Saturday, September 27, 2014

The Closing Bell

The Closing Bell

9/27/14

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%

            2015 estimates

Real Growth in Gross Domestic Product                   +2.0-+3.0
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Trading Range                      16331-17158
Intermediate Trading Range                    15132-17158
Long Term Uptrend                                 5148-18484
                                               
                        2013    Year End Fair Value                                   11590-11610

                  2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1955-2146
                                    Intermediate Term Uptrend                        1922-2722
                                    Long Term Uptrend                                    771-2020
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          47%
            High Yield Portfolio                                     53%
            Aggressive Growth Portfolio                        49%

Economics/Politics
           
The economy is a modest positive for Your Money.   This week’s economic data was generally weak: positives---August new home sales, weekly jobless claims, the University of Michigan’s final September index of consumer sentiment and the September Richmond Fed manufacturing index; negatives---weekly mortgage and purchase applications, August existing home sales, August durable goods orders, the Kansas City Fed manufacturing index, the August Chicago national activity index and the September Markit manufacturing and services PMI’s; neutral---weekly retail sales.

August new and existing home sales along with August durable goods orders were the important numbers this week.  The good news is that we finally received an upbeat primary indicator (August new home sales).  The bad news is that (1) there were two negative primary indicators (August existing home sales and durable goods orders) which does nothing to assuage my concerns about the US economy starting to be impacted by the weak global economy and (2) existing home sales are roughly ten times the size of new home sales.  So even our positive indicator was the least important of the three.

In short, while our outlook remains the same, the primary risk to it also is unchanged.

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, the weakening in the global economic outlook, along with...... the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.’
           
        The pluses:

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

       The negatives:

(1)   a vulnerable global banking system.   We knew that the banksters couldn’t stay out of the spotlight for too long.  This week, Barclay’s was fined for failing to segregate client funds [ala MF Global]


An absolutely must read article on major US bank exposure to the derivative markets (medium):

And another must read article about the relationship between Wall Street and the Fed as disclosed by 47 hours of secretly taped conversations (medium):

‘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.’

Out for elections.

(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. 

Global central bank policy continued as a lead headline this week.  [a] Draghi made another of his ‘whatever is necessary’ comments in response to a question about the lousy EU economy {which by the way, continues lousy according to the data} on the same day that the Germans made another of their ‘over our dead bodies’ comments.  In sum, the economy deteriorates and the ruling class flaps its gums.  [b] the Chinese premier commented that he would likely replace the head of the Bank of China, who happens to be a monetary hawk.  The implication here being that China is about to rejoin the League of QEInfinity, and [c] we received yet another signal that the Japanese are living in some parallel universe---in a form of a report noting the increase in equity holdings of the Bank of Japan. 

The problem, of course, is that [a] none of this QE bullshit is having an impact on any of the respective economies and [b] what effect that it does have is on asset prices which keep getting more and more overvalued.  How long the Markets or the central banks themselves will remain complicit in these incongruous results is anyone’s guess.  Certainly, I thought that it would end long ago.  Nevertheless, unless the outcomes change, at some point asset prices will become so disconnected to the underlying economics that either policy or price adjustments or both are inevitable.

(3)   rising oil prices.  Last week, it appeared as though Ukraine was fading as a geopolitical flashpoint.  This week, Russia decided to let the West know that it was not to be trifled with: [a] in response to Italy’s seizure of some homes of one of Putin’s buddies, Russia is threatening to freeze foreign assets, and [b] in response to the EU re-selling Russian gas to Ukraine, it is threatening to cut off gas supplies to the EU.  Clearly, this crisis is not as close to over as I had thought, although I do believe that there is a diminishing likelihood of a major military confrontation.

Syria/Iraq/ISIS just turned very hot.  So far, this conflict has had little impact oil prices because everyone wants the revenues therefrom so little damage has been inflicted on production or refining facilities.  However, we are now bombing ISIS refining resources and that may bring in kind retaliation---though I am still unclear on exactly how capable ISIS is of doing so.

In short, the risk here seems to be more geopolitical than economic [oil].  Of course, in a war zone, anything can happen so there remains some probability of higher oil prices that could negatively impact global economic growth.

(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  The ECB and BOJ continue to pump up the volume; their respective economies continue to be unresponsive.  Even worse, the one hold out among our major trading partners [China] now appears to be giving up on its attempt to curb speculation in its real estate market in order to join this crowd of losers.  I can only repeat the question that I posed in last week’s Closing Bell---what the fuck are these guys thinking about? 

I shake my head and conclude that in the absence of some earthshaking development that alters the current dynamics of QEInfinity, I see continued deterioration rather than improvement in global economic activity; and that belief is what drives me to the conclusion that global recession is the number one risk to our economy.

To be sure so far, the EU/Japan and the rest of the world have ‘muddled through’ with little impact on our economic progress.  Indeed, that is our forecast; but as I noted, it is now the biggest risk in that outlook.  And unfortunately, we may be seeing the first signs of that weakness affecting our own economy.

                         Another must read from David Stockman (medium):

Bottom line:  the US economy continues to progress though with each passing week’s dataflow, that proposition is being increasingly called into question.  It is still too early to tell, but the worry is that these incoming stats presage the impact of a slowing global economy on the US.

The economic news from Japan, China and Europe, three of our major trading partners, keeps getting worse. True, this week the Chinese appear ready to join the easy money crowd.  Why, I haven’t a clue since QEInfinity has to date done little to improve their economies.

Semantics aside, the US and ISIS are now at war. ‘By all rights, severely disabling this group ought to be a walk in the park.  But with a pacifist president who is being pushed by His party to look tough ahead of the elections and a lack of support from an imaginary ‘coalition of the willing’, the outcome of this conflict is anything but assured.  Truth be told, US policy has done nothing but make the Middle East more volatile and uncertain since we invaded Iraq.  Now with a weak and reluctant president, stability seems out of the question.  I have no idea how this morality play ends; but I fear it won’t be good for the US.’

In sum, the US economy remains a plus, though less so with each passing week. The rest of the world is not in such great shape and my main concern is that its growth rate slips further and starts to impact the US economy.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were down; August existing home sales fell while new home sales soared,

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims fell less more than forecast, the University of Michigan’s final September index of consumer sentiment was in line,

(3)                                  industry: August durable goods orders were less than anticipated. the August Chicago national activity index was much weaker than expected; both the September Markit manufacturing and services PMI’s were lower than estimates; the September Richmond Fed manufacturing index was ahead of forecasts while the Kansas City Fed index lagged,

(4)                                  macroeconomic: none.

The Market-Disciplined Investing
           
  Technical

            If you feel like you are on the Texas Giant roller coaster, join the crowd.  The indices (DJIA 17113, S&P 1982) rebounded sharply on Friday after the big down Thursday.  For all the recent volatility around the upper boundary of the Dow’s short and intermediate term trading ranges, in the end, nothing changed technically.  It closed within short (16332-17158) and intermediate (15132-17158) term trading ranges, within its long term uptrend (5148-18484) and bounced off its 50 day moving average. 

The S&P closed within uptrends across all timeframes: short term (1955-2146, intermediate term (1922-2722) and long term (771-2020).  It is also above its 50 day moving average after having broken below it on Thursday.

Volume fell on Friday; but breadth roared back.  The VIX declined, closing within a very short term uptrend and above its 50 day moving average but within short and intermediate term downtrends.

The long Treasury sold off on Friday, but that was more a function of Bill Gross leaving Pimco (fears of some portfolio liquidation) than any macroeconomic factors.  It remained within short and intermediate term trading ranges and above its 50 day moving average.

GLD was down on Friday (what’s new), remaining stuck within very short, short and intermediate term downtrends and below its 50 day moving average.  It is nearing the lower boundary of its long term trading range.  It is almost sure to challenge that boundary, though breaking a long term trend line is a difficult process.

Bottom line: the confusion and volatility that marked the bond, commodities and real estate (REIT’s) markets last week leaked over into the stock market this week.  Moreover, many of those internal divergences that I keep harping on just keep getting more disparate. 

I have said for the last three weeks that the above were manifestations of something going on beneath surface of the Markets.  I don’t know if it is the realization that (1) the US could be headed for a recession, (2) investors have finally grasped that QE hasn’t, isn’t and likely will not work, (3) the probability is rising substantially of an explosion in one of the several geopolitical hotspots, or (4) some combination thereof.
I don’t have the answer as to what it is but I am very happy that our Portfolios are not part of the stats depicting margin debt, net free credit or derivatives exposure but rather have lots of firepower if things go awry.

 Our strategy remains to do nothing.  Although it is 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 (17113) finished this week about 44.6% above Fair Value (11829) while the S&P (1982) closed 35.0% overvalued (1468).  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 US economic stats continued to disappoint this week.  While poor existing home sales and durable goods orders were partially offset by promising new home sales, the balance of data continues to at least hint that the economic global slowdown is starting to impact the US.  Reinforcing that notion, the numbers out of Japan and the EU this week remain subpar.  It is still too soon to alter our forecast, but clearly the more stats we get pointing to a slowdown, the more probable it becomes.

Perhaps more important than the data has been investor reaction to the data.  Market sentiment changed noticeably after the FOMC meeting.  The pin action in stocks, bonds, commodities and currencies became disjointed as each market appeared to be discounting its own separate scenario.  And that only muddies the clarity on the future course of both the economy and the Markets.  I have no clue what this all means but one thing I can say it is that when the outlook becomes more uncertain, the directional momentum in prices diminishes.

The Russia/West standoff raised its ugly head this week.  While Putin has pretty much what he wants in terms of territory, he clearly is not going to lower his profile when challenged---as illustrated by Russia’s move toward freezing foreign assets and threatening to shut off gas to all of the EU.  This keeps alive the prospect of some geopolitical flare up as long as the West keeps pushing for more sanctions.  Investors’ reaction Thursday to the most recent Russian countermoves is an indication of the magnitude of the risk one of those geopolitical flare ups carry in investors’ minds.

The situation in the Middle East can only be described as the greatest clusterfuck in the history of US foreign affairs.  Obama seems to think that He can imagine some ideal outcome and then micromanage a war to that end.  Once again He demonstrates His complete lack of understanding of history.  I have no idea how this mess ends.  My hope is that the players are too busy killing each other to have the time to come after the US---the operative word being ‘hope’.

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 global ‘muddle through’ scenario seems increasingly at risk).  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.
            
          On being wrong (medium and a must read):

DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 9/30/14                                  11829                                                  1468
Close this week                                               17113                                                  1982

Over Valuation vs. 9/30 Close
              5% overvalued                                12420                                                    1541
            10% overvalued                                13011                                                   1614 
            15% overvalued                                13603                                                    1688
            20% overvalued                                14194                                                    1761   
            25% overvalued                                  14786                                                  1835   
            30% overvalued                                  15377                                                  1908
            35% overvalued                                  15969                                                  1981
            40% overvalued                                  16560                                                  2055
            45%overvalued                                   17152                                                  2128
           
Under Valuation vs. 9/30 Close
            5% undervalued                             11237                                                      1394
10%undervalued                            10646                                                       1321   
15%undervalued                            10054                                                  1247

* 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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