The Closing Bell
8/27/16
We are going to Italy to celebrate my wife’s sixtieth birthday. We will be gone for three weeks---back on
September 19. As always, I will have my
computer with me. So if something big
occurs, I will be in touch. That said,
stocks would have to be down 30-40% before reaching Fair Value and warranting
any action.
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 17724-19458
Intermediate Term Uptrend 11333-24160
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 2080-2316
Intermediate
Term Uptrend 1923-2525
Long Term Uptrend 862-2400
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 55%
Economics/Politics
The
economy provides no upward bias to equity valuations. The
dataflow this week was a wash: above
estimates: July new home sales, July Chicago national activity index, July
durable goods orders, weekly jobless claims, the July trade deficit; below
estimates: weekly mortgage and purchase
applications, July existing home sales, August consumer sentiment, the August Markit
manufacturing index and the August Richmond Fed manufacturing index; in line
with estimates: month to date retail chain store sales, the August Kansas City
Fed manufacturing index, the August Markit flash services PMI, revised second quarter GDP and corporate profits.
However, the primary
indicators were slightly positive: July new home sales (+), July durable goods
orders (+), July existing home sales (-) and revised second quarter GDP (0). So I
score this week as a plus by a hair. This
keeps alive the notion that the economy could be stabilizing but is not enough
to warrant a change in our forecast. The
score is now: in the last 49 weeks, fifteen have been positive to upbeat, thirty-one
negative and three neutral.
Overseas, the
data was also evenly divided. That
leaves the current lengthy dreadful trend in the global economy solidly to the
downside. Meanwhile, the developing
problems in the Italian, German, Portuguese and Greek banking systems remain a
question mark.
Central banks
didn’t alter their strategy this week.
In the US, all the recent dovish/hawkish see sawing back and forth among
the FOMC members continued with Yellen’s speech on Friday as she first sounded
a bit hawkish, then made a very dovish statement. This was followed by hawkish comments from
Fischer---in short, keep everyone confused because that’s what the Fed is. Across the pond, the ECB has begun buying
private placement corporate debt issues; which is about as close to ‘helicopter
money’ as you can get without actually doing it. In other words, central bank QE continues
unabated and with it, the severe distortion in asset pricing and allocation.
In summary, this
week’s US economic stats were marginally better, while the international data
treaded water. The Fed continued its
strategy of talking a lot, doing nothing, masking it with double talk and praying
for a miracle to extract it from the hole in which it has dug itself. For the moment, I am not altering our outlook
though the yellow warning light for change is flashing.
Business cycle
risk report (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. This article says all that needs to said for
this week’s coverage of this issue:
Deutschebank
sends up a warning flag (medium):
(2) fiscal/regulatory
policy. What fiscal policy?
And:
(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.
We started the
week with a statement from Fed vice chair Fischer which had a hawkish
tone. [recall last week, two regional
Fed heads gave hawkish comments, one a dovish comment and the latest FOMC
minutes were indecipherable]. Everyone
assumed that Janet would put a cherry on top with her Jackson Hole speech on
Friday---and she did with another rendition of her ‘on the one hand, on the
other hand’ waltz.
A summary of
her remarks (medium):
Markets’
reactions (short):
Then in a follow
up interview, Fischer said that Janet’s comments were consistent with a
September rate hike---which led to a second 180 in the Markets.
Bill Gross on
Friday’s events (short):
The yield curve
on Friday’s events (short):
As you know, I
have no problem with a September rate hike; indeed, I thought that
normalization should have begun two years ago.
That is not the problem. The
problem is that the Fed members can’t get on the same page, whether deliberately
to generate a smoke screen or because they are truly confused. They all see the same data, but their promise
of open and transparent communication with the Markets ain’t workin’; and it is
confusing the hell out of everybody---whatever the reason.
I will never
forget what my freshman English teacher told me: you are only as smart as you can communicate
that intelligence to others. In other
words, you could be Albert Einstein; but if you can’t explain the theory of
relativity, you might as well have the IQ of a sack of rocks. By that definition, this Fed has the IQ of a
sack of rocks.
And how is this
for dazzling with your footwork (short):
As I noted in
Thursday’s Morning Call, the mass confusion the Fed has created, in my opinion,
is ‘(U)unfortunately,…. the result of the
Fed’s pursuit of an ill-conceived monetary policy, lying about the goals of
that policy, failing to achieve even a modicum of success in improving the
economy, driving asset prices to extreme speculative levels, neglecting to
admit any of the above and creating the fantasy that they have matters under
control when in fact they are clueless and powerless to correct the disaster
which they have created for the economy and the Markets.’
The reckoning
looms (medium and a must read):
And speaking of
reckoning, how would you like to be a Japanese pensioner? (medium):
And if all this
wasn’t enough, it now appears that the ECB, which has been desperate for any measure
that would expand its QE program, is now buying private placement corporate
debt. If they were buying private
placement government debt, it would be called ‘helicopter money’. One has to wonder when central bankers will
recognize the futility of their efforts and, more importantly, the damage they
are doing to the financial markets?
What is
especially important is that despite central bank efforts to keep interest
rates low, Libor rates are rising---not the outcome that was planned. To be fair, some experts are pointing to the
change in rules regulating US money market funds which has created a lot of cross
currents in the short term interest rate Markets. Others disagree. This is something to watch because a
flattening yield curve has historically been associated with recession.
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.
There is no
recovery for central banks to create (medium and today’s must read):
(4) geopolitical
risks: Brexit, Turkey, war in the middle east, global terrorism, Chinese
aggression in the South China Sea and now Ukraine [again] are on ‘simmer’. While each has the potential to develop into
something bigger, none of them have risen to the level of crisis. Barring some dramatic development or the
appearance of a general negative narrative to which they could contribute, this
risk will remain of lesser importance.
(5)
economic difficulties in Europe and around the globe. The international economic stats, while in
short supply this week, were directionless.
[a] the August EU flash composite and services PMI were
better than expected while the flash manufacturing PMI was worse; the August
German flash manufacturing PMI and the German Info Institute business climate
index was below estimates; the July UK sentiment index rose,
[b] the August
Japanese manufacturing PMI remained in negative territory but was slightly
better than forecast and July PPI was the highest in ten months,
[c] is Portugal
the next shoe to drop?
So this week is neutral---which hardly matters in the midst
of an otherwise abysmal trend. Plus, it says nothing about by the mounting banking
problems in Italy and Germany.
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 inconsistent further
increasing the loss of central bank credibility; 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: July new home sales were substantially better
than expected while July existing home sales were equally bad; weekly mortgage and
purchase applications were down,
(2)
consumer: month to date retail chain store sales growth
were flat with the prior week; weekly jobless claims were slightly better than
estimates; August consumer sentiment was below projections,
(3)
industry: July durable goods orders were better than
consensus; the July Chicago national activity index was better than forecast; the August Markit flash manufacturing PMI was
lower than anticipated while the services PMI was in line; the August Richmond
Fed manufacturing index was very disappointing,
(4)
macroeconomic:
revised second quarter GDP was in line; the GDP price index rose more
than projected; corporate profits fell; the July trade deficit was less than
expected.
The
Market-Disciplined Investing
Technical
On Friday, the
indices (DJIA 18395, S&P 2169) sold off slightly. But that in no way portrays the intraday
volatility generated by the confusion created by the Yellen/Fischer combo
statements. That volatility was present
in all Markets. If you look at the
charts of TLT, GLD, VIX, UUP, they all had major intraday price swings on huge
volume. That said volume on the equity
exchanges rose only slightly, while breadth weakened further. The VIX was up
modestly; but intraday, it pushed above its 100 day moving average only to
retreat later and has now made a fourth higher low---not a great signal for
stocks.
The Dow ended
[a] above rising 100 day moving average, now support, [b] above its 200 day
moving average, now support, [c] within a short term uptrend {17724-19458}, [c]
in an intermediate term uptrend {11333-24160} 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 {2080-2316},
[d] in an intermediate uptrend {1923-2525} and [e] in a long term uptrend
{862-2400}.
The long
Treasury declined, ending above its 100 day moving average, well within very
short term, short term, intermediate term and long term uptrends, but is near
challenging the low of the recent tight trading range.
GLD also fell, but
finished above its 100 day moving average and within short term and
intermediate term uptrends. Like TLT, it
is near dropping out of a recent trading range.
Bottom line: the
charts of the Averages, TLT and GLD continue to point up; but all have worrying
short term technical problems---which I have talked about ad nauseum for the
last two weeks. And Friday’s intraday
volatility on big volume did nothing to decrease my concerns. There are enough contradictory signals from
different Markets to suggest that something is amiss. Be careful.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (18395)
finished this week about 46.6% above Fair Value (12543) while the S&P (2169)
closed 49.9% 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 positive again; but just barely.
Certainly not on the scale of last week and hardly improve the case that
the economy is stabilizing. While I am
leaving open that possibility, I am not close to altering our forecast.
Overseas, the
economic numbers were a wash. But we
received an indication that the Portuguese government is on the verge of
default. Adding that to the ongoing
problems in the German, Greek and Italian banking systems, there remains little
hope that the US could expect any global improvement to ease its unsteady
growth (or lack thereof) pattern.
‘Muddle through’ continues to be our scenario for the global economy;
but that is increasingly in question.
What concerns me
about all this is that, (1) most Street forecasts for the moment are more
optimistic regarding the economy and corporate earnings than either the numbers
imply or our own outlook suggests 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/global central
banks remaining accommodative. However,
the Fed seems to have a death wish because it seems to be doing everything in
its power to disabuse investors of the notion that it has clue about what it is
doing policy wise. Of course that is SOP
of late; and, I believe that its genesis is the hope by the Fed that if it can
blow smoke up our skirts long enough then it will somehow be miraculously
rescued from the hole it has dug for itself.
Judging by
Friday’s pin action, investors are still hanging on every word uttered by this
group of eggheads; though at some point skepticism ought to set in. Indeed of late, there are growing signs of just
that among some economists and large investors.
I have no idea when the realization dawns on investors that the Fed
policy has done little to help the economy and much to distort price discovery. Stocks may be 1%, 5%, 10% higher when that
happens; but it seems very likely to occur.
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 latest from
Doug Kass (medium):
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 8/31/16 12574
1554
Close this week 18395 2169
Over Valuation vs. 8/31 Close
5% overvalued 13202 1631
10%
overvalued 13831 1709
15%
overvalued 14460 1787
20%
overvalued 15088 1864
25%
overvalued 15717 1942
30%
overvalued 16346 2020
35%
overvalued 16974 2097
40%
overvalued 17603 2175
45%
overvalued 18232 2253
50%
overvalued 18856 2331
Under Valuation vs. 8/31 Close
5%
undervalued 11945
1476
10%undervalued 11316 1398
15%undervalued 10687 1320
* 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 74hard way.
