Saturday, July 18, 2015

The Closing Bell

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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