Saturday, July 30, 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                                 17403-19149
Intermediate Term Uptrend                     11277-24107
Long Term Uptrend                                  5541-19431
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2039-2278
                                    Intermediate Term Uptrend                         1907-2509
                                    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 returned to the negative column:  above estimates: June new homes sales, month to date retail chain store sales, July consumer confidence, the July Chicago PMI and the Dallas and Richmond Fed’s July manufacturing indices; below estimates: the May Case Shiller home price index, June pending home sales, weekly mortgage and purchase applications, weekly jobless claims, the July Markit flash services PMI, the July Kansas City manufacturing index, June durable goods orders, second quarter GDP and price deflator and the June trade deficit; in line with estimates: none.

The primary indicators were also disappointing: June new home sales (+), June durable goods orders (-) and second quarter GDP (-).  With such a marked turn in the numbers, the question is which is the outlier---this week’s return to the long term negative trend or the prior four upbeat weeks bounce, indicating a stabilization in the economy?  The answer is that I don’t know; but you see the reason I have held off making a change in our forecast.  It also leaves open the chance that this year will be a repeat of the prior two---a lousy first quarter, a rebound in the second quarter and then a return to mixed to negative numbers for the rest of the year. 

The score is now: in the last 45 weeks, thirteen have been positive to upbeat, thirty negative and two neutral. 

While sparse, the numbers from abroad improved slightly.  Much more of this is needed to provide any proof that the global economy is getting better. 

Meanwhile, the developing problems in the Italian, German, Portuguese and Greek banking systems remain in question.  Of course, you wouldn’t know it by reading the results of the latest EU banking ‘stress’ test that were released last night.  On the plus side, there were a number of banks, particularly the British banks, which have made definite progress in building capital and getting nonperforming loans under control.  That said, in performing the ‘stress’ test the EU banking authorities didn’t issue pass or fail ratings, excluded Greek and Portuguese banks, presumably because they are in such bad shape and there were no penalties for being lousy or near insolvent. 

As expected the Italian banks were among the weakest banks with one of them rated as the worst of all banks measured.  But who cares.  This ‘stress’ test was like my grandson’s soccer league.  There are no winners or losers and everyone gets trophy no matter how sh*tty a player he is.  So I guess there is no banking crisis; there is just a bunch of bankers walking around with a stick of dynamite stuck up their ass waiting for that unexpected kick.

The FOMC met this week; and while it acknowledged that the economy was improving, it still did nothing by way of monetary tightening.  To be fair, it is likely that even if the committee was convinced that it was time to raise rates, they likely wouldn’t due to the potential impact on the election.  That said, I don’t believe the elections had had jack to do with the decision.  The only thing that matters is asset prices.

In addition, the ECB left rates unchanged, which is to say, quite low.  And Bank of Japan after doing three days of the green apple two step ended up leaving rates unchanged and barely increasing its asset buyback program.  I don’t know if this means that the Bernank was unsuccessful in pushing the ‘helicopter’ money strategy onto the Japanese or if the Japanese rejected it or if he actually recommended restraint.  It would be interesting to know because it could have implications here.

In short, global QE seems to be, at least temporarily, stalled.

In summary, this week’s US stats turned negative again; while the international data was marginally improved.  Central banks have thankfully put monetary expansion on hold for the moment.  However, we still 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 have seriously impaired balance sheets notwithstanding the happy face being put on by EU banking officials.  Conditions are so bad in the Greek and Portuguese banks that those same authorities wouldn’t even release their results in the latest ‘stress’ test.  Clearly, the EU strategy is to pray that their banking system will ‘muddle through’; and it may.  But it still poses the risk of a Lehman Brothers type crisis.

(2)   fiscal/regulatory policy.  

Martin Feldstein on the deficit (medium):

David Stockman on fiscal policy (medium and a must read):

Alan Greenspan on the coming stagflation (medium):

(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 G20 met this week and mumbled through its analysis and recommendations for stimulating global growth.

The ECB met and left policy unchanged; but promised that more monetary ease was coming.

The FOMC met and, aside from stating the obvious, did nothing. 

In Japan, government took a page out of our Fed’s playbook, leaking multiple versions of new improved fiscal policies to spur domestic growth and then presented an aggressive stimulus program but with insufficient details on implementation.  That turned investor attention to the Bank of Japan, who it was hoped would provide the means [i.e. abundant QE] for the execution of the as yet unclear fiscal measures.  Well, that didn’t work out so well because the BOJ did very little---leaving everyone guessing about what will really happen.  Of course, since the Japanese copied the Fed in their presentation, it is not surprising that they got a similar result---confusion. 
It may just be coincidence but there is a definite pattern to the above; that is, no central bank did anything of substance to further the cause of QEInfinity.  Whether that means that they all think the global economy has improved to the point no further monetary stimulus is necessary or that they have all figured out that QEInfinity hasn’t worked and more of the same won’t either or that it is just a coincidence is anyone’s guess at this point.

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. 

(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 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 in 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 (and now Portugal)Plus the Catalan parliament voted to secede from Spain, which only adds to the potential risk of social/political and financial instability in the EU.  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.’

(5)   economic difficulties in Europe and around the globe.  The international economic stats, while meager this week, were tilted to the positive side.

[a] second quarter UK GDP was stronger than projected, but July retail sales were quite weak; July Italian business and consumer confidence rose while July German business sentiment declined less than anticipated; July German and Spanish unemployment fell while Italian unemployment rose; second quarter French GDP was disappointing; July EU flash inflation advanced in line,

[b] June Japanese exports and imports fell markedly though not as much as estimated; the July Japanese manufacturing PMI rose slightly but remained in negative territory.

While I will take any improvement in a seriously negative trend, this week’s turnaround is hardly impressive.  Certainly, this upbeat blip in an otherwise cheerless trend toward a weakening global economy is no reason to question its overall direction.  Add the mounting banking problems in Europe and little support for the US economy can be expected from abroad.

You must read this stunning self critique by the IMF of its failed policy in Greece.  The question is will it have any effect on the next crisis?

Bottom line:  the US economy remains weak though there is a 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: June new home sales were strong, but pending home sales were weak; the May Case Shiller home price index was disappointing; weekly mortgage and purchase applications were down,

(2)                                  consumer: month to date retail chain store sales were better than the prior week; July consumer confidence was up more than anticipated while consumer sentiment was up less; weekly jobless claims rose more than expected,

(3)                                  industry: July durable goods orders were much worse than estimates; the July Dallas and Richmond Fed’s manufacturing indices were better than consensus while the Kansas City index was worse; the July Chicago PMI was higher than projected; the July Markit flash services PMI was less than forecast,

(4)                                  macroeconomic: second quarter GDP was one half of expectations while the price deflator was much higher; the June US trade deficit was larger than projected.
The Market-Disciplined Investing

The indices (DJIA 18432 S&P 2173) closed near the flat line again yesterday (Dow down, S&P up).  Volume rose and breadth continued weak.  The VIX plunged 6.7%, closing back below the lower boundary of its former short term trading range (having successfully challenged, then regaining it the day following the reset, staying there four days and now finishing well below).   I remain on the fence on this directional call.

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 {17403-19149}, [c] in an intermediate term uptrend {11277-24107} 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 {2039-2278}, [d] in an intermediate uptrend {1907-2509} and [e] in a long term uptrend {862-2246}. 

The long Treasury rose nicely, ending above its 100 day moving average and well within very short term, short term, intermediate term and long term uptrends. 

GLD jumped 1%, ending above its 100 day moving average and within very short term, short term and intermediate term uptrends. 

Bottom line:  ‘the equity Market keeps sleeping through a heavy calendar economic data, earnings reports and central bank meetings---although to be fair there wasn’t much new in any of this.  This pin action is encouraging in that the current sideways consolidation after a ten percent up move suggests that the bulls are still in control.’ 

But I am uneasy over the simultaneous volatility in the VIX and the bond, gold, oil and currency markets.  Something seems amiss.  Be careful.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (18432) finished this week about 46.9% above Fair Value (12543) while the S&P (2173) closed 40.2% 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 quite negative---a clear reversal of the prior four weeks’ data.  To be sure, we can’t ignore those four weeks; so I leave open the possibility that the economy is stabilizing.  However, I can’t ignore the US growth pattern of the last two years [down Q1, rebound in Q2, more weakness in Q3/Q4].  What we need is more information and until we receive a sustained directional bias to the contrary, our forecast of recession stands. 

Overseas, we saw a slight improvement in the economic numbers.  That said, we are yet to see any consequences of (1) the Brexit.  As you know, I am an optimist on this point; but I still expect some weakness, (2) the banking problems in Germany and Italy; (3) the Catalan secession vote.  I am making no predictions here; but the best thing that could happen is nothing. 

What concerns me is that, (1) most Street forecasts for the moment are more optimistic regarding the economy and corporate earnings [down 3% in the second quarter at the latest count] than either the numbers imply or our own outlook 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.

That said, the Market to date has been inversely correlated to the economy because of the heavy influence of monetary policy [weak economy = easy Fed = rising stock prices].  So you would think that a recession would be good for the Market.  The obvious problem with this rationale is that by extension, if we got a depression, stock prices would soar---which defies logic I don’t care how easy the Fed may be.  On the other hand, by implication, an improving economy would suggest a decline in stock prices especially when they are already in nosebleed territory.

So as I see it, stocks are at or near a lose/lose position.  If the economy is in fact going into recession, sooner or later the deterioration in corporate income, dividends and balance sheets will overwhelm the present positive psychological predisposition toward an irresponsibly easy monetary policy.  If the economy does improve, then sooner or later the fixed income market will force the Fed to tighten and the QE magic will be gone.  Or it may be that some exogenous event hits investors between the eyes and they suddenly recognize Fed policy for the sham that it is.

 In any case, at the moment, investor psychology seems inextricably tied to its confidence in the Fed remaining accommodative.  On that score, the central banks did little to build investor confidence this week: the ECB did nothing but promised more; the Fed did nothing and the Japanese put on their best Kabuki dance, promising much and delivering little.  Plus the bankers, the white washed EU ‘stress’ test notwithstanding, are faced with some potentially harrowing events: ECB bank illiquidity, the fallout from Brexit and the whatever results from the Catalan secession.

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                                               18432            2173

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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