The Closing Bell
10/22/16
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 11503-24348
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 1966-2568
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 modestly positive one for the data: above estimates: September building permits, weekly
mortgage and purchase applications, September existing home sales; month to
date retail chain store sales, the Philly Fed manufacturing index and the
latest Fed Beige Book; below estimates: September housing starts, weekly
jobless claims, September industrial production and the October NY Fed
manufacturing index; in line with estimates: the October housing index,
September leading economic indicators and September CPI.
However, the primary
indicators were mixed: September building permits (+), September existing home
sales (+), September industrial production (-) and September housing starts (-)
and September leading economic indicators (0). Overall, I score the week as marginally positive:
in the last 55 weeks, seventeen were positive, thirty-five negative and three
neutral.
Overseas, the
data was also mixed and some of it of questionable value. Still it is better than being all negative. But the weight of evidence continues to point
to a struggling global economy.
Other factors
figuring into the global outlook:
(1) the
hope remains for an OPEC production cut, ‘….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. On that front,
we had both bad and good news this week:
Merkel reiterated that the government would not come to the bank’s
rescue; but several sovereign wealth funds are rumored to be interested in
making an investment. That may help
Deutschebank (‘may’ being the operative word) but it doesn’t solve the problem
of a global banking system that is too leveraged and carrying too many nonperforming
loans on its collective balance sheet.
Finally, we knew
that the central banks couldn’t hold their tongues for more than a week. The BOJ and ECB both backed off recent
hawkish statements, while our own beloved Fed sent out contradictory
indicators: nine Fed regional bank heads said they wanted higher rates, while
Yellen suggested that the Fed may be preparing to move the inflation goal posts
(higher) which would indicate a willingness to not raise rates even if
inflation reaches or exceeds the current 2% objective.
In summary, this
week’s US economic stats were barely positive while the international data was
mixed---providing little new directional insight. The central banks remained on theme, which is
to say, giving multidirectional statements leaving us all confused about future
policy moves. This was enough to keep the ‘stabilizing global economy’ 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.
Updated third
quarter GDP forecasts (short):
The
negatives:
(1)
a vulnerable global banking system. Deutschebank remains the focal point of this
concern as Merkel reiterated that the government would not bail out the bank in
case of insolvency.
In addition, it was reported that [a] Deutschebank’s
CEO has been unable to date to negotiate a settlement with the DOJ over its $14
billion fine, [b] the bank said that it was reducing the size of its
derivatives portfolio and [c] it was revealed that the ECB allowed the bank to
cheat on its latest stress test---a clear sign that the regulators are worried,
[d] Qatar is rumored to be making an investment in the bank.
Clearly this is a very fluid situation; so any
conclusion, at the moment, would be highly suspect. But to summarize, what we don’t know is [a]
whether financial authorities are working to come to Deutschebank’s aid, [b]
whether a much reduced settlement with the US DOJ is in the making and [c] if
the bank will receive outside financing.
What we do know is that Deutschebank [a] has a very
weak balance sheet, [b] has a giant notional position in derivatives which we
have no clue about the inherent risk; though the bank itself is doing what it
can to reduce it [c] the ECB is worried enough to give the bank a pass on its
stress test [d] but none of which have as yet put the bank’s solvency in
question.
One other item: on Friday, data was released showing a
decline in US oil company defaults. That
clearly is a plus for the banks; but not for the Saudi’s whose primary purpose
in pushing oil prices lower was to destroy the US fracking industry.
On the other hand, the overall risk of defaults is
growing (medium):
(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.
After Wednesday’s
night debate in which Trump made one of the stupidest, ill-advised political
statements of all time, I am now praying that the dems won’t sweep congress,
giving them a free hand to raise spending, raise taxes, increase regulations. Please recognize that this is not a
political/social statement, but an economic one. Whatever one thinks of the social value of
such an agenda, the economic consequences are likely to only exacerbate current
economic problems.
Cooking the
books (short 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.
This week, the
central banks were back at it again, which is to say, vacillating between
threatening to end QE/ZIRP and whining that the economy wasn’t strong enough to
do so.
(1)
BOJ moved out the date for when it will achieve
its 2% inflation goal. It also stated
that while it was not going to lower rates at present, it was still prepared to
initiate more QE,
(2)
both Yellen and Draghi suggested that they might
join the BOJ in its yield curve ‘steepening’ policy---a chickens**t way of
holding on to QE but appearing to be doing something.
(3)
the ECB then left rates unchanged at its latest
meeting but declined to discuss tapering, scheduled to begin in 2017---suggesting
that it is not abandoning QE anytime soon.
As more EU corporate bonds
get downgraded, ECB problems grow (medium):
(4)
meanwhile, nine of the twelve Fed regional bank
heads called for higher rates. Apparently
they haven’t been watching the flow of economic data. Or are they starting to
worry about inflation?
(5) speaking
of which, worries about inflation and money supply growth are starting to creep
into the narrative.
[a] concern is
mounting that inflation is about to accelerate---which is likely the reason
behind Yellen’s comments that it might be wise to let the economy ‘run hotter’
than might otherwise be appropriate. Her
intent apparently being to find an excuse not to raise rates even though the
Fed’s inflation objective may be reached or exceeded. The difference here is that the Market’s won’t
give a s**t about the Fed’s policy mumbo jumbo.
If the fear suddenly becomes inflation, rates will rise with or without
Fed. So far, it is not clear at all that
is occurring; but attention is necessary.
[b] shrinking
money supply. It is difficult to know
how relevant this is; after all, how important is removing $1 billion in high powered
money when you have added $4 trillion.
Nonetheless, there was a time when this signaled monetary tightening,
usually based on rising inflation fears and usually resulting in an economic
slowdown.
I am not sure
how the mix of (potentially) raising interest rates, shrinking the money
supply, a lousy economy and increasing inflation all figure into the Fed’s QE
[or not] plans. More importantly, I don’t
think that it does either. So if this is
all very confusing, don’t despair. It is only natural that investors/Markets
would be uncertain since the central bankers don’t have a clue.
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.
Economists
are blind to how little they know (medium):
(4) geopolitical
risks: Syria just keeps getting worse.
The US and Russia are now standing toe to toe in a d**k measuring
contest which I believe 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 August
German trade numbers were better than consensus; September UK inflation was
above forecasts while unemployment was in line,
[b] September
Chinese services and composite PMI’s fell slightly;
third quarter Chinese GDP growth was line, industrial production was
less than expected and retail sales in line; growth was driven by increased
government spending, record bank lending and a red hot property market.
In
short, a mixed week
Investors
remain hopeful that the tentative OPEC decision to cut oil production will pan
out. While clearly a potential positive,
the hard part still lies ahead, because there has been no allocation as yet as
who has to absorb the cut and by how much.
Plus remember that even if an agreement is reached, OPEC members have a
history of cheating’ and there are a lot of non-OPEC producers in the world
that will more than likely jack up production to fill the gap.
And speaking
of cheating, Nigeria dropped the price of its crude a dollar a barrel (medium):
Bottom
line: the US economy continues weak with
little aid coming from the global economy.
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: September housing starts were well below
estimates while building permits were better than projections; September
existing home sales were better than anticipated; weekly mortgage and purchase applications
were up; the October housing index was in line,
(2)
consumer: month to date retail chain store sales growth
was up versus the prior week; weekly jobless claims were more than consensus,
(3)
industry: September industrial production and capacity
utilization were up less than expected; the October NY Fed manufacturing index
was a big disappointment, while the Philly Fed index improved,
(4)
macroeconomic: September CPI was in line; the September
leading economic indicators were also in line; the latest Fed Beige Book
continued to paint a rosy picture of the economy.
The
Market-Disciplined Investing
Technical
The indices
(DJIA 18148, S&P 2141) traded in a very tight range this week. Volume picked up on Friday; but not nearly as
much as I would have expected on an options expiration day. Breadth was weak. The VIX fell 2 1/2%, closing below its 100
day moving average and in a short term downtrend---which remains supportive of
stocks. Nonetheless, it is still in a
very short term uptrend but is approaching the lower boundary. If it cannot successfully challenge that
lower boundary, it could be a tell that stocks have seen their highs.
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 {11503-24348}
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 {1966-2568} and [e] in a long term uptrend
{862-2400}.
The long
Treasury has been struggling in a narrow trading range the last couple of weeks. It has broken below its 100 day moving
average and is developing a very short term downtrend. However, it seems to have found support at a
key Fibonacci level and, more importantly, remains in short, intermediate and
long term uptrends. I would characterize
this chart as sound long term but in the midst of a big hiccup.
GLD is the worse
chart of the lot, with gold finishing below its 100 day moving average, in the
middle of challenging its 200 day moving average to the downside and and within
a short term downtrend. However, like
TLT and the S&P it has been in a very narrow trading range over the last
two weeks, holding above a key Fibonacci level.
Bottom line: at
the risk of sounding like a broken record, the Averages appear to be at an
inflection point---trading in a very tight range as investors stew over a number
of fundamental issues that currently lack clarity. I have no insight as to which way prices will
break; but I think that stocks are at a point where the technical indicators
will tell us how the aforementioned fundamental issues are getting resolved in
investors’ minds.
Fundamental-A
Dividend Growth Investment Strategy
The DJIA (18148)
finished this week about 43.5% above Fair Value (12644) while the S&P (2141)
closed 37.0% 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 improved, though only marginally so.
The global stats were equally inconclusive. Still I give the week’s numbers a plus rating
though I don’t believe they helped the odds of no recession.
The potential
OPEC production cut and the solvency issues surrounding Deutschebank remain in
the background as factors that could impact economic growth stability. There was little new news on either this
week; but they have not gone away.
Finally, while
this earnings season started out negatively, it has since improved
considerably. Still it is early in the
process, 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.
It was back to
business as usual for the central banks this week, that is, reverse your most
recent statement but cover it up with more oblique rhetoric. I continue to believe that the lot of them
have realized what a dangerous corner into which they have backed themselves;
and they have no idea how to extricate themselves. Hence the strategy: muddy the waters and hope
for a miracle. The big fly in their
ointment is if inflation starts to pick up noticeably. If that happens, bond markets will fall even
more than they have to date and the Fed will likely cease to retain its magical
psychological hold over the Markets.
As you know, I
believe that sooner or later, the price will be paid for 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
has never been a plus. Unfortunately,
the situation in the Middle East, especially as it relates to the escalation of
violence in Syria, is pushing both powers toward a moment when either someone
has to blink or the s**t hits the fan. I
am not sure this standoff has reached the crisis point, but clearly we are
getting closer.
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 rising of 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---though 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 18148 2141
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.
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