The Closing Bell
10/17/15
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)
-1.0-+2.0%
Inflation
(revised) 1.0-2.0%
Corporate
Profits (revised) -7-+5%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Downtrend 17076-17792
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
2016 Year
End Fair Value 12600-12800
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Downtrend 1986-2048
Intermediate
Term Uptrend 1936-2728
Long Term Uptrend 797-2145
2014 Year End Fair Value
1470-1490
2015 Year End Fair Value
1515-1535
2016
Year End Fair Value 1560-1580
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, with no bias in either direction. Given the negative trend of the last six weeks,
a neutral week of data in and of itself is a positive: above estimates: weekly
jobless claims, month to date retail chain store sales, September small
business optimism index, October consumer sentiment, September CPI, ex food and
energy, September industrial production; below estimates: September retail
sales, August business inventories/sales, October NY and Philly Fed
manufacturing indices, the September US budget deficit, September PPI; in line
with estimates: weekly mortgage and purchase applications, September CPI.
The primary
indicators included September industrial production (+) and September retail
sales (-). So here too the numbers were
evenly matched.
However, tilting
the overall balance to the negative side were several anecdotal developments: (1)
Walmart slashed its earnings guidance, supporting the aforementioned poor
retail sales numbers (2) Delta’s CEO said that there was a worldwide glut of
wide bodied aircraft [Boeing]---yet another example of the misallocation of
assets fostered by zero interest rates, (3) Illinois delayed pension payments,
citing liquidity problems.
Overseas, the data
flow remained lousy.
The Fed released
its latest Beige Book report this week.
The tone was less optimistic than recent predecessors which was not that
surprising given the recent stream of discouraging data. That was followed the next day by a WSJ
article by Fed mouthpiece Hilsenrath suggesting that a rate hike in 2015 was
now off the table. Putting a cherry on
top, on Thursday, it seemed like every central banker in the world was talking
up more QE. And why not? These clowns are deeply invested in QE working;
and since it has not, it must be because there was not enough of it. So, gentlemen, start your printing presses.
I have lowered
our 2015 economic forecast again (see above).
The key numbers are (1) GDP growth which now incorporates the possibility
of negative growth [i.e. recession] and (2) lower corporate profits.
In summary, the
economic stats both here and abroad remained sub-par while the Fed is
scrambling to hold off the ultimate price that will be paid for its ill-conceived
policies.
Our forecast:
a much below average secular rate of
recovery, exacerbated by a declining cyclical pattern of growth with an
increasing chance of a recession 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
negatives:
(1)
a vulnerable global banking system. Nothing much occurred this week in the US,
save the quarterly bank current earnings reports which were mixed.
However, a Hong Kong based research firm said that Chinese
banks’ nonperforming loan ratio is six times higher than reported---the
importance of which is the higher risk of a major Chinese bank failure.
On the other hand, the UK seems to be following in the US’s
footsteps in forcing the big banks to separate out their investment banking
operations.
‘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 in the international financial
system.’
(2) fiscal/regulatory
policy. No mischief this week.
(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.
It would seem
that the Fed [and regrettably the economy] is in a massive negative feedback
loop---the worse the economy gets, the easier the Fed policy which begets
additional worsening in the economy which……..well you get the picture. So why does an easy Fed not lead to a better
economy? Because the money is not being
used for savings/investment, it is being used to speculate/chase yield. And the Market’s reaction to every news item announcing
more QE is a testimony to that fact.
Debt fueled
buybacks now eating into earnings (medium and a must read):
Plus, are debt
markets near full capacity (medium):
My thesis
remains:
[a] QE {except
QEI} has had little impact on the economy; so unwinding it will have an equally
small effect on the economy,
[b] however, QE
led to significant asset mispricing and misallocation; unwinding it will have
an equally significant effect on asset prices,
[c] in any
case, the Fed has once again waited too long to begin the process on monetary
normalization. That will compound their
asset mispricing problem if the Markets decide to take matters into their own
hands and they will be less circumspect in correcting the pricing problem,
[d] the Fed
knows that it has made a mistake, but appears to think that its only
alternative is to bulls**t the Markets and pray for luck. The danger here is that in a desperate
attempt to extricate itself from the problem, it may make another equally
disastrous misjudgment and only make matters worse.
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: Syria was front and center this week as [a] Russia and Iran sent in more
men and material and [b] Russia continued its aggressive bombing campaign against
rebels. I am not worried about who is
killing who in this war. As far as I am
concerned, the US is a net winner in any case.
I am concerned about the possibility of ‘shots
fired’ between US and Russian forces whether accidental or not---for obvious
reasons. I am also uneasy about the continuing
erosion of respect accorded to the US.
Weakness is not a quality admired by our major adversaries and could
lead them to pursue even more aggressive anti-US policies.
Given the cluelessness
of our current foreign policy, the risks exist of either [a] further humiliation
which will be difficult for the next administration to walk back or [b] an inappropriate
US response in an attempt to prove it has cojones. While I have no idea about the odds of either
transpiring, they are not zero and that makes me a bit nervous.
(5) economic
difficulties, overly indebted sovereigns and overleveraged banks in Europe and around
the globe. This week’s overseas economic
stats included: terrible Chinese trade and inflation data, even worse Indian
trade stats, lowered expectations for Russian GDP growth, declining UK
inflation, poor German economic morale and Brazil’s credit rating being
downgraded by Fitch. In addition, there
was a report that the Chinese banks are much more leverage than is currently
assumed. The only bright spot was UK
employment and forecast 2015 GDP growth.
Of course, in
the ivory tower world of central banking, the reflex action to weak data is
more QE. And as I noted above, there were
no disappointments---the apparent working assumption being that if a whole of lot
QE didn’t work, then doubling down must be the answer.
In sum, the
international economic news was lousy, so the monetary spigots will likely be
opened wider---enabling the central bankers to push the misallocation and
pricing of assets to its logical conclusion.
This combo keeps the yellow flashing on our global ‘muddling through’ assumption;
a flashing red light is not that far away.
Global trade in six charts (short):
Bottom line: the US data continues to reflect very sluggish
growth in the economy. In addition, global
economic trends are still deteriorating; and the Fed remains paralyzed by fear
of the consequences of prior policy mistakes.
As a result, I have lowered our economic forecast again; and I may have
to do so again. A deteriorating global
economy and a counterproductive central bank monetary policy are the biggest economic
risks to our forecast.
This week’s
data:
(1)
housing: weekly mortgage and purchase applications fell
but that was largely a reversal from last week’s accounting impacted up move,
(2)
consumer: weekly jobless claims fell more than
expected; month to date retail chain store sales improved from the prior week; September
retail sales were in line, but ex autos they were less than anticipated;
October consumer sentiment was stronger than projected,
(3)
industry: September small business optimism index
slightly better than estimates; August business inventories were flat but sales
fell; September industrial production was down less than estimates; October NY and
Philadelphia Fed manufacturing indices were below consensus,
(4)
macroeconomic: September PPI and PPI, ex food and
energy were below forecasts; September CPI was in line, ex food and energy were
above expectations; the September US budget surplus was less than anticipated.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 17215, S&P 2033) blew through their September highs on their second
attempt; though to date little else has changed in the technicals. The Dow ended [a] below its 100 and 200 day
moving averages, both of which represent resistance, [b] in a short term
downtrend {17076-17792}, [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 and 200 day moving averages, both of which represent
resistance, [b] below the upper boundary of a very short term downtrend, [c] in
a short term downtrend {1986-2048}, [d] in an intermediate term uptrend {1936-2728}
[e] a long term uptrend {797-2145}. However,
it is nearing its 100 day moving average and the upper boundary of its short
term downtrend. Clearly, a successful
challenge of those barriers will lift a heavy lid off the Market.
Volume increased;
breadth was mixed. The VIX (15.0) was
off 6%, finishing [a] back below its 100 day moving average, which I am now calling
resistance, [b] within a short term downtrend and [c] in intermediate term and
long term trading ranges. A return to
the 12-13 zone would again represent an opportunity to buy cheap portfolio
insurance.
The long
Treasury was up, ending above its 100 day moving average, still support; and
within very short term, short term and intermediate term trading ranges.
GLD declined,
but still closed [a] above its 100 day moving average, now support [b] above the
upper boundary of its a short term trading range for the third day, re-setting
to an uptrend, [c] back below the upper boundary of its intermediate term downtrend,
voiding Wednesday’s break; clearly a disappointment for the gold bulls and a hitch
in calling a bottom on gold and [d] within a long term downtrend.
The dollar rose
back above the lower boundary of its short term trading range, negating Thursday’s
break. It remained below its 100 day
moving average and within an intermediate term trading range.
Bottom line:
stocks pushed back into overbought territory on Friday; although that has not
counted for a lot in the last two weeks of trading. In addition, the indices broke through their
September highs. If they hold, that
should provide additional upside momentum and raise the odds further that they
will challenge their all-time highs.
This might be a good set up for a nimble trader; however, given the
fundamentals and disparity between current prices and our Fair Values, it is
not a place for investors (like me).
Gold’s retreat
back below the upper boundary of its intermediate term downtrend lessened the
impact of its break above its 100 day moving average earlier in the week and Friday’s
re-set of its short term trend to up.
Certainly, GLD can challenge its intermediate term trend again; but for
the moment, it dampens this last week’s strong upward momentum.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (17215)
finished this week about 40.7% above Fair Value (12234) while the S&P (2033)
closed 34.0% overvalued (1517). 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 weaken. Plus, as I noted
above, there were a number discouraging anecdotal events this week; and the
global economy may be in worse shape than the US. Accordingly, this week, I lowered our forecast
for the second time this year, in which I incorporated the possibility of a
recession. Unfortunately, if the numbers
continue to be lousy, the odds of a negative GDP report will grow.
In sum, the US and
global economies are weak and getting weaker.
The risk here is that many Street forecasts are too optimistic; and if they
are revised down, it will likely be accompanied by lower Valuation estimates.
This week, the consensus
is that the Fed will remain easy.
Contributing to this notion was (1) the tone of the latest Beige Book
which was less upbeat than those of the recent past and (2) an article by John
Hilsenrath basically saying the a rate hike was off the table for 2015. Neither of these come as a surprise given the
recent dataflow.
Unfortunately,
the Fed won’t stay accommodative because of the economy; it will do so to keep
the Markets happy. And of course, that
is part of the problem---saying one thing (data dependent) and acting another
(talking QE when Markets decline). For
reasons I can’t fathom, the Market is buying that routine for the moment. But that can’t go on forever because at some
point either (1) QE will continue ineffective and the economy will fall into
recession and corporate profits will get whacked neither of which are looked on
with favor by the Markets or (2) valuations get driven to such absurd levels
that no one will be willing to buy because there is zero return priced into
stocks.
And to be clear,
I don’t believe that there is any warm and fuzzy third alternative. The cold, hard facts, as I see them, are that
the Fed (1) has pursued a policy that has created another asset bubble, (2) it
has waited too long to attempt to correct that mistake, and (3) its only
choices are to do the right thing [i.e. return to a normalized monetary policy],
which will be painful, or to continue to pursue a disastrous strategy hoping
and praying for a miraculous way out, which I believe will end even more
painfully when hope and prayer prove an empty strategy.
That said, I
have no idea at what point investors figure out this no win equation; although
if economic conditions continue to worsen, option (1) may not be that far off. However, whenever and whatever happens, I believe
that the cash generated by following our Price Discipline will be welcome when
investors wake up because I suspect the results will not be pretty.
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 they are or
are not and the 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,
our 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; a potential escalation of
violence in the Middle East) 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 any further bounce in stock 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.
Thoughts
from a bull (medium):
DJIA S&P
Current 2015 Year End Fair Value*
12300 1525
Fair Value as of 10/31/15 12234
1517
Close this week 17215
2033
Over Valuation vs. 10/31 Close
5% overvalued 12845 1592
10%
overvalued 13457 1668
15%
overvalued 14069 1744
20%
overvalued 14680 1820
25%
overvalued 15292 1896
30%
overvalued 15904 1972
35%
overvalued 16515 2047
40%
overvalued 17127 2123
45%
overvalued 17739 2199
Under Valuation vs. 10/31 Close
5%
undervalued 11622
1441
10%undervalued 11016 1365
15%undervalued 10398 1289
* 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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