6/25/16
Statistical
Summary
Current Economic Forecast
2015
estimates
Real
Growth in Gross Domestic Product (revised)
-1.0-+2.0%
Inflation
(revised) 1.0-2.0%
Corporate
Profits (revised) -7-+5%
2016 estimates
Real
Growth in Gross Domestic Product -1.25-+0.5%
Inflation
(revised) 0.5-1.5%
Corporate
Profits (revised) -15-0%
Current Market Forecast
Dow
Jones Industrial Average
Current Trend (revised):
Short
Term Trading Range (?) 17498-18726
Intermediate Term Trading Range 15842-18295
Long Term Uptrend 5541-19413
2015 Year End Fair Value
12200-12400
2016 Year End Fair Value
12600-12800
Standard
& Poor’s 500
Current
Trend (revised):
Short
Term Trading Range 2037-2110
Intermediate
Trading Range 1867-2134
Long Term Uptrend 830-2218
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 negative: above estimates: weekly mortgage applications, month to
date retail chain store sales, weekly jobless claims, the June Markit manufacturing
flash PMI; below estimates: weekly purchase applications, May new and existing
home sales, the May Chicago national activity index, May durable goods, June
consumer sentiment, May leading economic indicators; in line with estimates: none.
In addition, the
primary indicators were universally downbeat: May new home sales (-), May
existing home sales (-), May durable goods (-) and May leading economic
indicators (-). Clearly, this week was
solidly in the negative column. The score is now: in the last 40 weeks, nine
have been positive to upbeat, twenty nine negative and two neutral. While these numbers in aggregate point at
recession, the past eight weeks stats have see sawed back and forth, raising
the question as to whether the economy is attempting to stabilize at an even
slower rate of growth than before. At
the moment, I believe the odds are low that this is occurring; but I leave it
as a possibility.
The numbers from
abroad were almost nonexistent and, hence, of little consequence this
week. That said, the international stats
have been bad enough, long enough that there is no reason to question the
overall trend.
Central banks
remained active. Yellen did her
semiannual Humphrey Hawkins testimony before congress, confirming the Fed’s dovish
reversal. She did one other extraordinary
thing---suggest that stocks were overvalued and that perhaps Fed policy wasn’t
working as it should.
I mentioned two
weeks ago that it seemed that the world was finally waking up to the fact that
QE and ZIRP have done little to foster economic growth and, indeed, may have
been a determent. Whether Yellen’s half-baked
mea culpa was recognition of this fact and a hint that policy changes are in
the offing is anyone’s guess. But if it
is the latter and the state sponsor of the mispricing and misallocation of
assets is about to alter course, the Market could be in for a rough ride.
In addition to
Janet’s comments, we got more evidence that the central banks were waking up to
their misdeeds as the Bank of Japan confessed that its aggressive pursuit of ‘free
money’ has not worked.
Finally, the
Brexit. I am not going to repeat the analysis
in yesterday’s Morning Call except for the bottom line. The fundamentals are not as negative as the
establishment crowd suggests. Remember,
it is this group that made a mess of things in the first place. Of course, it could scare the s**t out of the
central banks and delay or eliminate the chances that they will take any
corrective policy steps. However, as I suggested
above, it could the epiphany in which investors realize just how overvalued
many asset types have become.
In summary, this
week’s US data did little to allay my concern about a slowing economy/recession. Nor did the international data numbers. And the consequences of the Brexit vote, while
likely not nearly as bad as portrayed by the doomsayers, will probably not help
in the short run. The big question, are the central banks about to follow in
the footsteps of the Brexit vote (i.e. lose credibility like the EU)?
The new normal
(medium):
Our forecast:
a recession or a zero economic growth rate, caused
by 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. In the first phase of the latest Fed stress
test, the US banks continued to build capital strength---so US banks’ financial
condition further improved. In the very
near term, they will likely be tested by Brexit fallout. But given the reforms that have taken place, I
think US banks will be okay. That
doesn’t mean that all is well in the international ‘too big to fail’ land.
(2) fiscal/regulatory
policy. A good old fashioned college ‘sit
in’ in congress. Need I say more?
(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.
Yellen
confirmed the Fed’s 180 on future interest rate hikes by providing a long list
of economic concerns not the least of which were lofty stock valuations and the
risk that the Fed had delayed too long a transition to normalized monetary
policy. She was joined in her self-criticism
by Bank of Japan which has been the most profligate of all the central banks.
This comes on
top of a growing chorus of disparaging comments from outside sources. Whether
this marks the end of central bank credibility is still open to question. Certainly the Markets to date have taken it all
in stride. And their reaction to Brexit could make it a moot point---or simply exacerbate
it. We will likely know soon enough.
You know my
bottom line: QE [except QE1] and negative interest rates have done nothing to
improve any economy, anywhere, anytime; so its absence will do little
harm. What it has done is lead to asset
mispricing and misallocation. Sooner or later, the price will be paid for that.
The longer it takes and the greater the magnitude of QE, the more the pain.
(4) geopolitical
risks: one word---Brexit. As I have
already noted, I believe it is a long term plus. However, in the short term, there could be
disruptions; but not enough to alter our economic forecast. But remember, our outlook already calls for a
recession---which I hypothesize is a function of lousy monetary, fiscal and
regulatory policies.
To be sure
there is no short supply of Cassandra’s whining about the potential disasters
coming out of Brexit---but they are all part of cadre that implemented the
aforementioned lousy monetary, fiscal, regulatory policies in the first place. So for me, their pissing and moaning counts
for naught. But if economic conditions
do worsen, ten bucks says that they will point to Brexit as the convenient
target to deflect their own incompetence.
Now what
(short):
Greenspan on
the Brexit (medium):
(5)
economic difficulties in Europe and around the globe. There was a dearth of international economic
stats this week:
[a] Japanese exports fell for the fifth month in a row,
[b] the June Japanese Markit flash PMI came in flat
with May’s report.
This hardly deserves being counted. So I will conclude with the question that I posed
several weeks ago: is the global economy sufficiently weak to keep downward
pressure on the US economy?
Bottom line: the US economy remains weak though there is an
outside chance that it could be stabilizing.
Further, there is little promise that the global economy is growing and
the Brexit won’t help short term. Meanwhile,
our Fed remains confused; its policy subject to the slightest change in the
data. Central bank credibility is a growing
issue; though to date, investors don’t seem to care.
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 applications were up, but
purchase applications were down; May
existing home sales rose less than expected; May new home sales fell less than
consensus but largely due to a big downward revision in the April number,
(2)
consumer: month to date retail chain store sales were stronger
than the prior week; weekly jobless claims declined more than estimated; June
consumer sentiment declined slightly,
(3)
industry: May durable goods were well below forecast; the
May Chicago national activity index fell versus an anticipated increase; the
June Markit manufacturing flash PMI was slightly above projections,
(4)
macroeconomic: May
leading economic indicators declined versus consensus for an increase.
The Market-Disciplined Investing
Technical
The indices
(DJIA 17399, S&P 2037) had a volatile week, investors having completely
botched the bet on Brexit. Volume on Friday increased; but much of that was
related to the rebalancing of the Russell.
Breadth was terrible. The VIX was
up 49% (not a misprint), reflecting the turmoil in the Market. That staggering one day increase
notwithstanding, there is plenty of room left on the upside if the Averages
start breaking support levels (see below).
The Dow closed
[a] right on its rising 100 day moving average, now support, [b] above its 200
day moving average, now support, [c] below the lower boundary of its short term
trading range {17498-18726}; if it remains there through the close on Tuesday,
it will reset to a downtrend, [c] in an intermediate term trading range
{15842-18295} and [d] in a long term uptrend {5541-19413}.
The S&P
finished [a] above its rising 100 day moving average, now support, [b] above
its 200 day moving average, now support, [c] right on the lower boundary of its
short term trading range {2037-2110}, [d] in an intermediate term trading range
{1867-2134} and [e] in a long term uptrend {830-2218}.
The long
Treasury was up on heavy volume on Friday, reversing an otherwise really lousy
week of trading. While it is above its
100 day moving average and well within very short term, short term, intermediate
term and long term uptrends, it is bumping up against a stiff resistance level
which has already rejected TLT once.
That resistance needs to be overcome before I would get too optimistic
about still lower interest rates.
GLD was strong
on Friday, pushing through the upper boundaries of both its short term and
intermediate term trading ranges. If it
is able to confirm those breaks next week, there is no resistance until it gets
to 140 (the upper boundary of its long term downtrend). If it does reset those two trends, I will likely
add to our GDX position.
Bottom
line: as a result of Friday’s carnage, the
DJIA is challenging several support levels while the S&P hovers above its
comparable levels. So as bad as Friday seems, it would take more downside
momentum to have any impact on the overall direction of the Market---making it too
soon to be talking about even a modest correction.
Indeed, the universe
of media pundits talked all day about how contained the decline was and how few
the signs of panic. That leaves open the chance of a rebound from the current
level based not only on the lack of panic but also on the fact that the indices
are right on support levels. I am
watching for follow through before getting too beared up.
I am paying
particular attention to GLD because it busted through to major resistance
levels on Friday. Again, follow through
is the key; but the clock is now ticking on a major change in trend.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (17399)
finished this week about 39.0% above Fair Value (12512) while the S&P (2037)
closed 31.6% overvalued (1547). 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 US and
global economic numbers did little to influence our or likely anyone else’s
outlook. So I am sticking with our forecast
of recession.
What concerns me
is that, (1) most Street forecasts for the moment are more optimistic regarding
the economy and corporate earnings than our own but (2) even if all those
forecasts prove correct, our Valuation Model clearly indicates that stocks are
overvalued on even the positive economic scenario and (3) that raises questions
of what happens to valuations when reality sets in.
More on
valuations (must read):
In two days of
congressional testimony, Yellen did her part to contribute to declining central
bank credibility by (1) confirming the recent reversal in the Fed economic outlook
and (2) worrying about stock valuations [to which the Fed contributed mightily]
and the timing of a transition to normalized monetary policy [which is a poster
child for closing the barn door after the horse is out]. To be sure, investors haven’t yet reacted to
this phenomena---perhaps they either don’t believe it or just don’t care. Whatever the reason, the key point at the
moment is that the central banks apparently retain carte blanche to do anything
they want, however destructive it may be in the long term.
However, Brexit
could be the big challenge to equity prices.
As you well know, I have railed ad nauseum about the stock
overvaluation. Typically, corrections
come from one of those ‘huh oh’ moments, often some exogenous event. Brexit may qualify as such. We will just have to see.
Whether it is or
not, at some point, investors are going to realize that the Fed and its foreign
cohorts have screwed up the transition from extremely accommodative to
normalized monetary policy just like they have every other single time
throughout history. When that happens, I
believe that the cash generated by following our Price Discipline will be
welcome.
Net, net, my two
biggest concerns for the Markets are (1) declining profit and valuation
estimates resulting from the economic effects of a slowing global economy and
(2) the unwinding of the gross mispricing and misallocation of assets caused by
the Fed’s wildly unsuccessful, experimental QE policy.
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. Near
term that could be influenced by Brexit.
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 [which may be occurring now];
a potential escalation of violence in the Middle East and around the world)
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.
At the moment,
we need to see if the Brexit is the catalyst that triggers the mean reversion
of valuations. I am sticking with the
values as determined by our Model so it is too soon to be buying. It is not too soon to be working on our Buy
List. Patience, that is why we have all
that cash.
DJIA S&P
Current 2016 Year End Fair Value*
12700 1570
Fair Value as of 6/30/16 12512
1547
Close this week 17399
2037
Over Valuation vs. 6/30 Close
5% overvalued 13137 1624
10%
overvalued 13763 1701
15%
overvalued 14388 1779
20%
overvalued 15014 1856
25%
overvalued 15640 1933
30%
overvalued 16265 2004
35%
overvalued 16891 2088
40%
overvalued 17516 2165
45%
overvalued 18142 2243
Under Valuation vs. 6/30 Close
5%
undervalued 11886 1469
10%undervalued 11260 1392
15%undervalued 10635 1314
* 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.
