Friday, July 4, 2014

The Closing Bell

The Closing Bell

7/5//14

Statistical Summary

   Current Economic Forecast

           
            2013

Real Growth in Gross Domestic Product:                    +1.0-+2.0
                        Inflation (revised):                                                           1.5-2.5
Growth in Corporate Profits:                                            0-7%

            2014 estimates

                        Real Growth in Gross Domestic Product                   +1.5-+2.5
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                               16145-17624
Intermediate Uptrend                              16416-20748
Long Term Uptrend                                 5083-18464
                                               
                        2013    Year End Fair Value                                   11590-11610

                    2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     1895-2062
                                    Intermediate Term Uptrend                        1837-2637
                                    Long Term Uptrend                                    762-1999
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          44%
            High Yield Portfolio                                     53%
            Aggressive Growth Portfolio                        46%

Economics/Politics
           
The economy is a modest positive for Your Money.   Not a lot of data this week; and what we got was mixed: positives---the June ADP private payroll report, June nonfarm payrolls, the May trade deficit  and the June Markit PMI; negatives---weekly mortgage and purchase applications, the June ISM manufacturing and nonmanufacturing indices, May construction spending and May factory orders; neutral---weekly jobless claims.

The only standout datapoints were the big jump in the ADP private payrolls report and June nonfarm payrolls.  There is good news and bad news there.  It is great that employment is picking up; unfortunately employment is a lagging indicator---so it tells us nothing about the near term economic outlook.  That said, there was nothing that would alter our forecast.

However, the prospects for a rising inflation rate are still with us.  This notion is being supported by the recent pin action in the bond and gold markets.  While, it is too soon to raise our inflation outlook, the yellow light continues to flash.
  
 ‘a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet, and a business community unwilling to hire and invest because the aforementioned along with...... the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.’
           
            Recession probability model (short):

        The pluses:

(1)   our improving energy picture.  The US is awash in cheap, clean burning natural gas.... In addition to making home heating more affordable, low cost, abundant energy serves to draw those manufacturers back to the US who are facing rising foreign labor costs and relying on energy resources that carry negative political risks.

This factor is increasing in importance as the turmoil in Ukraine and Iraq threaten global oil supplies.  On the other hand, the Canadians are revising their own energy strategy from exporting oil to the US [via the Keystone pipeline] to selling it to China---which clearly lessens the reserves the US will have to draw on in the event of a global energy crisis.  Another excellent move for hope and change.

       The negatives:

(1)   a vulnerable global banking system.  This week, BNP Paribas agreed to a fine of $9 billion for aiding and abetting financial transfers with sanctioned nations.  While some analysts argue that this action by the US ultimately undermines the strength of the dollar as a global medium of exchange [transactions can take place in another currency which the US can’t trace], I think embargos are a lot safer means of bringing rogue nations to heel than military action.  Furthermore, I have my doubts that long term the dollar will lose its place as the global currency for taking actions that benefit most nations, in particular those with banking systems large enough to thwart an embargo in the first place.

In addition, it appears that the DOJ is about to sue Citicorp for mortgage securities fraud.

 ‘My concern here.....that: [a] investors ultimately lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly a collapse of the EU financial system.’

(2)   fiscal policy.  With election season in full swing, nothing is likely to happen to alleviate the problems of an inefficient tax code, too much irresponsible spending and too much government regulations.  The one bright spot is that the growing economy is generating sufficient tax revenue to drive down the budget deficit.

On nonfiscal matters, the good news is that Obama has been unable to get measures that He favors through the normal legislative process and indeed has suffered a couple of setbacks from the Supreme Court.  The bad news is that He now appears intent on using executive mandate to accomplish His goals.  I am not sure how constitutional this all is; although I have no doubt that our Founders are collectively rolling over in the graves.

(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 stated in the last Closing Bell that I thought that the Fed had begun to show its true colors, i.e. that it intends to pursue the same reactive policies of the past Feds, insuring that it will be a day late and a dollar short with any tightening move and thereby increasing the risk of inflation going to unhealthy levels. 

Yellen’s remarks this week to the IMF support that notion.  Indeed, she made a point of saying that financial stability was better managed via macroprudential policies; which is to say, nonmonetary policies.  Forget the fact that any financial instability will likely come as a result of the unprecedented expansion of the Fed’s balance sheet.  So in effect, Yellen is saying that the Fed may have created the conditions for financial instability but it is not going to use monetary policy to cure it.  Leaving her and the rest of Fed the luxury of continuing to pump up the money supply/leave interest rates low. 

Question: where were all those macroprudential policies during the last two financial crises?  And why do we [she] think that they will be there if another happens tomorrow?  I got to believe that when the Fed chairperson starts disavowing any knowledge or liability for financial instability, her sphincter is having spasms.

My bottom line is that I continue to believe that the Fed hasn’t a clue how to extricate itself from its current historically overly expansive monetary policy.  That, in turn, has rendered it frozen in the headlights of oncoming inflation.  QEInfinity is not likely to end well, especially for the Markets.
                      
                          The Fed’s dilemma (medium and a must read):
                   http://streettalklive.com/index.php/blog.html?id=2281

(3)   rising oil prices.  Violence in Ukraine and Iraq remain in the headlines and with that, the risk of a development that would negatively impact global oil supplies.  To be sure, prices have already reacted to ongoing events and to date, the price of oil [gasoline] hasn’t reached the ‘uncle’ point for consumers. Indeed, this week, prices declined as the news flow became less intense.  Hence, this risk is still a ‘potential’ one.  That said, given our continuing diplomatic ineptitude, I am concerned that things could get worse. 

The latest from Ukraine (short):

Now Kuwait? (short):

(4)    the sovereign and bank debt crisis in Europe and around the globe.  So far, Abe’s multiple policy ‘arrows’ haven’t done jack shit to halt the Japanese economy’s continued descent into recession and deflation.  He is now stumbling around trying to find a new ‘arrow’ but to little avail.   If Japan isn’t a world class example that monetary policy is the problem not the solution, I don’t know what is.

China’s real estate market continues to imploding as housing prices slid further in June.  In addition, we still don’t know the extent of the damage to financial system from those vast quantities of warehoused commodities that were used as collateral for [multiple] loans and have since disappeared. We also don’t know if this problem also exists at multiple ports. 

I have no idea the extent to which this touches the banking systems outside China; but if it does, our banks could be in for another round of losses/failures.  Even if it is confined to the Chinese banking system, the potential losses there would likely be sufficient to threaten that country’s economic growth with at least some spillover effect on the rest of the globe.

Thoughts on long term Chinese economic policy (long but a very good read):

Despite the recent further lowering of interest rates by the ECB, the economic dataflow has not improved.  Of course, it has only been a month; so it is too soon to declare this policy move a failure.  Further, many thought that the ECB would approve some version of QE at its June meeting.  Well, that didn’t happen.  Of course, neither of these policy instruments [lower interest rates, more monetary expansion] have worked anywhere else in the world.  So it is a fair question to ask why the ECB expects it to work there.  In addition, neither effectively address the twin issues of over indebted sovereigns and overleveraged banks

Another gem from the IMF (medium and today’s must read):

‘I remain dumbfounded by the economic and securities communities’ willingness to accept at face value that QE has, is and will work anywhere, anytime.  To be sure, nothing untoward has occurred yet.  But then no one except the Chinese has even attempted the unwinding process and the last chapter has not been written on the Chinese real estate implosion.’ 

Bottom line:  the US economy continues to progress despite little to no help from fiscal and monetary policy. Plus the risk is rising that it will soon have to battle either inflationary forces brought on by QEInfinity or a recession resulting from the unwinding of QEInfinity of both [stagflation].

Overseas, the environment is worse.  Japan is sinking into recession at the same time its central bank is burning up its presses printing money.  China is trying to do something to wind down its expansive monetary and fiscal policies.  But either a collapsing housing market or the commodity re-hypothecation scandal or both could very well get out of hand and negate any efforts by the authorities to do the right thing.  Whatever the outcome, some heartburn seems inevitable.  The ECB appears intent on mimicking the failures of our Fed and the Bank of Japan and, to date, has gotten the same results---which is to say, nada. 

Finally, violence continues in Ukraine and Iraq.  I have no idea if either or both drive up energy prices further; but I believe that the odds grow every day that they will.  And that won’t be good for economic growth.

In sum, the US economy remains a plus, though the recent growth and inflation numbers are somewhat worrisome.  Unfortunately, those are not the only potentially troublesome headwinds. 

Peak optimism or peak propaganda? (medium):

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications were both down,

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims rose marginally; June nonfarm payrolls grew much more than anticipated; the June ADP private payroll report was well ahead of forecasts,

(3)                                  industry: both the June ISM manufacturing and nonmanufacturing indices came in slightly lower than estimated while the June Markit PMI was somewhat above; May construction spending was much lower than anticipated; May factory orders fell more than expected,

(4)                                  macroeconomic: the May US trade deficit was lower than forecast.
           
The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 17068, S&P 1985) had another great week, finishing above their 50 day moving averages and remaining within uptrends across all time frames: short [16145-17624, 1895-2062], intermediate [16416-20748, 1837-2637] and long term [5088-18464, 762-1999].  Plus the Dow closed above 17000 and the S&P is a whisker away from the upper boundary of its long term uptrend.

Volume on Friday was up slightly; breadth improved.  The VIX fell, remaining within its very short term, short term and intermediate term downtrends, below its 50 day moving average and extremely close to the lower boundary of its long term trading range.  In the meantime, internal divergences within the Market persist.  The latest check of our internal indicator shows that in a 146 stock Universe, 45 are at all-time highs, 24 are almost there and 77 aren’t close.

The long Treasury got obliterated this week.  At Friday’s close, it confirmed the break below the lower boundary of its short term uptrend.  That re-sets it to a trading range.  Unfortunately, it also closed below its 50 day moving average.  It also finished at the same level as its prior low.  So if it moves down further, it will make a new lower low after having just made a new lower high.  That in turn will quickly re-set the short term trend to down.  The TLT chart appears to be gaining some clarity which, regrettably, appears to be to the downside.

GLD was down on Friday, closing back into the prior week’s trading range.  That isn’t necessarily terrible news.  But GLD just hasn’t managed any follow through momentum to the upside.  Unlike the TLT, its chart is getting murkier---making me wonder if we did not yet again get a head fake from GLD.

Bottom line: technically speaking, the Averages have investors tip toeing through the tulips. All-time highs and big ‘round’ number upside objectives are on everyone’s mind.  Beneath the surface though, volume is light and divergences grow.  As I noted in the last Closing Bell: ‘Of course, all these non-confirming indicators could re-sync with the indices.  But the point is that at present they are becoming less not more in sync.’ 

The bond and gold markets also continue to muddy the picture.  Last week, GLD was firmly supporting the stock guys’ scenario: growth and inflation.  This week, it seems to be having second thoughts.  On the other hand, last week bonds acted as if they doubted the growth and inflation thesis.  This week, they were absolutely trashed---suggesting otherwise.  This pin action combo keeps me a bit uncertain about what is and is not being discounted.  That said, the damage to the bond market was sufficient that I am lightening up on the muni bond ETF in our ETF Portfolio; I am sitting on my hands with respect to GLD.

 On stocks, our strategy remains to do nothing save taking advantage of the current momentum to lighten up on stocks whose prices are pushed into their Sell Half Range or whose underlying company’s fundamentals have deteriorated.

A word of caution.  If you absolutely, positively just can’t help but buy something be sure to set very tight trading stops.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17068) finished this week about 45.0% above Fair Value (11775) while the S&P (1985) closed 35.7% overvalued (1462).  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.

The economic data flow continues to reflect a slow sluggish recovery though it is now faced with the potential of a rise in inflation.  For the moment, I continue to stick with our economic outlook. Unfortunately, our Valuation Model has this scenario very generously priced into stocks; and that ignores a plethora of potential problems that could negatively impact the economy or the securities markets or both.  It would seem that investors have all these issues discounted.  However, when stocks are priced for perfection, it doesn’t take much of an exogenous event to turn psychology on its head; and, suddenly, all those ‘discounted’ problems come back to haunt.

The Fed is at the top of the list of those headwinds.  It has done little (save QE1) to help the economy and has made a mess of asset pricing (the securities markets).  It made clear in its recent FOMC meeting which Yellen reinforced this week at the IMF summit that it will ignore mounting inflationary forces until it is too late to prevent the resultant damage.  I maintain my belief that the Fed will botch the return to a normal monetary policy and that the Markets will pay dearly for the Fed’s mistake.

Of course, the Fed isn’t the only central bank capable of mischief.  The deeper Japan sinks into recession/deflation (and it sunk further judging by this week’s economic data) the more desperate its policy machinations.   We haven’t seen the end game to this experiment; but any further impairment to its economy could impact our own while a forced unwind of the yen ‘carry trade’ could destabilize securities prices in the US market.

The EU continues struggling to get out of recession/deflation.  While the ECB has stated that it will take whatever measures necessary to avoid another downturn, it has done little to nothing to back up that statement.  Expectations were for some sort of QE to come out of the ECB June meeting.  Didn’t happen.  Further, it seems oblivious to its main problems: its heavily indebted sovereigns and its many overleveraged banks.  My concern here is about a disruption in our financial system resulting from problems in either.

The Chinese have been trying to do the right thing by wringing speculation out of its financial system.  Regrettably, it is now faced with a second problem---commodity re-hypothecation, i.e. using the same collateral to back multiple loans.  To date, it has been traced to a series warehouses in only one Chinese city; but the rumor mill is speculating this scandal is more widespread.  I have no clue how either or both of these difficulties will ultimately impact that country’s banking system.  Clearly, the risk is of a Chinese Lehman Brothers and its effect on the global financial community.

The turmoil in Ukraine and Iraq have put upward pressure on oil prices.  Although, to date, markets have handled these problems fairly well.  As long as the violence in both areas remains reasonably under control, oil/gasoline prices in the US are unlikely to reach a level that starts to impact economic activity.  Helping matters out in the short term has been the opening up of Libyan oil reserves for export.  That said, the last act has not been played in either Ukraine or Iraq; and either conflict could blossom out of control which could push prices to a level that effects our economy.

Overriding all of these considerations is the cold hard fact that stocks are considerably overvalued not just in our Model but with numerous other historical measures which I have documented at length.  This overvaluation is of such a magnitude that it almost doesn’t matter what occurs fundamentally, because there is virtually no improvement in the current scenario (improved economic growth, responsible fiscal policy, successful monetary policy transition) that gets valuations to Friday’s closing price levels. 

Bottom line: the assumptions in our Economic Model haven’t changed (though our inflation forecast may have to be revised up).  The assumptions in our Valuation Model have not changed either.  I remain confident in the Fair Values calculated---meaning that stocks are overvalued.  So our Portfolios maintain their above average cash position.  Any move to higher levels would encourage more trimming of their equity positions.

 I can’t emphasize strongly enough that I believe that the key investment strategy today is to take advantage of the current high prices to sell any stock that has been a disappointment or no longer fits your investment criteria and to trim the holding of any stock that has doubled or more in price.

Bear in mind, this is not a recommendation to run for the hills.  Our Portfolios are still 55-60% invested and their cash position is a function of individual stocks either hitting their Sell Half Prices or their underlying company failing to meet the requisite minimum financial criteria needed for inclusion in our Universe.
        
            It is a cautionary note not to chase this rally.
                           
           
DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 7/31/14                                  11775                                                  1462
Close this week                                               17068                                                  1985

Over Valuation vs. 7/31 Close
              5% overvalued                                12363                                                    1535
            10% overvalued                                12952                                                   1608 
            15% overvalued                                13541                                                    1681
            20% overvalued                                14130                                                    1754   
            25% overvalued                                  14718                                                  1827   
            30% overvalued                                  15307                                                  1900
            35% overvalued                                  15896                                                  1973
            40% overvalued                                  16485                                                  2046
            45%overvalued                                   17073                                                  2119

Under Valuation vs. 7/31 Close
            5% undervalued                             11186                                                      1388
10%undervalued                            10597                                                       1315   
15%undervalued                            10008                                                  1242

* 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 with somewhat higher inflation. 

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 40 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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