Saturday, July 11, 2015

The Closing Bell

The Closing Bell

7/11/15

Statistical Summary

   Current Economic Forecast
           
            2014

                        Real Growth in Gross Domestic Product                       +2.6
                        Inflation (revised)                                                           +0.1%
                        Corporate Profits                                                             +3.7%

            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                                 17551-20375
Intermediate Term Uptrend                      17763-23895
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                                     2070-3049
                                    Intermediate Term Uptrend                        1861-2629
                                    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                          53%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        53%

Economics/Politics
           
The economy provides no upward bias to equity valuations.   The dataflow this week, what there was of it, was mixed: above estimates: weekly mortgage and purchase applications, month to date and June retail chain store sales and the May US trade deficit; below estimates: the June Markit PMI services index, May wholesale inventories/sales, consumer credit and weekly jobless claims; in line with estimates: the June ISM nonmanufacturing index.

There were few important indicators (the ISM nonmanufacturing index, the Markit PMI services index and May wholesale inventories/sales) and they were mixed/negative. But to be fair this week’s data didn’t add a lot to our understanding of the condition of the economy.  Coupled with last week’s mixed results this represents a step back from the gangbusters week we had two weeks ago.  But that kind of erratic pattern is exactly what one would expect in a sluggishly growing economy.   To be sure, the numbers have improved over the last month; but they had to, else I would have had to consider lowering our growth forecast even more or worse forecasting recession.  Net, net, I remain satisfied that our current forecast is right on target:

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 conflicting profit incentives and a business community hesitant to hire and invest because the aforementioned, the weakening in the global economic outlook, along with the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.

        The pluses:

(1)   our improving energy picture.  Oil production in this country continues to grow which is a significant geopolitical plus.  However, we never saw the ‘unmitigated’ positive forecast by the pundits when oil prices were cratering.  Not surprisingly, when oil prices started to recover somewhat, this same crowd trumpeted the pluses that rising prices will have on capital spending.  This week, prices started getting whacked again on news of rising inventories and the prospects of an Iranian nuke deal that will allow them to start exporting their oil again.  I guess now the narrative will return to the ‘unmitigated’ positives of lower oil prices. I am still waiting.

       The negatives:

(1)   a vulnerable global banking system.  This week JP Morgan, our ‘fortress bank’, found its dick in the wringer once again.  This time it is paying a fine for the improper collection and selling of consumer credit card information.

My concern here is that: [a] investors ultimately lose confidence in our financial institutions 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 from either subprime debt problems in the student loan or auto markets or turmoil in the EU financial system resulting from a Greek default or exit from the EU.
      

(2)   fiscal policy.  Not exactly a US fiscal policy issue, but one that is still of concern is the current financial dilemma of Puerto Rico.  As I have reported, the governor has stated that the state can’t payback its debts.  His latest position is that the island needs to renegotiate the terms of its massive debt.  While not likely to impact the US economy in any meaningful way, there may be some probability of disruptions in the muni bond market [a] not just in Puerto Rican debt but also in other weak municipal credits, [b] especially if investor psychology turns less sanguine.

(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.  

On Wednesday, the FOMC released the minutes of its last meeting.  While this is some disagreement, I interpreted them as slightly more hawkish than the statement issued following the meeting.  Confirming that view in a speech on Friday, Yellen said that she expects an interest rate rise this year.

That said, I don’t know how anyone can make a judgment regarding potential Fed action at its September meeting or any other time as long as the current level of uncertainty surrounding the Greek bail out and the Chinese market plunge remains.

On the other hand, the Chinese central bank is scrambling to do everything possible to stem the decline in its securities’ market.  And the ECB had made it clear that its ‘whatever it takes’ policy is alive and well and will be pursued with vigor should the outcome of the Greek bailout negotiations lead to financial unrest.  So far, the Chinese experience is showing once again that monetary policy is of little help in most circumstances.  We await judgment on the potential ECB/Greek turmoil.

This study is a follow up to the Rogoff/Reinhart research that suggested that a country’s growth slows as its debt to GDP rises above 90%.  In this study, the authors posit that economic growth is inversely related to growth in the financial sector.  (medium and a must read):

(4)   geopolitical risks: tensions continue in Ukraine and there is no letup in the fighting in the Middle East.  However, they are taking a back seat to the Greek standoff. 

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

[a] the continuing standoff between the Troika and the Greeks over a bail out agreement.  This drama is playing out like an Alfred Hitchcock movie in which you never know what will happen next.  As of this moment, the Greeks have offered to comply with the Troika’s demands on raising taxes and reducing pension.  We will get the response from the EU Monday morning, though as of last night, it didn’t sound all that promising.    Markets continue to trade as though there will be an agreement.  Could be; although I am not so sure that a Grexit wouldn’t be the best solution for the Greeks in the long run.

This is a bit long but is a great discussion from my  ‘go to’ expert on the whole bail out process, Tsipras’ disastrous leadership and why this isn’t over (long but a must read):

[b] the carnage in the Chinese stock market.  While I have noted that there is little chance of a direct impact on our economy/market---since foreign investors own a small portion of the total Chinese market---there are indirect effects: {i} this week, we saw the yen jump as a recipient of ‘safe haven’ trades.  That puts the yen ‘carry’ trade at risk which would have a bearing on global money managers portfolios, {ii} the decline in the Chinese markets in part reflects a slowdown in economic activity (witness the simultaneous drop in agricultural and industrials commodities) which impacts all of that country’s trading partners and {iii} since we can never trust the data we get out of China, there may be factors driving the market down that we don’t even know about. 



In other economic news, the UK released two conflicting measures of its manufacturing sector, while German factory orders were disappointing. Neither are particularly encouraging given that the UK and Germany have two of the strongest economies in Europe.  Certainly, there is nothing to suggest that our own economy will get any kind of boost from Europe.

    ‘Muddling through’ remains the assumption for the global economy in our Economic Model with the proviso that a Greek default/exit or a sharp decline in economic activity in China would likely force a re-evaluation occurs of our own forecast. This remains the biggest risk to forecast.
           
Bottom line:  while the US economic news for the last two weeks has been mixed, it is still an improvement from the first eighteen weeks of the year.  Thus, it is positive in that it, hopefully, is taking the recession scenario off the table.  But, in my opinion, that in no way suggests any acceleration in our growth prospects above the rates that existed in the preceding couple of years.

The international data did little to demonstrate any kind of pick up in global economic growth. Indeed, the potential risks associated with a Grexit or a significant decline in China’s economic growth rate would be a threat to our own forecast.

This week’s data:

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

(2)                                  consumer: month to date retail chain store sales were up; June retail chain store sales improved; weekly jobless claims rose more than forecast; consumer credit increased less than consensus,

(3)                                  industry: the June PMI services index was below forecast, while the June ISM nonmanufacturing index was in line; May wholesale inventories rose 0.8% but sales were up only 0.3%,

(4)                                  macroeconomic: the May US trade deficit was lower [better] than estimates.

The Market-Disciplined Investing
         
  Technical

The indices (DJIA 17760, S&P 2076) had a real roller coaster ride this week, suffering severe whackage after the NO vote in the Greek referendum and the plunge in the Chinese markets and then rallying on good news from both fronts as well as short covering.  In the process, they challenged a number of key support levels, then voided those breaks: both finished back above their 200 day moving averages and both closed above the lower boundaries of their short term uptrends.  However, they remain below their 100 day moving averages and the Dow ended below the lower boundary of its intermediate term uptrend.  If it finishes there on Monday, that trend will be negated.  At this point, the key remains follow through; though in which direction is the question.

Longer term, the indices are for the moment within their uptrends across all timeframes: short term (17551-20375, 2070-3049), intermediate term (17763-23895, 1861-2629) and long term (5369-19175, 797-2138).  

Volume fell on Friday, not especially encouraging for the bulls.  Breadth rose.  The VIX dropped 15%, bouncing off of the upper boundary of its intermediate term downtrend but still above its 100 day moving average and the depressed levels of two weeks ago.

The long Treasury was down 1.5%, closing below its 100 day moving average and below the upper boundary of its short term downtrend---clearly losing its recent cache as a safe haven.

GLD continues to do nothing, having done nothing when other safe haven bets were responding last week.  Oil traded higher but remains below its 100 day moving average and near the lower boundary of its short term trading range; while the dollar declined, closing below its 100 day moving average and the lower boundary of a very short term downtrend.

Bottom line: after the extreme volatility this week, it seems hard to believe that the S&P ended right on its close from the week before.  At the moment the indices are in a very short term range bounded by their 100 day moving averages on the upside and the lower boundaries of their short term uptrends on the downside.  On a slightly long term basis they have been flat since the first of the year. 

With the headlines as emotionally packed as they have been, it is likely that purely technical factors will continue to take a back seat.  Next week those headlines include the Greek bail out (which despite Tsipras’ capitulation, is not a done deal), the Chinese markets (which are being torn asunder by government attempts to control prices) and earnings season (which starts in earnest).  Nonetheless, it should be interesting watching the bulls and bears continue to battle it out in the present trading range. 

On a short term trading basis, the bias has switched to the upside with the risk being the indices’ lower boundaries of their short term uptrends and the upside marked by the upper boundaries of their long term uptrends.  Longer term, however, the spread between the upper and lower boundaries of the Averages’ long term uptrends should make investors cautious about making any investments at current levels.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17760) finished this week about 46.3% above Fair Value (12137) while the S&P (2076) closed 37.8% overvalued (1506).  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 preceding two weeks of mixed data properly reflects, I think, our forecast of no recession but decelerating growth.  Hence, there is no need to challenge the longer term growth of productive capacity assumption in our Valuation Model.

The Fed has already done its part to assure ‘a botched…transition from easy to tight money’---irrespective of what it does in September.  It is now facing the probability that unless it gets very lucky, (1) if it tightens, it will run the risk of hampering or even stopping what sluggish growth the US economy currently has or (2) if it doesn’t tighten, it still may have to implement QEIV due to the aforementioned economic lethargy and/or events in Greece/China that produce a shock that would necessitate a further infusion of liquidity to maintain stability within our financial institutions---and that is just what we need: more pricing distortion in the securities market and more asset misallocation.   

Of course, nothing says botched central planning like the current clusterf**k unfolding in China. After originally encouraging investment is stocks, the Chinese government now attempting to stem the current decline in prices by mandating stock buying by government related entities, banning trading by some of the biggest shareholders, allowing more than one half of the listed companies to suspend trading in their stocks and carrying on a publicity campaign demonizing anyone that might be selling. 

And the latest gambit---brokers refusing to accept Sell orders (short):

Of course, save for the order of magnitude, its efforts at distorting asset pricing and allocation is no different than the US, Japanese and EU central banks.  I believe that sooner or later these efforts to control free market price/asset allocation discovery will ultimately bring pain to most markets.  The only question is when.

The Greek bailout dilemma keeps not getting resolved as the parties continue to dance around a solution.  Clearly, as long as the dance goes on, there is a probability of an agreement; and the more ‘last chances’ the Greeks are given, the higher that probability. At the moment, the Greeks are again at a ‘last chance’ moment.  The difference this time is that they appeared to have given in to the Troika’s demands.  There is a Sunday meeting to appraise the new Greek plan.  So we will know more Monday morning.

As I noted above, I think that there is strong long term economic argument for a Grexit.  On the other hand, it would seem like a potentially dangerous political decision to allow Greece to exit the EU, given the chance of a Russian overture should that occur.   I have no idea how this crisis gets resolved; though if history is any guide it somehow will end positively, even if it doesn’t correct failed fiscal policies that caused the problem in the first place.  Further, I remain unclear as to the ultimate consequences of a default or Grexit; but I suspect that they would impact the Markets negatively.

Finally, on not quite so grand a scale as Greece, the chickens of fiscal mismanagement are coming home to roost in Puerto Rico.  The focus of the government is now on debt relief (lowering interest rates, extending maturities) which if successful will have a clear impact on the value of Puerto Rican municipal debt.  It could likely lead to some spill over into all junk rated municipal debt especially in any period of market malaise.

Bottom line: the assumptions in our Economic Model are unchanged.  If they are anywhere near correct, they will almost assuredly result in changes in Street models that will have to take their consensus Fair Value down. 

The assumptions in our Valuation Model have not changed either; though there are scenarios (Grexit/China) 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; but 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.
                       

            More on valuation (short):


DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 7/31/15                                  12137            1506
Close this week                                               17760            2076

Over Valuation vs. 7/31 Close
              5% overvalued                                12743                1581
            10% overvalued                                13350               1656 
            15% overvalued                                13957                1731
            20% overvalued                                14564                1807   
            25% overvalued                                  15171              1882   
            30% overvalued                                  15778              1957
            35% overvalued                                  16384              2027
            40% overvalued                                  16991              2108
            45%overvalued                                   17598              2183
            50%overvalued                                   18205              2259
            55% overvalued                                  18812              2334

Under Valuation vs. 7/31 Close
            5% undervalued                             11530                    1430
10%undervalued                            10923                   1355   
15%undervalued                            10316                   1280



* 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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