The Closing Bell
7/9/16
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 17498-18167
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 862-2246
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 the strongest in 42 weeks: above estimates: weekly
mortgage and purchase applications, month to date retail chain store sales, June
nonfarm payrolls, the June ADP private payroll report, weekly jobless claims, June
services PMI and the June ISM services index; below estimates: the May trade
deficit; in line with estimates: May factory orders and June retail chain store
sales.
The primary
indicators were weighed to the plus side: June nonfarm payrolls (+) and May
factory orders (0). So this was clearly
a very upbeat week, the second in a row.
Plus most of the positive weeks have come in the last twelve weeks,
suggesting a decline in the rate of deceleration in economic growth and perhaps
even a turnaround. That said, (1) it is
too soon to make that call, (2) primarily because the pattern of the economic
indicators over the past couple of years has been a lousy first quarter, a
bounce back in the second quarter and then a return to mixed to negative
numbers for the rest of the year.
On the other
hand, we can’t ignore the recent progress.
So I am turning on the flashing yellow light indicating that a change in
trend may be occurring; but I am not altering our recession forecast---at least
for the time being. The score is now: in the last 42 weeks, eleven have been
positive to upbeat, twenty nine negative and two neutral.
Unfortunately, the
numbers from abroad continued to be negative.
Ironically, what improvement there was came in Europe. Given the as yet unknown consequences of
Brexit and the developing problems in the Italian, German and Greek banking
systems, it hardly makes sense at this time to be getting jiggy about progress
there.
The minutes from
the most recent FOMC meeting were released this week. They reflected the same confused/cowardly group
of academics that we have become accustomed to---meaning the likelihood of a
return to normalized monetary policy is still in the distant future. This seems a step back from the recent hints
from central bankers in general that they realized QE and ZIRP haven’t worked
and policy changes were in order.
While the FOMC’s
pabulum will undoubtedly make that QEInfinity crowd happy, it will do nothing
to correct the 1000 pound gorilla in the room---asset pricing and allocation
have been distorted beyond recognition and there is a price to be paid for it.
In summary, this
week’s stats from the US were positive.
In addition, the US dataflow has been sufficiently upbeat in the last
eight weeks to bring into question our recession forecast. On the other hand, the international data continues
to stink; and we haven’t even seen the potential fallout from Brexit and/or the
mounting EU banking difficulties. So for
the moment, I am not altering our outlook though I did switch on the warning
light.
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.
We are all Keynesians now
(a bit long but a must read):
The
negatives:
(1)
a vulnerable global banking system. While the US banks continue to improve their
balance sheets, the same cannot be said for their EU counterparts. Concerns are
now blossoming over the solvency of Deutschebank as well as the entire Italian
banking system. Either one of these
could simulate a Lehman Brothers type crisis in their respective countries and increase
the likelihood that the contagion could spread throughout Europe. Remember all these EU banks are tied via
counterpart risk in the derivatives markets.
I can’t tell you that this risk could be devastating to the European
banking system [and perhaps beyond]; but neither can anyone else---and that’s
the risk. We do know that the notional
value of these derivatives are in the trillions. All it takes is one default and the dominoes
start falling.
Contagion from the Italian banking system (medium and a must
read):
More banker mischief:
(2) fiscal/regulatory
policy. None and there won’t be until
next year---although we do know that the FBI is at the top of its game.
(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.
I have provided
enough disparaging commentary that there shouldn’t be any questions on my
thoughts on the FOMC minutes released on Wednesday. The bottom line is that I doubt there will be
any rate hikes this year; and if the confusion portrayed in the aforementioned minutes
persists, there may never be.
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: Brexit fall out is by far the greatest issue under this risk. I have
said before that I doubted the doom and gloom consequences to the UK espoused
by its opponents. However, they may be
different for the rest of the EU, especially if Brexit leads other countries
voting to withdraw---and that precipitates problems in the financial
system.
That said, the
suspension of redemptions in seven UK property funds is clearly not a plus for
the UK or the Markets. Remember, when
the brown stuff hits the fan, investors don’t sell what they want to sell, they
sell what they can sell. And now we have
the first subsector of an asset class that can’t be sold. That is not a positive indicator of what
happens next.
Not helping
matters are already minor banking crises developing in Germany and Italy that
are largely the result of the papering over of massive nonperforming loans in
already highly leveraged balance sheets.
Nor is the fact that sovereign credit ratings are deteriorating at an
increasing rate. I have no idea how this
story ends; but I know what has already happened and that is the bank stocks
are getting crushed. That is at least a
hint that bankruptcy is a possibility---which would add another subsector of an
asset class that can’t be sold.
Judging by our
Market’s reaction, investors clearly at this point believe that the consequences
are minimal. And they may be. But I can’t dismiss this risk so easily. There remains, in my opinion, some
probability that Brexit and/or the growing banking crisis in Germany and Italy
could catalyze the undoing of years of lousy [collective and individual] monetary,
fiscal and regulatory policies.
(5)
economic difficulties in Europe and around the globe. There international economic stats this week
were mixed to negative.
[a] the June EU Markit flash composite index was above
estimates; May German factory orders were flat while industrial output declined;
May German and Japanese trade surpluses declined,
[b] the June China Markit flash services PMI was
better than expected,
[c] May UK
industrial production fell less than forecast but retail sales were lousy.
Add the potential fallout from the Brexit and the mounting
banking problems in Europe and little support for the US economy can be
expected from abroad.
Bottom line: the US economy remains weak though there is an
outside chance that it could be stabilizing.
Further, there is little aid from the global economy 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 and purchase applications were
up,
(2)
consumer: month to date retail chain store sales were
stronger than the prior week; June retail sales were mixed; the June ADP
private payroll report showed a better than anticipated increase in jobs; June
nonfarm payrolls were exceptionally strong; weekly jobless claims fell versus
an expected rise,
(3)
industry: May factory orders were in line; the June
services PMI as well as the June ISM nonmanufacturing index were above estimates,
(4)
macroeconomic: the May trade deficit was bigger than
consensus.
The Market-Disciplined Investing
Technical
With Friday’s
Titan III shot, the indices (DJIA 18146, S&P 2129) have now shaken off the
Brexit surprise. Volume on Friday rose
slightly but was still low. Breadth was strong. The VIX (13.3) fell 10%. It remains below its 100 day moving average
and appears to be setting up to challenge the lower boundary of its short term trading
range (12.7) for a sixth time.
The Dow closed
[a] above rising 100 day moving average, now support, [b] above its 200 day
moving average, now support, [c] within a short term trading range {17498-18167},
[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] above the upper boundary of its short
term trading range {2037-2110}; if it remains there through the close on
Tuesday, it will reset to an uptrend, [d] in an intermediate term trading range
{1867-2134} and [e] in a long term uptrend {862-2246}.
The long
Treasury was up on good volume on Friday.
It continues to trade above its 100 day moving average and well within
very short term, short term, intermediate term and long term uptrends.
GLD was up on
Friday, ending above its 100 day moving average and within short term and
intermediate term uptrends.
Bottom
line: the indices kicked in the
afterburners on an ‘everything is awesome’ scenario on Friday. Both are either challenging or near
challenging multiple resistance levels. I
noted previously, this zone of heavy congestion is likely to make the upward
progress an effort--- though Friday’s moonshot certainly doesn’t support that
notion. The only negative wrinkle in an
otherwise bullish chart pattern is the lack of volume.
That TLT and GLD
are also both rallying is somewhat confusing to me. The best explanation that I have is that TLT
and GLD are up based on a lousy outlook for everywhere but the US; and stocks
are up based on the prevailing belief that the Fed can do no wrong---no matter
what is reported in the US dataflow. I
don’t need to tell you what I think of that notion.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (18146)
finished this week about 44.6% above Fair Value (12543) while the S&P (2129)
closed 37.3% overvalued (1550). 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 economic
numbers made for very good reading. It
was one of the strongest weeks in the last year and was the second upbeat week
in a row---something we haven’t seen. We
got a cherry on top on Friday as the June nonfarm payroll number greatly
exceeded expectations---which had investors wee weeing in their pants. Before you do the same, read the following
analysis of the number. Both of these
are from bulls.
At the moment,
the issue in my mind is, is the recent improvement in the dataflow a true sign
of stabilization or just a temporary rebound of a very poor first quarter? Time will give us the answer. But as I have said repeatedly, the health of
the Market right now is less dependent on the health of the economy and more
related to the gross mispricing of assets.
That said,
international developments are not contributing to any improvement in our own economy,
assuming that there even is one. Global datapoints have shown economic
weakening in all quarters; and the fallout from the Brexit (even though I don’t
think it will be nearly as bad as many others do) plus the problems within the
EU banking system could potentially lead to an EU Lehman Brothers moment---‘potentially’
being the operative word.
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.
On the other hand,
the Fed is doing its dead level best to keep QEInfinity crowd in la la
land. This week’s release of the minutes
of the most recent FOMC showed a Fed that it completely unwilling to make a
decision on the state of the economy or to alter its grossly irresponsible
monetary policy.
As you know, I
believe that this is the direction from which a Market correction will come. To be sure, investors to date haven’t given a
rat’s ass. But I also believe that
sooner or later, the price will be paid for flagrant mispricing and
misallocation of assets.
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; an EU banking crisis [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.
DJIA S&P
Current 2016 Year End Fair Value*
12700 1570
Fair Value as of 7/31/16 12543
1550
Close this week 18146 2129
Over Valuation vs. 6/30 Close
5% overvalued 13170 1627
10%
overvalued 13797 1705
15%
overvalued 14424 1782
20%
overvalued 15051 1860
25%
overvalued 15678 1937
30%
overvalued 16305 2015
35%
overvalued 16933 2092
40%
overvalued 17560 2170
45%
overvalued 18187 2247
Under Valuation vs. 6/30 Close
5%
undervalued 11915
1472
10%undervalued 11288 1395
15%undervalued 10661 1317
* 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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