10/29/16
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 17092-18693
Intermediate Term Uptrend 11529-24374
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 Trading Range 1995-2103
Intermediate
Term Uptrend 1972-2574
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 55%
High
Yield Portfolio 54%
Aggressive
Growth Portfolio 55%
Economics/Politics
The
economy provides no upward bias to equity valuations. This
week was a negative one for the overall data: above estimates: September pending home sales,
both the October Markit manufacturing and services indices, the September trade
deficit and third quarter GDP; below estimates: weekly mortgage and purchase
applications, month to date retail chain store sales, October consumer
confidence and consumer sentiment, weekly jobless claims, the October Richmond
Fed manufacturing index, the October Chicago national activity index; in line
with estimates: the August Case Shiller home price index, September new home
sales, September durable goods/ex transportation combo, the Kansas City Fed
manufacturing index.
However, the primary
indicators were slightly positive: September new home sales (0), September
durable goods/ex transportation combo (0) and third quarter GDP (+). With the total data negative but the primary
stats positive, I score the week as neutral.
However, I would note that this is the second week in a row when the
majority of the primary indicators were neutral. Another factor to consider is that the
earnings season to date has come in better than expected. So the question is, is this a sign of a
potential turn toward stability or simply a pause in a downward trend? Our forecast assumes the latter; but I have
been and remain on alert for a change in trend.
This week the score is: in the last 56 weeks, seventeen were positive,
thirty-five negative and four neutral.
Overseas, the
data was very upbeat, extending the trend of mixed to positive data weeks. Combine this with the aforementioned pause in
the downward slope of US stats and the question I posed above becomes even more
relevant.
Other factors
figuring into the global outlook:
(1) the
hope remains for an OPEC production cut, but Russia this week said ‘no dice’,
this following Iraq’s demand to be excluded from the math and Nigeria raising
oil prices. As a reminder: ‘….it would clearly be a positive if (1) it
is actually enacted…., (2) there is no cheating and (3) the non OPEC don’t
spoil the party by jacking up production to fill the gap and (4) demand doesn’t
fall due to declining global economic activity.’
(2) the
solvency of Deutschebank. This week we
again had both bad and good news: the bank witnessed heavy withdrawals both in
demand deposits and from its ETF management group, which is one of its most
profitable division. Plus, it is announced
that its past accounting of its derivative operations is being studied for
possible irregularities. On the other
hand, the bank’s third quarter earnings were better than forecast,
(3) China’s
currency is in a steady decline. This
may be good for the Chinese economy but not so much for the rest of the world. The question becomes will we start seeing
competitive devaluations---not a plus of global growth.
Finally, on the
monetary front, the ECB hinted at a more dovish approach to QE while our own
Fed continued to suggest a December rate hike ‘if the data warrants’---its
usual weasel language to give itself an out.
The Market has priced in a 70%+ probability of a hike. I believe it is less than that---not because I
don’t want it. I do. But because of the Fed’s lack of courage.
In summary, this
week’s US economic stats were negative though the primary indicators were slightly
positive---furthering the notion that the economy is now bumping along with no
direction. Meanwhile the international stats
were much improved. Not that it means
the worst is over; we need a lot more data before making that judgment. However, a pause at least keeps alive the
hope that the global economy will muddle through. Meanwhile central bank policies have started
to work at cross purposes with (1) the ECB giving some dovish mewings, (2) the
Fed continuing to sound tough on a December rate hike and (3) the Chinese allowing
their currency to decline in value. There
may be enough here to keep the ‘stabilizing global economy’ scenario on the
table as a possibility, but not enough the raise the odds of its occurrence. The yellow warning light for change continues
to flash slowly.
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. There was very little news on this factor
this week. What little there was focused
on the troubled EU banking system as Monte Paschi [Italy] continues to be
unable to get financing to stay alive and Deutschebank is losing customers
concerned about its solvency---witnessing an E8 billion exit from its prized
ETF management group and a loss of demand deposits.
Misstatements on Deutschebank’s derivative book
(medium):
The Bank of England wants to know UK bank exposure
(medium):
Unfortunately, the
EU is not the only one having problems with bank balance sheets. Chinese bank liabilities keep growing
(short):
(2) fiscal/regulatory
policy. What fiscal policy? The annual deficit is soaring, the national
debt is growing, both major party presidential candidates promise more
spending---one promising higher taxes, one lower taxes. Yeah, that ought to work.
My biggest
concern here is that the dems win the trifecta on November 8th ---taking
the presidency and both houses of congress, in which case we are apt to see
higher spending, higher taxes and more regulation. That said, the deluge of WikiLeaks releases
on the Clinton’s may be starting to have a mitigating influence. All we can hope for is a divided government
to diminish the likelihood of ruling class mischief [think Obamacare].
Counterpoint
from a very smart, liberal economist (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.
This week, the
central banks provided their usual helping of confusion. As I noted above, the ECB is crawfishing on
QE and the Chinese are in the midst of a currency devaluation. To date, the rest of the world is letting the
latter slide; but if it keeps it up, there will surely be retaliation.
As for the Fed,
it stayed on theme [a December rate hike] though I don’t believe the data supports
that [by their standards]. (must read):
Meanwhile, I leave
on the table concerns about rising inflation and a shrinking money supply [down
again this week]. That said, it is too
soon to know if either will become a real issue; but they are factors that have
to watched and accounted for.
‘My bottom line here is that while I would
welcome a rate hike as a step toward monetary policy normalization, if it
happens, it [a] will likely be similar to last December’s hike---small,
insignificant and solitary, [b] have little impact on the economy, since all
those rate cuts had little effect, [c] will be potentially disruptive to the
Markets, since all those rate cuts served as rocket fuel to security prices.’
Fed policy has
utterly failed (medium and a must read):
(4) geopolitical
risks: Syria just keeps getting worse. Russia
now has a carrier group steaming for the Syrian coast which will only increase
the likelihood of some accidental encounter becoming a full blown crisis. As I said last week ‘I believe [this situation] is
a lose, lose for the US---if Obama blinks, which is His modus operandi, US is
gets another humiliation and if He doesn’t, Putin ups the ante moving us closer
to a shooting war.’
(5)
economic difficulties in Europe and around the globe. This week:
[a] the October
EU manufacturing, services and composite PMI’s were all better than estimates
as was third quarter UK, French and Spanish GDP’s,
[b] the
October Japanese Markit manufacturing PMI was above forecasts while exports
fell.
In short,
a very upbeat week---this following a couple of mixed data weeks. Clearly this is a change from the steady
decline in the global economic numbers that we have witnessed over the last
year. It is way too soon to be making judgments
about what this could mean; but again it is has to be watched as a potential
sign of a halt in the falling global economic activity.
Investors
remain hopeful that the tentative OPEC decision to cut oil production will pan
out; though the prospects seem to be getting dimmer as time goes on. As I noted above, this week Russia said that
it would not take part in a production cut.
Even if OPEC is
successful in achieving an agreement, the hard part still lies ahead, because [a]
there has been no allocation as yet as who has to absorb the cut and by how
much, [b] OPEC members have a history of cheating’ and [c] there are a lot of non-OPEC
producers in the world that will more than likely jack up production to fill
the gap.
Bottom
line: the US economy continued weak although
the global economic numbers were very positive---but at this moment, only a one
off occurrence. Meanwhile, the ECB and
Bank of China are emphasizing monetary ease while the Fed keeps pushing the
December rate cut narrative; 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: September new home sales were up but by less
than the August number was revised down; weekly mortgage and purchase
application were down; the August Case Shiller home price index was in line;
September pending home sales rose more than estimates,
(2)
consumer: month to date retail chain store sales growth
was down versus the prior week; both October consumer confidence and consumer
sentiment were disappointing; weekly jobless claims were lower than forecast,
(3)
industry: September durable goods orders were below
projections, but ex transportation they were above; the September Chicago
national activity index was negative and the August number was revised down; both
the October Markit flash manufacturing and services indices were better than
anticipated; the October Richmond Fed manufacturing index was negative while
the Kansas City Fed index was flat,
(4)
macroeconomic: the September trade deficit was less
than expected; the first reading of third quarter GDP growth was better than
estimates.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 18161, S&P 2126) down slightly on Friday. Volume rose; breadth negative. The VIX was up yet again, this time by 5%,
closing in a short term downtrend but above its 100 day moving average (now
resistance; if it remains there through the close on Monday, it will revert to
support), above its 200 day moving average (now resistance; if it remains there
through the close on Wednesday, it will revert to support) and continued the
strong follow through off the lower boundary of its very short term uptrend. The implications for stocks are not good.
The Dow ended
[a] below its 100 day moving average, now resistance; [b] above its 200 day moving average, now
support, [c] within a short term trading range {17092-18693}, [c] in an
intermediate term uptrend {11529-24374} and [d] in a long term uptrend
{5541-19431}.
The S&P
finished [a] below its 100 day moving average, now resistance, [b] above its
200 day moving average, now support, [c] within a short term trading range {1995-2193},
[d] in an intermediate uptrend {1972-2574} and [e] in a long term uptrend
{862-2400}.
The long
Treasury ended down on the day (and down big for the week), closing below its
100 day moving average (now resistance), below its 200 day moving average for
the second day (now support; if it remains there through the close Tuesday, it
will revert to resistance), below a key Fibonacci level and in a developing a
very short term downtrend. In addition,
other segments of the debt market continued to be pounded. While TLT remains in short, intermediate and
long term uptrends, it is nearing the lower boundaries of the first two. It sure looks like a challenge of these
uptrends is coming.
GLD rose, finishing
below its 100 day moving average (resistance) and within a short term downtrend. But in ended back above its 200 day moving
average, negating Wednesday’s break and continued to hold above a key Fibonacci
level. A slight improvement in an awful
looking chart.
Bottom line: stocks
continued trading in a very tight range; but the VIX is going nuts to the
upside---nor a normal pattern for a flat Market and only further muddies the
technical waters. The fixed income markets
continued their decline---reflecting either higher interest rates, higher
inflation or both. However, GLD rose
fractionally, suggesting that precious metals investors are neither worried about
higher rates nor excited about higher inflation.
So we are now looking
a multiple crosscurrents in multiple Markets.
I continue to have no explanation other than confusion. Patience.
Stuck
in the middle (short):
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (18161)
finished this week about 43.6% above Fair Value (12644) while the S&P (2126)
closed 36.1% overvalued (1562). 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
data was mixed while the global stats were very upbeat. That helps keep an ‘economic stabilization’ scenario
as a possibility; but it is far too early to be to make that call or take
recession off the table.
The potential
OPEC production cut, the solvency issues surrounding Deutschebank and Monte
Paschi, the declining yuan, potentially higher inflation and a shrinking US
money supply remain in the background as factors that could impact economic
growth stability.
Finally, while
this earnings season started out negatively, it has since improved and may turn
out to be the first up quarter for earnings in the last five. Still it ain’t over till it’s over; so no
sweeping conclusions can be made yet.
That said, even if the outcome is more positive than expected, the rate
of progress is so puny that, in my opinion, it would have little impact on
valuations.
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.
The central
banks seem to be getting at loggerheads with each other. The ECB sounded dovish this week and the Chinese
continue to allow the yuan to fall.
Meanwhile the Fed reiterated its intent on raising rates in December;
and the bond Market seems to agree as yields have been heading north. As you know, I still have doubts about an
increase. But I tend to give more weight
to the actions of the bond guys than the stock boys. So clearly I have to question my own
assumption on this issue. It would fit
with a declining money supply and a concern about inflation; though as I mentioned
last week, Yellen pointedly stated that it might be wise to let the economy run
‘hotter’ at this moment than might otherwise be the case. At the moment, I am sticking with the
assumption that the Fed won’t raise rates; but I am lowering my own odds of
this occurring to 50/50. The big issue
is if it does, will it be accompanied by volumes of dovish rhetoric (meaning no
policy direction on further increases) and/or will the bond market turn up the
heat for even more hikes?
As you know, I
believe that sooner or later, the price will be paid for the flagrant
mispricing and misallocation of assets.
One last note, I
think that the political situations both here and abroad have the potential to
start impinging on economics and Markets in a meaningful way. On the international side, a US/Russia
showdown would not be a plus for anybody but especially for the US given our
current weak leadership (Obama does not want His legacy to include war with
Russia).
‘In the US, barring an extraordinary
occurrence, a Clinton victory seems almost inevitable. That by itself isn’t so bad as long as
congress can act as a governor. But my
concern is…..a dem sweep of congress; and solely from an economic growth
standpoint, I think that would be a long term negative for the economy because
it would enhance an already deleterious combination of too much taxes, too much
spending and too much regulation---which sooner or later will get factored into
the equity discount rate.’
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. In addition, the political situation is
getting dicey.
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.
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.
I would use the current
price strength to sell a portion of your winners and all of your losers.
DJIA S&P
Current 2016 Year End Fair Value*
12700 1570
Fair Value as of 10/31/16 12644
1562
Close this week 18161 2126
Over Valuation vs. 10/31 Close
5% overvalued 13276 1640
10%
overvalued 13908 1718
15%
overvalued 14540 1796
20%
overvalued 15172 1874
25%
overvalued 15805 1952
30%
overvalued 16432 2030
35%
overvalued 17069 2108
40%
overvalued 17701 2186
45%
overvalued 18333 2264
50%
overvalued 18966 2343
Under Valuation vs. 10/31 Close
5%
undervalued 12011
1483
10%undervalued 11379 1405
15%undervalued 10747
1327
* 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.
