Time for a Change

Tom Connolly’s Equity Market Discussion
for the upcoming week beginning Oct 31, 2016


There is a quite a bit to cover and to help you focus on what may be of the greatest interest to you, I am providing an index of the contents of this issue. In this newsletter we will cover the following:

1. Summary Comments
2. Valuation
3. Momentum
4. Economic data
5. Connolly Portfolio

1. Summary Comments:
Before Friday’s revelations of the FBI action investigating HRC emails, I was net short of the market. This net short position reflected Put Options, S&P Futures and individual equity short sales. On Friday morning, I sold some of my long holdings in Qualcomm, General Electric, and Cisco, and continued my buying of Gold and Silver miners while also increasing my holdings of Bitcoin. I took these actions given my view of the equity market being over-valued and the week’s release of 3rd quarter strong results and positive forward outlook for the company New Gold.

After the Friday FBI announcement, I added to my holdings of volatility and increased my net short positions.

In summary, I believe the current equity market is extremely over-valued, has been for quite some time, and is now exhibiting an internal loss of momentum to the upside with increasing downside metrics that portend a material decline. Any catalyst event that ignites a material move from the valuation levels we are presently at is now heavily weighted to the downside vs the upside.

2. Valuation
The most important valuation metrics that I rely upon indicate the following:

a. Price to Cash flow multiple for 2016: The price of stocks trade today at a 20.81X multiple of the projected 2016 per share cash flow they generate. This exceeds the historic median of 17.14X

b. Price to Cash flow multiple forecast for 2017: The price of stocks trade today at an 18.31X multiple of the projected 2017 per share cash flow they generate. This exceeds the historic median of 15.14X

c. Number of equities within my 187 company portfolio that are currently valued above their discounted cash flow value: 84 or 45% of the 187 companies that I track are trading at prices that exceed the discounted cash flow value of each company.

d. Growth in cash flow and price from November 2007: Historically, the growth in cash flow has been closely correlated with the growth in share prices. The recent declines in cash flow during 2016 without a corresponding decline in share price has broken this correlation. When comparing the growth in cash flow and price for each year commencing with 2007, utilizing the month of October data (comparing Oct. 2007 vs Oct. 2016, Oct 2008 vs Oct 2016, etc), we find the divergence of price to cash flow is expanding such that we are valued today as the market was in October 2007, right before the market gave way to a material decline. This divergence must resolve itself at some point. Consider the data:

              October 31, 2016 current mkt price and cash flow vs Prior Years
price cash flow
% change % change
vs 2007                66.80% 66.33%
vs 2008              180.46% 60.88%
vs 2009 118.09% 94.95%
vs 2010   84.16% 43.82%
vs 2011   75.77% 21.15%
vs 2012   69.06% 19.31%
vs 2013   30.92% 16.25%
vs 2014   17.60%   5.36%
vs 2015     5.85%  -0.62%

e. Number of companies within the 187 Portfolio that have declined in price this year: 34% of stocks within the portfolio have a lower price than their December 31, 2015 price. This is up from 27% on September 2, 2016 yet the price of the portfolio has risen. This indicates the advance is becoming more narrow, being led higher by fewer stocks, a typical sign of a market top.

f. Current cash flow growth estimates and trend: The current forecast of year-end 2016 cash flow growth over or under 2015 now shows a .43% decline. In April of 2016 the forecast was for a 6.80% growth in cash flow for the year, and since then every month has seen the forecast reduced until we are now at a negative growth rate.

g. Current market enterprise value divided by Earnings (EBITDA): This multiple is now at 14.06X. A high multiple indicates greater risk. Greater risk arises when the market value of the 187 companies plus their debt less their cash is growing faster than their earnings. The prior record high was on October 19, 2007 at 13.06X. We now exceed the 2007 high.

h. Market decline needed to bring the various valuation measures back to historical averages: A 15% decline is needed within the 187 portfolio to bring the various metrics back to historic averages. A reversion to the mean. Typically, in a major move the market overshoots and goes further then the needed correction. An equity market decline greater than 15%, absent governmental interference, would not be a surprise.

3. Momentum
The various oscillators for the Dow Jones Industrial Average, the S&P 500 and the NASDAQ have all turned with strength to the downside indicating a correction is in process. The current oscillator readings, based on trends in point moves of the indexes, indicate the market has completed its advancing stage and that we now reside in a falling market. The oscillator indicators are meaningfully below the level that would indicate the decline is finished. Every one of the following oscillators are pointing to a further market decline:
2. S&P 500
4. Relative Strength

The other Momentum indicators are confirming the weakness:

5. New Highs and Lows on both the NYSE and the NASDAQ are pointing to a turn lower: On both a daily and a weekly basis the number of New Highs are declining while New Lows are increasing.
6. Companies on both the NYSE and the NASDAQ that show an increase in price vs a decline in price are falling faster than the indexes: The number of Advancing issues (companies showing higher prices), less the number of Declining issues has swung lower and they are leading the indexes on a downward trajectory. The composite of advancing issues less declining issues is falling faster than the point declines in the Indexes. This is a leading indicator and reflects the opposite of what has existed since the market correction of February 2016.
7. Volume of shares traded on the NYSE are being led by higher volume in declining stocks then volume in rising stocks: Total share volume on days when the market declines is higher than the volume on days when the market rises. This indicates more shares are being sold at lower prices than shares are being purchased at higher prices.

4. Economic Data
The strengthening vs weakening economic data comparisons indicate a weak environment. Summarizing and grouping the data into buckets that reflect what is occurring in the economy, the monetary changes in the US, the interest rate environment within the US, the US equity market trends, and the movement of the US dollar against the currencies of key trading partners, reveal negative trends in all cases other than in the expansion of money. The weighted summary metrics (positive is good, negative is bad) for the following macro-economic measures are as follows:

ECO. IND -108.13
MONEY IND 170.63
MKT IND -118.50
EXCH INDIC -117.39

5. Connolly Portfolio

The performance of the portfolio at this time is very dependent on rising gold and silver prices and on an equity market decline.

The Connolly Portfolio’s YTD performance vs the market, and its current composition as of October 28, 2016, are as follows:

Connolly Portfolio YTD gain as of October 28, 2016 equals + 3.29%
S&P 500 Index YTD gain as of October 28, 2016 equals + 4.03%
NASDAQ Index YTD gain as of October 28, 2016 equals + 3.65%

The Portfolio’s composition as of October 28, 2016 is as follows:
• Cash 55.1%
• Equities 19.4%
• Gold & Silver 23.4%
• Fixed Income 2.1%

As always, be careful out there.


Current State

Tom Connolly’s Equity Market Discussion
for the upcoming week beginning Oct 10, 2016

Summary Comments:

Beginning to feel like the boy who cried wolf. My assessment of the market remains one of heightened caution. It has been a caution that has not been proven to be profitable, and that fuels doubt as to the value of the financial models that I place so much faith in. While doubt is very much alive, I do not see future success in changing my investment approach. Why?

Because, we are at valuation levels that stop me from investing on the long side of the market. I cannot get caught up in the emotion and money flow into equities in an environment that has more “bubble’ attributes then value attributes. The present state of the market reflects the following summary of extremes:

• Cash flow multiples based on forecasted 2016 results are at 20.90X, a new all-time high in a non-crisis market.

• Cash flow multiples based on forecasted 2017 results are at 18.48X, a new all-time high in a non-crisis market.

• Discounted cash flow values of equities within the 187 Portfolio, as a basket, are now below the current price of the basket. This has never happened before.

• The S&P 500 earning yield is above the 10-year treasury yield by the lowest margin in the past 18 months.

• A full third of the companies that I track have current year cash flow estimates that are lower than the prior year, yet 71% of those companies with negative cash flow growth are actually at prices that are higher than the prior year. Why would a company be worth more today when it is under-performing?

• The momentum oscillators of the DJIA and the NASDAQ are at peak levels that have consistently preceded a downturn.

• The momentum indicators of shares traded in rising stocks versus declining stocks show expanding volume in declining shares now outstripping volume into rising shares.

• New Highs in the market peaked roughly a month or so ago, and while the indexes have been relatively stable or rising, the number of new highs are declining.

• Projected S&P 500 earnings for 2016 are lower than the 2015 earnings by -.03%.

• Forward cash flow growth rates looking out three to five years are at levels meaningfully below the historic average growth rate of 10.85%. Today the average annual growth rate in cash flows over the next three to five years is 8.72%, the lowest level in the past ten years other than the forecasts that existed in 2009 at the height of the Great Recession fear (which were at 7.59%)

• Commodity indexes are rising and reaching breakout levels that point to momentum and asset allocation shifts to emerging markets and commodities, shifts that will divert investments out of US equities.

The above factors keep me in a consistent and similar investment mode of being light on equities, heavy in Gold and Silver, selective in making new investments in commodity related alternatives, and meaningfully weighted toward cash. This portfolio set-up has yielded a below market performance over the past two months, and is testing my patience. For the year, I am now underperforming the broader market given the material declines in Gold and Silver, and while my portfolio is still positive for the year, stronger results would have been realized at this juncture by simply holding the broad market indexes such as the S&P 500. Nonetheless, I remain a believer in the analyses I have undertaken and the view that the level of risk vs reward in today’s equity markets is not favorable and does not warrant increased capital allocations to stocks at this time.

The Connolly Portfolio’s YTD performance vs the market, and its current composition as of October 7, 2016, are as follows:

Connolly Portfolio YTD gain as of October 7, 2016 equals + 1.73%
S&P 500 Index YTD gain as of October 7, 2016 equals + 5.37%
NASDAQ Index YTD gain as of October 7, 2016 equals + 5.69%

The Portfolio’s composition as of October 7, 2016 is as follows:
• Cash 55.7%
• Equities 19.9%
• Gold 22.2%
• Fixed Income 2.2%

Returning my attention back to the market and to the beauty of Fall Foliage in Vermont, I wish you all great success.

As always, be careful out there.