Saturday, July 23, 2016

The Closing Bell

The Closing Bell


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 Uptrend                                 17334-19084
Intermediate Term Uptrend                     11243-23973
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 Uptrend                                     2025-2264
                                    Intermediate Term Uptrend                         1903-2505
                                    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%

The economy provides no upward bias to equity valuations, though that could be changing.   The dataflow this week was mixed:  above estimates: June housing starts, June existing home sales, weekly jobless claims, the Chicago national activity index and the July flash manufacturing PMI; below estimates: the July housing index, weekly mortgage and purchase applications, month to date retail chain store sales, the Philly Fed index; in line with estimates: June leading economic indicators.

However, the primary indicators were weighed to the positive side: June housing starts (+), June existing home sales (+) and June leading economic indicators (0).  That clearly puts the week in the plus again, extending the streak of upbeat weeks to four in a row.  So the economy is, at the least, taking a pause in the midst of cyclical weakness and, at the most, beginning to stabilize after a tough ten months.  I remain as yet unsure 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. 

The growth pattern of the US economy (medium and today’s absolute must read):

I am not altering our recession forecast but the red light for change is flashing. The score is now: in the last 44 weeks, thirteen have been positive to upbeat, twenty nine negative and two neutral. 

On the other hand, the numbers from abroad continued to be negative as China suspends reporting on several important economic indicators (that can’t be good news).  In addition, the consequences from the Brexit and the developing problems in the Italian, German and Greek banking systems remain in question. 

In the last two weeks, the Fed has been out in force beating the ‘no rate hike’ drums, suggesting to me that an increase is off the table at least until after the election.  It is somewhat ironic that this latest campaign to quell fears of tighter money comes in the midst of a marked improvement the economic data as well as a Market moonshot---which, as we all know, is the true object of their ‘data dependency’. 

In addition, the ECB left rates unchanged, which is to say, quite low.  However, the Bank of Japan poo pooed the idea of ‘helicopter’ money.  I don’t know if this means that the Bernank was unsuccessful in pushing the idea onto the Japanese or if these guys are just lying to prevent the algos from front running the policy.  We will likely know soon enough.

In summary, this week’s stats from the US were positive, keeping alive the prospect that our recession forecast may be wrong.  On the other hand, the international data continues to disappoint; and we haven’t even seen the potential fallout from Brexit and/or the mounting EU banking difficulties.  For the moment, I am not altering our outlook though the red warning light is flashing. 

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.  Deutschebank and the Italian banking system continue on red alert.  The latter was not helped this week by an EU high court ruling that its current bailout plan was illegal.

 Either one of the above could stimulate a Lehman Brothers type crisis in their respective countries and increase the likelihood that the contagion could spread throughout Europe. 

(2)   fiscal/regulatory policy.  None and there won’t be until next year.  That said, in his acceptance speech, The Donald not only promised a lot of stuff that costs money but also to lower taxes.  Same old, same old.

(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.  

As I noted above, the Fed is doing what it does best---standing around looking like a deer in the headlights.

As for other central banks, the ECB left rates unchanged [surprise, surprise] and the BOJ said that there was no need for ‘helicopter’ money.

Why helicopter money won’t work (medium):

You know my bottom line: QE [except QE1] and negative interest rates have done nothing to improve any economy, anywhere, anytime; so their absence will do little harm.  What they have 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. 

Comments from a former BIS chief economist (medium):

(4)   geopolitical risks: Brexit vote proved a nonevent, the Middle East quagmire is, at the moment, just white noise while terrorism has gained center stage.  Of course, the latter can go on forever with little impact on the US or global economy.  Their risk is largely psychological and they to only have economic or Market influence if they add fuel to a larger negative narrative---like the vanishing anchovies off the Peruvian coast back in the mid-70’s inflation crisis.  And as we all know, at the moment, there is no negative narrative anywhere is sight---at least that anyone is paying attention to.

That said, lurking in the weeds is the potential banking crises developing in Germany and Italy.  Of course, the willingness of the central banks to continue paper over bank insolvencies is without limit and the willingness of the Markets to ignore the obvious has been story line for the last eighteen months.  So this too may only matter in the context of the aforementioned as yet unappreciated larger negative narrative.

A sanguine look at the Italian banking problem and its potential solution (medium):

(5)   economic difficulties in Europe and around the globe.  The international economic stats this week were mixed to negative.

[a] the June UK inflation rate rose, unemployment fell to an eleven year low, retail sales declined and its flash composite PMI was a disaster; German and EU economic sentiment declined; the EU flash composite PMI fell but less than anticipated,

[b] China suspended the reporting of two key economic indicators {any thoughts on why?}
[c] the July Japanese manufacturing PMI rose slightly but remained in negative territory.

Add 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 a growing chance that it could be stabilizing.  However, there is little aid from the global economy; and the potential consequences of the Brexit and the mounting EU banking crisis could make things worse.  Meanwhile, our Fed remains confused, inconsistent and seemingly oblivious to 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: the July housing index was below estimates; June housing starts were quite strong and existing home sales were above expectations; weekly mortgage and purchase applications were down,

(2)                                  consumer: month to date retail chain store sales were weaker than the prior week; weekly jobless claims fell versus forecasts of a rise,

(3)                                  industry: the July Philadelphia Fed manufacturing index was disappointing while the June Chicago NAI and the July flash manufacturing PMI were better than consensus,

(4)                                  macroeconomic: the June leading economic indicators were up and in line.

  The Market-Disciplined Investing

The indices (DJIA 18570, S&P 2175) maintained their relentless advance on strong breadth and benign volatility (VIX)---indeed, after trying to rebound from resetting to a downtrend, it (12) fell again on Friday and is not the far from the lower boundary of its intermediate term trading range (10.3).

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 uptrend {17334-19084}, [c] in an intermediate term uptrend {11243-23973} and [d] in a long term uptrend {5541-19431}.

The S&P finished [a] above its rising 100 day moving average, now support, [b] above its 200 day moving average, now support, [c] within a short term uptrend {2027-2266}, [d] in an intermediate uptrend {1903-2505} and [e] in a long term uptrend {862-2246}. 

The long Treasury was up on Friday.  It seems to have stabilized after a couple of tough weeks and 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 down on Friday, but remained above its 100 day moving average and within very short term, short term and intermediate term uptrends.

Finally, on Friday, the dollar closed above the upper boundary of its short term downtrend.  If this trend gets broken and opens up the possibility of further advances of the dollar, it will not bode well for revenue and profit growth on the large US multinationals.

Bottom line:  the bulls control the field.  Both Averages are in solid uptrends across all timeframes; and so far, consolidations have been very tame. On top of that the VIX seems headed for new lows.  I believe that a challenge of the indices’ upper boundaries of their long term uptrends is highly likely; but I question its success.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18570) finished this week about 48.0% above Fair Value (12543) while the S&P (2175) closed 40.3% 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 were again positive.  Now we have a trend---at least a very short one.  But that is not quite enough to prompt a change in forecast.  If you didn’t read the above post (The growth pattern of the US economy), please do.  The author expresses much more eloquently than I my hesitancy in altering our outlook.  Of course, investors have no such timidity.  They may be right; but I am going to opt for getting more information.  That said, as I have repeatedly said, the health of the Market right now is less dependent on the health of the economy and more on continuing central bank ease.

Overseas---still no improvement.  The effects of Brexit are clearly visible in the latest UK numbers; whether that spreads to the rest of the EU remains to be seen. Of course, the EU has its own set of problems (banking system) to deal with.  In Asia, Japan remains in recession.  Plus we have no idea what is happening in China because things have deteriorated enough that lying about the numbers no longer suffices.  This week the government simply refused to report the data.  In short, if the US economy has started to gain strength, it is doing it on its own.

What concerns me is that, (1) most Street forecasts for the moment are more optimistic regarding the economy and corporate earnings [down 4% in the second quarter at the latest count] 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 continues to press forward to even greater heights on asset mispricing and misallocation.  Despite the recent improvement in the dataflow, virtually the entire membership of the FOMC have in the last two weeks voiced the ‘no rate hike’ mantra.  I can understand that the QE narrative would remain unchanged at the same time the dataflow turns upbeat because that whole data dependency spiel was just a lot smoke.  What I don’t understand is the seeming unwillingness to consider tightening when the Market is at all-time highs---which, after all, has been the true determinant of Fed policy lo these many years.  My only explanation is that these guys/gal are so paralyzed by fear of QE unraveling, they are frozen into inaction.

As you know, I 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                                               18570            2175

Over Valuation vs. 7/31 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
            50% overvalued                                  18814              2325

Under Valuation vs. 7/31 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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