly retail sales and the June CPI headline number.
The standout
numbers this week are, in my opinion, the improved jobless claims, durable
goods orders and existing home sales offset by the disappointing new home sales. As to jobless claims, we all celebrate
growing employment. However, it is a
lagging indicator and does not mean quite as much about the future as, say,
industrial production or consumer spending.
So improving jobless claims are not inconsistent with the recent series
of poor primary economic stats---in other words, it is possible for employment
to be improving at exactly the same time the economy is starting to soften.
Second, since existing
home sales tend to be around ten times new home sales, it clearly carries a lot
weight. However, new home sales have a
larger multiplier effect on the economy because of its greater use of labor and
resources (lumber, copper, plastic, etc.).
Finally, this
latest existing home sales along with the durable goods orders are the first
upbeat primary economic indicators in the last couple of weeks. That doesn’t mean they are outliers. Indeed, it raises the question as to whether the
latest string of poor numbers is the outlier. At the moment, I have no idea which is
which.
But ‘which is
which’ along with Fed policy is critical to our forecast:
(1)
if the recent disappointing data is the outlier
and just more of the same erratic flow of the last five years [economy
continues to grow] and the Fed remains easy until forced by the Market to
tighten, then the risk to our outlook is on the side of inflation,
(2)
if the recent disappointing data is the outlier
and just more of the same erratic flow of the last five years [economy
continues to grow] and the Fed actually raises rates as unemployment declines,
then there is a chance that the economy can transition to normal without
serious disruptions,
(3)
if this week’s durable goods orders and existing
home sales are the outliers [the economy
is weakening] and the Fed remains easy until forced to by the Markets, then it
will likely get lucky, not tighten whatever the employment numbers and any softening
in economic activity will probably be less than it otherwise would have been,
(4) if
this week’s durable goods orders and existing home sales are the outliers [the
economy is weakening] and the Fed actually raises rates as unemployment
declines, then it could make any decline in economic activity worse.
My uncertainty
over the relative probabilities of any of these alternatives occurring leaves
me in a wait and see mode. We need more
clarity on the economy first and foremost.
Bur clearly Fed actions are also important. As you know, my assumption at this point is
that it will leave rates unchanged until it gets beaten over the head by the
bond market. In other words, there is
some chance it could get lucky; but only because the economy is headed back
into recession. That said, I await more
data; for the moment leaving our forecast unchanged but with the yellow light
flashing.
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
negatives:
(1) a
vulnerable global banking system. This
week, the NY Fed slammed Deutsche Bank for shoddy bookkeeping and holding excessive
risk [derivatives] on its balance sheet.
Across the pond, UK regulators are pushing hard for a settlement in the
FX rigging probe {Citi and JP Morgan among the defendants}.
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.’
A five week
recess begins next week.
Memo to the
ruling class (medium 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.
The more I see
and hear from the Fed, the more convinced I am that ‘this time will not be
different’, that the Fed has no clue how to extricate itself from its current
historically overly expansive monetary policy.
To date, I expected that ‘the botched return to normal’ scenario would
play out with the Fed staying too loose too long and that would lead to higher
inflation.
However as I
mentioned above, with the recent softness in many of the primary economic
indicators, I am starting to consider another possible outcome---that of a
recession. To be sure, this week’s
existing home sales and durable goods numbers belie that scenario; but the
string of poor stats is long enough that it remains a possibility.
If that happens,
the Fed staying ‘too loose, too long’ could actually work in the economy’s
favor, ameliorating somewhat the forces pushing economic activity lower.
On the other
hand, if the Fed is truly focusing on employment [which is a lagging indicator]
as a signal to raise rates and that number improves, then the Fed could be
tightening monetary policy just as the economy is rolling over. The result being that higher rates exacerbate
the slide in economic activity.
All that said, I
have long maintained that the end result of the current extraordinarily irresponsible
monetary experiment would likely be much greater for the Markets than for the
economy. The point being that once
investors realize that there is no goldilocks outcome, the Markets will take it
in the snoot however gentle any economic decline or advance in inflation.
Fed hubris (medium and today’s
must read):
(3)
rising oil prices.
Violence in Ukraine, Iraq and now Israel/Palestine remains a threat to
global oil supplies. To date, there has
been little impact on prices. However,
the entire issue of sanctions against Russia, if and how it chooses to respond
in particular to heavily gas dependent Europe has yet to be determined as is [a]
whether Iraq can hold together as state and [b] whether the Israeli/Palestinian
conflict widens to encompass more of the Middle East.
More on Iraq
(medium):
More from
Ukraine (medium):
More from
Gaza/Israel (short):
(4)
economic
difficulties, overly indebted sovereigns and overleveraged banks in Europe and around
the globe. Europe remains a trouble
spot. The Espirito Santo problem appears
to be more systematic than originally thought, though there has been no Lehman
moment. The ECB remains on the sidelines
not just with respect to the Portuguese situation but with any actions to deal
with its overly indebted sovereigns and overleveraged banks. As to the latter, this week New York Fed’s
statement regarding Deutsche Bank’s inadequate financial controls and over
exposure to the derivatives suggests that the ECB has not be able, to date at least, to address the causes of last
financial crisis.
Earlier this
week, I linked to an interview with a Chinese regulator who cautioned about the
current risks in that country’s real estate market. In addition, recent actions by the Bank of
China suggest that it has retreated from its attempt to tighten its monetary
policy as well deal with excess speculation and fraud in its financial
system. These factors along with the
problems with collateralized warehoused commodities keep China as a potential
trouble spot.
Bottom line: the US economy continues to progress despite
little to no help from fiscal and monetary policy. However, the recent weakness
in the dataflow has me concerned that its already sluggish growth rate could suffer
additional softness. On the other hand, the Fed’s hesitancy to further tighten its
expansive monetary leaves the risk that at some point it may be battling inflationary
forces brought on by QEInfinity.
I recognize that
these risks are contradictory in nature.
Unfortunately, the preconditions for both are present; but at this
moment, we just don’t have enough information to determine which is the more
likely to occur.
Overseas, the
environment is worse. The Portuguese
bank insolvency and the NY Fed’s comments on Deutsche Bank’s is illustrative of
risks that still exist to the EU’s overly leveraged financial system.
Prior to this
week, the only bright spot in global monetary policy was the Chinese efforts to
wind down its expansive monetary and fiscal policies. Recent events suggest that its central bank has
reverted to the US and Japanese QEInfinity model. 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 risks of recession/inflation are growing. Unfortunately, that is not the only potentially
troublesome headwinds.
This week’s
data:
(1)
housing: weekly mortgage and purchase applications were
both up; June existing home sales were ahead of expectations while new home
sales fell well short,
(2)
consumer: weekly
retail sales were mixed; weekly jobless claims fell more than anticipated,
(3)
industry: June durable goods orders were up more than
expected; the June Chicago Fed National Activity Index came in below estimates
as did the July Markit flash PMI; the July Richmond and Kansas City Feds’
manufacturing indices were above forecasts,
(4)
macroeconomic: June CPI was in line, though ex food and
energy, it was less than anticipated.
The Market-Disciplined Investing
Technical
The
indices (DJIA 16960, S&P 1978) finished the week above their 50 day moving
averages (though the Dow is getting very near to its average) and remained
within uptrends across all time frames: short [16232-17711, 1916-2082], intermediate
[16593-20891, 1858-2658] and long term [5101-18464, 762-1999].
Volume on Friday
was flat, breadth poor. The percentage
of stocks above their 50 day moving average has declined from 87.5% to below
65% recently. That is not terrible, but
the trend is down. The VIX rallied 7%, but
still closed below its 50 day moving average and within short and intermediate
term downtrends. Its latest pin action
continues to support the notion of higher stock prices.
The long Treasury’s
pin action was schizophrenic again last week.
It rose above the upper boundary of a short term trading range, confirmed
the break and a reset to an uptrend, sold off back below that boundary one day
following the confirmation then rebounded back above it the next day. It
finished the week above its 50 day moving average and within an intermediate
term trading range. I am sticking with
the short term uptrend for the moment.
However, the chart has led to confusion (at least for me) of late; so I currently
have little confidence in the strength of that trend.
In reality, I am
less worried about the chart itself and more concerned on what this price
action could be telling us about the economy.
A weak performance would suggest an improving economy and probably
higher inflation. A continued move up
would point to either a recession (or at least greater economic weakness than
most expect) or some geopolitical situation spiraling out of control (flight to
safety). At the close Friday it would
seem to be saying to expect some sort of downturn in the economy’s rate of growth. But as I noted, given the recent facilitations
in bond prices, I am yet to be convinced that is the case. This is one of those cases where patience is
needed.
More on the
underperforming high yield bond market (medium):
GLD had a good
day on Friday, closing above its 50 day moving average and within a short term
trading range and an intermediate term downtrend.
Bottom line: technically
speaking, the Averages remain in uptrends across all timeframes, the growing
number of divergences, the confusing pin action of the bond market 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.
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.
Fundamental-A Dividend Growth
Investment Strategy
The DJIA (16960)
finished this week about 44.0% above Fair Value (11775) while the S&P (1978)
closed 35.2% 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.
This week’s data
added to my confusion over the direction of economic activity; and it wasn’t
helped by the schizophrenic pin action in the bond market. The alternatives to our current ‘historically
low long term secular growth rate of the economy’ are (1) a recession as is
being suggested in recent datapoints and (2) inflation brought on by the Fed
remaining too accommodative for too long.
I have no opinion about how this
plays out. So for the moment, aside from
awaiting more information, it seems foolish to me to be committing capital with
both uncertainty and valuations at high levels.
Furthermore, the
economy and Fed aside, there is no shortage of other risks that could
dramatically impact valuations. The
Japanese economy is on life support, its government deeply in debt, its bank
overleveraged and its government is ramping up the pursuit of policies that
haven’t worked for over a decade. If
that isn’t a prescription for disaster, I don’t know what is. Certainly, we can’t know the extent of any
spillover effects on the US economy; but a further slowdown from a major
trading partner will clearly not help our own growth rate and gosh only knows
what happens if the yen carry trade starts unwinding.
The EU continues
struggling to get out of recession/deflation though we did get some positive
flash PMI numbers this week.
Nonetheless, aside from a faltering economy, the ECB must now contend with
another bank failure that could prove systemic. Plus the EU, as a whole, has
decisions to make on helping Ukraine and imposing sanctions of Russia, either
of which could precipitate a cut off of energy supplies from Russia this
winter. On top of all that, the ECB has
done nothing to solve the problems of overly indebted sovereigns and
overleveraged banks---as witnessed by the SEC complaint against Deutsche Bank
this week for too high an exposure to the derivatives market. Europe may muddle through. Obviously, it has so far. But the odds are not zero that its economy or
its banking system or both could face a calamity with spillover effects on the
US.
The Chinese appear
to have given up their short lived attempt to wring speculation out of its
financial system. That may lift the
pressure short term on the highly speculative real estate market and on
resolving the commodity re-hypothecation scandal. Unfortunately, the inner workings of the
Chinese economy are too opaque to have a valid opinion on how this all works
out. Clearly, there is a risk of a
Chinese Lehman Brothers and its effect on the global financial community.
The turmoil in Ukraine
and the Middle East increased this week.
However, the oil market continues to tell us that as long as the 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 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.
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 16960
1978
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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