Saturday, July 12, 2014

The Closing Bell

The Closing Bell

7/12//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                               16168-17647
Intermediate Uptrend                              16422-20781
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                                     1900-2064
                                    Intermediate Term Uptrend                        1846-2646
                                    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.   There was almost no data released this week; and what we got was mostly secondary indicators: positives---weekly mortgage and purchase applications and weekly jobless claims; negatives---the June Small Business Optimism Index; neutral---weekly retail sales and May wholesale inventories and sales.

With such a paucity of stats, it makes little sense to opine on how they might impact our forecast, since clearly there is none.  That said, there was a notable economic event of sorts---the release of the minutes from the latest FOMC meeting.  While on the surface there was not much new, to me, it was clear from reading those minutes that the Fed has decided not to take a proactive role in any further tightening (raising interest rates) on monetary policy. 

As I noted in Thursday’s Morning Call, following the market has been the Fed’s traditional approach to a monetary transition---which is precisely the reason that it has failed so miserably at it.  In short, interest rates are not likely to rise until the bond boys get fed up and refuse to buy government paper at historically low yields.  When that occurs is anybody’s guess.  But until it does, Fed policy will likely keep a bid under the securities markets.

That scenario, of course, increases the probability of inflation getting out of hand.  The gold market seems to be agreeing.  On the other hand, this week’s global economic news (lousy numbers plus a bank default) suggests something very different---recession among our trading partners and another crisis in the financial system.  The operative words are ‘this week’---meaning that it is a bit early to project this into a trend.  However, it does give me pause from accepting as a foregone conclusion the easy money/higher growth/inflation scenario.  At this point, we just need to await further data.
  
A review of the current inflation stats (medium):

Our forecast:

 ‘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.’
           
        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.

The US is now the largest energy producer in the world.  That has enormous economic and geopolitical implications all of which are positive.  Regrettably, we have achieved this status in spite of our government’s policies on coal, drilling on Federal lands and the Keystone pipeline.  I don’t think it unreasonable to suggest that our overall economic state would improve considerably with a bit more enlightened energy policy.

Here is a very negative take on US energy resources (medium):

       The negatives:

(1)   a vulnerable global banking system.  Citicorp got whacked this week for mortgage fraud and Commerzbank for violation of trading sanctions.  To be clear, the point of this keeping this potential negative in front of us is to underline [a] the wanton disregard for rules and regulations {most designed to either prevent a financial meltdown or the damage depositors} by bank management and [b] the inability of the regulators to stop this behavior before the fact {read disastrous consequences}

 ‘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.’


(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. 

As I stated above, it has become increasingly clear that any transition to tighter money will in driven by market actions [higher bond yields] not the Fed.  This week’s evidence was the FOMC equivocating over policy ‘normalization’ [higher interest rates] in its latest minutes.

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.  It apparently has chosen to do nothing until forced to do so by the bond market; and if history is any guide, the outcome will be higher inflation.

(3)   rising oil prices.  Violence in Ukraine, Iraq and now Israel/Palestine remains a threat to global oil supplies.  That said, oil prices have been down nine days in a row.  Whatever the threat of rising prices, it clearly is diminishing in investors’ minds. 


(4)    the sovereign and bank debt crisis in Europe and around the globe.  Europe was front and center this week with the missed interest payment by a Portuguese bank.  That in turn negatively impacted not only the securities of  banks that owned its shares but Portuguese bank stocks and bonds in general and to a lesser extent the banks of other southern European countries.  To be clear, this is not now a Lehman Bros moment and may never be; but it does illustrate some of the points that I have been making [a] EU bank balance sheets are overleveraged and [b] there is too much counterparty risk {they all own pieces of each other and pieces of the same securities that can potentially fail}.

Germany blesses ‘bail in’ solution to bank insolvency (medium):  new

And the IMF gives the ‘all clear’ on Bulgarian banks two weeks before a bank run (medium):

Japanese economic news this week remained dismal, indicating that Abe’s money for nothing policy hasn’t worked and still is not working. I don’t know how this play ends; but my money is riding on its being a tragedy.

Not much out of China this week, though problems in the real estate market and collateralized of warehoused commodities have not shown any signs of improvement.  Until there is, China will remain a potential trouble spot.

Credit guarantee companies are folding right and left (medium):

‘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 at some point it may be battling inflationary forces brought on by QEInfinity and the uncertainty of the Fed about how to undo what it has wrought.

Overseas, the environment is worse.  To start, this week’s terrible economic news out of both Europe and Japan raises the specter of a global recession.  Of course, we knew that these economies were struggling to stay above water.  But the magnitude of the numbers suggested that recession could come faster and go deeper than previously expected.  It also emphasized how worthless QE has been in Japan and is apt to be in Europe.  That said, I have emphasized that one week doesn’t make a trend.  However, if the numbers continue to disappoint, this could turn many economic forecasts (including our own) on their heads.

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.

Finally, violence continues in Ukraine and throughout the Middle East.  Somewhat surprisingly, the Markets have taken this strive in stride and may continue to do so.  That doesn’t mean oil prices aren’t at risk of moving higher on already existing geopolitical circumstances.

In sum, the US economy remains a plus, though the risk of mounting inflation is growing.  Unfortunately, that is not the only potentially troublesome headwinds. 

This week’s data:

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

(2)                                  consumer:  weekly retail sales were mixed; weekly jobless claims rose,

(3)                                  industry: May wholesale inventories were slightly below estimates but sales were strong; the June Small Business Optimism Index was below expectations,

(4)                                  macroeconomic: na.

The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 16943, S&P 1967) had a volatile week, finishing above their 50 day moving averages and remaining within uptrends across all time frames: short [16168-17647, 1900-2064], intermediate [16422-20781, 1846-2646] and long term [5088-18464, 762-1999].  

Volume on Friday fell; breadth improved.  The VIX fell, but closed above the upper boundary of its very short term downtrend for the second day, thereby confirming that break. It is also above its 50 day moving average.  On the other hand, it remains within short and intermediate term downtrends.  Its latest pin action could be pointing to a rise in volatility; it is just a bit early to tell.  I will be watching for signs of a change in direction.

The long Treasury staged a major comeback this week.  At Friday’s close, it confirmed the break above the upper boundary of its very short term downtrend.  In addition, it is back above its 50 day moving average and remains within short and intermediate term trading ranges.  The sudden turnaround was undoubtedly due to the rise in the value of the ‘safety’ trade as global economic numbers and the problems in Portugal’s banking system surfaced. 

The question is, are these problems just temporary blips in the long term economic outlook or is global economic growth not as robust as was thought at the start of the week?   The answer to that question is particularly important for bonds because  prices will react entirely differently in each of these scenarios (i.e. down prices if global growth and inflation are picking up; up prices if growth is slowing and the EU banking system is weaker than thought).  The bottom line is that the news pointing to slow growth and bank insolvency has a lot less longevity; and so if I had to bet right now, I would go with the easy money, growth and inflation scenario.  That, of course, doesn’t mean that I am right; so I maintain my confused state on what the bond guys are trying to tell us---assuming that they even know.

GLD was also up on Friday, closing above the upper boundary of a very short term downtrend for the second day, thereby confirming that break (notice the pattern?).  It remains above its 50 day moving average but within a short term trading range and an intermediate term downtrend. Like bonds, this pin action could be pointing to a change in momentum (direction).  The difference is that GLD could rise whichever of the aforementioned economic scenarios play out---as an inflation hedge in the easy money, growth, inflation outlook and as a source of safety for the economic slowdown, bank crisis scenario. 

Bottom line: technically speaking, the Averages remain in uptrends across all timeframes, the growing number of divergences and the less certain global economic outlook notwithstanding.  This is a circumstance where ultimately something has to change.  Either the outlook clarifies and the divergences resolve themselves or stocks have to start discounting something other than perfection. 

Bonds still have me confused as to exactly what is being discounted.  On the other hand, my uncertainty notwithstanding, gold will likely benefit from either growth/inflation or as a flight to safety.  Our Portfolios will likely start to nibble GLD next week.

 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.

Stock performance in July option expiration week (short):

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16943) finished this week about 43.8% above Fair Value (11775) while the S&P (1967) closed 34.5% 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 information value of this week’s US economic data flow was virtually nil.  Nonetheless, the overall trend continues to reflect a slow sluggish recovery though the risk of higher inflation is now greater than reflected in our forecast.  However, I want to see second quarter GDP numbers and more global economic data before revising our estimate.

Unfortunately, since I don’t believe that the US economy is going to grow any faster, any upward revision in inflation will lower the discount factor in our Valuation Model.   As you know, our Model already shows that stocks are very generously priced---and that ignores a plethora of potential problems that could negatively impact the economy or the securities markets or both. 

Somewhere out there is an event that will force the ‘decompression’ of future value out of stock prices; I just don’t know what and when.  As long as the ‘buy the dip’ crowd is hanging around, this market is not apt to fall of its own weight.  So I wait, comfortable with the price/value stability of cash.

The Fed is at the top of the list of problems that could go wrong.  Given the tone of the FOMC minutes released this week, it seems clear to me that the Fed is not going to do anything else (raise interest rates) by way of tightening under forced to do so by the bond market.

 If history is any guide, this will be a repeat of past botched transitions and will lead to higher inflation at a minimum.  Since interest rates are already mispriced (too low), once the markets start to price in inflation they will likely also start to price in a more normal ‘real’ interest rate.  That is a double whammy on the discounting mechanism for stocks.  In short, once the bond guys decide not to accept government paper at its current low prices, rates are apt to spike and that will likely not be well received by the stock crowd.

Of course, the Fed isn’t the only central bank mucking up the works.  Japan received another blow to its economic outlook this week with an atrocious industrial equipment order number.  Yet it continues to pursue a policy that hasn’t, isn’t and won’t work.  Indeed, like our own Fed’s policy, it is only making matter worse.  I can’t fathom what the end game is here; but it probably won’t be pleasant for the Japanese workingman and will likely generate fallout that will impact our own economy and banking system.

The EU continues struggling to get out of recession/deflation but will little luck.  Like Japan, it got some really lousy economic data this week. On top of that, a Portuguese bank failed; and while it was a small bank, it nonetheless shows that the EU banks remain fragile.  This all may prompt the ECB to institute some form of QE, though (1) I don’t know why it would work there since it hasn’t worked anywhere else and (2) it doesn’t really address Europe’s biggest economic problems---overly indebted sovereigns and overleveraged banks.  My concern here is about a disruption in our financial system resulting from problems in either.

Further, the data this week could be presaging a more rapid and steeper decline in global economic activity.  I emphasize that it is much too early to tell whether this was an outlier or a sign of things to come; but it does add one more worry to already big list.

Portuguese bank jitters intrude on QE euphoria (medium):

Unfortunately, Portugal is a proxy for most of Europe (medium):

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.

Despite the turmoil in Ukraine and the Middle East oil prices have actually declined over the last week.  Clearly, the oil market is telling us that as long as the any violence remains contained, oil/gasoline prices in the US are unlikely to reach a level that starts to impact economic activity.  That said, the last act has not been played in either Ukraine or Middle East; 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 and our global ‘muddle through’ scenario seems more at risk than a week ago).  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.

This from Lance Roberts:

However, let me pose another idea. What if "bubbles" really aren't about asset valuations, volatility or price levels? Rather, what if they are all about "psychology" instead. If we look back in history, we can clearly see that valuations in 2007 were substantially lower than in 2000, yet the markets crashed anyway. The same is true for 1929 which was even lower still. 
Yet, what all "bubbles" have in common is a "psychological" factor. A "belief" that the current trend, either positive or negative, will not end. It is at during these times that "everyone is on the same side of the boat" and what causes the rapid deflation is the rush to the other side. 
In other words, whatever "trigger event" occurs that creates a "rush for exits" will have nothing to do with fundamentals, valuations, volatility, or prices. It will be a psychological "panic" that spreads through the financial markets like a pandemic which causes financial instability, increases volatility and destroys prices.
For now, there is no visible sign that the current bullish trend is ending. However, when it does, questions will be asked, fingers pointed, and blame laid. The answer will simply be; "no one could have seen it coming."
"If everyone is thinking alike, then no one is thinking." Benjamin Franklin
 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                                               16943                                                  1967

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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