Saturday, October 25, 2014

The Closing Bell

The Closing Bell

10/25/14

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%

            2015 estimates

Real Growth in Gross Domestic Product                   +2.0-+3.0
                        Inflation (revised)                                                          1.5-2.5
                        Corporate Profits                                                            5-10%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Downtrend (?)                      15702-16782
Intermediate Trading Range                    15132-17158
Long Term Uptrend                                 5148-18484
                                               
                        2013    Year End Fair Value                                   11590-11610

                  2014    Year End Fair Value                                   11800-12000                                          

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Downtrend (?)                          1796-1927
                                    Intermediate Term Trading Range             1740-2019
                                    Long Term Uptrend                                    771-2020
                                                           
                        2013    Year End Fair Value                                    1430-1450

                        2014   Year End Fair Value                                     1470-1490         

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          47%
            High Yield Portfolio                                     53%
            Aggressive Growth Portfolio                        49%

Economics/Politics
           
The economy is a modest positive for Your Money.   Though slow, this week’s economic data was again weighed to the positive side: positives---weekly mortgage applications, September existing home sales, September leading economic indicators and the September Chicago Fed National Activity Index; negatives---weekly purchase applications, the October Markit flash PMI, the combo of revised August new home sales and September new home sales and October Kansas City manufacturing index; neutral---weekly retail sales, weekly jobless claims and September CPI.

While the volume of this week’s data leaned negative, the plus primary indicators (September existing home sales, September leading economic indicators) outnumbered the minus’ (August/September new home sales) two to one.  Tilting the balance even further to the positive is the fact that existing home sales (a plus) are about ten times the number of new home sales (a minus). Nonetheless, however hopeful these stats, this is only the second week in which they have been a net positive; and even then, I would not characterize the readings as robust.  So it is way too soon to be rejoicing about an overall improvement in the data.

In addition, while the statistics from overseas weren’t as bad as they have been, they were still mixed at best.  As a result, a slowdown in the global economy still ranks as the number one threat to our forecast.

That said, the modest improvement in the dataflow over the last two weeks does lead to the question, are the more upbeat stats marking the beginning of an improvement in the economy (ies) or are they just a pause before another onslaught of lousy numbers resume? 

The answer is that I don’t know; so the point is that (1) much more information is needed before I can feel comfortable that the economy isn’t losing steam, (2) but at least I am questioning whether or not a slowdown is inevitable.  

In short, our outlook remains the same, and the primary risk (the spillover of a global economic slowdown) remains just so.

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, 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.’
           
            Update on big four economic indicators (medium):

        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.

To date, this rising supply has led to a fairly dramatic decline in energy prices.  Initially, consensus was that this was a major positive in that it served as a tax cut to consumers and a lower cost of production for industry---which was absolutely correct.  However of late, as global economic activity slows, concern is growing that lower prices may be suggesting potential recession.  In short, this positive appears to be transitioning into a double edged sword.

       The negatives:

(1)   a vulnerable global banking system.   This week, a Spanish source reported that eleven banks in six countries have failed the ECB stress test [the ECB will announce results on Sunday].  The article below suggests that the problem may be larger than that and is a must read:
 

And it was revealed that the NY Fed knew about the London whale well before the disaster:

2007 redux (medium):

‘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.  As you know, the elections approach and the polls are telling us that the republicans will keep the House and win control of the Senate.  Many believe that this will somehow be a plus for fiscal policy---the assumption being that the GOP is more fiscally responsible than the dems.  Pardon my skepticism but that simply can’t be supported by the facts from the last two decades. 

Sure, the rhetoric is there.  Yes, the Tea Party has had an impact on policy positions.  But I am waiting for some proof before giving the GOP a gold star for fiscal responsibility; hence, I think caution is the word in anticipating some conservative fiscal renaissance. 

Of course, even if the republicans’ hearts are in the right place, it may make no difference initially because Obama can veto any measures not sufficiently ‘progressive’.  The good news is that if a standoff occurs, it will be the dems/Obama this time that get tarred with the obstructionist brush.

I think that the most likely outcome will be gridlock which itself, I think, is a positive---witness the decline in the budget deficit the last two years.  That said, this country needs tax and regulatory reform to boost its secular growth rate and those measures will likely remain nothing more than wishful thinking until at least 2016.

(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. 

The major news item this week was the rumor, twice denied, that the ECB, as part of their new, improved QE, would begin buying corporate debt in the near future.  Even assuming that is true, a study [linked to in Thursday’s Morning Call] suggests that the universe of possible purchase candidates is so small, that this program would have virtually no impact  [oh darn, back to the drawing board].

Not that it would make a difference if the numbers were substantially larger.  As I keep documenting, QE [except for QEI] hasn’t worked anywhere in any amounts; and there is no reason to assume it would in this case.  In particular, coming as it does on the heels of Draghi’s admission that economic conditions in the EU aren’t going to improve until fiscal reform takes place. 

Speaking of fiscal reform, we got another stunning bit of news this week, to wit, the IMF stated that it approved of the second round of Japanese tax increases.  So let me get this right.  The Japanese economy is sinking like a stone and a tax increase is just what the doctor ordered to kick start activity. 

No more comment needed.

(3)   geopolitical risks.  Two items of note this week: (1) the Russian/Ukrainian negotiations regarding the pricing of gas this winter fell apart.  Not particularly surprisingly.  Putin has made it clear that he will not be intimidated by US/EU sanctions and will respond in kind.  That suggests higher gas prices/lower supplies to the EU/Ukraine this winter; and that’s not likely to make for great headlines, (2) a Canadian of Algerian decent, who had converted to Islam, shot and killed a soldier.  This is the second such incident in Canada in as many weeks and raises the potential of stepped up terrorist activity outside the Middle East. 

(4)    economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  For the first time in a while, the economic news out of the rest of the world was at least mixed.  That hardly means a turnaround, but we have to take positive news where we get it.  At the moment, I don’t think it means much more than that the slide into recession is not a straight line; but my hope is that it marks the beginning of a bottoming in economic activity.  So I remain alert to further data.

My hopes aside, the facts on the ground are that the global economy continues to struggle just to stay flat. So at this moment, there is little to assuage my concerns over continued deterioration in global economic activity and that drives me to the conclusion that global recession is the number one risk to our economy.

      The slowdown in China’s growth (medium):

Bottom line:  the US economy finally showed some signs of improvement, however paltry.  Likewise, the data from Japan, China and Germany, three of our major trading partners, provided a modicum of hope that their economies might be stabilizing.  Of course, one week’s stats are hardly something on which to hang that hope; so it does little to lessen my concerns.

Unfortunately, there hasn’t been the slightest hint that the global economy will receive any help from changes in either monetary or fiscal policies.  Yes, the US has elections very shortly that could alter the balance of power in congress; but that may mean little if Obama hunkers down and refuses to compromise.  As for Europe, France, Italy and Germany have all let it be known that they have no intent in following suggested fiscal reforms suggested by the ECB.   As for monetary policy, it remains QEForever, its continuing lack of success notwithstanding.

Geopolitically, the world is a mess.  The standoff in Ukraine has clearly not been resolved; and winter (i.e. the need for gas) is rapidly approaching.  The ground action in Syria/Iraq is going against us; and this week, the war got a little closer to home.  True it was Canada, not the US; and the terrorist was homegrown versus imported.  But that will be of little consolation if we wake up to similar headlines here.

In sum, the both the US and EU economies showed signs of improvement this week, though we need a lot more of that to feel comfortable that the global economy is not going to pull us into recession.

This week’s data:

(1)                                  housing: weekly mortgage applications were up but purchase applications were down; September existing home sales were much better than anticipated; September new home sales were also up but the August number was revised down hugely,

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

(3)                                  industry: September Chicago Fed National Activity Index was much better than forecast expectations; the October Markit manufacturing flash PMI was below forecast as was the Kansas City Fed October manufacturing index,

(4)                                  macroeconomic: September leading economic indicators were stronger than anticipated; September CPI was slightly more than forecast.
           
The Market-Disciplined Investing
           
  Technical

            The indices (DJIA 16805, S&P 1958) gave us another wild ride this week.  The Dow finished above the upper boundary of its short term downtrend (15702-16782) on Friday; if it remains above that level through the close on Tuesday, the trend will re-set to a trading range.  It also ended within an intermediate term trading range (15132-17158), a long term uptrend (5148-18484) and below its 50 day moving average.

The S&P closed above the upper boundary of its a short term downtrend (1796-1927) for the second day; if it ends there on the bell Monday, the trend will re-set to a trading range.  It also finished within an intermediate term trading range (1740-2019), a long term uptrend (771-2020) and below its 50 day moving average.

Volume declined; breadth was mixed.  By one measure, the Market is again dramatically overbought. The VIX fell, ending within a short term uptrend, an intermediate term downtrend and above its 50 day moving average.  
 
The long Treasury rose on Friday, closing within a very short term trading range, a short term uptrend, an intermediate term trading range and above its 50 day moving average.

GLD was down on Friday.  It broke its very short term uptrend this week, re-setting to a trading range.  It remained within short and intermediate term downtrends and below its 50 day moving average.

Bottom line: equities recovered smartly this week; but did so with stunningly schizophrenic volatility.  Many of the indicators that we follow daily made multiple trend changes in those five days despite the smoothing effect of our time and distance discipline.  I am at a point where I feel completely out of touch with Market sentiment. When I am, it is always best to do nothing.  Nonetheless, I would use any rise in prices to Sell stocks that are near or at their Sell Half Range or whose underlying company’s fundamentals have deteriorated. 

Fundamental-A Dividend Growth Investment Strategy

The DJIA (16805) finished this week about 42.0% above Fair Value (11829) while the S&P (1958) closed 33.3% overvalued (1468).  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 slightly more upbeat economic dataflow both here and aboard hardly seemed sufficient to warrant the euphoria we witnessed in equities.  But when combined it with last week’s souped up QE comments from the global central bankers, investors were provided with a goldilocks scenario (an improving economy and an easier Fed) to discount.  Not that I think this will happen.  Investors just don’t seem to get that they can’t have it both ways.  If the global economy is suddenly healing, QE is terminal.  If it is slipping into recession, QE/the central banks are going to get pilloried for not stimulating growth.  But I suppose that is tomorrow’s problem.

In the end, as I have been insisting for a long time, this is not about the economy in any case.  It is about asset mispricing which (excluding the stick save of QEI) appears to have been the major result of global QEInfinity.  Clearly, markets are still intoxicated by the prospect of more free money; but at some point, the realization will set in that it has totally failed to generate the outcomes promised by the central bankers and so widely anticipated investors.  Whenever that happens, I believe that valuations will retreat to more sensible levels. 

Fed’s grand illusion

The farce of European stocks (short):

Geopolitics re-emerged this week as a possible source of Market heartburn.  Russia and Ukraine couldn’t agree on a pricing contract for winter gas.  Hardly surprising.  I guess that I don’t have to point out who has the hammer in any negotiations; and if nothing gets done, it will be a tough winter in euroland. 

In addition, the war in the Middle East has made its way to the Western Hemisphere with the two incidents in Canada.  That doesn’t mean that the US will get hit; but it suggests that the odds aren’t zero. 

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 global ‘muddle through’ scenario is at risk).  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.


          

DJIA                                                   S&P

Current 2014 Year End Fair Value*              11900                                                  1480
Fair Value as of 10/31/14                                11852                                                  1472
Close this week                                               16805                                                  1958

Over Valuation vs. 10/31 Close
              5% overvalued                                12444                                                    1545
            10% overvalued                                13037                                                   1619 
            15% overvalued                                13629                                                    1692
            20% overvalued                                14222                                                    1766   
            25% overvalued                                  14815                                                  1840   
            30% overvalued                                  15407                                                  1913
            35% overvalued                                  16000                                                  1987
            40% overvalued                                  16592                                                  2060
            45%overvalued                                   17185                                                  2134
           
Under Valuation vs. 10/31 Close
            5% undervalued                             11259                                                      1398
10%undervalued                            10666                                                       1324   
15%undervalued                            10074                                                  1251

* 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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