The Closing Bell
8/22/15
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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 Downtrend 17083-17970
Intermediate Term Trading Range 15842-18295
Long Term Uptrend 5369-19241
2014 Year End Fair Value
11800-12000
2015 Year End Fair Value
12200-12400
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Trading Range (?) 2043-2135
Intermediate
Term Uptrend 1886-2650
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 to the negative side of mixed: above estimates: July housing
starts, July existing home sales, weekly mortgage applications, the July Philly
Fed manufacturing index; below estimates: July building permits, weekly
purchase applications, weekly jobless claims, month to date retail chain store
sales, the July NY Fed manufacturing index and July leading economic indicators;
in line with estimates: July CPI.
A note to start
with. I listed July CPI (which was below
estimates) as a neutral because one’s perspective would define whether was
positive or negative. If you are the Fed
or worried about deflation/recession, it is negative. If you view inflation as a negative, it is
positive.
The primary
indicators included July housing starts (+), July building permits (-) July existing
home sales (+) and July leading economic indicators (-). So the primary indicators were balanced. However, the anecdotal evidence remains
negative (plunging oil and copper prices) and the latest Atlanta Fed third
quarter GDP estimate remains well below consensus. In addition, overseas developments this week
were very concerning: currency valuations, capital outflows, poor data.
Also this week,
the Fed released the minutes from the latest FOMC meeting. I covered that in our Morning Calls and
re-hash a bit of it below. But the
bottom line is that monetary policy (except for QE1) has not, is not and is not
apt to be of any help to our economy.
All it has done is create asset mispricing and misallocation of major
portions.
So in total, the
stats were negative, the primary indicators were neutral, anecdotal data was
negative, the Fed is a menace and the global economy provided no relief. For the time being, I am staying with our
forecast but it appears increasing likely that I will have to revise it down
again.
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.
On the other hand, there has been no ‘unmitigated’ positive from lower
oil prices; plus there is mounting evidence that the continuing decline in oil
prices is at least partly a function of falling demand---and that feeds the
global economic slowdown [deflation] story.
Here is another
upbeat piece from our in house optimist; this one on why falling oil prices are
a plus. What his analysis leaves out is
the global repercussions; there are some big emerging market economies in which
oil is a huge source of national income.
Pushing them into recession has consequences.
The
negatives:
(1)
a vulnerable global banking system. This week JPMorgan was
in advanced talks with the SEC to pay more than $150M for steering clients to
its own investment products without proper disclosures. Citigroup agreed with
the New York attorney general to return $4.5M in management fees charged on
some 15,000 frozen accounts, while BNY Mellon will shell out $14.8M to settle
several intern-related bribery cases. Will it ever
end?
That said, recent developments should curb financial
institutions’ ability to wreak economic havoc by imposing the capital
surcharges for the too big to fail banks and commencing enforcing compliance with
the ‘Volcker rule’ [banning taxpayer insured banks from making bets with their
own money {i.e. prop trading desks}].
These measures should over the long term help mitigate the ability of
the banksters to endanger the financial system.
(2) fiscal/regulatory
policy.
(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.
The debate over
whether the Fed will raise rates in September received a minor shock this week
when the minutes from the latest FOMC meeting were released. The tone of the narrative, aside from sounding
as confused as ever, was more dovish than assumed on the Street---meaning the
probability of a rate hike in September just went down. That is not really a surprise if you have
been watching the bond market, which always seems to be a step ahead of the
stock jockeys.
I think that the
import of the minutes also reflect the Fed’s worry that it has once again
botched the transition from easy to a more normal monetary policy, has no idea
what to do other than pray for a miracle and fears the ills from multiple QE’s
[asset mispricing and misallocation] may be soon be upon us.
Adding to this
sad narrative was a study released by the St. Louis Fed confirming what we have
known all along: QE hasn’t and won’t lead to inflation or economic growth, but
has had a significant impact on the Markets [read asset mispricing and misallocation].
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: the joke of the week is the revelation that a provision of the Iranian
nuke deal is that the Iranians will self-inspect their nuclear facilities. Yes, you read that correctly. If the administration’s green apple two step
around many of the terms of this agreement has managed to confuse and confound the
electorate to date, this will surely clarify the workability of the deal and
whether the world is going to be safer as a result.
It appears that
Russia is not done with Ukraine. It was reported
this week that the eastern portion of Ukraine will hold a vote in November
similar to that of Crimea---in which it would secede from Ukraine and join
Russia. That is not going to make US/NATO/Russia
relations any friendlier. Whether that
spills over into the economic arena remains to be seen.
(5) economic
difficulties, overly indebted sovereigns and overleveraged banks in Europe and around
the globe. This week:
[a] most of the
EU parliaments signed off on the Greek bailout; particularly significant was
the approval from Germany, which has been the principal advocate for the
harshest punishment for the Greeks. The
near term result is that the tail risk associated with a Grexit or a default is
off the table.
[b] China
continued to defend both the yuan and its stock market though it did allow a big
drops in the latter on Monday and Friday.
So it seems to be trying to stand by its stabilization pledge. However, there are several forces working
against those efforts:
{i} for reasons
related to prestige, China wants the yuan to be included the IMF’s basket of benchmark
currencies and to do so, it must show ‘flexibility’ in managing the yuan---meaning
that if it stages too strong a defense of the yuan, the IMF (which believes
that the yuan is roughly 10% overvalued) will consider it ‘inflexible’ and deny
entry into its basket of currencies. (And
deny it did on Wednesday. The big
question is, will the Chinese government back off too strong a defense of
yuan? Stay tuned.)
{ii} China is experiencing
massive capital outflows (citizens/companies selling yuan to buy another
currency), which puts downward pressure on the yuan as well as chewing up its
massive reserves. This makes the
stabilization effort all the more difficult.
The spillover
effects of a volatile Chinese currency and stock market are important because:
{i} a depreciating
yuan makes Chinese products more price competitive in a world in which total
demand appears to be shrinking, which in turn damages other economies, in
particular, emerging markets. That ups
the risk of recession and trade war,
{ii} a falling
stock market (1) could be signaling a weaker than assumed Chinese economy and
that it could spill over into other regional markets and (2) big losses could cause
internal dissent because the Chinese government had encouraged speculation in
stocks and provided the money for margin debt.
[c] elsewhere
around the globe, {i} Japanese second quarter GDP fell 1.6% and {ii} news out
of the emerging markets is turning decidedly negative (slowing growth, capital outflows
and currency devaluations). Much of the
latter is tied to the mounting difficulties in China (August manufacturing PMI
down for fifth straight month) and provides further evidence of the weakening
in the global economy.
Turmoil in the emerging markets (medium and a must
read):
Turmoil in Europe (short):
For the moment, I
am holding to our global economic ‘muddling through’ assumption; but the yellow
light is flashing.
Bottom line: the US economic data continues to reflect very
sluggish growth in the US economy.
However, the flow of anecdotal numbers remains discouraging; and this
week we were flooded with a host of bad news from the emerging markets. Much of it was directly related to the
Chinese economy, reinforcing the notion that economic conditions there are
worse than portrayed by official pronouncements. The biggest economic risk to our forecast is
growth problems in the rest of the world.
The warning light is now flashing.
This week’s
data:
(1)
housing: July housing starts were up slightly but
building permits were down; July existing home sales were up versus estimates of
a decline; weekly mortgage applications rose while purchase applications fell;
the August National Homebuilders index was in line,
(2)
consumer: month to date retail chain store sales growth
declined from the prior week; weekly
jobless claims were higher than expected,
(3)
industry: the August NY Fed manufacturing index was
terrible while the Philly Fed index was up,
(4)
macroeconomic: July leading economic indicators fell
versus an anticipated increase; the headline July CPI number as well as the ex
food and energy figure were below forecasts.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 16459, S&P 1970) got pulverized on Friday. The Dow ended [a] below its 100 and 200 day
moving averages, both of which represent resistance, [b] in a short term downtrend,
re-setting from a trading range {17083-17970}, [c] in an intermediate term
trading range {15842-18295} and [d] in a long term uptrend {5369-19175}.
The S&P
finished [a] below its 100 day moving average, leaving it as resistance, [b] below
its 200 day moving average; if it remains below that MA through the close next
Tuesday, it will revert from support to resistance, [c] below the upper
boundary of a very short term downtrend, [d] below the lower boundary of its
short term trading range {2043-2135}; if remains there through the close on
Monday, it will re-set to a downtrend and [e] within an intermediate term
uptrend {1889-2651} and a long term uptrend {797-2145}.
Volume spiked
but that was heavily influenced by option expiration; breadth was awful. The VIX soared 46%, finishing [a] above its
100 day moving average; if it remains there through the close next Tuesday, it
will revert to support, [b] above the upper boundary of its short term trading
range; if it remains there through the close next Tuesday, the short term trend
will re-set to up, [c] above the upper boundary of its intermediate term
downtrend; if it remains there through the close next Wednesday, it will re-set
to a trading range and [d] a long term trading range.
Further
correction or a bottom? (medium):
The long
Treasury remains strong, ending [a] above its 100 day moving average, now
support, [b] within short and intermediate term trading ranges and [c] above the
lower boundary of a very short term uptrend.
GLD was up again
on Friday, but remained below its 100 day moving average and in short,
intermediate and long term downtrends.
However, it is in a very short term uptrend. This could be signaling that a bottom has
been made; however, that very short term uptrend needs to be challenged, at
least once, before I would have any confidence in that judgment.
Oil continues to
crash, finishing below its 100 day moving average and within short and
intermediate term downtrends.
Excess supply or
lower demand (short):
The dollar declined,
closing below its 100 day moving average, now resistance, and within short and
intermediate term trading ranges.
Bottom line: Wheww!
this week was brutal; not just in the magnitude of the drop in prices but also
in terms of the trends that were broken.
If the S&P ends below the lower boundary of its short term trading
range on Monday, that trend will re-set to down and will join the DJIA. Along with breaking below the 100 and 200 day
moving Averages, that alters the momentum to the downside---for the first time
in a number of years.
That doesn’t
mean that the bear market has begun. But,
at the least, considerable technical damage has been done; so it will likely
take time for repair. That said, the
first two steps toward a bear market have been taken (breaking the moving
averages and the short term uptrends).
If this down move takes out the intermediate term uptrends, strap in.
Bonds continue
to suggest no Fed rate hike and/or a weakening economy---though admittedly as a
safe haven trade, they were helped by the plunge in equity markets this week. They are receiving support from oil, which
seems to be screaming deflation. Here
too it is a too soon to make that call.
But for the first time is some time, stocks, bonds and oil are pointing
in the same direction---slowing global growth accompanied perhaps by a whiff of
deflation.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (16459)
finished this week about 35.2% above Fair Value (12169) while the S&P (1970)
closed 30.5% overvalued (1509). 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
data continues to support our forecast and hence the economic assumptions in our
Valuation Model. But I should add, just
barely. Unfortunately, a number of
factors are working against the numbers maintaining their current positive
bias---negative anecdotal economic stats, currency and stock market problems in
China, growing economic turmoil in emerging markets and collapsing commodity
prices. I am not ready to say that American
business and labor can’t overcome the hurdles presented by declining global
economic activity. But I am getting
close; and this clearly poses a risk to the economy and the Market.
The Fed continues
to send mixed signals to the Market; the latest being a seeming retreat from a September
rate hike. Don’t get me wrong. I don’t think the FOMC’s decision will make a
hill of beans to the economy one way or the other. However, we may have reached the point where any
Fed action won’t matter to the Market---something that I have worried about
persistently in these pages.
By that I mean,
if the falling currency valuations and lousy economic data (finally) convince
investors that QEInfinity is a sham, then the notion that the Fed (central banks)
have investors’ backs (i.e. QE = higher stock prices) is toast. Then reality sets in: that all the QEInfinity
foisted on the global economy has accomplished nothing and, indeed, the global
economy is now stumbling in spite of it and that currency devaluation is becoming
the new remedy for slowing economic growth---and does have an impact on economies
and asset prices and it is negative.
In short, investors
may be at or near that ‘emperor’s new clothes’ realization that asset prices
are high not because of fundamentals but because of an irresponsible decision
to experiment with an unproven policy tool (QE) that has not only failed but
left the global economy in tatters.
Net, net, my two
biggest concerns for the Markets are (1) the economic effects of a slowing
global economy and (2) Fed [central bank] policy actions whatever that are or
are not and/or loss of confidence in those actions.
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. Unfortunately,
those assumptions may be too optimistic, making matters worse.
The assumptions
in our Valuation Model have not changed either; though at this moment, there
appears to be more events (greater than expected decline in Chinese economic
activity; turmoil in the emerging markets and commodities; miscalculations by
one or more central banks that would upset markets) that could lower those
assumptions than raise them. 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.
Where
investors believe the tail risk is now (medium):
Is
the bull market over (medium)?
More
on valuation (medium and a must read):
DJIA S&P
Current 2015 Year End Fair Value*
12300 1525
Fair Value as of 8/31/15 12169
1509
Close this week 16459
1970
Over Valuation vs. 8/31 Close
5% overvalued 12777 1584
10%
overvalued 13385 1659
15%
overvalued 13994 1735
20%
overvalued 14602 1810
25%
overvalued 15211 1886
30%
overvalued 15819 1961
35%
overvalued 16428 2037
40%
overvalued 17036 2112
45%overvalued 17645 2188
50%overvalued 18253 2263
Under Valuation vs. 8/31 Close
5%
undervalued 11560
1433
10%undervalued 10952 1358
15%undervalued 10343 1282
* 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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