The Closing Bell
7/18/15
Statistical
Summary
Current Economic Forecast
2014
Real
Growth in Gross Domestic Product +2.6
Inflation
(revised) +0.1%
Corporate
Profits +3.7%
2015
estimates
Real
Growth in Gross Domestic Product (revised)
0-+2%
Inflation
(revised) 1.0-2.0
Corporate
Profits (revised) -5-+5%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Uptrend 17591-20515
Intermediate Term Uptrend 17821-23961
Long Term Uptrend 5369-19175
2014 Year End Fair Value
11800-12000
2015 Year End Fair Value
12200-12400
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Uptrend 2077-3056
Intermediate
Term Uptrend 1864-2629
Long Term Uptrend 797-2145
2014 Year End Fair Value
1470-1490
2015 Year End Fair Value
1515-1535
Percentage
Cash in Our Portfolios
Dividend Growth
Portfolio 53%
High
Yield Portfolio 54%
Aggressive
Growth Portfolio 53%
Economics/Politics
The
economy provides no upward bias to equity valuations. The dataflow
this week was mixed: above estimates: June housing starts, the July NAHB index,
May business inventories and sales, the July NY Fed manufacturing index, weekly
jobless claims, the June budget surplus and June PPI; below estimates: weekly
mortgage and purchase applications, month to date retail chain store sales,
June retail sales, July consumer sentiment, the July Philly Fed index, June
small business optimism index and June import/export prices; in line with
estimates: July CPI
There were several
important indicators (June retail sales, industrial production and housing
starts) which were weighed to the plus side.
So the overall take on the week is mixed to positive. Thus, the recent trend towards stabilization
continues, indicating a righting of the economic ship following a disastrous
period extending from January to mid-May.
This doesn’t mean that growth is accelerating; it just means that it has
stopped decelerating. Indeed, our
revised forecast points to a slowing in the rate of growth. Supporting that notion, this week, (1) the
White House budget office lowered its 2015 estimates for GDP growth and
inflation and (2) the latest Beige Book revealed an economy weaker than in the
prior report. Our forecast remains:
a much below average secular rate of
recovery, exacerbated by a declining cyclical pattern of growth resulting from
too much government spending, too much government debt to service, too much
government regulation, a financial system with conflicting profit incentives
and a business community hesitant 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. Oil production in this country continues to
grow which is a significant geopolitical plus.
However, we never saw the ‘unmitigated’ positive forecast by the pundits
when oil prices were cratering. While
there has been some stabilization in prices of late, with the improving
prospects of an Iranian nuclear deal [which would lift sanctions, enabling Iran
to again be able to sell its oil], oil prices have turned down again. I am still waiting for the ‘unmitigated’
positive.
The
negatives:
(1)
a vulnerable global banking system. No incidents this week of bankster
malfeasance. However, the troubles in
Greece and China, were they to flare up again, have the potential to create
stress within the global financial system because there is still no way of
knowing just how exposed institutions are to their debts via the derivatives
market. No question, the notional values
are known. But as we saw with Lehman,
Bear Stearns and AIG, we have limited ability to measure the financial strength
of the counterparties.
My concern here is that: [a] investors ultimately
lose confidence in our financial institutions 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 from either subprime
debt problems in the student loan or auto markets or turmoil in the EU financial
system resulting from a Greek default or exit from the EU.
(2) fiscal
policy. We did receive this week more
evidence of the benefits of divided government---a shrinking budget
deficit. Of course, full implementation
of Obamacare is not in there. But good
news is still good news. In addition, we
now have slew of republican presidential candidates running on platforms to
lower taxes and spending. If only. Pardon my cynicism; but the cold hard facts
are that republicans have been just as fiscally irresponsible in the past as
democrats---and if you don’t believe me take a look at the deficits Bush 43 and
his republican congress racked up during his regime.
I want to
believe that this country could witness a return to fiscal rectitude in 2017. And clearly there is a probability [and hope]
that our political class could experience another Reagan moment. But first there is Hillary to get by [by the
way, this is strictly an economic judgment, not a political/social one]; then
assuming a republican president and congress, they have to deliver---for which
I am hopefully skeptical. Of course, we
could end up with Hillary and a republican dominated congress which would likely
lead to more deadlock. While a plus, the
kind of tax, spending and regulatory reform this country needs to return to its
long term secular growth rate would probably remain a pipedream. In short, we remain a long way from fiscal
reform, if we get any at all.
On another
matter, Puerto Rico met with its creditors this week; and not a moment too
soon, because yesterday it missed an interest payment. I have seen nothing yet as related to a plan
to extricate the island from its debt problem; although the governor is
focusing debt restructuring in the discussions. On Thursday, the senate introduced a bill that
would allow Puerto Rican public entities to declare bankruptcy. Clearly if passed, that would strengthen the
hand of the government in those negotiations. Hopefully, that will help the
parties reach an outcome that will not be too disruptive to our muni bond
market or investor psychology.
(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.
On Wednesday
and Thursday, Yellen gave her Humphrey Hawkins testimony. In it, she provided little new in terms of
Fed policy, in general, and the timing of any interest rate rises, in
particular. Not that it matters, because
the Fed is already too late in the timing of its transition to tighter monetary
policy---and that assumes that nothing untoward occurs in Greece or China. If one or the other were to bloom into a
crisis, it would likely terminate any Fed plans to raise rates or shrink its
balance sheet.
But back to the
US, the US economic dataflow has been subpar for the last six years and the Fed
has done nothing but pump money into the banking system with little sign of
results [save QEI]. It now appears that
the economy is, at the very least, starting to slow its rate of growth. So why would the Fed start tightening
now? Of course, it could do a ‘one and
done’ increase just to prove it still knows how to raise rates. But that is hardly a transition to normal
monetary policy.
In the
meantime, even assuming no recession and no further Fed easing in response, all
those reserves sit on the bank balance sheet and all that debt sits on the
Fed’s balance sheet---waiting for investors to recognize the futility of the
QEInfinity and the harm that it has done to the US economy via the mispricing
and misallocation of assets.
Of course, the
Fed remains in good company, as this week [a] the Bank of China scrambled to
stop the plunge in stock prices and [b] the Bank of Japan left its outrageously
aggressive monetary policy in tact even as it simultaneously lowered
projections for both economic growth as well as inflation---which bear witness
to the complete failure of its own version of QE.
You know my
bottom line: sooner or later, the price will be paid for asset mispricing and
misallocation. The longer it takes and
the greater the magnitude of QE, the more the pain.
(4) geopolitical
risks: tensions continue in Ukraine and there is no letup in the fighting in
the Middle East. However this week, the
US and allies did reach an agreement with Iran on that country’s nuclear
program. Leaving aside the long term
political and foreign issues, an approval of the treaty would have several
short term positive economic impacts: [a] oil prices are likely to decline further
as a result of Iran being able to export its production, and [b] relief from
current trade sanctions are likely to lift Iranian economic activity which will
benefit global growth.
Ian Bremmer on
the Iran deal (medium):
Another expert
(medium):
(5) economic
difficulties, overly indebted sovereigns and overleveraged banks in Europe and around
the globe. The headlines this week were:
[a] call in the
dogs and piss on the fire, this hunt is over.
This week the Greeks folded, approving extremely onerous terms in order
to remain in the EU [a vassal of Germany].
The EU financial ministers are meeting now to decide the form of short
term funding to keep Greece from declaring bankruptcy---their first moves being
to approve a loan allowing Greece to repay loans to the IMF and the ECB and to
provide funding for Greek banks which now re-open on Monday. So the can has apparently been kicked. However, remember that all that has been done
was to loan Greece money to pay debts.
Nothing has happened to lessen its onerous debt load or improve the
economy. So I don’t think that the last
chapter of this tale has been written. Nonetheless, it has lessened economic
and market uncertainty for the time being.
The problem
with the euro (medium and a must read):
[b] the velocity of the selloff in the Chinese
stock market was checked somewhat this week with the aid of government intimation
of investors. The question is, can the
government’s willingness to resort to any measure to stem the selling actually
prevent it? Clearly if government
efforts are successful short term, it would end the turmoil in the markets and
likely save from bankruptcy a number of highly leveraged entities. Although I can’t imagine that this will be
good for raising capital in the future.
In other
economic news, there was a slew of good economic datapoints out of China: improved
trade numbers as well as second quarter GDP; and June retail sales and
industrial production came in ahead of consensus. There is some debate as to whether all these
upbeat reports are just part of the government’s effort to curb investor
pessimism. We know that the Chinese lie
when it is convenient but there is no way of knowing the truth. In any case, it will be interesting to see
whether a totalitarian state can control pricing in its capital markets and those
market still function.
Here is a must
read analysis on the veracity of Chinese economic data (medium):
The Chinese bazooka (medium):
In addition,
the ECB left its interest rates unchanged, as did the Bank of Japan which
ironically also just happened to lower its 2015 GDP growth and inflation
forecast at the same time.
‘Muddling
through’ remains the assumption for the global economy in our Economic Model which
will certainly improve in likelihood if the Greek bailout and Chinese
government’s market intimidation efforts are successful.
Bottom line: the US economy continues to recover from the
doldrums of the first five and half months of the year, putting the threat of
recession even further behind us. On the
other hand, this improvement has not been robust enough to assume a return to
the recovery rate of this cycle much less to the average secular rate of the
past several decades.
The
international data did little to demonstrate any kind of pick up in global
economic growth. However, the increased likelihood that Greece will avoid a
disaster and the seeming initial success of the Chinese government’s
browbeating of investors lessens the odds of some black swan upsetting the
global applecart.
The outlook for
global growth (short):
This week’s
data:
(1)
housing: June housing starts were up more than
consensus; weekly mortgage and purchase applications were down; the July NAHB
index was slightly ahead of expectations,
(2)
consumer: month to date retail chain store sales growth
declined from the prior week; June retail sales were very disappointing; weekly
jobless claims declined; July consumer sentiment was well below estimates,
(3)
industry: the June small business optimism index was
well below forecast; May business inventories rose more than anticipated and
sales increased; June industrial production improved; the July NY Fed
manufacturing index was better than consensus while the Philadelphia Fed index
was very disappointing,
(4)
macroeconomic: the June US budget surplus was slightly
higher than estimates; June export prices were below expectations while import
prices were in line; both the headline and ex food and energy June PPI figures
were above forecasts, while both the CPI numbers were in line.
The
Market-Disciplined Investing
Technical
The indices (DJIA
18086, S&P 2126) moved significantly higher this week likely reflecting the
Greeks/Troika pulling back from the abyss, better pin action in China and more
pabulum from Yellen. In the process,
they voided challenges to their short term uptrends and traded back above their
100 day moving averages, re-setting them from resistance to support. Clearly the follow through I referred to last
week was to the upside. Now little
stands between the Averages and their all-time highs (18295/2135) and the upper
boundaries of their long term uptrends.
A challenge of one or both seems inevitable; though I continue to
believe that they will be unsuccessful on the latter.
Longer term, the
indices are within their uptrends across all timeframes: short term (17591-20515,
2077-3056), intermediate term (17821-23961, 1864-2629) and long term (5369-19175,
797-2145).
Volume rose on
Friday; breadth was very poor. The VIX
(11.9) dropped, ending below its 100 day moving average and very near the lower
boundaries of its short term trading range (10.3) and long term trading range
(9.6).
The long
Treasury was up, but closed below its 100 day moving average and within its short
term downtrend.
GLD can’t catch
a break. It was down (again) on Friday,
ending below its 100 day moving average and the lower boundary of its
intermediate term trading range for the second day. If it remains there through the close on
Tuesday, the intermediate term trend will re-set to down.
Oil was unchanged, finishing below its 100
day moving average and near the lower boundary of its short term trading range. The dollar continues strong. Yesterday it negated its very short term
downtrend and closed above its 100 day moving average. If it remains there through the close on
Monday, it will re-set from resistance to support.
Bottom line: while
volume is low and divergences continue to appear, the Averages are
smoking. They have unsuccessfully
challenged their short term uptrends and re-set their 100 day moving averages
from resistance to support. At the
moment, the indices are in a very short term trading range that has existed since
early this year, bound by their 100 day moving averages on the downside and their
all-time highs and the upper boundaries of their long term uptrends on the upside. If they can’t move out of this range to the
upside, it would suggest that the Averages are continuing to build a long term
top. On the other hand, at the very
least, an assault on the upper boundaries of these ranges seems
inexorable---although you know that I don’t think that upper boundaries of
those long term trends will be broken.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (18086)
finished this week about 49.0% above Fair Value (12137) while the S&P (2126)
closed 41.1% overvalued (1506). 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 economic
data continues to support our forecast and hence the economic assumptions in our
Valuation Model.
The Fed has
already done its part to assure ‘a botched…transition from easy to tight money’---irrespective
of what it does in September. It is now
facing the dilemma of (1) either tightening, potentially exacerbating the US
and global economies’ struggle to keep their collective heads above water or
(2) not tightening and leave itself with no policy tools [save another QE which
has already shown that it doesn’t work] with which to respond to a recession,
if it occurs. In either case longer
term, it still must shrink its balance sheet dramatically and hope that either
inflation or loss of faith by bond investors don’t create a market
nightmare. In my opinion, successfully
correcting a policy that has led to the gross mispricing and misallocation
assets is now a matter of luck because, as I often remind you, it has never
done it on skill.
Of course, the
Fed has not been alone in its misguided pursuit of QE. The Japanese central bank polices are even
more egregious. The Bank of China has
been aggressively playing catch up of late as it tries to address a weakening
economy (this week’s data notwithstanding) and a falling market. The ECB has been late to the party and, with
the seeming resolution of the Greek bailout, may be saved from pushing its
version to the extremes of those of the US and Japan. Still there is global asset mispricing and
misallocation writ large; and hence, a huge risk to the Market.
Overseas, the
economic data has been nothing to cheer about, except the Chinese numbers which
may be more of a function of government mandate than reality. That suggests that the US economic growth
isn’t going to get any help from our trading partners.
On the other
hand, the risk of a Greek ignited financial crisis has dropped considerably, at
least over the short term. In addition,
the Chinese government, for better or worse, has managed to decrease
substantially the velocity of its recent stock market decline. I have no idea whether these efforts will
have a lasting effect or simply represent a temporary containment of more
powerful market forces. Indeed, I think
that the $64,000 question that will likely be answered over the next week or so
is, which is more powerful, a strong central government with unlimited
regulatory and police power or a free market?
And if the answer turns out to be the former, then the $128,000
question, does that mean the process of liberalizing the Chinese economy has
come to an end?
Whatever the
case, the financial/market risks posed by the Greek and Chinese situations
clearly subsided this week. That is not
to say that they have gone away; but there is at least a reasonable probability. That means that investor attention will
likely now shift back to what is and has been, in my opinion, the main issue
for the last 18 months: the substantial overvaluation of US equities.
Finally, the
Puerto Rican government met with investors this week in an attempt to
renegotiate the terms of its debt. The governor has said that he wants help in
terms of debt relief (lowering interest rates, extending maturities). And the US senate appears to be trying to
strengthen his hand by introducing a bill this week that would allow PR public
entities to declare bankruptcy. I am not
so much worried about any fallout’s impact on equity markets as I am about the
potential effect on the muni market---to which our ETF Portfolio has exposure.
Bottom line: the
assumptions in our Economic Model are unchanged. If they are anywhere near correct, they will
almost assuredly result in changes in Street models that will have to take their
consensus Fair Value down for equities.
The assumptions
in our Valuation Model have not changed either; though this week’s events have
raised the odds of our international ‘muddle through’ assumption may work
out. That said, our Model’s current
calculated Fair Values under the best assumptions are so far below current
valuations that a simple process of mean reversion is all that is necessary to
bring Market prices down significantly.
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; but
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.
Actual versus estimated
earnings growth (short):
DJIA S&P
Current 2015 Year End Fair Value*
12300 1525
Fair Value as of 7/31/15 12137
1506
Close this week 18086
2129
Over Valuation vs. 7/31 Close
5% overvalued 12743 1581
10%
overvalued 13350 1656
15%
overvalued 13957 1731
20%
overvalued 14564 1807
25%
overvalued 15171 1882
30%
overvalued 15778 1957
35%
overvalued 16384 2027
40%
overvalued 16991 2108
45%overvalued 17598 2183
50%overvalued 18205 2259
55%
overvalued 18812 2334
Under Valuation vs. 7/31 Close
5%
undervalued 11530
1430
10%undervalued 10923 1355
15%undervalued 10316 1280
* 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.
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 47 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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