The Closing Bell
11/1/14
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 (?) 15857-17158
Intermediate Trading Range (?) 15132-17158
Long Term Uptrend 5159-18521
2013 Year End Fair Value
11590-11610
2014 Year End Fair Value
11800-12000
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Trading Range 1820-2019
Intermediate
Term Trading Range 1740-2019
Long Term Uptrend 775-2032
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 fairly balanced: positives---weekly mortgage and
purchase applications, weekly retail sales, October consumer confidence and
sentiment, the October Dallas and Richmond Fed manufacturing indices, October
Chicago PMI and third quarter GDP; negatives---September pending home sales,
the August Case Shiller home price index, weekly jobless claims, September
durable goods orders, September personal income and spending and the October
Markit flash services PMI; neutral---none.
While the volume
of this week’s data was fairly balanced, the primary indicators reversed last
week’s readings with two negatives (September durable goods orders and September
personal income and spending) and one positive (third quarter GDP). The question, of course, is, does this mark a
resumption of a deteriorating dataflow or is it simply a pause in an improving
one? Clearly, even if it is the latter,
the economy’s progress continues to be defined by fits and starts and not one
of steady, accelerating growth.
Goldman lowers
its fourth quarter GDP numbers (short):
Unfortunately,
the international statistics, after one week of relief, were back to
disappointing with deflation and slumping retail sales in Germany, rising
unemployment in Italy and slowing GDP in Japan.
So whether or not economic conditions are stabilizing in the US, they
continue to weaken overseas, leaving a slowdown in the global economy as the
number one threat to our forecast.
In short, our
outlook remains the same, and the primary risk (the spillover of a global
economic slowdown) remains just so.
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
$2 trillion shortfall (medium):
The
pluses:
(1)
our improving energy picture. The US
The
negatives:
(1) a
vulnerable global banking system. This week, 25 banks failed the most recent ECB
stress test. There are two problems,
however, [a] the ECB has no regulatory power {as does the Fed} to enforce
change on those banks that fail. So how much
fudging do you think that the ECB will do to make it appear that those that
flunked have self-corrected? Answer: it
was reported that most of those banks have since met guidelines. Yeh, right. [b] the stress test was run
against an extreme inflationary scenario; and as I have been reporting, inflation
is not the EU’s issue. Deflation is. So
one has the question the very premise of this test.
Elsewhere,
western banks have suddenly discovered what the world already knew---the
Chinese lie a lot and their financials aren’t worth the paper that they are
printed on.
Finally, the
growing size of global shadow banking assets/liabilities (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. The elections approach and the polls are
still predicting a GOP landslide. Despite
all the hooraying about fiscal change, I think that the best we can hope for is
more gridlock until the White House changes hands. Two reasons: [a] in recent history, the
republicans have never been as fiscally responsible in their actions as they
claim and [b] the imperial presidency.
Power has increasingly been concentrated in that office with the complicity
of both parties. Meaning it is tough for
congress to get anything done without the support of the White House. Plus the republicans have consistently
demonstrated that they don’t have the cojones to play hard ball with Obama.
Hence, I think we
be grateful for gridlock and hope that Hillary ‘corporations don’t create jobs’
Clinton doesn’t inherit the throne.
(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.
Well, the Fed
did it---to its credit; it ended QE.
Bear in mind that [a] doesn’t mean the its balance sheet will return to
normal, as it expects to roll over all maturing debt or [b] interest rates are
going down. Nonetheless, it is a first
step and the bond markets are going to have to deal with the absence of a buyer
of $85 billion in Treasury debt every month.
Of course, it
is way too soon to know if the termination of QE will negatively impact the
economy; but as you know, I don’t think that it will. In my opinion, the progress forged by the US
economy has been on the backs of industry and labor and has been made despite harmful
monetary and fiscal policy.
That said, the
corollary to the above thesis (QE did little for the US economy) was that it
had a major impact on asset pricing (driving them up). Despite the selloffs following QEI, QEII, and
Operation Twist, to date, that theory seems questionable as asset prices have
soared following the end of QE. Of
course, it has only been three days; and it may be that it is the end of global
QE not just US QE that will mark the beginning of asset price deflation.
To that end, on
Friday the BOJ tripled down on its most recent double down, pushing its QE to
mind boggling heights. Putting aside the
colossal irresponsibility of this action, it does provide a new cheap and ready
source of liquidity to all the hedge funds, carry traders and yield chasers of
the world. So we will apparently have to
await the end of this version of the QEInfinity experiment, the most radical to
date of all the QE’s, to see the impact on asset pricing.
And (short):
(3)
geopolitical risks. Two items of note this week:
[a] the
Russian/Ukrainians finally reached an agreement on winter gas prices and
delivery. Ukraine will pay roughly
current market prices {no discount for you} and will pay off its $3 billion
debt to Russia, half before the gas starts flowing. Likely the source of funds for the debt
obligation will come from the usual western banking sources {translation: US
taxpayers}, since Ukraine is broke.
So let’s
see. {i} Russia gets $3 billion in cash
to help weather sanctions, {ii} Russia gets more money from the new gas
deliveries {iii} Putin chuckles all the way to the bank since the cash is
coming from the morons who imposed the sanctions in the first place, {iv} now
Russia has real geopolitical leverage for the next six months: You want to fuck with me? Excuse me, while I
adjust this gas valve. Now what were you
saying?
[b] US/Israeli
relations have fallen to the state of junior high school name calling and
rumors abound that the US has already agreed to a nuclear Iran. What can go wrong here?
(4)
economic
difficulties, overly indebted sovereigns and overleveraged banks in Europe and around
the globe. The news out of the rest of
the world turned negative this week with German regional inflation down and
September retail sales crashing 3.2%, Italian employment declining and the Japanese
government lowering its GDP forecast. In
sum, the better global economic stats appear to have been a one week phenomenon---something
not indicative of an improving international economy or a strengthening in the
balance sheets of either sovereigns or their captive banks.
EU earnings reports
(short):
We did receive
a startling report [not] that western banks were getting nervous about the
financial arrangements with Chinese banks based on several instances of imaginary?/creative?/fraudulent?
accounting, most of it related to that country’s real estate market. Of course, we have known that these guys lie
when it suits them and what better time than when you are up to your navel in
alligators? I have no idea what the US
financial system’s exposure is to China, so this is may be nothing more than a tempest
in a teapot. But it is something that
needs to be watched.
Bottom line: the US economy continues to show signs of
improvement; although there was virtually no follow through from Japan, China
and Germany, three of our major trading partners. While this raises hopes that the US might be
able to withstand the impact of a faltering global economy, it is by no means
assured and leaves the risk of a either a significant slowdown in growth
(China) or recession (EU, Japan) as the primary risk to our economy.
The Fed did end
QE, God bless them. While this may
demonstrate confidence in the strength of the US recovery, its negative impact
on global QE infused liquidity was trumped by Japan’s new Super Mario
QEInfinity. So the hedge funds, carry
traders, yield chasers and prop trading desks are safe for the time being. In addition. Draghi swears that he is going
to do the same---like that is somehow great news. Unfortunately (for him), the ECB doesn’t have
the legal authority or the financial flexibility to match the Japanese; and
even if it did, it would only allow sovereigns to become more indebted and
banks to become more leveraged. Hardly a
prescription for long term global economic growth.
Geopolitically,
the world is a mess. While the standoff
in Ukraine has been resolved, the solution heavily favors the Russians who have
taken to aggressively surfing NATO airspace.
The ground action in Syria/Iraq is going against us; and this week, the differences
between Israel and the US regarding policy toward Iran broke into the open the
form of sophomoric name calling. If
those differences are real and if they involve the US recognition of Iran’s
rights to a nuclear bomb and if Israel continues to view this as an existential
threat (I know, a lot of ‘ifs’), conditions could heat up considerably.
In sum, the US showed
limited signs of improvement this week, while the rest of the world produced
nothing but disappointing data.
This week’s
data:
(1)
housing: weekly mortgage and purchase applications were
up; September pending home sales rose less than anticipated; the Case Shiller
home price index was below forecasts,
(2)
consumer: weekly
retail sales were up; weekly jobless claims were below expectations; September personal
income rose slightly less than estimated while personal spending fell; October
consumer confidence was much better than anticipated while consumer sentiment
was slightly ahead of forecasts,
(3)
industry: September durable goods orders were extremely
disappointing; the October Markit flash services PMI came in slightly below
expectations; October Chicago PMI smoked estimates; both the October Dallas and
Richmond Feds manufacturing index were
much stronger than anticipated,
(4)
macroeconomic: the initial third quarter GDP report was
stronger than expected but less than second quarter’s reading.
The Market-Disciplined Investing
Technical
The
indices (DJIA 17388, S&P 2018) gave us another wild ride this week. The Dow finished above the upper boundaries
of its short term (15857-17158) and intermediate term (15132-17158) trading
ranges. If it remains above 17158 through Monday, the short term trend will
re-set to up; if closes there on Tuesday, the intermediate term trend will
re-set to up. It also ended within a
long term uptrend (5159-18521) and above its 50 day moving average.
The S&P closed
right on the upper boundaries of its short and intermediate term trading ranges,
within a long term uptrend (775-2032) and above its 50 day moving average.
Volume accelerated
nicely on Friday; breadth improved. The VIX fell, ending within a short term
uptrend, an intermediate term downtrend and above its 50 day moving
average. The Market is now extremely overbought. I ran a study on our own internal indicator
at the close Friday. In a Universe of
148 stocks, 36 are over their prior highs (similar to the Dow’s Friday close), 12
are right on those highs (similar to the S&P) and 100 aren’t. Clearly this is not an upbeat reading on
breadth.
The long
Treasury was down on Friday, closing within a very short term trading range, a
short term uptrend, an intermediate term trading range and above its 50 day
moving average. TLT’s pin action this
week had been remarkably stable versus stocks or gold---suggesting that changes
in the US and Japanese QE’s will not materially affect long Treasury rates.
GLD got crushed
this week, ending within very short term, short term and intermediate term down
trends, below the lower boundary of its long term trading range and below if 50
day moving average.
Bottom line: equity
prices were extremely over stretched at the close Friday as were a number of divergent
indicators. So a retreat/pause would not
be surprising next week. That said,
there is no telling how long it is going to take investors to lose the
irrational euphoria that accompanied the Japanese QE announcement. Surprisingly (OK, not to me), I haven’t heard
or read a single comment from any economic or Market guru that I respect who
doesn’t believe that that exercise is going to end badly.
I said last week
that I felt like I had lost touch with Market sentiment and that remains truer
than ever. Nevertheless, I would use the
current spike in prices to Sell stocks that are near or at their Sell Half
Range or whose underlying company’s fundamentals have deteriorated.
Market tops take
time to form (medium):
Fundamental-A Dividend Growth
Investment Strategy
The DJIA (17388)
finished this week about 46.4% above Fair Value (11876) while the S&P (2018)
closed 36.7% overvalued (1476). 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
slightly more downbeat US and lousy international economic dataflow hardly
phased the Market. Monetary events
dominated investor psychology. First,
the Fed followed through and ended QE.
Credit to them. I thought that
this would bring softness in asset prices.
Clearly that was wrong. However,
Japan turned on the after burners on its QE program and the ECB keeps mewing
about a version of its own. And stocks
loved it. Clearly global QE isn’t
over. Perhaps it is the shutting down of
all sources of free money with which to speculate that will ultimately impact
asset prices. Must read:
Nevertheless, in
anticipation that the whole thesis that QE has driven asset price could be proven
wrong, I started and continue to play with the assumptions in our Models---the
point being to find a set of assumptions that will put stock valuations at
least close to current levels.
‘The problem is, as I have reported on past
occasions when I did the same, that the growth rates necessary to get
valuations close the current level have to be historically unprecedented, for
periods historically unprecedented with interest rates and inflation remaining
at very low rates for an extended period of time; and the probability of that
happening has to be virtually 100%.
Geopolitics
re-emerged this week as a possible source of Market heartburn. While Russia and Ukraine agreed on a pricing
contract for winter gas, it put Russia in the driver’s seat at a time that it
is getting more aggressive in its dealings with NATO.
An increasing number
of Russian incursions on NATO airspace:
In addition, the
war in the Middle East took another unnerving turn. The White House unleashed some fairly sophomoric
name calling on Israel apparently tied to a more dovish shift in US policy
towards Iran. All I know about
international intrigue is from Len Deighton and John LaCarre books so my
opinions hardly qualify as anything more than mumblings. However, Netanyahu has made it clear that Israel
views an Iranian nuclear bomb as an existential threat; and Israel has made a
habit of responding to similar past threats with fairly aggressive action. Somehow that must mean that the odds of more instability
in the Middle East have gone up.
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 is 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.
DJIA S&P
Current 2014 Year End Fair Value*
11900 1480
Fair Value as of 11/30/14 11876 1476
Close this week 17388
2018
Over Valuation vs. 11/30 Close
5% overvalued 12469 1549
10%
overvalued 13063 1623
15%
overvalued 13657 1697
20%
overvalued 14251 1771
25%
overvalued 14845 1845
30%
overvalued 15438 1918
35%
overvalued 16032 1992
40%
overvalued 16626 2066
45%overvalued 17220 2140
50%overvalued 17814 2217
Under Valuation vs. 11/30 Close
5%
undervalued 11282 1402
10%undervalued 10688
1328
15%undervalued 10094 1254
* 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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