Saturday, August 2, 2014

The Closing Bell

The Closing Bell

8/2/14

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                                         ????
Intermediate Uptrend                              16624-20922 (?)
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                                         ????
                                    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.   This week’s data releases weighed to the constructive side: positives---weekly purchase applications, weekly retail sales, July consumer confidence, July consumer sentiment,  the ISM manufacturing index, the July Market flash services PMI, the July Dallas Fed manufacturing index and second quarter GDP: negatives---weekly mortgage applications, the May Case Shiller home price index, weekly jobless claims and second quarter employment costs, the July Chicago PMI and July construction spending; neutral---July pending home sales, the July ADP private payroll report, July nonfarm payrolls and July personal income and spending.

A detailed look at the second quarter GDP report (medium and a must read):

The standout numbers this week were second quarter GDP, July nonfarm payrolls, personal income and spending and second quarter employment costs along with the FOMC meeting.  Leaving the Fed aside for the moment, all of the other datapoints support our forecast of a sluggishly growing economy and suggest that the recent series of poor stats was another one of those hiccups that we have experienced in this recovery but to which there is no follow through.  I am not going to take recession off the table just yet; but there is no longer a flashing yellow light.

On the other hand, second quarter employment costs point to building inflationary pressures and directly support our original thesis that inflation will ultimately prove the culprit of QEInfinity.  Of course, the FOMC statement suggesting an interest rate hike is nowhere in the offing only reinforces that scenario. 

As a result, I am almost back to what has been our base forecast for the last three years with emphasis on the Fed appearing to be in the process of botching the transition to normal monetary policy yet again.

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.’

            Update on big four economic indicators:
           
And this from David Stockman (medium):

        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.  This week, the Bank of Portugal said there are indications of “seriously harmful acts of management” at the lender [Espirito Santo] and a failure to comply with the central bank’s directives.

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.’

With congress starting a five week recess in which much campaigning will be primary objective, both parties scrambled to present legislation that would score political points; to wit (1) the GOP introduced a half assed immigration bill and voted to sue Obama over misuse of executive power and (2) the dems introduce their own half assed legislation designed to prevent companies from moving overseas to avoid taxes.  Clowns to the left of me, jokers to the right.

I am an equal opportunity critic here.  Obama, Reid and Boehner are, in my opinion, a disgrace to their office.  Ninety-nine percent of comments by politicians that I see, hear and read are garbage.  It is small wonder that the economy is struggling and that the US is a laughing stock to the rest of the world.  The only good news is that these morons are so incompetent that nothing is getting done [he who rules least, rules best].  I continue to maintain that the only solution is the throw every last one of these guys out on his can.

The causes of inequality (medium):

(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 you know, the FOMC met this week and did little to alter the outlook for policy.  It tapered another $10 billion per month and left wide open the issue of timing of a rate hike.  Which leaves my conclusion on Fed policy unchanged: the Fed has no clue how to extricate itself from its current historically overly expansive monetary policy. 

As you know, I have long 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.  Last week, I introduced the notion that the recent softness in many of the primary economic indicators could portend recession.  This week’s data went a long way to dispelling that thesis.  I am not taking it off the table with just one week of contrary stats; but the multitude and quality [primary indicators] was such that I think the odds of slower to no growth are much less than at this time last week.

That said, I continue to maintain 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.

                         The consequences of substituting debt for income (medium):

(3)   rising oil prices.  Violence in Ukraine and the geopolitical ramifications of the US/EU imposed sanctions on Russia as well as the continuing turmoil in Iraq and Israel/Palestine remain a threat to global oil/gas supplies/prices.  To date, none of this has served to disturb the oil market.  However, all of these issues remain unresolved.  Indeed they continue to deteriorate---which leaves open the prospect that we still may face higher prices.

Clueless in Gaza (medium):

(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  Europe remains a trouble spot.  The Espirito Santo problem grows.  Economic data this week did not make for good reading.  And the EU is walking a tight rope with Russian sanctions.  If he is so inclined, Putin can make this winter miserable for the Europeans.    In addition, the risk is also still there that conditions relating to sovereign debt and overleveraged banks could deteriorate sufficiently to plunge Europe into an economic crisis.  So far, the EU has ‘muddled through’.  Indeed, that is our forecast; but potential risks remain from multiple sources.

Here is an interesting take on why the EU bureaucrats want an end to austerity (short):


Why bond yields are so low in Japan and the EU (short):

The news out of Japan this week was no better than that from the EU.  Industrial production fell off of a cliff precisely at the time the government forecast a turnaround in economic activity.  That doesn’t mean that it still can’t happen; but until the stats improve, a recession or worse remains the risk.

The Bank of China appears to have unfurled a full on QE.  While Chinese stocks are rallying, the yuan carry trade may be in danger.


Bottom line:  the US economy continues to progress despite little to no help from fiscal and monetary policy. As you know, recent weakness in the dataflow had me concerned that its already sluggish growth rate could suffer additional softness. However, the strength in several primary indicators this week goes a ways towards dispelling that notion.  And given the Fed’s hesitancy to further tighten its expansive monetary policy, reinforces the risk that at some point we will be battling inflationary forces brought on by QEInfinity.  I am not dismissing the recession alternative scenario; but after the data we got this week, it seems the less likely.

Overseas, the environment is worse.  The Portuguese bank insolvency, terrible economic data out of the EU and the threat of Russian reprisal over sanctions highlight the risks that still exist to the EU’s overly indebted sovereigns and overly leveraged financial system. 

Japan’s monetary/fiscal policies make the US look like a paragon of virtue.  How that country’s economy avoids imploding is a mystery to me---which is not to say that it won’t.

Finally, violence continues in Ukraine and throughout the Middle East.  Somewhat surprisingly, the Markets have taken this strive in stride---at least until last Thursday.  With respect to the former, the whole issue of sanctions confounds me.  It appears that it has gone far enough that someone now has to blink---and my money is on Obama.  I don’t think that will be well received by the Markets.  On the other hand, rumors abound that the Germans and Russians are negotiating a resolution to this crisis.  Ah if only that is the case.  Then the worse we will have to endure is a lot of political speak from Obama on how He was responsible for the whole thing.

In sum, the US economy remains a plus, though the risks of inflation are growing.  Unfortunately, that is not the only potentially troublesome headwinds. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were mixed; June pending home sales were down but in line; the Case Shiller home price index was down versus forecast of being up,

(2)                                  consumer:  weekly retail sales were up; the July ADP private payroll report showed employment up but by less than estimates as did July nonfarm payrolls; July personal income and spending grew in line; weekly jobless claims rose more than anticipated; Consumer Confidence was much stronger than forecasts while Consumer Sentiment was slightly above consensus,

(3)                                  industry: the July Markit flash services PMI was slightly better than expected as was the July Dallas Fed manufacturing index as was the ISM manufacturing index, the July Chicago July PMI fell off a cliff as did July construction spending,

(4)                                  macroeconomic: second quarter GDP smoked the estimates, while employment costs increased more than anticipated.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 16493, S&P 1925) had a rough week.  Both took out their 50 day moving averages.  The Dow broke its short term uptrend, re-setting to a short term trading range.  It also closed below the lower boundary of its intermediate term uptrend for the second day.  A finish there on Monday will confirm the break of that uptrend and a re-set to a trading range.  The S&P confirmed the break of its short term uptrend, resetting it to a trading range. 

That leaves the Averages in sync with the break of their 50 day moving averages and short term uptrends.  If there is no rebound on Monday, then they will be out of sync on their intermediate term uptrends; but will remain in harmony of their long term uptrends [5101-18464, 762-1999].  

Volume on Friday was down, breadth mixed---but stocks are very oversold.  The VIX was up again, remaining above its 50 day moving average and within a very short term uptrend.  It is still in a short term downtrend though it closed near its upper boundary.  A break of that resistance level would point to more weakness in stocks.

The longer a stock run up lasts, the larger the correction (short):

After weakness early in the week, on Friday the long Treasury bounced hard off the lower boundary of its short term uptrend and closed right on the upper boundary of its former short term trading range.   I think that this pin action is a plus and raises my confidence in strength of the uptrend; although I remain nervous based on its recent confusing performance.  It also finished above its 50 day moving average and within an intermediate term trading range. 

As I noted last week, the importance of the bond market’s performance is what it tells us about what bond investors think about the economy.  Right now, it seems to be saying that either there is a risk of a geopolitical flare up or that economic risks are weighed toward recession versus inflation.  If the latter, then that obviously doesn’t square with my interpretation of this week’s economic data.  Of course, it could be the former; and for the moment, I am in that camp.  However, as I noted in the Economics section, I have not totally dismissed the recession scenario.

More on the underperforming high yield bond market (medium):

GLD was up on Friday, closing above its 50 day moving average, within a short term trading range and an intermediate term downtrend and appears to be building a pennant formation.

Bottom line: the technical action this week was fairly disruptive: 50 day moving averages were breached, short term uptrends were broken and the Dow is two days into a three day challenge of its intermediate term uptrend.  By historical standards, that doesn’t mean that the bull market is over and mean reversion is upon us.  However, given the damage, if you are fully invested, you might want to be rethinking that position unless you are a long term follower of ‘buy and hold’.

It also means that stocks could be in the process of adjusting price to account for all those oft mentioned divergences.  The question is will those divergences quickly correct themselves (meaning this sell off will be a mild one) or if they stay same or, God forbid, get even worse (meaning that this could be the beginning of ‘the big one’).  The good news is that our Portfolios are currently positioned for this sell off and we can deal with whatever emotional repercussions there are calmly and without the risk of panic. 

That said, I want to reiterate that it is way too soon to be betting on mean reversion and way too soon to panic.  It is a time to look very carefully at your holdings,  be sure that they are the highest quality, reasonably priced and that you won’t be sad to own them 10%, 15%, 20% lower---in other words, be sure that you know what you own.    

 Our strategy remains to do nothing.  It is too early to be making a Buy List but not too late to Sell stocks that are near or at their Sell Half Range or whose underlying company’s fundamentals have deteriorated.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16493) finished this week about 39.7% above Fair Value (11806) while the S&P (1925) closed 31.3% overvalued (1465).  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.

I think that this week’s plethora of data added some clarity to the economic picture in the sense that the likelihood of recession now seems less.  On the other hand, the odds of a too easy Fed leading to higher than expected inflationary pressures is back to being the leading economic risk from Fed policy.  If events play out that way, I believe that a reversal in the policy (historically easy money) that drove asset prices to unrealistic levels will have a negative impact on those same extremely overvalued assets.

Furthermore, the economy and Fed aside, there is no shortage of other risks that could dramatically impact valuations.  The Japanese economy is a mess and getting worse daily.  Yet its government persists in pursuing policies that haven’t worked for over a decade.  Go figure.  While we can’t know the extent of any spillover effects on the US economy, a further slowdown from a major trading partner will clearly not help our own growth rate.

The EU continues struggling to get out of recession/deflation---witness this week’s inflation and PMI numbers.  In addition, it is now contending with another bank failure that could prove systemic; and new sanctions imposed on Russia risks reprisals that would only exacerbate European growth difficulties.  Finally, the lack of reforms to correct overly indebted sovereigns and overleveraged banks increases the probability of magnifying any economic problems and their potential spillover effects on the US.

The China appears to have joined the QEInfinity ranks---this after a very short lived attempt to wring speculation out of its financial system.  I have no idea if the recent spurt of monetary/fiscal sanity created enough economic slack to absorb this new infusion of money without re-stimulating dicey behavior.  We will know soon enough.

I can’t imagine the end game to the turmoil in Ukraine and the associated trade war.  Until Thursday, global markets and in particular the energy markets have been unconcerned.  Now there appears to be at least a realization that (1) this US/Russian standoff has reached the point where someone has to blink and (2) it is not apt to be Putin.  The good news is that rumors abound that Germany and Russian are working on a negotiated settlement.  Assuming that occurs and assuming Obama is wise enough to go along, we could get this trouble spot off our radar.  The only consequence being more lost prestige for the US as Obama once again leads from behind.

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. 

Another unsettling valuation indicator (medium):

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.

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.
                       
                This from a long time bull (short):
            http://www.cnbc.com/id/101884659
   
           
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 8/31/14                                  11806                                                  1465
Close this week                                               16493                                                  1925

Over Valuation vs. 8/31 Close
              5% overvalued                                12396                                                    15385
            10% overvalued                                12986                                                   1611 
            15% overvalued                                13576                                                    1684
            20% overvalued                                14167                                                    1758   
            25% overvalued                                  14757                                                  1831   
            30% overvalued                                  15347                                                  1904
            35% overvalued                                  15938                                                  1977
            40% overvalued                                  16528                                                  2051
            45%overvalued                                   17118                                                  2124

Under Valuation vs. 8/31 Close
            5% undervalued                             11215                                                      1391
10%undervalued                            10625                                                       1318   
15%undervalued                            10035                                                  1245

* 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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