The Closing Bell
8/20/16
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 Uptrend 17627-19363
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 2069-2308
Intermediate
Term Uptrend 1920-2522
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 53%
Economics/Politics
The
economy provides no upward bias to equity valuations. The
dataflow this week was a wash: above
estimates: July housing starts, weekly jobless claims, July industrial
production and capacity utilization and the July leading economic indicators;
below estimates: July building permits,
weekly mortgage and purchase applications, month to date retail chain store
sales, the August NY Fed manufacturing index; in line with estimates: the
August housing index, the August Philly Fed manufacturing index, July CPI.
However, the primary
indicators were quite positive: July housing starts (+), the July leading
economic indicators (+) and July industrial production and capacity utilization
(+). Neutralizing those housing numbers
was the worse than expected building permits.
However, even with that, the balance was still positive. So I score this week as a plus. Still even if we include that four week
stretch of upbeat stats, this is not enough to warrant a change in our
forecast; though it could be a signal that the rate of decline in economic
activity has lessened. The score is now:
in the last 48 weeks, fourteen have been positive to upbeat, thirty-one negative
and three neutral.
Just to be clear
about something: the economy’s rate of decline may be flattening out. But characterizing that as ‘improvement’ is a
relative statement, i.e. the economy may be improving but only in the sense
that it may not be getting worse. That
is not to say that it won’t get better.
But all those opinions you hear about the economy getting better are
misleading. The economy may not be
getting worse; but we can’t even say that with any certainty. If it was doing as well as Fed participants and
others say, rates would be higher.
Corporate
default rates heading higher (medium):
Overseas, the data
improved. But much of it was out of the
UK where the numbers reported were better than expected; but remember that
following Brexit, experts were all in agreement that it would have a terrible impact
on the UK economy. Accordingly, forecasts
were lowered. So beating lowered
estimates maybe nothing more than proving all the Brexit doomsayers wrong.
Meanwhile, the
developing problems in the Italian, German, Portuguese and Greek banking
systems remain a question mark.
Central bank
obfuscation proceeded with vigor this week as three Fed chiefs (Dudley,
Bullard, Williams) gave conflicting versions of the future course of US
monetary policy; and the FOMC minutes revealed a group that is, at best, in
total disagreement and, at worst,
clueless. The good news is that, as far
as the economy goes, all their QEInfinity efforts [post QEI] have done little
to help the US economy and in all likelihood will be shown to have had a
negative impact---so if this disagreement/confusion/cluelessness keeps them
from doing more QEInfinity, that is a plus.
The bad news, of course, is that Fed policy has severely distorted asset
pricing and allocation for which a penalty will ultimately be paid, in my
opinion.
The Fed has only
made things worse (medium):
In summary, this
week’s US and international economic stats were better. The Fed continued its strategy of doing the
green apple two step, hoping investors don’t notice the abject failure of their
policies 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.
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. Following last week’s brazen request by several
of the major US banks asking the Fed for an extension of the implementation of
the Volcker Rule [requiring them to exit private investments], this week, no
less than the Vice Chairman of the FDIC, slammed those banks’ balance sheets
and accounting procedures, stating that their capital is woefully
inadequate---showing us the real reason for asking for that extension.
And in yet
another example of major bank criminality, JPMorgan,
Citigroup and Morgan Stanley are being sued by funds in the U.S. for allegedly
manipulating a key Australian interest rate benchmark to generate hundreds of
millions of dollars in illicit profits. The class action claims they sought to
fix the bank bill swap rate, the local equivalent of Libor, which is used to
price floating-rate bonds and syndicated loans.
(2) fiscal/regulatory
policy. While I hate to contemplate what
post-election fiscal/regulatory policy might look like, I don’t have to wait to
get worried. Here are updates on two of
my favorite concerns which may only get worse.
More
on student loans (medium):
http://www.slate.com/blogs/moneybox/2016/08/15/mass_student_loan_forgiveness_is_a_terrible_idea.html
Obamacare
death spiral (medium):
Bonus ‘extreme
government lack of accountability’ fact of the day (medium and a must read):
(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
frequently opined that the Fed is clueless about how to extract itself from the
QE trap it has created for itself.
Nowhere was it clearer than in this week’s release of the latest FOMC
meeting minutes. I blistered them in our
Thursday Morning Call; so I don’t want to be repetitive. But my bottom line was: ‘Its (the Fed) latest stab at
monetary profundity was little more than a bunch of schizophrenic nonsequiturs which
it then was foolish enough to reveal to the public. This blizzard of bulls**t aside, I remain
convinced that there will be no September rate hike.
Joining me in
deriding the irresponsible monetary policies of the central banks was a BIS
report highlighting the negative consequences of artificially low rates (see
Monday’s Morning Call for the link).
The Fed’s
ineptitude (medium and today’s must read):
And if you are
not yet sick and tired of having to listen to the nonsensical pontifications of
central bankers, then you are in for a treat; because Yellen is scheduled to
make a major speech next Friday. As you can imagine, I wait breathlessly.
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.
The Fed’s
liquidity trap (medium):
(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 was tilted to the positive side.
[a] July UK CPI rose, June unemployment was unchanged
and July retail sales were better than expected---much of the reason for this
seemingly better data is likely the result of lowered forecasts due to the
Brexit.
[b] second
quarter Japanese GDP and corporate investment were below forecast while July
trade numbers were terrible,
[c] July
Chinese home prices increased more than anticipated.
The above notwithstanding, the trend to a
weaker global economy is so long and so pronounced that one week’s slightly
positive dataflow hardly promises better things ahead. 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 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: July housing starts were much stronger than
anticipated though building permits were less; weekly mortgage and purchase applications
were down; the August housing market index was in line,
(2)
consumer: month to date retail chain store sales were less
than the prior week; weekly jobless claims fell more than estimates,
(3)
industry: July industrial production and capacity
utilization were better than forecast; the August NY Fed manufacturing index
was very poor, while the Philly Fed index was in line,
(4)
macroeconomic: July CPI was flat; ex food and energy it
was less than expected; July leading economic indicators were much better than projected.
The
Market-Disciplined Investing
Technical
On Friday, the
indices (DJIA 18552, S&P 2183) sold off fractionally. Volume was up but remained low; breadth weakened
slightly. The VIX was down, finishing below
its 100 day moving average, within a short term downtrend but very close to the
lower boundary of its intermediate term trading range (support). Given the trouble the VIX had in taking out
its short term trading range, it could have even more difficulty with the
intermediate term.
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 {17627-19363}, [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 {2069-2308}, [d]
in an intermediate uptrend {1920-2522} and [e] in a long term uptrend {862-2400}.
The long
Treasury declined, but ended above its 100 day moving average and well within
very short term, short term, intermediate term and long term uptrends. It has broken out of a pennant formation to
the downside indicating lower prices (higher yields). However, given the strong upward bias
provided by the trends, it is way too soon to be thinking of a meaningful move
down.
GLD also fell, but
also finished above its 100 day moving average and within short term and intermediate
term uptrends. Like TLT, the trend lines
point higher. But I am concerned about
its failure at its second try to surmount a key Fibonacci level, then its negating
a very short term uptrend.
Bottom line: the
charts of the Averages, TLT and GLD all point up; but all have worrying short
term technical problems. Conversely, the
VIX is headed down but has its own technical hurdles to overcome for that to
continue. All these problems are, for
the moment, individually minor but in aggregate, they warrant attention. That is the reason that I have been stewing
over the pin action in the VIX and the bond, gold, oil and currency markets and
worrying that something is amiss. That
said, it could be a function of nothing more than the late summer
doldrums. Still be careful.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (18552)
finished this week about 47.9% above Fair Value (12543) while the S&P (2183)
closed 40.8% 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 turned positive again. They may
be another of the erratic signs of late that the weakening in the economy is
slowing down. ‘May be’ being the operative
words. I leave open the possibility that the economy is stabilizing---though I am
not close to altering our forecast.
Overseas, there
was also a slight improvement in the dataflow though much of that, I suspect,
is the result of the UK beating Brexit related lower expectations. Japan, on the other hand, recorded some terrible
numbers---QEInfinity quadrupled notwithstanding. Further, we haven’t yet seen any of the
potential economic consequences of the Brexit or the banking problems in
Germany and Italy. ‘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. The Fed
kept that hope alive this week via its favorite route---confuse everyone so
that those who want to be fooled can continue to hope for QE.
In the short
run, that may help investors rationalize a goldilocks scenario but somehow,
some way, sometime either unwinding QEInfinity or QEInfinity’ lack of success will
become a Market issue. 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 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 18552 2183
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.
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