Saturday, May 23, 2015

The Closing Bell

The Closing Bell

5/23/15

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 (revised)      0-+2%
                        Inflation (revised)                                                          1.0-2.0
                        Corporate Profits (revised)                                            -5-+5%

   Current Market Forecast
           
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Uptrend                                 17220-20025
Intermediate Term Uptrend                      17378-22506
Long Term Uptrend                                  5369-19175
                                               
                        2014    Year End Fair Value                             11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Uptrend                                     2021-3000

                                    Intermediate Term Uptrend                       1826-2593
                                    Long Term Uptrend                                    797-2138
                                               
                        2014   Year End Fair Value                                     1470-1490

                        2015   Year End Fair Value                                      1515-1535        

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          51%
            High Yield Portfolio                                     52%
            Aggressive Growth Portfolio                        53%

Economics/Politics
           
The economy is a neutral for Your Money.   The preponderance of data this week was negative though two primary indicators were pluses: positives---April new home sales and building permits, April leading economic indicators and April CPI ex food and energy; negatives---weekly mortgage and purchase applications, May homebuilder confidence, April existing home sales, month to date retail sales, weekly jobless claims, the April Chicago national activity index, the May Markit flash manufacturing index and the May Philly Fed and Kansas City manufacturing indices; neutral---none.

Clearly volume wise this was a rough week.  To be sure, the new home sales and leading economic indicators were very important positives.  But new home sales were more than offset by the headline existing home sales (which are ten times the magnitude of new home sales).  Realtors are countering that the disappointing number was a function of low supply versus low demand.  Bear in mind that they are just talking their book.  In fact, in the same existing home sales press release, inventories (i.e. supply) were listed as climbing in April.  So I am counting the new versus existing home sales as a wash.  In short, we are at sixteen out of seventeen weeks of lousy data and counting.


There was a bevy of Fed related news all of which I covered in Morning Calls and discuss briefly below.  In sum though it was confusing in part because Fed seems to be trying to weasel the economic data to look better than it is.  I continue to wonder if the Fed’s motive is to keep the door open for a rate hike sooner later than later. If that occurs as you know, I don’t think the economic impact will be that great.  That said, since the economy appears to be weakening, a rate hike won’t exactly be constructive.

Our forecast:

 ‘a much below average secular rate of recovery, exacerbated by a declining cyclical pattern of growth,  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 hesitant to hire and invest because the aforementioned, the weakening in the global economic outlook, along with...... the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.’
           
        The pluses:

(1)       our improving energy picture.  Oil production in this country continues to grow which is a significant geopolitical plus.  However, we have yet to see the ‘unmitigated’ positive attributed to lower oil prices by the pundits.  Not surprisingly, with oil prices up, this same crowd is trumpeting the pluses that rising prices will have on capital spending.  If they keep trying, the law of averages says that they will eventually be right.  But who will listen?

       The negatives:

(1)   a vulnerable global banking system.  This week:

[a] UBS got its wrist slapped for currency manipulation. 

[b] five banks including Citi, JP Morgan and Bank of America plead guilty to currency manipulation---but no one goes to jail.

Unfortunately, this reverses the hopeful signs we saw last week that the regulators may be attempting to impose justice on the too big to fail banks.  For those banks to plead guilty [which is a first] and no one be held accountable is unconscionable.


SEC commissioner chides agency for not enforcing the law (medium and must read):

‘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.

The US love affair with debt (medium):

Which is mathematically impossible to pay off (medium):

(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets. 

This week witnessed more confusion out of the Fed.  First, there were two articles published: one by the San Francisco Fed arguing that the seasonal adjustment factors in recent economic data releases should have been doubled in which case the economy would look normal.  Later in the week, the Bureau of Economic Analysis agreed and suggested that there will be indeed be some seasonal adjustments to the seasonal adjustments.  However, the caveat in this exercise is that whatever increase is applied to the first quarter seasonal adjustment may be taken from the subsequent quarters.  In short, the overall trend wouldn’t change, it would just be less volatile.  [So far, no one is suggesting that the already poor second quarter numbers need another seasonal adjustment.  But then the second quarter is over yet.]

In the second article, the NY Fed which has been tweaking its econometric model said that the economic outlook is great [although the spread of possible outcomes is so wide as to be meaningless].

Add that to the convoluted narrative in Wednesday’s release of the most recent FOMC minutes: the Fed [a] thinks that the first quarter economic weakness was transitory, but it is worried about the potential impact of the strong dollar, economic weakness in growth in China and the outcome of the Greek bailout negotiations, [b] has little support for a rate hike in June; but contends that any decision will be data dependent and, therefore, it is not ruling out an increase in June and finally the coup de grace, [c] is concerned about the effect of a rate hike on the markets,  in view of the increased role of high-frequency traders, decreased inventories of bonds held by broker-dealers, and elevated assets of bond funds---all a result of Fed/regulatory policy.

Finally, Yellen spoke on Friday but didn’t add much to the narrative.  She did say that she expects a rate hike in 2015, though provided no guidance on timing.  Judging by the Market’s reaction, investors continue to believe that it will be later rather than sooner---perhaps at their own peril.     

I am very unclear what this all means; and I am not sure the Fed even knows.  It is full of on the one hand/on the other hand, wishy washy, afraid to make a firm statement comments, which I can only assume were deliberate and, I think, the best evidence there is that in fact the Fed is either clueless or realizes what it has done and is scared s**tless. 

I do have one scenario that links this all together: the Fed knows that QE has not only not worked but has created problems that will only get worse the longer QE lasts.  Therefore, the time has arrived to bite the bullet which it does under the guise of projecting a stronger economy than there is evidence to support.  Then when the consequences occur (which will be largely Market related), it can point to all those studies showing that the economy is OK and blame the Market reaction on high frequency traders, broker dealers and bond funds.  Bear in mind this is just the cynical thoughts of an elderly market participant.

The Fed was not the only central banking making the news this week: [a] the Banks of England and Japan both reiterated their undying devotion of QE, and [b] the ECB said that it would ‘front load’ its QE.  So whether or not, the Fed starts to taper, the QE crowd is still going to have plenty of sources for cheap money.

Finally, in a speech Draghi re-emphasized that the ECB could not pull the EU economy out of a ditch all by itself.  Fiscal [budget and regulatory] reforms were essential to returning to historical growth rates.  Good for him.  Every government in the world should take note, not the least of which is our own.  I think it doubtful that any economy can return to its former self until consumer and business confidence returns and that won’t happen until the shackles have been removed.

(4)   geopolitical risks: this week:

[a] ISIS took Ramadi but perhaps worse is the delusional spin the administration is putting on its ISIS strategy. http://www.powerlineblog.com/archives/2015/05/delusional-white-house-calls-isis-strategy-a-success.php

[b] the Iranian nuke negotiations seem right on track as the Ayatollah said in a speech that there would be no surprise inspections and no inspections of certain ‘facilities’.  The spin will undoubtedly be that he is just saying that for {Iranian} public consumption; and that is not really what will be in the agreement.  Rather than make a sarcastic, cynical statement, I will wait till we see the agreement; if we see it.

[c] and last but certainly not least, in a speech Obama proclaimed that one of the great security risks to the US is climate change.  Cue the sarcastic statement.  

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  The key datapoints this week were

[a] upbeat prints of Japanese first quarter GDP and May composite PMI.  Hopefully, this is a signal that perhaps another major economy is starting to come out of the doldrums.  As you know, I have been a bit cautious about accepting these numbers at face value; however, there no reason at present to question their validity. 

[b] the EU PMI and German business confidence were disappointing.  Not enough to deep six the prospect of a latent economic improvement but sufficient to the leave the question open. 

[c] the really bad international economic news this week was the Chinese composite PMI; not only because it was the third negative PMI report in a row but also because it was just another in a steady stream of poor data from all sectors of the economy.

Nevertheless with both Japan and the EU showing some signs of life, our ‘muddle through’ scenario, which has been gasping for air of late, may end up being right on.

In addition,

The Greek/Troika bailout discussions continued---and seemed to be going nowhere until yesterday when the leaders of Greece, France and Germany met.  While there was no agreement, ‘significant progress’ was said to have been made.  And not a moment too soon; because Greece has notified the IMF that it would not be able to make the June 6 E1.5 billion payment and the ECB met to discuss raising the discounts applied to Greek bank assets used as collateral for loans.  Maybe this latest meeting falls in historical euro pattern of pulling victory from the jaws of defeat at the last possible second; if so, it runs counter to every other official statement made this week.

My bottom line here hasn’t changed: I don’t know how this ends, I don’t know what that means for the markets but I do believe that there will be unintended consequences; and since those are by definition unknowable, this situation demands some caution.    

    ‘Muddling through’ remains the assumption for the global economy in our Economic Model with the proviso that if a Greek default/exit occurs, all bets are off. This remains the biggest risk to forecast.
     
Bottom line:  the US economic news maintained its downward path, the promise for first quarter upward revisions notwithstanding.  Until we start getting concrete evidence that the economy is not slipping further, the risk remains that I may have to revise our forecast down again.

The international data didn’t improve the odds.  While Japan may be showing some signs of life, EU data was all negative and China was terrible.  Finally, the Greek/Troika negotiations are nearing zero hour with no apparent resolution in sight.  An agreement may still happen; but the odds are falling and the unintended consequences by definition, unknown. 

The Fed is keeping things interesting (1) seeming to suggest from several sources that the economy is not as bad as many think---we are just getting bad numbers and (2) admitting that the risks associated with any rate hike are a product largely of its own policies.  I am as confused as ever as to what these guys will do next; though I am more sure that whatever they do it will have more impact on the Markets than it has on the economy.

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications declined; the May NAHB confidence index was below expectations; April housing starts and building permits were very strong; May existing homes sales were a disappointment,

(2)                                  consumer: month to date retail chain store sales slowed; weekly jobless claims rose more than anticipated

(3)                                  industry: the April Chicago national activity index fell versus forecasts of an advance; the May Markit flash manufacturing index was below consensus; the May Philadelphia and Kansas City Fed manufacturing indices were below expectations,

(4)                                  macroeconomic: April leading economic indicators were up more than estimates;      April CPI was, in line; ex food and energy, it was above forecast.

The Market-Disciplined Investing
         
  Technical

The indices (DJIA 18232, S&P 2126) turned in a flattish week.  Both closed above their 100 day moving average but they were out of sync on their all-time highs, which is to say that the S&P finished above that level while the Dow ended below. 

Longer term, the indices remained well within their uptrends across all timeframes: short term (17220-20025, 2021-2593), intermediate term (17378-23506, 1826-2593 and long term (5369-19175, 797-2138).  

Volume fell on Friday; breadth also declined.  The VIX dropped all week, finishing below its 100 day moving average and the upper boundary of a very short term downtrend---both positives for stocks.  In addition, it is again nearing the lower boundaries of its short and long term trading ranges.  The closer it gets, the more attractive it becomes as portfolio insurance.


The long Treasury had a bit more volatile week than stocks; though the results were the same---basically flat.  It remained below its 100 day moving average, the upper boundary of a short term downtrend and near the lower boundary of its short term downtrend.  So overall the momentum continues to the downside. 


The divergence in performance between the stock and bond markets (the stock market rising on weak economic numbers/easy Fed while the bond market falling presumably on better growth and higher inflation) was clearly muted this week.  My guess is that most investors have made their bets based on available data and thus are biding their time awaiting the next defining event. 

In the meantime, this week gold, oil and the dollar reversed their recent trends which adds to the tension posed by the conflicting scenarios embodied in the pin action of the equity and fixed income markets.

I have no idea how all these factors resolve themselves.  But till they do, I think patience is needed.


As I noted above, GLD traded back below its 100 day moving average and the neckline of its head and shoulders pattern.  Given its erratic price movement over the last year, I am not sure that there is a message in GLD; and if there is one, it is probably labeled ‘confused’.

Bottom line: the Dow hasn’t made a new high in three months which itself was only fractionally higher than the prior high; on the other hand, the S&P did make a new high but just barely and on anemic volume. 

Clearly, there is some uncertainty among investors.  The question which I posed early in the week is, is this ‘a consolidation before a challenge of the upper boundaries of their (the Averages) long term uptrend or are the buyers blowing their wad trying unsuccessfully to break materially higher.’? 

I feel almost certain that, having come this far, the indices will at least make an old school try at challenging those upper boundaries.  That said, I also believe that challenges will be unsuccessful---which, from a strictly technical viewpoint, makes the short term risk/reward in the Market right now unattractive.

Longer term, the trends are solidly up and will be so until the short term uptrends, at the very least, are negated.
             
Fundamental-A Dividend Growth Investment Strategy

The DJIA (18232) finished this week about 51.0% above Fair Value (12073) while the S&P (2126) closed 41.8% overvalued (1499).  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 poor US and international economic stats confirm the economic assumptions in our Valuation Model.  It does seem that recovery is taking hold in Europe, the latest PMI number notwithstanding.  In addition, the Japanese economy is showing signs of life.  Unfortunately, China is still struggling and the US ain’t so hot itself.  All that said, as I have explained numerous times that won’t impact the numbers in our Valuation Model, but it will almost certainly force changes in Street Models which will likely cause heartburn for equity prices.

QE continues to be the policy du jour (England, Japan, ECB) globally; although the two recent Fed studies along with opaque FOMC minutes and Friday’s Yellen speech may be giving a subtle message that interest rate hikes are not that far away.  Certainly, that notion is being supported by the bond market.

We should also be concerned about the growing number of voices pointing to the lack of liquidity in the bond markets (lack of supply, the downsizing of bank trading) which gained credence this week from none other than the FOMC minutes.  In sum, rate increases may be closer than once thought; irrespective of the timing, even the Fed is worried about the lack of liquidity in the markets should that tightening process be interpreted negatively by investors.  And if it is worried, maybe 50% in cash is not enough.

Another great article by David Stockman on the Fed and the market (medium and a must read):

The Middle East just keeps getting more complex.  ISIS captured Ramadi (Iraq) this week and now controls sizeable territory in Syria and Iraq.  Meanwhile, Iran’s Supreme Leader says ‘no way, Melvin’ to any inspections of its nuclear facilities.  But don’t worry about it because our president says His Middle East strategy is working.  In fact, it is working so well His next target in assuring US security is, drumroll, climate change.  If that works as well as the rest of His foreign policy, better go buy a gas mask.  That, of course, has nothing to do with the Market---unless, that is, the bad guys capture, disable or disrupt the flow of oil.

Friday’s joint statement from the Greeks, French and Germans (‘significant progress’) aside, the cold hard facts are that Greece has an E1.5 trillion IMF payment due June 5.  Granted that there is a grace period following the nonpayment; but the euros are still cutting it pretty close if they are going to step back from the cliff.  My bottom line is that I have no idea how this resolves itself but if a default/Grexit occurs that are apt to be unintended consequences (e.g. this week’s statements out of the Portuguese government) that are disruptive to the Market.

Or maybe this: UK analyzing a Brexit (medium)

‘As I noted last week, I have no clue how to quantify the aforementioned geopolitical risks’ impact on our Models even if I could place decent odds of their outcome because: (1) the outcomes are mostly binary, i.e. Greece either exists the EU or doesn’t and (2) they all most likely incorporate potential unintended consequences, which by definition are unknowable.  Better to just say these are potential risks with conceivably significant costs and then wait to see if we ‘muddle through’ or have to deal with those costs.  The important investment takeaway, I believe, is to be sure that your portfolio had at least some protection in the downside.’

Bottom line: the assumptions in our Economic Model are unchanged but still in danger of being revised down again.  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. 

The assumptions in our Valuation Model have not changed either; though there are scenarios listed above that could lower Fair Value.  That said, our Model’s current calculated Fair Values are so far below current valuation that any downward revisions by the Street will only bring their estimates more in line with our own.

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 2015 Year End Fair Value*              12300                                                  1525
Fair Value as of 5/31/15                                  12073                                                  1499
Close this week                                               18232                                                  2126

Over Valuation vs. 5/31 Close
              5% overvalued                                12676                                                    1573
            10% overvalued                                13280                                                   1648 
            15% overvalued                                13883                                                    1723
            20% overvalued                                14487                                                    1798   
            25% overvalued                                  15091                                                  1873   
            30% overvalued                                  15694                                                  1948
            35% overvalued                                  16298                                                  2023
            40% overvalued                                  16902                                                  2098
            45%overvalued                                   17505                                                  2173
            50%overvalued                                   18109                                                  2248
            55% overvalued                                  18713                                                  2323

Under Valuation vs. 5/31 Close
            5% undervalued                             11434                                                      1420
10%undervalued                            10832                                                       1345   
15%undervalued                            10230                                                  1270



* 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 hard way.








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